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STRATEGIC MANAGEMENT

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Strategic Management
Third Edition
Strategic Management
Concepts and Cases
Third Edition
JE FF DYER
ROBERT JENSEN
Brigham Young University,
Marriott School
Brigham Young University,
Marriott School
PAUL GODFREY
DAV ID BRYCE
Brigham Young University,
Marriott School
Brigham Young University,
Marriott School
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ISBN: 9781119563143
The inside back cover will contain printing identification and country of origin if omitted from this page. In addition, if the ISBN on the
back cover differs from the ISBN on this page, the one on the back cover is correct.
Library of Congress Cataloging-in-Publication Data
Names: Dyer, Jeff (Professor of strategy), author.
Title: Strategic management : concepts and cases / Jeff Dyer, Brigham Young
University, Marriott School, Paul Godfrey, Brigham Young University,
Marriott School, Robert Jensen, Brigham Young University, Marriott
School, David Bryce, Brigham Young University, Marriott School.
Description: Third edition. | [Hoboken] : Wiley, [2020] | Includes index.
Identifiers: LCCN 2019047716 (print) | LCCN 2019047717 (ebook) | ISBN
9781119609827 (paperback) | ISBN 9781119563136 | ISBN 9781119609803
(adobe pdf) | ISBN 9781119563143 (epub)
Subjects: LCSH: Strategic planning.
Classification: LCC HD30.28 .D9223 2015 (print) | LCC HD30.28 (ebook) |
DDC 658.4/012—dc23
LC record available at https://lccn.loc.gov/2019047716
LC ebook record available at https://lccn.loc.gov/2019047717
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
About the Authors
JEFF DYER (Ph.D., UCLA, 1993) is the
Horace Beesley Professor of Strategy
at the Marriott School, BYU, where he
serves as Chair of the Department of Organizational Leadership and Strategy.
Before joining BYU, Dr. Dyer was a professor at the University of Pennsylvania’s
Wharton School, where he maintains an
adjunct professor position and continues to teach Executive MBAs. Dr. Dyer has considerable consulting experience, having spent 5 years working as a strategy
consultant and manager at Bain & Company, where he consulted with such clients as Baxter International, Kraft, Maryland
National Bank, and First National Stores. Since then he has
been a consultant, speaker, or trainer for a variety of companies, including Adobe, AT&T, Cisco, General Electric, General
Mills, Gilead Sciences, Harley-Davidson, Hewlett Packard, Intel, Johnson & Johnson, and Sony. Dyer is the only strategy
scholar in the world to have published at least six times in the
Harvard Business Review and six times in Strategic Management Journal, the top academic journal in the strategy field.
In 2012, he was ranked the world’s #1 “most influential” management scholar among scholars who completed their Ph.D.s
after 1990. This ranking, published in Academy of Management
Perspectives, was based upon an equal weighting of academic
citations (academic influence) and non-“.edu” Google searches (business influence). His book The Innovator’s DNA is a
business bestseller and has been published in 13 languages,
and his new book, The Innovator’s Method, has already hit top
10 business bestseller lists.
PAUL C. GODFREY (Ph.D., Washington,
1994) currently serves as the William and
Roceil Low Professor of Business Strategy in the Marriott School of Management at Brigham Young University. Paul
teaches classes to BYU undergraduates,
as well as MBA and Executive MBA students. He was honored in 2013 with the
Marriott School’s Teaching Award, and in
2017 with the school’s research award. His research has appeared in the Academy of Management Review, the Strategic
Management Journal, the Journal of Business Ethics, and the
Journal of Management Inquiry. He has recently published a
book on eliminating poverty with Stanford University Press.
He has also co-edited two other books and served as a special
issue editor for two academic journals. He currently serves as
Associate Academic Director of the Economic Self-Reliance
Center at the Marriott School. He currently consults with a
variety of for-profit and not-for-profit organizations. Paul received
his MBA and Ph.D. degrees from the University of Washington
and a Bachelor of Science degree in Political Science from the
University of Utah.
ROBERT J. JENSEN (Ph.D., Wharton,
2006) is an associate professor of Strategy and International Business and is
a Whitman Faculty and Peery Research
Fellow at the Marriott School of Management, Brigham Young University. He received his Ph.D. from the Wharton School,
University of Pennsylvania. He has published in many of the top management
journals including Strategic Management Journal, Organization Science, Management Science, and the Journal of International Business Studies. His professional awards include the
McKinsey & Company/SMS Best Conference Paper prize, honorable mention, a finalist for the Blackwell Best Dissertation
Prize from the Academy of Management, as well as the William
H. Newman Best Paper from a Dissertation award, and runner
up for the Booz Allen Hamilton/SMS Ph.D. fellowship. His work
was honored as the best paper published in Competitiveness Review in 2009 and his papers have been selected seven times for
the best paper proceedings of the Academy of Management. His
research interests include leveraging knowledge assets through
transfer and replication including the problems of overcoming
the stickiness, or difficulty, of such transfers. He also researches the boundaries of the firm in extreme locations such as the
Bottom of the Pyramid including the rise of hybrid organizations
in such locations. He is also currently working on a study of the
factors, both student, faculty, and course content factors, that
impact student success in management classes, particularly in
online settings, and which professor characteristics and routines can best be replicated in that medium.
DAVID J. BRYCE (Ph.D., Wharton, 2003)
is Associate Professor of Organizational
Leadership and Strategy at the Marriott
School of Management and has been an
adjunct Associate Professor of Management at the Wharton School where he
has taught strategy in the MBA program
for executives. David earned a Ph.D. in
strategy and applied economics from the
Wharton School and is author on a number of thought-leading
articles for senior executives, including articles in the Harvard
Business Review. He conducts research in the area of corporate
strategy and has published in top academic journals such as
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Management Science and Organization Science. For more than
20 years, he has served as consultant on important strategic
challenges to executives of start-ups, mid-market companies, and major corporations, including Eli Lilly, Prudential,
Procter & Gamble, Microsoft, Johnson & Johnson, and the
LG Group. He has worked with clients on enterprise strategy,
new market entry, branding, pricing, positioning, and growth.
He has also conducted many strategy-oriented leadership
training sessions over the past 10 years within the Fortune
50, including extensively at Microsoft. Prior to his academic
career, he held partner, vice president, and other senior positions at several global management consulting firms.
Preface
Why does the world need another strategy textbook? The answer is that we simply have not
been able to find a textbook that we felt fully met the needs of our students. What are those
needs? First, we wanted to write a textbook that would engage students’ interest using numerous practical examples and tools that would help them actually do analysis to answer key
strategic questions.
For example, leading firms and strategy consulting firms have tools to teach strategists
how to actually conduct a “5 Forces” analysis, calculate a scale or experience curve, or conduct
a net promoter score analysis. We wanted to provide those tools. We also wanted to create
interactive learning tools that would connect with a new generation of learners. This meant we
needed to provide interactive digital learning experiences such as the “white board” animated
videos that we have created to support our textbook. When students are more engaged, they
learn more—and they enjoy it more! Not surprisingly, this increases student satisfaction with
the course and the professor.
As we looked at how we could create an enjoyable and engaging strategy course learning
experience, we realized as an author group that we were somewhat uniquely qualified to
create that type of experience. Why? Because we collectively have over 13 years of full-time
management consulting experience at top consulting firms.
Why does this matter? Because we have practical experience applying strategy concepts
and tools to real companies—practical experience that we have embedded in this textbook.
Perhaps just as important, we know how to write to a management audience, having published
three books targeting a practitioner audience, seven articles in Harvard Business Review, and
another four articles in Sloan Management Review. Perhaps most important is the fact that
we’ve tested the text, cases, video animations, and strategy tools with large groups of business
students at BYU and Wharton over the past 10 years—with remarkable results. Average student
satisfaction ratings have been 6.6/7.0 across multiple instructors for strategy courses using our
materials. The bottom line is that we see better student satisfaction and higher teaching ratings
because of using this material. In just the past year, we have class tested Strategic Management
at over 40 institutions with over 900 students. In exit surveys, 76 percent of students rated the
experience as positive or very positive. A few of their quotes are in the margin below.
Key Course Differentiators
Because this is a strategy book, we should tell you that our strategy in writing this book is to
offer unique value. The key differentiators of this book can be summarized with the acronym
TACT—Text, Animated Executive Summary Videos, Cases, and Tools.
Text. Each of our chapters is written in an accessible Harvard Business Review style
with lots of practical examples, and each chapter is roughly 20 percent shorter than
the chapters of the average strategy textbook. You can assign the whole chapter (not
just a few pages) and feel confident that your students will not perceive it as a waste of
time. This is not to say that we haven’t included core strategy concepts, frameworks,
and theories. They are all there.
Animated Executive Summary Videos. In WileyPLUS each chapter is accompanied by
at least one 8–10 minute animated video that brings the content to life. Today’s students love to learn through interactive technology, and student response to our
animated videos has been positively off the charts. Research shows that student recall
increases by more than 15 percent when material is presented with a white board
animation versus a typical talking head lecture.1 These animated videos allow you to
1
Study by Richard Wiseman. Available at http://www.sparkol.com/blog/how-scribe-videos-increase-your-studentslearning-by-15/
MY FAVORITE ASPECT WAS THE
EXAMPLES USED TO EXPLAIN THE
CONCEPTS. IT REALLY HELPED ME
UNDERSTAND THE MATERIAL.
–BILL BOCHICCHIO, STUDENT,
VILLANOVA UNIVERSITY
THE WHITEBOARD ANIMATIONS WERE
VERY ENTERTAINING AND HELPED
EXPLAIN SOME OF THE CONCEPTS IN
REAL LIFE SITUATIONS.
–CAMERON LANDRY, STUDENT,
MCNEESE STATE UNIVERSITY
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flip the classroom. When students view the videos before class, they get the core concepts in a memorable way. Then you have more time to discuss questions and help
them deeply understand and synthesize the concepts and tools. In WileyPLUS, we also
provide strategy in your career videos that will help students tie what they are learning
to the workplace and decipher how strategy affects their current and future career
plans. This brings a new level of relevance to the study of strategy.
THE CASES WERE MY FAVORITE
PART—UNDERSTANDING REAL WORLD
EXAMPLES HELPED PUT THINGS INTO
PROPER PERSPECTIVE.
– PHILIP SIEKMANN, STUDENT,
PENNSYLVANIA COLLEGE OF
TECHNOLOGY
I LIKED THE EXAMPLES AND THEIR
OVERALL RELEVANCE. I ALSO LIKED
THE STRATEGIC TOOLS AND THE
EXPLANATIONS.
–DAVID GRANTHAM, STUDENT,
KENNESAW STATE UNIVERSITY
I FOUND IT TO BE A VERY EASY READ.
IT WAS ONE OF THE FEW BUSINESS
TEXTBOOKS THAT I ENJOYED READING
WHICH MADE LEARNING EASIER
AND MORE FUN.
–TAYLOR LEE, STUDENT, SAN JOSE
STATE UNIVERSITY
Cases. We will admit that differentiating cases isn’t easy, but we think we’ve done a
few things to make using our cases easier. Our cases offer new, shortened, and updated
“classic” cases on familiar companies (e.g., Walmart, Coke and Pepsi, Intel, Southwest,
Nike, etc.). If you build your course around these cases, you’ll experience very low
switching costs moving to our book. We’ve also written cases on companies and topics
that millennials gravitate to such as Tesla, Uber, Facebook, ESPN, Amazon, skype,
Samsung, and the AT&T-Apple alliance.
We also provide brief Case Notes and PowerPoint presentations to summarize key
take-aways for each case.
Tools. Almost every chapter will offer a “Strategy Tool” to teach students how to apply
a theory, framework, or concept. Students will feel like they have learned how to do
something—actually conduct analysis that will help with strategic decisions. Some of
these tools are used in Fortune 500 companies and in strategy consulting firms such
as Bain, BCG, and McKinsey when they do strategy analysis for clients. For example,
the book shows the student how to assess the attractiveness of an industry, how
to calculate and use scale or experience curve, how to create a net promoter score to
assess whether a differentiation strategy is working, and how to decide whether
to “make” versus “buy.” Many of the end-of-chapter cases integrate the strategy tool
into the case so you can easily have students apply the tool as they analyze the case.
Our students tell us that these tools help them feel that they are acquiring useful
analytical skills to help them in making strategic decisions.
We think the combination of well-conceived and executed Text, Animated Executive Summary
Videos, Cases, and Tools can dramatically improve student satisfaction with your strategy
course. Indeed, a random sample of strategy professors who reviewed our text book preferred
it over their current textbooks by almost 4:1. That’s a pretty powerful endorsement.
So, does the world need another strategy text? We answer “yes,” and we offer one that
provides students with a well-designed, engaging, and learning-rich combination of TACT: Text,
Animated Executive Summary Videos, Cases, and Tools. We’ve also found that when our students enjoy their courses, we enjoy teaching much more.
What’s New in Edition 3?
When you open the book, you’ll see much that’s new, from new color schemes to layouts.
There’s more that’s new, however, than just cosmetics; we’ve taken time to respond to feedback from users of the first edition, sharpened our ties to the overarching framework of our
book, and provided new updates and cases. Let’s look at each of these in turn:
User Feedback. While we continue to get rave reviews for the second edition, we also
received some very insightful critique. We’ve heard feedback that some of our models
don’t mesh well with other readings strategy faculty use. As a result, we’ve updated
Chapter 3 to eliminate confusion around the company diamond model and the strategy diamond many faculty use. We’ve continued to polish the Strategy and Your Career
sidebars, and we created a set of videos in WileyPLUS with the authors answering frequently asked questions about strategy careers.
Sharper Focus. We approach strategy—the search for competitive advantage—as
the answer to four critical questions: Where should we compete? Why do we win with
customers? How do we deliver unique value to win with customers? How will we win
over time, or sustain our competitive advantage? Several chapters now include a
PREFACE
specific section that details new thinking about the answers to these four questions.
For example, we explore the idea that “where you compete” is less at the industry
level and more at the “job-to-be-done” level. We also discuss new thinking that suggests unique value is less about cost versus differentiation and more about cost and
differentiation—meaning that companies are increasingly offering differentiated products at a lower price. We have created five new video animations that instructors can
use to illustrate this new thinking in a way that is easy for students to understand.
New Content and Cases. We’ve updated a number of chapter opening vignettes. In
Chapter 9, for example, we replaced Lincoln Electric with Huawei, the Chinese telecom giant that has expanded into making smartphones to compete directly with
Apple and Samsung around the globe. In Chapter 10, we now introduce the chapter
content with a case on “voice wars,” highlighting the emerging battle between
personal digital voice assistants like Alexa, Google, and Siri. In the third edition, we’ve
updated a number of existing cases in our library and have added cases on Facebook
and the 2016 election, ESPN, EcoLab and Vivint Smart Home. We continue to write
new cases in between each edition to keep the companies fresh and give instructors
new material. Similar to our case library, our animation library will continue to grow.
You’ll soon see new “tool” animations on how to solve a business problem and how
to present a business solution.
If you are a current user of our book, let us say “Thank You!” for your support and your
wonderful feedback. If you are thinking about adopting our text, we’d encourage you
to give our total offering (text, animations, cases, PowerPoints, tools) a very serious
look. This edition keeps all that was great about the first edition—an approachable
text that helps students understand and use real-world strategy tools to supplement
strategy models—and builds on those strengths to offer a text that better meets your
needs, emphasizes a simple framework to help students see an overarching vision
of strategy, and content that builds on the latest and greatest strategic moves by
companies.
Instructor Resources
Companion Website. The Strategic Management Website at http://www.wiley.com/
college/dyer contains myriad tools and links to aid both teaching and learning, including resources listed here.
Teaching Notes. The Teaching Notes offer helpful teaching ideas. They offer chapterby-chapter text highlights, learning objectives, chapter outlines, and answers to endof-chapter material.
Case Notes. Written for each case presented with Strategic Management, each Case
Note includes a brief case summary, learning objectives for the instructor, learning
outcomes for the students, and a brief teaching plan with questions and answers.
In addition, we’ve provided a matrix showing alternative teaching approaches for
each case.
Test Bank. This comprehensive Test Bank contains over 100 questions per chapter.
The multiple-choice, fill-in, and short-essay questions vary in degree of difficulty. All
questions are tagged with learning objectives, Bloom’s Taxonomy categories, and AACSB Standards. The Computerized Test Bank allows instructors to modify and add questions to the master bank and to customize their exams. In addition, a Respondus Test
Bank is available for use with learning management systems.
PowerPoint Presentation Slides. This robust set of slides for chapters and cases can
be accessed on the instructor companion site. Lecture notes accompany most slides.
A set of slides without lecture notes is available on the student companion site.
Practical Application Guide. This brief manual, authored by Sheri B. Schulte, University of Akron, provides an introduction to a “flipped classroom” approach of teaching
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Strategic Management. It contains practical exercises linking to key topics throughout
the text. Each exercise is accompanied by facilitator’s instructions, questions for classroom discussion and follow up, and suggested answers.
WileyPLUS
WileyPLUS is a research-based online environment for effective teaching and learning.
WileyPLUS builds students’ confidence because it takes the guess-work out of studying by
providing students with a clear roadmap: what to do, how to do it, if they did it right. Students
will take more initiative so you’ll have greater impact on their achievement in the classroom
and beyond.
WileyPLUS for Instructors
WileyPLUS enables you to:
• Assign automatically graded homework, practice, and quizzes from the chapters, cases,
animations, and test bank.
• Track your students’ progress in an instructor’s grade book.
• Access all teaching and learning resources, including an online version of the text, and student and instructor supplements, in one easy-to-use website. These include animated executive summary videos, additional cases, teaching notes, and full-color PowerPoint slides.
• Create class presentations using Wiley-provided resources, with the ability to customize
and add your own materials.
WileyPLUS for Students
In WileyPLUS, students will find various helpful tools, such as an ebook, animations, videos,
additional cases, a virtual Career Center, and flashcards.
Acknowledgements
Writing a book is a daunting task, and we’ve had much help in this process. We
thank our colleagues in the Academy for years of interactions too numerous to
mention, but each of which enlarged our view and clarified our understanding of
how to teach strategy most effectively. Thanks to our colleagues and our students
at BYU and the Wharton School for their excellent feedback on drafts of our book.
Their insightful comments on the text, animations, cases, and tools brought gaps
and holes to light that we would have missed. Thank you to James Aida, Preston Alder, David Benson, Jared Brand, Tyler Cornaby, Caleb Flint, Mark Hansen,
Michael Hendron, Bryson Hilton, Chad Howland, Benjamin King, David Kryscynski, Jake Lundin, Christian Mealey, Matthew Moen, Kyle Nelson, Lee Perry, Erin
Pew, Zachary Sumner, David Thornblad, Joseph Woodbury, and Bryant Woolsey
for their research and assistance writing the cases. And, thank you to Sheri Schulte
for contributing the Practical Application Guide.
We gratefully acknowledge the advice, cooperation, wisdom, and work of
the team at John Wiley who shepherded this book from its inception to its publication. Executive Editor Lisé Johnson, Product Designer Wendy Ashenberg, and
Senior Marketing Manager Anita Osborn have all taught us about the process
of bringing such a massive undertaking to fruition. Their professionalism has
enriched the content of the book and our own lives, and their patience with us as
we moved through the process has been inspiring. In addition, we’d like to thank
the remainder of the team at Wiley: Thomas Nery, Elena Sacarro, Dorothy Sinclair,
and Cecilia Morales.
Finally, we’d like to thank the numerous reviewers who have contributed
valuable time and incredible feedback:
Reviewers
A D Amar, Seton Hall University
Al Lovvorn, The Citadel
Amad Hassan, Morehead State University
Amit Shah, Frostburg State University
Barry VanderKelen, California Polytechnic State University,
San Luis Obispo
Brian Boyd, Arizona State University
Brian Connelly, Auburn University
Carla Jones, Sam Houston State University
Charles Wainwright, Belmont University
Chip Baumgardner, Penn College
Christopher Penney, Mississippi State University
Dali Ma, Drexel University
Daniel Marrone, Farmingdale State College
David Boss, Ohio University
David Hover, San Jose State University
Dean Frost, Bemidji State University
Don Okhomina, Fayetteville State University
Don Stull, Texas Tech University
Donna Galla, American Military University
Edward Ward, St. Cloud State University
George Puia, Saginaw Valley State University
Ghoreishi Minoo, Millersville University
Herve Queneau, Brooklyn College
Hugh O’Neill, University of North Carolina
Ismatilla Mardanov, Southeast Missouri State University
James Fiet, University of Louisville
James Spina, University of Maryland
Jamie Collins, Sam Houston State University
Jeff Gutenberg, Geneseo, The State University of New York
John Guarino, Averett University
John Keifer, Ohio University
John Lipinski, Middle Tennessee State University
John Morris, Oregon State University
John Walker, Iowa State University
Jorge Walter, Portland State University
Joseph Goldman, University of Minnesota
Joshua Aaron, East Carolina University
Joy Karriker, East Carolina University
Kalyan Chakravarty, California State University, Northridge
Kimberly Goudy, Central Ohio Technical College
Konghee Kim, St. Cloud State University
Kristal Davison, University of Mississippi
Kristin Backhaus, SUNY New Paltz
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AC K N OW L E D G E M E N TS
Linda Edelman, Bentley University
Lucas Hopkins, Middle Georgia State University
Luke Cashen, Nicholls State University
M. Nesij Huvaj, University of Connecticut
Melissa Waite, Brockport, The State University of New York
Meredith Downes, Illinois State University
Michael Hennelly, West Point
Michael McDermott, Northern Kentucky University
Mike Montalbano, Bentley University
Mitchell Adrian, McNeese State University
Patricia Norman, Baylor University
Paula Weber, St. Cloud State University
Peter Pinto, Bowling Green University
Quentin Fleming, University of South Carolina
Ram Subramanian, Stetson University
Richard Kernochan, California State University, Northridge
Roman Nowacki, Northern Illinois University
Tatiana Manilova, Bentley University
Tim Holcomb, Florida State University
Timothy Gubler, University of California, Riverside
Uma Gupta, Buffalo State, The State University of New York
William Forster, Lehigh University
William Hayden, SUNY Buffalo
William Norton, Georgia Southern University
Yanli Zhang, Montclair State University
Focus Group Participants
Mitchell Adrian, McNeese State University
Frances Amatucci, Slippery Rock University of Pennsylvania
Elsa Anaya, Palo Alto Community College
Bindu Arya, University of Missouri, St Louis
Koren Borges, University of North Florida
Kalyan Chakravarty, California State University, Northridge
Larry Chasteen, University of Texas, Dallas
William Forster, Lehigh University
Dean Frost, Bemidji State University
Anne Fuller, California State University, Sacramento
Donna Galla, American Military University
Lucas Hopkins, Middle Georgia State University
Dawn Keig, Brenau University
Vance Lewis, University of Texas, Dallas
Sali Li, University of South Carolina
John Lipinski, Middle Tennessee State University
Cindy Liu, Cal State Polytechnic University
Daniel Marrone, Farmingdale State College
Don Okhomina, Fayetteville State University
Michael Provitera, Barry University
Herve Queneau, Brooklyn College
Timothy Rogers, Ozarks Tech Community College
Veronica Rosas-Tatum, Palo Alto Community College
Mark Ryan, Hawkeye Community College
Stephen Takach, University of Texas, San Antonio
Beverly Tyler, North Carolina State University
Edward Ward, St. Cloud State University
James Weber, St. Cloud State University
Carol Young, Metropolitan State University
Wiley Technology Summit Participants
Lakami Baker, Auburn University
Brent Beal, University of Texas, Tyler
Larry Chasteen, University of Texas, Dallas
Dean Frost, Bemidji State University
Stephen Hallam, University of Akron
David King, Iowa State University
Donald Kopka, Towson University
Marie Milena Loubeau, Miami Dade College
Don Okhomina, Fayetteville State University
Thomas Shirley, San Jose State University
Thomas Swartwood, Drake University
Class Testers
Mitchell Adrian, McNeese State University
Rajshree Agarwal, University of Maryland, College Park
Francis Amatucci, Slippery Rock University
Jeff Bailey, University of Idaho
Lakami Baker, Auburn University
Chip Baumgardner, Penn College
Brent Beal, University of Texas, Tyler
Gregory Blundell, Kent State University, Kent
John Buttermore, Slippery Rock University
McKay Christensen, Brigham Young University
Daniel Connors, Providence College
Dean Frost, Bemidji State University
James Glasglow, Villanova University
David Gras, Texas Christian University
John Guarino, Averett University
Uma Gupta, Buffalo State University
Stephen Hallam, University of Akron
John Hopkins, Clemson University
Paul Hudec, Wisconsin School of Engineering
David King, Iowa State University
Donald Kopka, Towson State University
David Kryscynski, Brigham Young University
Martin Lewison, Farmingdale State College
George Mason, Providence College
Stuart Napshin, Kennesaw State University
Scott Newbert, Villanova University
Roman Nowacki, Northern Illinois University
Don Okhomina, Fayetteville State University
Paulo Prochno, University of Maryland, College Park
Rhonda Rhodes, Cal Poly Pomona
William Ritchie, James Madison University
Douglas Sanford, Towson University
Ben Shaffer, University of Wisconsin, Milwaukee
Lois Shelton, California State University, Northridge
Thomas Shirley, San Jose State University
Richard Smith, Iowa State University
Roger Strickland, Santa Fe College
Thomas Swartwood, Drake University
Ram Subramanian, Montclair State University
Xiwei Yi, University of Houston, Downtown
Yuping Zeng, Southern Illinois University, Edwardsville
ACKN OW LE D G EMEN TS
Student Focus Group Participants
Rachel Abel, Auburn University
William Annan, Villanova University
Andrea Arbon, Brigham Young University
Vincent Arrington, McNeese State University
Brian Basili, Villanova University
Kelly Becker, Clemson University
Cody Brackett, Iowa State University
Doreen Compher, The University of Akron
Lincoln Eppard, Iowa State University
Laura Eppley, Kent State University
Hannah Gay, University Wisconsin, Milwaukee
Yuliya Gitman, Drake University
Laura Jones, University of Texas at Tyler
Daniel Larsen, Iowa State University
Tyler Look, Auburn University
Miranda Matuke, Bemidji State University
Michael Minocchi, Kent State University
Monica Ghadiyaram, Virginia Tech
Moriah Mitsuda, Brigham Young University
Ashley Mueller, University Wisconsin, Milwaukee
Rebeka Perkins, Santa Fe College
Zaineb Sehgal, University of Texas at Tyler
Bryttan Thompson, Iowa State University
Mythy Tran, Santa Fe College
Taylor VanDevender, McNeese State University
Corrie VanDyke, Clemson University
Kelsey Vetter, Iowa State University
Christopher Wahl, Drake University
Courtney Weiner, Towson University
Stew Williamson, Brigham Young University
Sarah Wright, The University of Akron
Lynn Wu, Virginia Tech
xv
Brief Contents
vii
CA S E 03B
ESPN in 2019: A Network in Search of a
Solution C-37
xiii
CA S E 04
Southwest Airlines: Flying High with
Low Costs C-41
CA S E 05
Harley-Davidson: Growth Challenges
Ahead C-56
CA S E 06
Ecolab and the Nalco Acquisition:
Sustainable Advantage Through Shared
Values C-68
CA S E 07
Nike: Sourcing and Strategy in Athletic
Footwear C-78
CA S E 08
AT&T and Apple: A Strategic
Alliance C-87
CA S E 09
Samsung: Overtaking Philips, Panasonic,
and Sony as the Leader in the Consumer
Electronics Industry C-100
CA S E 10
Tesla Motors: Disrupting the Auto
Industry? C-114
11 Competitive Strategy and Sustainability 194
CA S E 11
Smartphone Wars in 2013
12
Implementing Strategy 215
CA S E 12
13
Corporate Governance and Ethics 233
Lincoln Electric: Aligning for Global
Growth C-137
14
Strategy and Society 249
CA S E 13
ICARUS Revisited: The Rise and Fall of
Valeant Pharmaceuticals C-145
CA S E 14
Safe Water Network: Mastering the
Model at Dzemeni C-156
ABOUT THE AUTHORS
PREFACE
ix
ACKNOWLEDGEMENTS
1
What Is Business Strategy? 1
2
Analysis of the External Environment:
Opportunities and Threats 17
3
Internal Analysis: Strengths, Weaknesses,
and Competitive Advantage 44
4
Cost Advantage 61
5
Differentiation Advantage 79
6
Corporate Strategy 98
7
Vertical Integration and Outsourcing 117
8
Strategic Alliances 133
9
International Strategy 152
10
Innovative Strategies That Change the
Nature of Competition 177
264
GLOSSARY
INDEX
269
C-124
C AS E 01
Walmart Stores: Gaining and Sustaining
a Competitive Advantage C-1
CA S E 15
Facebook at a Crossroads: Russian
Interference in the 2016 Election C-169
C AS E 02
Coca-Cola and Pepsi: The Shifting
Landscape of the Carbonated Soft Drink
Industry C-12
CA S E 16
CVS in 2015: From Neighborhood
Pharmacy Provider to Healthcare
Company C-182
C AS E 03A
ESPN in 2015: Continued Dominance in
Sports Television? C-25
CA S E 17
Uber Technologies Inc. C-192
ADDITIONAL CASES CAN BE FOUND IN WILEYPLUS
Contents
ABOUT THE AUTHORS
PREFACE
vii
ix
ACKNOWLEDGEMENTS
xiii
1 What Is Business Strategy?
1
What Is Business Strategy? 2
Competitive Advantage 3
The Strategic Management Process 4
What Information and Analysis Guides Strategy
Formulation? 7
Mission 8
External Analysis 8
Internal Analysis 9
How Are Strategies Formulated? 10
Strategy Vehicles for Achieving
Strategic Objectives 10
Strategy Implementation 11
Who Is Responsible for Business Strategy? 12
Who Benefits from a Good Business Strategy? 13
Summary 14
Key Terms 14
Review Questions 15
Application Exercises 15
References 15
2 Analysis of the External
Environment: Opportunities
and Threats 17
Determining the Right Landscape: Defining a Firm’s
Industry 19
Five Forces that Shape Average Profitability Within
Industries 21
Rivalry: Competition Among
Established Companies 21
Buyer Power: Bargaining Power and Price Sensitivity 24
Supplier Bargaining Power 25
Threat of New Entrants 26
Threat of Substitute Products 28
Overall Industry Attractiveness 29
Where Should We Compete? New Thinking About the Five
Forces and Industry Attractiveness 30
How the General Environment Shapes
Firm and Industry Profitability 31
Complementary Products or Services 33
Technological Change 33
General Economic Conditions 34
Demographic Forces 35
Ecological/Natural Environment 35
Global Forces 36
Political, Legal, and Regulatory Forces 36
Social/Cultural Forces 36
Summary 37
Key Terms 37
Review Questions 37
Application Exercises 38
Strategy Tool 38
References 42
3 Internal Analysis: Strengths,
Weaknesses, and Competitive
Advantage 44
The Value Chain 46
The Resource-Based View 47
Resources 47
Capabilities 47
Priorities 49
Creating a Sustainable Competitive Advantage:
The VRIO Model of Sustainability 49
Value 50
Rarity 50
Inimitability 50
Organized to Exploit 53
Assessing Competitive Advantage with VRIO 53
The Competitive Advantage Pyramid: A Tool for
Assessing Competitive Advantage 54
Gathering Data for the Competitive Advantage
Pyramid Analysis 55
Using the Competitive Advantage Pyramid 56
Summary 58
Key Terms 58
Review Questions 58
Application Exercises 59
References 59
4 Cost Advantage
61
Economies of Scale and Scope 63
Ability to Spread Fixed Costs of Production 63
Ability to Spread Nonproduction Costs 63
xviii
CON TENTS
Specialization of Machines and Equipment 64
Specialization of Tasks and People 64
Evaluating Economies of Scale: The Scale Curve 65
Economies of Scope 66
Learning and Experience 67
The Learning Curve 67
The Experience Curve 67
Experience Curves and Market Share 69
How Strategists Use the Scale and Experience
Curves to Make Decisions 70
Proprietary Knowledge 72
Lower Input Costs 72
Bargaining Power over Suppliers 72
Cooperation with Suppliers 73
Location Advantages 73
Preferred Access to Inputs 74
Different Business Model or Value Chain 74
Eliminating Steps in the Value Chain 74
Performing Completely New Activities 74
Revisiting Tata 75
Summary 75
Key Terms 76
Review Questions 76
Application Exercises 76
Strategy Tool 76
References 77
5 Differentiation Advantage
What Is Product Differentiation? 80
Sources of Product Differentiation 81
Different Product/Service Features 81
Quality or Reliability 83
Convenience 83
Brand Image 85
How to Find Sources of
Product Differentiation 85
Customer Segmentation 85
Mapping the Consumption Chain 88
Building the Resources and Capabilities to
Differentiate 91
New Thinking: Achieving Low Cost and
Differentiation 92
Assessing Differentiation Performance 93
Strategy in Your Career: What Is Your Unique
Value? 94
Summary 94
Key Terms 95
Review Questions 95
Application Exercises 95
Strategy Tool 95
References 96
79
6 Corporate Strategy
98
Corporate Versus Business Unit Strategy 99
Creating Value Through Diversification 100
Levels of Diversification 100
Value Creation: Exploit and Expand Resources
and Capabilities 101
The Eight Ss 102
Destroying Value Through Diversification 106
Methods of Diversification 108
The Acquisition and Integration Process 109
Making the Acquisition 109
Integrating the Target 109
Summary 113
Key Terms 114
Review Questions 114
Application Exercises 114
References 115
7 Vertical Integration and
Outsourcing
117
What Is Vertical Integration? 118
The Value Chain 119
Forward Integration and
Backward Integration 119
Three Key Reasons to Vertically Integrate
Capabilities 120
Coordination 121
Control 123
Dangers of Vertical Integration 124
Loss of Flexibility 124
Loss of Focus 125
Advantages of Outsourcing 126
Dangers of Outsourcing 128
Summary 129
Key Terms 129
Review Questions 129
Application Exercises 130
Strategy Tool 130
References 131
8 Strategic Alliances
133
What Is a Strategic Alliance? 134
Choosing an Alliance 135
Types of Alliances 137
Nonequity or Contractual Alliance 137
Equity Alliance 138
Joint Venture 138
Vertical and Horizontal Alliances 138
120
CONTENTS
Ways to Create Value in Alliances 140
Combine Unique Resources 140
Pool Similar Resources 141
Create New, Alliance-Specific Resources 142
Lower Transaction Costs 142
The Risks of Alliances 143
Hold-Up 143
Misrepresentation 143
Building Trust to Lower the Risks of Alliances 143
Building an Alliance Management Capability 146
Improves Knowledge Management 146
Increases External Visibility 146
Provides Internal Coordination 147
Facilitates Intervention and Accountability 147
Summary 148
Key Terms 148
Review Questions 148
Application Exercises 149
Strategy Tool 149
References 150
9 International Strategy
152
The Globalization of Business 153
Why Firms Expand Internationally 155
Growth 155
Efficiency 156
Managing Risk 157
Knowledge 157
Responding to Customers or Competitors 158
Where Firms Should Expand 158
Cultural Distance 159
Administrative Distance 160
Geographic Distance 161
Economic Distance 161
How Firms Compete Internationally 162
Multidomestic Strategy—Adapt to Fit the Local
Market 163
Global Strategy—Aggregate and Standardize to Gain
Economies of Scale 165
Arbitrage Strategy 166
Combining International Strategies 167
How a Firm Gets into a Country: Modes of Entry 168
Exporting 168
Licensing and Franchising 168
Alliances and Joint Ventures 169
Wholly Owned Subsidiaries 170
Choosing a Mode of Entry 171
Summary 171
Key Terms 172
Review Questions 172
Application Exercises 172
xix
Strategy Tool 173
References 174
10 Innovative Strategies That Change
the Nature of Competition
177
What Is an Innovative Strategy? 178
Incremental Versus Radical Innovation 179
Categories of Innovative Strategies 181
Reconfiguring the Value Chain to Eliminate Activities
(Disintermediation) 181
Low-End Disruptive Innovations 182
High-End/Top-Down Disruptive Innovations 184
Reconfiguring the Value Chain to Allow
for Mass Customization 185
Blue Ocean Strategy—Creating New Markets
by Targeting Nonconsumers 185
Create a Platform to Coordinate and Share Private
Assets 186
Free Business/Revenue Models 187
Hypercompetition: The Accelerating Pace of
Innovation 189
Innovation and the Product/Business/Industry Life Cycle
(S-Curve) 190
Introduction Stage 190
Growth Stage 190
Maturity Stage 191
Decline Stage 191
Summary 192
Key Terms 192
Review Questions 192
Application Exercises 192
References 193
11 Competitive Strategy and
Sustainability
194
Understanding the Competitive Landscape 195
Strategic Groups and Mobility Barriers 195
Strategy Canvas 197
Evaluating the Competition 199
What Drives the Competitor? 200
What Is the Competitor Doing
or Capable of Doing? 200
How Will a Competitor Respond to Specific Moves? 200
Using Game Theory to Evaluate Specific Moves 201
Principles of Competitive Strategy 205
Know Your Strengths and Weaknesses 205
Bring Strength Against Weakness 205
Protect and Neutralize Vulnerabilities 205
Develop Strategies That Cannot Be Easily Copied 206
xx CON TE N TS
14 Strategy and Society
Competitive Actions for Different Market
Environments 206
Competition Under Monopoly 206
Competition Under Oligopoly 207
“Perfect” Competition 208
Dynamic Environments 210
Sustaining Competitive Advantage 210
Summary 212
Key Terms 212
Review Questions 212
Application Exercises 213
Strategy Tool 213
References 213
12 Implementing Strategy
215
Alignment: The 7 S Model 217
Strategy 217
Structure 217
Systems 219
Staffing 219
Skills 219
Style 220
Shared Values 220
Strategic Change 222
The Three Phases of Change 223
The Eight Steps to Successful Change 224
Measurement 227
Line of Sight 227
Summary 230
Key Terms 230
Review Questions 230
Application Exercises 231
References 231
13 Corporate Governance
and Ethics
Strategy and Social-Value Organizations 250
The Tools of Strategy and the Creation of Social Value 251
External Analysis and the Value Net 251
Internal Analysis: Resources and Capabilities 253
Cost Leadership, Differentiation, and Innovative
Strategies 253
Corporate Strategy and Alliances 254
Implementation and Governance 254
Strategy and Social Change 255
Corporate Social Responsibility (CSR) 255
CSR and Firm Performance 256
Social Entrepreneurship 256
Types of Social Entrepreneurship 257
Skills of Social Entrepreneurs 258
Challenges in Social Entrepreneurship 259
Summary 261
Key Terms 261
Review Questions 261
Application Exercises 261
References 262
264
GLOSSARY
INDEX
269
CA S E 01
Walmart Stores: Gaining and Sustaining
a Competitive Advantage C-1
CA S E 02
Coca-Cola and Pepsi: The Shifting
Landscape of the Carbonated Soft
Drink Industry C-12
CA S E 03A
ESPN in 2015: Continued Dominance in
Sports Television? C-25
CA S E 03B
ESPN in 2019: A Network in Search of a
Solution C-37
CA S E 04
Southwest Airlines: Flying High with
Low Costs C-41
CA S E 05
Harley-Davidson: Growth Challenges
Ahead C-56
CA S E 06
Ecolab and the Nalco Acquisition:
Sustainable Advantage Through
Shared Values C-68
233
The Purposes of the Corporation 234
The Shareholder Primacy Model 235
The Stakeholder Model 236
Governance: Boards and Incentives 238
The Board of Directors 239
Compensation and Incentives 240
Corporate Ethics 241
Corporate Culture and Ethics 243
Creating an Ethical Climate 244
Summary 246
Key Terms 246
Review Questions 246
Application Exercises 247
References 247
249
CONTENTS
xxi
C ASE 07
Nike: Sourcing and Strategy in Athletic
Footwear C-78
CA S E 13
ICARUS Revisited: The Rise and Fall of
Valeant Pharmaceuticals C-145
C AS E 08
AT&T and Apple: A Strategic
Alliance C-87
CA S E 14
Safe Water Network: Mastering the
Model at Dzemeni C-156
C AS E 09
Samsung: Overtaking Philips,
Panasonic, and Sony as the Leader
in the Consumer Electronics
Industry C-100
CA S E 15
Facebook at a Crossroads:
Russian Interference in the 2016
Election C-169
CA S E 16
CVS in 2015: From Neighborhood
Pharmacy Provider to Healthcare
Company C-182
CA S E 17
Uber Technologies Inc. C-192
C AS E 10
Tesla Motors: Disrupting the Auto
Industry? C-114
C AS E 11
Smartphone Wars in 2013
C AS E 12
Lincoln Electric: Aligning for Global
Growth C-137
C-124
ADDITIONAL CASES CAN BE FOUND IN WILEYPLUS
CHAPTER 1
What Is Business Strategy?
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Define business strategy, including the importance
of competitive advantage, the four choices that are
critical to strategy formulation, and the strategic
management process.
3. Discuss how strategies are formulated and implemented
in order to achieve objectives.
4. Explain who is responsible for, and who benefits from,
good business strategy.
2. Summarize the information that the company’s mission
and thorough external and internal analysis provide to
guide strategy.
STANCA SANDA/Alamy Stock Photo
Strategy at Apple
In 2000, Apple Computer held a loyal customer base but was limping along as a relatively minor player in the personal computer
market. Launched by Steve Jobs and Steve Wozniak, Apple was
one of the pioneers in the industry. Unlike other PC makers that
relied on Microsoft’s operating system and application software,
Apple wrote its own operating system software and much of its
application software, which was known as being easy to use. In
fact, Apple was the first to introduce software on a low cost personal computer with drop-down menus and a graphical user
interface that allowed customers to easily complete a task, such
as dragging a file to the trash to delete it. However, Apple’s investment in unique software led to high-priced computers and created
files that were originally incompatible with those of Microsoft’s
Windows operating system and Office software suite. As a result,
Apple rarely achieved more than about a 5 percent share of the
computer market.1
That all changed in 2001, however, when Apple entered an
entirely new market with the launch of an MP3 portable music player
called the iPod. Apple’s MP3 player was not the first on the market.
A company called Rio had offered an MP3 player for a couple of years
before iPod’s entry into the market. But iPod quickly took market
share from the Rio, for three primary reasons:
1. iPod had a mini hard drive that allowed it to hold 500 songs,
as opposed to the roughly 15 songs the Rio could hold using
flash memory.
2. iPod was the first to introduce a “fly wheel” navigation
button—the round button that was easy to use and allowed
users to quickly scroll through menus and songs.
3. iPod was backed with Apple’s name and an innovative design.2
These advantages helped iPod quickly move to industry leadership, despite the fact that an iPod cost 15 to 25 percent more than
a Rio.3 At the time the iPod was launched, it was difficult for most
consumers to access digital downloads of songs legally. Initially, the
iPod was snapped up only by a relatively small group of users, mostly
1
2 CHA PT E R 1
What Is Business Strategy?
teenagers and college students, who were illegally downloading
songs through Napster and other free downloading sites.
Apple recognized that to grow the market for iPods, it needed
to help consumers legally access songs to play on their iPods. As a
result, Apple developed software called iTunes, allowing customers to legally download songs. One main reason iTunes was able to
provide legal downloads before its competitors was because Steve
Jobs, as CEO of both Apple and Pixar (the animation movie production company), understood that music companies, like movie
companies, were concerned about people pirating their products.
So Apple worked with the music companies to sell songs that had
been digitized using software that prevented customers from
copying the songs to more than a few computers. iTunes was designed to be easy to use with the iPod. Customers now could easily
and legally access songs simply by connecting their iPods to their
computers and letting the software do the rest. Even a technologychallenged grandparent could do it.4
But Apple wasn’t done with its music player strategy. Apple’s experience in the computer business was that other companies could
make similar products, often at lower prices. Indeed, while Apple and
IBM were the pioneers of the personal computer industry and dominated it during the early years, lower-priced competitors such as Dell,
Hewlett-Packard, Lenovo, and ASUS eventually came to dominate
the market. Apple realized it needed to prevent easy imitation of its
business strategy A plan to
achieve competitive advantage
that involves making four
inter-related strategic choices:
(1) markets to compete in;
(2) unique value the firm will offer
in those markets; (3) the resources
and capabilities required to
offer that unique value better
than competitors; and (4) ways
to sustain the advantage by
preventing imitation.
competitive advantage When
a firm generates consistently
higher profits compared to its
competitors.
market The industry, customer
segment, or geographic area that
a company competes in.
unique value The reason a firm
wins with customers or the value
proposition it offers to customers,
such as a low cost advantage or
differentiation advantage or both.
music offering. So it created proprietary software called Fairplay that
restricted the use of music downloaded from iTunes to iPods only.
That meant consumers couldn’t buy a lower-priced MP3 player and
use it with iTunes because it was incompatible. If they wanted to use
a different MP3 player, they would have to download and pay for
music a second time.5 Now Apple has bundled an MP3 player into the
iPhone, which makes it move convenient for customers because they
don’t have to carry two devices.
To top it off, Apple did something that no other maker of computers, music players, or any other electronic device company had
done. It opened its own stores to sell Apple products. This required
that Apple learn how to operate retail stores. The Apple Stores helped
Apple create a direct link to its customers, making it easier for consumers to learn about and try out Apple products—and get their
products serviced.
As a result of Apple’s strategic initiatives, it has built a very secure
market position in music players, currently holding over 70 percent
of that market.6 But the battle isn’t over. Amazon has entered the industry, offering music buyers unrestricted use of its songs with a subscription to Amazon Music Unlimited. Moreover, other competitors
offering music via subscription include eMusic, Pandora.com, and
Spotify. Users can listen to any song they want for a small monthly
subscription fee. The $17 billion music industry is so large that it will
continue to attract new competitors who want to dethrone Apple.
How did Apple enter the music industry and within 10 years become the dominant seller of both
songs and music players? How did Pandora, a start-up, succeed in the music industry while former giant Sony (maker of the Walkman and Discman) struggled? For that matter, why is any
company successful? Understanding the series of actions taken by Apple to achieve a dominant position in the online music business will go a long way toward understanding business
strategy—a company’s dynamic plan to gain, and sustain, competitive advantage in its markets.
In this chapter, we’ll help you get started by answering some basic questions. We begin with the
most obvious: “What is a business strategy?”
What Is Business Strategy?
The word strategy comes from the Greek word strategos, meaning, “the art of the general.”
In other words, the origin of strategy comes from the art of war, and, specifically, the role of a
general in a war. In fact, there is a famous treatise titled The Art of War that is said to have been
authored by Sun Tzu, a legendary Chinese general. In the art of war, the goal is to win—but
that is not the strategy. Can you imagine the great general Hannibal saying something like,
“Our strategy is to beat Rome!” No, Hannibal’s goal was to defeat Rome. His strategy was to
bring hidden strengths against the weaknesses of his enemy at the point of attack—which he
did when he crossed the Alps to attack in a way that his enemies did not believe he could. He
achieved an advantage through his strategy.
In similar fashion, a company’s business strategy is defined as a company’s dynamic plan
to gain and sustain competitive advantage in the marketplace. This plan is based on the
theory its leaders have about how to succeed in a particular market. This theory involves predictions about which markets are attractive and how a company can offer unique value to
customers in those markets in a way that won’t be easily imitated by competitors. This theory
then gets translated into a plan to gain competitive advantage. This plan must be dynamic to
What Is Business Strategy?
3
respond to new information that comes as customers, competitors, and technologies change.
Apple’s theory of how to gain a competitive advantage in the music download business was to
create cool and easy-to-use MP3 players and smartphones that could easily—and legally—
download digital songs from a computer through the iTunes store. Apple sought to sustain its
advantage by making it difficult for competitor MP3 players or phones to download songs from
the iTunes store. The Apple Stores contributed to Apple’s advantage by providing a direct
physical link to customers that competitors couldn’t match. In this particular instance, Apple’s
plan to gain, and sustain, competitive advantage worked. But there have been other times,
such as with the Apple Newton Message Pad (the first handheld computer that Apple sold as a
personal digital assistant), that Apple’s approach to gaining and sustaining competitive
advantage did not work. Sometimes strategies are successful and sometimes they are not.
Strategies are more likely to be successful when the plan explicitly takes into account
four factors:
1. Where to compete, or the attractiveness of a market or customer segment in the targeted markets
2. How to offer unique value relative to the competition in the targeted markets
3. What resources or capabilities are necessary to deliver that unique value
4. How to sustain a competitive advantage once it has been achieved
The goal of the strategic plan is to create competitive advantage. First, let’s examine
the goal.
Competitive Advantage
What exactly do we mean when we use the term competitive advantage?7 In the sports world,
it is usually obvious when a team has a competitive advantage over another team: The better team wins the game by having a higher score. The ability to consistently win is based on
attracting and developing better players and coaches, and by employing strategies to exploit
the weaknesses of opponents. In the business world, the scoring is measured by looking at
the profits (as a percentage of invested capital) generated by each firm. We describe the most
common ways of measuring profits in Strategy in Practice: Measuring American Home Products’
Competitive Advantage.
Just as in sports, where an inferior team may outscore a superior team on a given day, it may
be possible for an inferior company to outscore a superior company in a particular quarter, or perhaps even a year. Competitive advantage requires that a firm consistently outperform its rivals in
generating above-average profits. A firm has a competitive advantage when it can consistently
generate above-average profits through a strategy that competitors are unable to imitate or find
too costly to imitate. Above-average profits are profit returns in excess of what an investor
expects from other investments with a similar amount of risk. Risk is an investor’s uncertainty
about the profits or losses that will result from a particular investment. For example, investors suffer a lot of uncertainty (and, hence, risk) when they put their money into a start-up company that
is trying to launch products based on a new technology, such as a solar power company. There is
much less risk in investing in a stable firm with a long history of profitability, such as a utility
company that supplies power to customers who have few, if any, alternative sources of power.9
Many organizations work to achieve objectives other than profit. For example, universities,
many hospitals, government agencies, not-for-profit organizations, and social entrepreneurs
play important roles in making our economy work and our society a better place to live. These
organizations do not measure their success in terms of profit rates, but they still use many of
the tools of strategic management to help them succeed (see Chapter 14). For these organizations, success might be measured using tangible outcomes such as the number of degrees
granted, patient health and satisfaction measures, people served, or some other measure of
an improved society.
The primary source of a company’s competitive advantage can come from several areas of
its operations. For example, the diamond company De Beers has an advantage that comes from
paying lower costs for its diamonds than other companies do, because De Beers owns its own
above-average profits Returns in
excess of what an investor expects
from other investments with a
similar amount of risk.
4 CHA PT E R 1
What Is Business Strategy?
Strategy in Practice
Measuring American Home Products’
Competitive Advantage
To see which firms in an industry are most successful, we typically
compare their return on assets (ROA), a calculation of operating
profits divided by total assets, or their return on equity (ROE),
which is operating profits divided by total stockholders’ equity.
The company that consistently generates the highest returns for
its investors, in terms of ROA or ROE, wins the game. For example, from 1971 to 2000, the pharmaceutical company American
Home Products averaged 19 percent ROA, compared to competitor
American Cyanamid’s 7 percent. American Home Products’ ROA
was higher than American Cyanamid’s every year for 30 years. This
is evidence that during this time period, American Home Products
had a competitive advantage over American Cyanamid.8 American Home Products’ advantage over American Cyanamid has frequently been attributed to its ability to develop more blockbuster
drugs (through more effective research and development) and to
quickly get those drugs to market through a larger and more effective sales force.
20
18
Operating Profit (ROA %)
16
14
12
10
8
6
4
2
American
Cyanamid
Pfizer
Upjohn
Schering Plough
Eli Lilly
Bristol Myers
Squibb
Merck
American Home
Products
0
Profitability of Different Firms in the Pharmaceutical Industry
Source: Annual reports; 1973–1992.
strategic management
process The process by which
organizations formulate a plan
and allocate resources to achieve
competitive advantage that
involves making four strategic
choices: (1) markets to compete in,
(2) unique value the firm will offer
in those markets, (3) the resources
and capabilities required to
offer that unique value better
than competitors, and (4) ways
to sustain the advantage by
preventing imitation.
diamond mines. Competitive advantage can also come from different functional areas within
the company. Biotechnology pioneer Genentech’s advantage comes primarily from research
and development that has produced several blockbuster drugs; Toyota’s advantage in automobiles has come primarily from its manufacturing operations (known as the Toyota Production System); Procter & Gamble’s advantage in household products comes largely from its sales
and marketing, and Nordstrom’s advantage as a retailer comes largely from its merchandising
and service.
The Strategic Management Process
The processes that firms use to develop a strategy can differ dramatically across firms. In some
cases, executives do not spend significant time on strategy formulation, and strategies are
often based only on recent experience and limited information. However, we propose that a
better approach to the formulation of strategy is the strategic management process outlined
in Figure 1.1. The strategic management process for formulating and implementing strategy
involves thorough external analysis and internal analysis. Only after conducting an analysis
of the company’s external environment and its internal resources and capabilities are a firm’s
What Is Business Strategy?
5
Mission
External Analysis
Internal Analysis
• Industry structure
• Opportunities/threats
[Chapter 2]
• Resources and capabilities
• Strengths/weaknesses
[Chapter 3]
Strategy Formulation
Cost
Advantage
[Chapter 4]
Differentiation
Advantage
[Chapter 5]
Corporate
Strategy
[Chapter 6]
Vertical
Integration
[Chapter 7]
Strategic
Alliances
[Chapter 8]
Dynamic
Strategic Actions
Disruptive
Business
Models
[Chapter 10]
Competitor
Interaction/
Game Theory
[Chapter 11]
Business Level
Strategies
Strategy
Vehicles
International
Strategy
[Chapter 9]
Strategy Implementation
Strategy
Implementation
[Chapter 12]
FIGURE 1.1
Governance
and Ethics
[Chapter 13]
Social Value
Organizations
[Chapter 14]
The Strategic Management Process
executives and managers able to identify the most attractive business opportunities and
formulate a strategy for achieving competitive advantage.
The central task of the strategy formulation process is specifying the high-level plan and set
of actions the company will take in its quest to achieve competitive advantage. After the plan
for creating competitive advantage is created, the final step is to develop a detailed plan to
effectively implement, or put into action, the firm’s strategy through specific activities.
The focus of the strategic management process should be to make four key strategic
choices, as shown in Figure 1.2:
1. Which markets will the company pursue? A company’s markets include the high-level
industry and specific customer segments in which it competes and its geographic markets.
2. What unique value does the company offer customers in those markets? This is the firm’s
value proposition, the reason the company wins with a set of customers.10
3. What resources and capabilities are required? What does the company need to have and
know how to do so that it can deliver its unique value better than competitors, and exactly
how will the company deliver its unique value through an implementation plan?11
4. How will the company capture value and sustain a competitive advantage over time? Firms
need to create barriers to imitation to keep other companies from delivering the same value.
external analysis Examining
the forces that influence industry
attractiveness, including
opportunities and threats that
exist in the environment.
internal analysis The analysis of
a firm’s resources and capabilities
(its strength and weaknesses) to
assess how effectively the firm is
able to deliver the unique value
(value proposition) that it hopes to
provide to customers.
6 CHA PT E R 1
What Is Business Strategy?
FIGURE 1.2
Markets to
Pursue
• What industry, customer segment, and
geographic markets are most attractive
as business arenas?
Unique Value to
Offer
• What value proposition will offer unique
value relative to competitors in the
areas of cost or differentiation or both?
Resources and
Capabilities to
Develop
• What resources and capabilities are
required in order to deliver that unique
value better than competitors?
Sustaining
Advantage
• How to create barriers to imitation to
prevent other companies from offering
that same value?
Four Key Strategic Choices in Strategic Management
Markets One of the first decisions a company must make is where to compete or which
markets it will serve. Leaders must choose the industries a company competes in and the
specific customer segments or needs it will address (the focus of Chapter 2) within those industries. For example, before iPod, Apple competed only in the computer industry. Its product markets included desktop and laptop computers. Launching iPod and iTunes took Apple into the
music industry. Later, when Apple launched the iPhone, it entered the cell phone business.
Apple targets the high-end customer segments within its industries. Its customers want the latest in technology, see themselves as innovators, appreciate design and elegance, and are not
price sensitive.
It is also important to select geographic markets to serve. Apple competes on a worldwide
basis, which allows it to spread heavy research and development costs across its many geographic markets. By contrast, Walmart started by focusing on rural markets, which allowed it to
offer lower prices than the “mom and pop” retail stores in small towns.12
Unique Value
cost advantage An advantage
that a firm has over its
competitors in the activities
associated with producing a
product or service, thereby
allowing it to produce the same
product at lower cost.
differentiation strategy An
advantage a firm has over
its competitors by making a
product more attractive by
offering unique qualities in the
form of features, reliability, and
convenience that distinguish it
from competing products.
After a company chooses the markets in which to compete, it then attempts
to offer unique value in those markets. This is often referred to as a company’s value proposition, or the value that it proposes to offer to customers. Companies typically try to achieve a
competitive advantage by choosing between one of two generic strategies for offering unique
value: low cost or differentiation. Companies such as Walmart, Ryanair, Taco Bell, and Kia attract
customers by being cost leaders, offering products or services that are priced lower than competitor offerings. A firm that chooses a low-cost strategy (the focus of Chapter 4) focuses on
reducing its costs below those of its competitors. Key sources of cost advantage include economies of scale, lower-cost inputs, or proprietary production know-how.
A firm that chooses a differentiation strategy (the focus of Chapter 5) focuses on offering
features, quality, convenience, or image that customers cannot get from competitors. Apple’s
unique value is offering iPods (music players), iPhones (smartphones), and iPads (tablets) that
are well designed, innovative, easy to use, and have features that competing products don’t
have (“there’s an App for that”). In similar fashion, Starbucks wins through differentiation by
offering multiple blends of high-quality coffee in convenient locations.
The traditional answer to offering unique value is to be either a low-cost (low-price) provider or a differentiator. In fact, strategy professor Michael Porter, whose five forces analysis
will be introduced later in this chapter, has cautioned that trying to do both simultaneously
What Information and Analysis Guides Strategy Formulation?
can result in being “stuck in the middle”—meaning that by trying to do both, companies don’t
effectively do the job of either low price or differentiation. Increasingly, however, companies
are finding ways to deliver on both low cost and differentiation.13 Does Amazon beat brickand-mortar stores because of price or differentiation (e.g., convenience)? Does Uber beat
taxis because of price or differentiation (e.g., convenience)? The answer, of course, is both.
Some companies have discovered ways to simultaneously offer both low price and a differentiated product—which turns out to be a powerful source of competitive advantage (see
“New Thinking: Achieving Both Cost and Differentiation Advantages” at the end of Chapter 5).
Resources and Capabilities Delivering unique value requires developing resources
and capabilities (the focus of Chapter 3) that will allow the company to perform activities better
than competitors. Indeed, perhaps the most critical role of the strategist is to figure out how to
build or acquire the resources and capabilities necessary to deliver unique value.
Resources refer to assets that the firm accumulates over time, such as plants, equipment,
land, brands, patents, cash, and people. Elon Musk is a key resource for Tesla because his reputation as a successful innovator allows the company to raise the large sums of money Tesla
needs for product development at a low price.
Capabilities refer to processes (or recipes) the firm develops to coordinate human
activity to achieve specific goals. To illustrate, Starbucks has key resources that allow it
to succeed through differentiation, including its Starbucks brand, its retail store locations,
its recipes to produce different coffee blends, and even some patents to protect those recipes. Its capabilities include its processes to roast coffee beans for the best flavor, create
new coffee blends, design stores with great atmosphere, and find optimal store locations.
These resources and capabilities have allowed Starbucks to deliver unique value to customers, thereby helping the company outperform other coffee shops within the coffee
retailing industry.
The development of key resources and capabilities needed to deliver unique value should
be part of the company’s strategy implementation plan. The strategy implementation plan
involves the company developing a set of processes (capabilities) within each function (e.g.,
R&D, operations, sales, service, HR, etc.) that align with the unique value the company hopes
to offer. For example, because Walmart’s unique value is “low prices,” every function of the
company is focused on how it can perform its activities at the lowest possible cost. Strategists
also have learned that it is helpful to align the firm’s structure (organization design), staffing
(people), skills (capabilities/processes), systems (e.g., information and reward systems), and
shared values and style (its culture) with its strategy for offering unique value (implementation
is discussed in detail in Chapter 12).
Sustaining Advantage
By being the first to offer music downloads through its easyto-use iTunes software, Apple encouraged its customers to store their entire music libraries
on iTunes. Designing iTunes so that it wouldn’t easily download songs to other music players
helped Apple to prevent competing MP3 players from taking market share from iPod. Of course,
Apple’s brand image and its Apple Stores also prevent competitors from easily imitating its
products and services. These actions helped Apple capture and sustain the value it created.
What Information and Analysis Guides
Strategy Formulation?
As Figure 1.1 shows, the earliest steps in the strategic management process involve analyses
and choices that later result in the formulation and implementation of a company’s strategy.
These choices are made within the context of the company’s mission and only after an analysis
of the external environment and internal organization.
7
8 CHA PT E R 1
What Is Business Strategy?
Mission
mission A company’s primary
purpose that often specifies the
business or businesses in which
the firm intends to compete—or
the customers it intends to serve.
A company’s mission outlines the company’s primary purpose and often specifies the business
or businesses in which the firm intends to compete—or the customers it intends to serve. People in business often use the terms mission, vision, or purpose somewhat interchangeably. For
our purposes in this book, we will use the term mission to refer to the primary purpose of the
organization.
Most business firms start with a mission, even if it isn’t formally stated. For example,
Starbucks founder Howard Schultz got the idea to introduce coffee bars to America when he
visited Italy and experienced the great coffee and convenience of Italian espresso bars. His
external analysis of the coffee shop industry in the United States led him to believe that there
was an opportunity to bring an exceptional coffee experience to America. Schultz once said
American coffee was so bad it tasted like “swill.” He discovered café latte when visiting an
espresso bar in Verona, Italy, and thought, “I have to take this to America.”14 So he launched
Starbucks, a company that offered higher-quality coffee than traditional coffee shops and
included many varieties at a premium price. In essence, Starbucks started with a mission to
bring high-quality coffee to the masses in the United States.
As companies grow and develop formal mission statements, these statements often define
the core values that a firm espouses, and are often written to inspire employees to behave in
particular ways. Starbucks formalized its mission as follows:
Our mission: to nurture and inspire the human spirit—one person, one cup, and one
neighborhood at a time.15
It then proceeds with the statement: Here are the principles of how we live that every day—
which is followed by a set of principles or values designed to guide employee behaviors. Even
after it has been formalized, however, a company’s mission is still open to interpretation, as
Strategy in Practice: Apple’s Evolving Mission shows.
External Analysis
SWOT analysis Strategic
planning method used to evaluate
the strengths, weaknesses,
opportunities, and threats
involved in a business.
External analysis is critical for addressing the first strategic choice: Where should we compete?
External analysis involves (1) an examination of the competition and the forces that shape
industry competition and profitability, and (2) customer analysis to understand what customers really want. The combined results of external analysis with internal analysis of the firm are
often summarized as a SWOT analysis. SWOT is an acronym for Strengths, Weaknesses,
Opportunities, and Threats.16 External analysis is particularly useful for shedding light on the
latter two: opportunities and threats.
Industry Analysis One of the central questions for the strategist is to determine which
markets or industries to compete in. The fact of the matter is, all industries are not created
equal. To illustrate, between 1992 and 2006, the average return on invested capital in US industries ranged from as low as zero to more than 50 percent.17 The most profitable industries
include prepackaged software, soft drinks, and pharmaceuticals. These industries are more
than five times as profitable as the least profitable industries, which include airlines, hotels,
and steel. This does not mean that a steel or airline company cannot be successful or profitable
(Southwest Airlines has been quite profitable18), but it does mean that the average profitability
of all firms in these industries is low compared to other industries. This makes the challenge of
making money in these low-profit industries even greater.
Why are some industries more profitable than others? Strategy professor Michael Porter
developed a model for conducting industry analysis called the Five Forces that Shape Industry
Competition.19 Understanding the five forces that shape industry competition is one of the
starting points for developing strategy, and will be discussed in detail in Chapter 2. This framework helps managers think about what the company can do to increase its power over suppliers and buyers, create barriers to other firms looking to enter the market, reduce the threat
of substitute products or services, and reduce rivalry with competitors.
What Information and Analysis Guides Strategy Formulation?
9
Strategy in Practice
Apple’s Evolving Mission
When Steve Jobs and Steve Wozniak launched Apple in 1976, their
primary purpose was to make great computers that people loved to
use. Twenty-four years later, Apple was still essentially a computer
company when it launched the iPod, a device that took the company into the music industry.
But did you know that Apple was not the first computer company to make a small, handheld MP3 player with a mini-hard drive
that could store your entire music library? That honor goes to Compaq
(later acquired by HP). Compaq developed an MP3 player before
Apple, but the company decided this was not an industry and product
market that it wanted to enter. Compaq decided not to pursue the
MP3 business because it saw its mission as being a computer maker,
and music players fell outside of that mission. Instead of refining the
design and launching its MP3 player on the market, Compaq sold
the technology to a Korean company. In contrast, Apple decided that
this product market was not outside its mission.
Apple’s decision was influenced by its external analysis.
Apple looked at the multibillion-dollar music business and quickly
realized that no company was offering legal digital downloads—so
the market was wide open because of the challenges of protecting
the files from easily being copied. Apple’s leaders also considered
its internal capabilities. Unlike Compaq—which only made computer hardware but not software—Apple had vast experience at
writing software for Apple computers. It also had far greater design
expertise than Compaq. In fact, the company had long been hailed
for the cutting-edge designs of the iMac and some of its other
computers. Apple decided to channel its internal capabilities at
writing software to navigate an MP3 player. Apple’s software engineers came up with the innovative “flywheel” design for navigating the iPod. Likewise, it channeled its design capabilities toward
designing a product that was elegant and small enough to fit in
your pocket.
As a result of formulating a strategy to enter the MP3 player
market—and subsequently the iPhone, iPad, and Apple Watch—
Apple’s mission has broadened. The company no longer focuses on
just being a computer maker. In fact, in 2007 it changed its name
from Apple Computer Inc. to Apple Inc. to reflect this change in
its mission.
Customer Analysis
External analysis also involves an analysis of customers or potential
customers, notably an analysis of their needs and price sensitivity. In particular, the strategist can
make better decisions about how to offer unique value by considering groups of customers who all
have similar needs. This is called customer segmentation analysis.20 For example, in the automobile industry, some customers want cars that are very stylish, powerful, luxurious, and packed with
technology and gadgets. These customers are the focus of companies such as Porsche, MercedesBenz, BMW, and Lexus. Others want trucks with the capacity to haul heavy items and move easily
over rough terrain. These customers are the focus of the truck divisions of Chevy and Ford. Still
others want economy cars for basic transportation—the focus of Hyundai and Kia.
External analysis should enlighten managers about the competitive forces that influence
the profitability of particular markets and industries, as well as opportunities and threats. In
addition, it should shed light on what customers want and what they are willing to pay to have
their needs met.
price sensitivity The degree
to which the price of a product
or service affects consumers’
willingness to purchase the
product or service.
segmentation analysis Dividing
up customers into groups or
segments based on similar
needs or wants.
Internal Analysis
Whereas external analysis focuses on a company’s industry, customers, and competitors,
internal analysis focuses on the company itself. Internal analysis completes the SWOT by focusing on strengths and weaknesses. More formally, internal analysis involves an analysis of the
company’s set of resources and capabilities that can be deployed—or should be developed—to
deliver unique value to customers. We discuss internal analysis in greater detail in Chapter 3.
In the 1980s, the resource-based view of the firm, also known as the resource-based model,
was developed to explain why some firms outperform other firms within the same industry.21 Why
does Nucor make money in the steel business when most of its US competitors do not? Why does
Southwest fly high in the air travel business while most of its competitors are (financially)
grounded? The resource-based model assumes that each company is a collection of resources
and capabilities (also referred to as competencies) that are deployed to deliver unique value.22
Firms that don’t have the resources and capabilities that are necessary to implement the
strategies they are contemplating may need to improve, change, or possibly create them in
order to offer unique value to their customers. This is where resource allocation becomes an
important dimension of strategy. After a company decides how it hopes to offer unique value,
it must allocate the resources necessary to build those resources or capabilities. For example,
resource-based review of firm
Determining the strategic
resources available to a company.
10
CH A PT E R 1
What Is Business Strategy?
after Target realized that it could not compete directly on prices with Walmart, it allocated additional resources to move “upmarket.” This involved investing heavily in a trends department,
a new mix of higher-quality products, relationships with designers, more expensive suburban
retail locations, and significant TV advertising to get the message out to customers.
How Are Strategies Formulated?
Formulating a strategy involves selecting which actions the company will take to gain and sustain competitive advantage. Remember, competitive advantage requires that the company do
all of the following:
• Provide unique value to a set of customers in the appropriate markets.
• Develop a set of resources and capabilities that allow the company to deliver that unique
value to customers better than competitors.
• Sustain the competitive advantage by figuring out how to prevent imitation of the
chosen strategy.
corporate strategy Decisions
about what markets to compete
in, made by executives at the
corporate level of an organization.
business unit strategy Decisions
about how to gain and sustain
advantage, made at the manager
level for each standalone business
unit within a company.
functional strategy Decisions
about how to effectively
implement the business unit
strategy within functional
areas like finance, product
development, operations,
information technology, sales and
marketing, and customer service.
strategy vehicles Activities and
strategic choices—such as make
versus buy, acquisitions, and
strategic alliances—that influence
a firm’s ability to enter particular
markets, deliver unique value to
customers, or create barriers to
imitating its product.
A company will also need to formulate, and then implement, strategy at three different levels of
the organization: corporate, business unit (product), and functional.
Corporate strategy refers to decisions that are made by senior corporate executives about
where to compete in terms of industries and markets. For example, Amazon’s corporate executives made the decision to use its Kindle to enter the electronic reader/tablet business where it
would face new competitors such as Apple. Similarly, Amazon’s launch of Amazon Web
Services—a business that provides web hosting, cloud storage, and marketplace software—was
made at corporate headquarters by the corporate management team. Business unit strategy
is made at the level of the strategic business unit—standalone business units in a company that
typically have their own profit and loss responsibility. Amazon’s online discount business would
be considered one business unit, whereas Kindle and Amazon Web Services would be different
business units. The general manager of each business unit addresses the questions we’ve identified regarding how to gain and sustain advantage in that particular market. Finally, within
each business unit are different functions such as product development, operations,
information technology, sales and marketing, and customer service. A functional strategy
should align with the overall business unit strategies to effectively implement the business unit
strategy (see Figure 1.3).
Strategy Vehicles for Achieving Strategic Objectives
In many instances, firms rely on a few key strategy vehicles to help them enter attractive markets and build the resources and capabilities necessary to deliver unique value. These strategy
vehicles include such things as diversification, acquisitions, alliances, vertical integration, and
international expansion. In some cases, a firm may choose to grow by diversifying, adding to its
products or opening a new line of business. Acquisition is a strategy vehicle used for growth and
diversification or to acquire key resources.
For example, when Apple acquired NeXT Computing, the late Steve Jobs’s start-up, Apple
acquired the operating system that became OSX—and the acquisition brought Steve Jobs back
to Apple.23 More recently, Apple acquired SIRI, a company that made voice recognition and
search software that was the technology behind SIRI (pronounced sir’-ee), Apple’s personal
assistant on the iPhone.
Sometimes companies decide to access new resources and capabilities through a strategic alliance—an exclusive relationship with another firm—rather than through acquisition.
For example, Apple teamed up with AT&T in an alliance to launch the iPhone in the United
States. AT&T put huge promotional dollars behind the iPhone—and paid Apple 10 percent of its
revenues from each iPhone subscriber—in order to be the exclusive distributor of iPhones for
the first five years.
How Are Strategies Formulated?
Corporate
Strategy
(Where to compete)
Business Unit 1
Strategy
(How to compete)
R&D
Strategy
(How to
implement)
Business Unit 2
Strategy
(How to compete)
Operations
Strategy
(How to
implement)
Marketing
Strategy
(How to
implement)
Identifies where to
compete in terms of
Provides guidance for
industries and
managing and allocating
markets
resources to distinct
business units
Identifies what unique
value to offer (cost or
differentiation) and
Provides a plan
how to deliver it
to achieve competitive
advantage
H.R.
Strategy
(How to
implement)
Strategies and tactics of the functional areas should
align with and implement the overall business unit strategy.
FIGURE 1.3
Multiple Levels of Strategic Analysis
Vertical integration, or the make–buy decision, is also a vehicle for achieving objectives.24
For example, when Apple decided to move into retailing by establishing Apple Stores, the
company made a decision to “make” stores that sold their own products, rather than simply
“buy” the retailing services of stores run by other companies, such as Best Buy or Walmart.
Finally, companies may use international expansion as a vehicle to achieve economies of scale,
access key resources, or learn new skills. Indeed, some companies use international expansion
as a primary source of competitive advantage. These strategy vehicles—discussed in detail in
Chapters 6 to 9—are important tools that strategists use to achieve key strategic objectives.
Strategy Implementation
The final step in the strategic management process is to implement the strategy that was chosen during the strategy formulation phase. Strategy implementation occurs when a company
adopts a set of organizational processes that enable it to effectively carry out its strategy. Effective implementation typically requires the following:
1. The functional strategies within the company—research and development, operations,
sales and marketing, human resource management—are well aligned with delivering the
unique value identified in the overall strategy. Implementation is generally more successful
when a company can measure how effectively functional activities are being performed to
support the overall strategy.
2. The organization’s structure, systems, staff (people), skills (processor capabilities), style,
and shared values (culture) are designed to facilitate the execution of the strategy. This is
the McKinsey 7 S framework, which is useful for creating the alignment necessary to ensure
effective implementation.
We discuss how companies can effectively create alignment with their strategy—or change
the organization to align with a new strategy—in Chapter 12. The Strategy in Practice: Walmart
Functional Strategies Implement the Overall Strategy feature describes some of the actions that
Walmart has taken to ensure that its functional activities align with and implement the overall
business unit strategy.
strategy implementation The
translation of a chosen strategy
into organizational action so
as to effectively implement the
activities required to achieve
strategic goals and objectives.
11
12
CH A PT E R 1
What Is Business Strategy?
Strategy in Practice
Walmart Functional Strategies Implement the
Overall “Low Cost” Strategy
When a company has a clear strategy regarding how it plans to offer
unique value, or “win” with customers, this helps guide the implementation of the overall strategy within each of the different business functions. As we’ve discussed, Walmart’s strategy is to win by
being a cost leader in its markets. Walmart’s functional areas support that strategy in a number of ways:25
• Walmart’s human resource management strategy focuses on
keeping labor costs as low as possible. Walmart pays relatively
low wages and has few layers of management, which minimizes
labor costs. Walmart also has a nonunion stance and once even
closed a store in Canada when the workers tried to unionize.26
Managers have small offices with inexpensive furniture, and
when they travel, they stay at inexpensive hotels and frequently
share a room.
• Walmart’s information technology and operations areas also
focus attention on cost reduction. Walmart has invested in
information technology to lower the costs of communicating
with thousands of suppliers and to provide suppliers with
real-time data on what products are selling, at what price, in
what store.
• Walmart purchasing department negotiates aggressively with
suppliers. Walmart uses its tremendous buying power to get the
lowest prices on products from its suppliers. It also offers a product mix that appeals to price-sensitive customers.
• Marketing does price checks at competitors. The goal of the
marketing staff is to ensure that Walmart’s prices are always as
low, if not lower, than competitors.
To ensure successful implementation, the organization should have clear metrics, or ways
to measure whether or not the plan is being implemented. In Chapter 12, we provide a strategy
tool, our version of the balanced scorecard, which suggests some useful metrics that functional
area leaders, and the CEO and top management team, can use to determine how effectively
strategies are being implemented.27
Who Is Responsible for Business Strategy?
strategic leaders Organizational
leaders charged with formulating
and implementing a strategy
with the objective of ensuring
the survival and success of an
organization.
deliberate strategy A plan
or pattern of action that is
formulated through a deliberate
planning process that is then
carried out to achieve the mission
or goals of an organization.
emergent strategy A plan or
pattern of action that develops
and emerges over time in
an organization despite a
mission or goals.
Strategic leaders are typically the leaders of an organization who develop strategy through the
strategic management process. These leaders are responsible for not only formulating strategy,
but also for explaining the strategy in a way that employees will understand—and in a way that
will motivate employees to execute it. Chapter 13 explains the role the board of directors and the
top management team play in formulating and implementing strategy. Theorist Henry Mintzberg
refers to strategies that are developed by management, using the strategic management process
shown in Figure 1.1, as “intended” or “deliberate” strategies.28 Deliberate strategies are implemented as a result of careful analysis of markets, customers, competitors, and a firm’s resources
and capabilities. Target’s move to upscale discount retailing came after it concluded that it could
not compete with Walmart on costs and prices. So it created a trends department, created partnerships with high-end fashion designers (e.g., Oscar de la Renta) and stores (Neiman Marcus),
offered a higher-end mix of products, and built stores in more affluent suburban areas as opposed
to rural towns. Target’s strategy to become Tar-zhay was the result of a deliberate strategic plan.
Emergent strategy is a strategy that was not expressly intended in the original planning of
strategy. Strategies that emerge when leaders recognize and act on unexpected opportunities
that occur through serendipity, such as ideas from people within the organization, are called
emergent strategies.29 Apple’s transformation from a computer company to a company known
mostly for its music players and cell phones was the result of a strategy that emerged after the
introduction of the iPod. The iPod opened up opportunities—such as the iPhone and iPad—
that the company’s senior executives did not necessarily foresee.
Successful companies typically have strategies that are partly deliberate, due to effective
strategic planning processes, and partly emergent, due to a willingness to respond to changes
in the external environment and to ideas that come from within the organization. That is why a
strategy needs to be a plan to gain and sustain advantage. In a successful company, everyone
in the organization has some responsibility for understanding the company’s strategy and for
offering ideas to improve the company’s strategic position.
Who Is Responsible for Business Strategy?
13
Ethics and Strategy
The Price Companies Pay to Stay Competitive
One of the central ethical challenges facing the strategist is making
decisions designed to deliver unique value to customers. A decision
could, for example, focus on providing low costs to customers but it
might result in reduced value for other stakeholder groups.
Over the past few years, an increasing number of US companies have shut down US facilities and fired American workers
as they have shifted their activities overseas to save money. For
example, IBM laid off more than 1,200 employees in New York
and Vermont because their jobs could be done more cost effectively in “Brazil, India, and now China.”32 In similar fashion, HP
announced layoffs of 500 customer service workers in Arkansas
due to global restructuring, the term often used to describe a
company’s plan to fire workers and move activities from one
location to another.33 And Eaton, a 101-year-old Cleveland-based
manufacturer of electronic components, moved its corporate
address to Ireland, where the top corporate tax rate is 12.5 percent versus 35 percent in the United States. These are only a few
of the many examples of organizations making difficult decisions
in order to stay competitive. But at what price?
In each of these instances, the company’s leaders are responding to customer demands (lower prices) and shareholder demands
(higher profit returns). But in doing so, they are neglecting employee
demands (job retention) and community demands (taxes provide
community benefits). Some may question whether it is ethical to fire
employees and avoid US taxes in order to better meet the desires of
customers and shareholders. Others will argue that if the company
does not keep its customers and shareholders happy, employees
will eventually lose their jobs anyway because the company will not
be cost competitive, and companies that go bankrupt cannot pay
taxes. The challenge of meeting the sometimes-competing needs
of various stakeholder groups is one that is constantly faced by a
company’s leaders. A typical response is to prioritize stakeholders’
needs—with customers and shareholders needs coming first—and
take strategic actions that best meet their needs. But actions that
take unduly from employees and communities to compensate
customers and shareholders are viewed by many as unethical.
Who Benefits from a Good Business Strategy?
Every organization has a set of stakeholders to whom it is accountable—and who therefore can
influence business strategy. Organizations have four primary stakeholder groups:
1. Capital market stakeholders (shareholders, banks, etc.)
stakeholders Those who have
a share or an interest in the
activities and performance of an
organization.
2. Product market stakeholders (customers, suppliers)
3. Organizational stakeholders (employees)
4. Community stakeholders (communities, government bodies, community activists)30
There is a lively debate that will be discussed in Chapter 13 about which of these four
stakeholder groups is the most important and should be the primary beneficiaries of successful
business strategies. Some people believe that shareholders (owners of the company) are the
most important. Others make the case that customers, employees, governments, or communities should be the primary beneficiaries of business activity. In the United States, shareholders typically receive highest priority, but each stakeholder group can influence the strategic
decisions that are made by a company.
Sometimes, different stakeholder groups have conflicting views as to the appropriateness of different strategic decisions. Imagine that your company can lower its product costs by
closing down your plants in the United States and moving production to China, where labor is
cheaper. This will require firing many of your US employees. Both the employee stakeholder
group and community stakeholder groups in the cities where your plants are located will perceive this move as negative, and they will try to stop the company from making this decision.
However, shareholders and customer stakeholder groups may applaud this decision. It could
increase profits for shareholders and lower prices for customers, or both. Because of conflicts
like this, companies need to make sure their strategic actions follow accepted ethical standards
for business activity. In the ideal situation, a firm has such an effective business strategy that
it generates above-average profit returns. Above-average returns allow companies to not only
meet the expectations of shareholders, but also satisfy the expectations of other suppliers of
capital, product-market, organizational, and community stakeholders. Since stakeholders
influence, and are influenced by, strategic decisions made by a company’s management team,
it is important to understand and consider the needs of different stakeholder groups when
making strategic decisions.31
shareholders Owners of
a company.
14
CH A PT E R 1
What Is Business Strategy?
Strategy in Your Career
Understanding business strategy and the strategic management
process is important for at least two reasons:
1. When you start your own company or are the president or general manager of a department or division within a company,
your primary job will be to formulate and implement an
effective business strategy. Even as a junior person in your
company, by understanding basic strategy principles you will
be more effective at developing and implementing ideas that
are consistent with, and support, your business unit’s overall
strategy. Being able to understand and contribute to your
firm’s strategy may lead to earlier promotions as you stand
out from your peers.
2. Understanding strategy will help you evaluate the strategy
of companies you choose to work for. An effective strategy
can give a company competitive advantage over its rivals.
Companies with competitive advantage typically provide superior advancement opportunities, higher pay, and
greater job security than companies without any competitive advantage.
In summary, understanding the strategic management
process—as well as the concepts that are fundamental to the formulation, and implementation, of strategy—will likely be very helpful as you pursue a successful career in business.
Summary
• A company’s business strategy is defined as a plan to achieve
competitive advantage. Formulating a strategy involves making four key choices: (1) what markets or industries the company
will pursue, (2) what unique value to offer the customer in those
markets, (3) what resources and capabilities will allow the firm to
deliver that unique value better than competitors, and (4) how the
company will sustain its advantage and prevent imitation of its
strategy by competitors.
• The strategic management process involves the selection of a
company mission as well as external and internal analyses that
contribute to the formulation of a company’s strategy. A company’s mission outlines the company’s primary purpose and scope
of activity. External analysis involves an analysis of the company’s
current (or potential) markets or industries to understand the environmental factors that influence a firm’s profitability. Internal analysis involves an analysis of the company’s set of resources and
capabilities (or new ones that need to be developed) that can be
deployed to create competitive advantages.
• These analyses contribute to the formulation of a company’s strategy. After the plan for creating competitive advantage is created,
the final step is to develop a plan to effectively implement the firm’s
strategy.
• Every organization has a set of stakeholders to whom it is
accountable—and who therefore can influence business strategy.
The four primary stakeholder groups are capital market stakeholders (shareholders, other suppliers of capital like banks), product
market stakeholders (customers, suppliers), organizational stakeholders (employees), and community stakeholders (communities,
government bodies).
• The chief executive officer and vice presidents of the different
business functions are ultimately responsible for a company’s strategy. They are often assisted by a VP of strategic planning (chief strategy officer), who may lead a planning staff, or in some cases by a
management-consulting firm. Good strategic leaders, however, will
seek information and ideas from anyone in the company.
• You need to understand business strategy because (1) it will give you
the tools to more effectively evaluate, and contribute, to the strategy of the company that employs you; and (2) it will give you the
knowledge you need to evaluate the strategy of organizations you
may want to join.
Key Terms
above-average profits 3
business strategy 2
business unit strategy 10
competitive advantage 2
corporate strategy 10
cost advantage 6
deliberate strategy 12
differentiation strategy 6
emergent strategy 12
external analysis 4
functional strategy 10
internal analysis 4
market 2
mission 8
price sensitivity 9
resource-based review of firm 9
segmentation analysis 9
shareholders 13
stakeholders 13
strategic leaders 12
strategic management process
strategy implementation 11
strategy vehicles 10
SWOT analysis 8
unique value 2
4
References 15
Review Questions
1. Why is it important for you to understand business strategy?
2. How would you describe or define strategy?
3. What are the four choices that are part of strategy formulation?
4. What are the two generic strategies, or primary ways, in which companies attempt to offer unique value relative to competitors?
5. Who is ultimately responsible for a company’s strategy? Who does
this individual (or individuals) call on for help in formulating strategy
for the firm?
6. According to Michael Porter’s “five forces” model, why do some firms
earn higher profits than other firms?
7. What are resources and capabilities, what is the difference between
them, and why do firms need to assess them?
8. What are three keys to the successful implementation of a
company strategy?
9. Who are the four primary stakeholder groups that influence strategic
decisions in a company?
Application Exercises
Exercise 1: Examine the Business Strategy of a Company
1. Identify a company you would like to learn more about that seems
to have a competitive advantage (earns above-average profit returns).
2. Gather data about the strategy of that company, using public
sources such as the company website or its annual reports, public
articles, and your own experience.
3. Identify the mission statement of the company, if it has one. How
does this mission statement guide the behavior and actions of people
in the company?
4. What markets or industries does the company focus on? Does this
differ from competitors in any particular way?
5. What unique value does it try to offer to customers? Why do most of
its customers pick its products over those of competitors?
6. Try to identify any resources or capabilities this company has
that help it offer unique value. This is the most difficult step in the
assignment, because companies often try to hide their sources of competitive advantage.
Exercise 2: Amazon is an online discount retailer that has successfully
entered other businesses, such as electronic devices with the Kindle,
Kindle Fire, and Echo as well Amazon Web Services. Read what you can
about Amazon’s entry into these new businesses, and try to explain:
1. why you think they chose to compete in those markets,
2. their unique value is in those markets—why they win with customers;
3. what resources and capabilities they possess that enable them to
succeed in the new markets; and what new capabilities they need to
develop; and
4. what makes it hard for competitors to imitate their offerings.
References
1
S. Levy, Insanely Great: The Life and Times of Macintosh, the Computer
that Changed Everything (New York: Penguin Books, 1994).
S. Levy, The Perfect Thing: How the iPod Shuffles Commerce, Culture,
and Coolness (New York: Simon and Schuster, 2006).
2
D. Yoffie, Apple Computer 2005 (Cambridge, MA: Harvard Business
School Press, 2005).
3
E. Smith, “Can Anybody Catch iTunes?” The Wall Street Journal (Nov.
27, 2006), pp. 41 +.
4
P. Kafka, “How Are Those DRM-free MP3s Selling?” Silicon Alley Insider
(2008), www.alleyinsider.com/2008/3.
5
http://www.afterdawn.com/news/article.cfm/2009/09/09/ipod
_market_share_at_738_percent_225_million_ipods_sold_more
_games_for_touch_than_psp_nds_apple.
6
For more discussion about competitive advantage, see J. Barney,
“Firm Resources and Sustained Competitive Advantage,” Journal
of Management 17(1) (1991): 99–120. R. Reed, “Causal Ambiguity,
7
Barriers to Imitation, and Sustained Competitive Advantage,” Academy
of Management Review 15 (1) (1990): 88–102. M. E. Porter, Competitive
Advantage, 2nd ed. (New York: The Free Press, 1998).
T. C. Powell, N. Rahman, and W. H. Starbuck, “European and American
Origins of Competitive Advantage,” Advances in Strategic Management,
27 (2010): 313–351.
8
For a discussion of risk versus uncertainty, see F. Knight, Risk, Uncertainty, and Profit (Chicago: Houghton Mifflin Co., 1921). According to
Knight, though the distribution of outcomes may be very wide, risk is
possible to measure, whereas uncertainty is immeasurable; even the
possible distribution of outcomes is unknown.
9
See M. Porter, “What Is Strategy,” Harvard Business Review (November–
December 1996): 61–78.
10
See B. Wernerfelt, “A Resource-Based View of the Firm,” Strategic
Management Journal 5(2) (1984): 171–180. Also see Barney, 99–120.
11
See http://www.dailymail.co.uk/news/article-1394087/Is-end-Mom-Pop
-stores-Mini-Wal-Mart-express-stores-coming- town-near-you.html.
12
16
CH A PT E R 1
What Is Business Strategy?
C. L. Hill, “Differentiation or Low Cost or Differentiation and Low Cost:
A Contingency Framework,” Academy of Management Review 13 (3)
(1988): pp. 401–412. J. Dyer, D. Bryce, and P. Godfrey, “Strategy 2.0:
New Answers to Strategy’s Big Questions,” Brigham Young University
Working Paper (2017).
13
H. Shultz, Pour Your Heart Into It: How Starbucks Built a Company One
Cup at a Time (New York: Hyperion, 1997).
14
15
See http://www.starbucks.com/about-us/company-information
/mission-statement.
The technique of SWOT analysis is credited to Albert Humphrey.
For more information see T. Hill & R. Westbrook, “SWOT Analysis: It’s
Time for a Product Recall,” Long Range Planning 30 (1) (1997): 46–52.
doi:10.1016/S0024-6301(96)00095-7. J. Scott Armstrong, “The Value
of Formal Planning for Strategic Decisions,” Strategic Management
Journal 3 (3) (1982): 197–211.
16
Harvard Business Review, HBR’s 10 Must-Reads on Strategy (2011),
http://books.google.com/books?id=aI-UUMi7jpsC&pg=PA48&lpg=P
A48&dq=1992+to+2006+average+return+on+invested+capital&sour
ce=bl&ots=Od-2BgCcJe&sig=c9BVKyhhl8tvBJDGPwOwb-K9IAM&hl=
en&sa=X&ei=B5SeUYGFOaPiiAL5h4HQDw&ved=0CDEQ6AEwAQ#v=
onepage&q=1992%20to%202006%20average%20return%20on%20
invested%20capital&f=false.
17
18
J. Mouawad, “Pushing 40, Southwest Is Still Playing the Rebel,” New
York Times (November 20, 2010),” http://www.nytimes.com/2010/11/21
/business/21south.html?pagewanted=all&_r=0.
M. Porter, “The Five Competitive Forces that Shape Strategy,” Harvard
Business Review (January 2008): 79–93.
19
For an overview of customer segmentation see D. Goldstein, “What Is
Customer Segmentation?” Mind of Marketing (May 2007), http://www
.mindofmarketing.net/2007/05/customer-segmentation-why-exactlydoes.html. Also see C. Christensen and M. Raynor, The Innovator’s
Dilemma, Chapter 3 for a discussion of segmenting customers based
on product attributes, demographics, or “job-to-be-done.” Also see
C. Christensen, “Integrating Around the Job to Be Done,” Harvard
Business School Press (2010), Module note. N9-611-004.
20
21
This is often called the resource-based view of the firm within the field
of strategic management. See Wernerfelt, 171–180, and Barney, 99–120.
See G. Hamel and C. K. Prahalad, “The Core Competence of the Corporation,” Harvard Business Review (May–June, 1990).
22
23
See D. E. Dilger, “Apple’s 15 Years of NeXT,” Apple Insider (December 21,
2011), http://appleinsider.com/articles/11/12/21/apples_15_years_of
_next.
See Business Dictionary, “Make or Buy Decision,” http://www
.businessdictionary.com/definition/make-or-buy-decision.html.
24
P. Ghemewat, S. Bradley, and K. Mark, “Wal-Mart Stores in 2003,”
Harvard Business Review (September 2003).
25
S. Berfield, “Walmart vs. Union-Backed OUR Walmart,” Bloomberg
Businessweek (December 13, 2012), http://www.businessweek.com
/articles/2012-12-13/walmart-vs-dot-union-backed-our-walmart.
26
27
R. S. Kaplan and D. P. Norton, “The Balanced Scorecard—Measures
that Drive Performance,” Harvard Business Review (February 1992).
H. Mintzberg, The Rise and Fall of Strategic Planning (New York: The
Free Press, 1994).
28
K. Moore, “Porter or Mintzberg: Whose View of Strategy Is the Most
Relevant Today?” Forbes (March 28, 2011), http://www.forbes.com
/sites/karlmoore/2011/03/28/porter-or-mintzberg-whose-view-of
-strategy-is-the-most-relevant-today/.
29
R. E. Freeman, Strategic Management: A Stakeholder Approach
(Boston: Pitman, 1984).
30
J. Harrison and R. E. Freeman, “Stakeholders, Social Responsibility,
and Performance: Empirical Evidence and Theoretical Perspectives,”
Academy of Management Journal 42 (5) (1999): 479–485.
31
A. Kelly. “IBM Layoffs: Computer Company Cuts Thousands of Jobs
as Part of Restructuring Plan.” International Business Times (June 12,
2013), http://www.ibtimes.com/ibm-layoffs-computer-company-cuts
-thousands-jobs-worldwide-part-restructuring-plan-1304949.
32
L. Jones and L. Turner. “Update: HP to Lay Off 500 in Conway,” Arkansas
Business (July 8, 2013), http://www.arkansasbusiness.com/article/93433
/reports-hewlett-packard-to-lay-off-500-in-conway?page=all.
33
CHAPTER 2
Analysis of the External
Environment: Opportunities
and Threats
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Explain the importance of correctly identifying and
choosing a firm’s industries and markets.
2. Identify and measure the five major forces that shape
average firm profitability within industries to evaluate
the overall attractiveness of an industry.
4. Discuss situations in which entry into both attractive
and unattractive industries follows “new thinking”
rather than conventional wisdom.
5. Identify the factors in the general environment that
affect firm and industry profitability.
3. Discuss how understanding the five forces that shape
industry competition is useful as a starting point for
developing strategy.
Tim Boyle/Getty Images News/Getty Images
State Farm Adjusts to a Changing World
George Jacob “G. J.” Mecherle founded the State Farm Mutual Automobile Insurance
company in 1922. Mecherle’s company targeted small-town and rural farmers as policy holders with a new value proposition: lower premiums. Insurers of the automobiles (still a relatively new innovation in the 1920s) based their policy premiums on payouts and accident
claims by urban drivers. Mecherle realized that rural customers, his target, had a far different
driving profile than auto owners in larger cities: They had far fewer opportunities for accidents and thefts. State Farm based its premiums on this lower incidence of risk.1 The company expanded into the life insurance market in 1929 and opened a homeowners line in 1935.
By 1942 the company had become the nation’s largest auto insurer, a title it still holds today.2
The Good Neighbor (taken from State Farm’s famous jingle written by Barry Manilow) wrote
just shy of $42 billion worth of premiums in 2016, gobbling up 18 percent of the US market.
Importantly, State Farm’s $42 billion in the auto market represented 65 percent of
its total Property and Casualty (P&C) revenue of almost $65 billion. The company’s 65,000
employees and 19,000 agents collected over $17 billion in homeowners premiums.3 The
17
18
CH A PT E R 2
Analysis of the External Environment: Opportunities and Threats
company’s auto line is almost 8 times its life insurance revenue,
and 60 times its sales of health insurance products.4 State Farm
is the market leader in the auto and homeowner lines of business
with over 81 million US policy holders and commands just over 10
percent of the market, 40 percent greater than Berkshire Hathaway’s 6 percent and more than double Allstate’s 4.9 percent. For
State Farm, P&C is the 800 lb. gorilla.
You might think of P&C insurance as a sleepy business with
known risks and very slow growth. You’d be wrong. P&C insurers
have seen, and continue to see, changes in their industry that
require innovation and new business models. The rise of the “gig”
economy and ridesharing companies like Uber or Lyft present one
challenge. Most of these drivers carry passengers in their personal
vehicles; when they pick up a rider, their car is no longer a “personal” vehicle, it becomes a “livery” or commercial-use vehicle.
Personal auto policies don’t cover livery uses, and drivers lose
their coverage. Rideshare companies established bare-bones,
low-cost policies to insure drivers, and State Farm created flexible
insurance to provide better coverage. When a driver engages the
App, State Farm’s policy (called a rider) continues their personal
coverage while their vehicle is in “livery” mode. State Farm survived, and profited from, the advent of ride sharing.
Services like Airbnb or Vacation Rental by Owner create similar problems for State Farm policy holders. When an Airbnb guest
arrives, the home ceases to be a personal dwelling and becomes
a “short-term rental” used to make a profit. State Farm, like most
other insurers, won’t cover most claims when a private dwelling
gets used for most business activities. Homeowners insurance
provides two types of coverage: property and liability. Coverage
remains in force for most weather related property damage, but
policies don’t cover damage caused by short-term renters (e.g.,
if guests host a party at the house that ruins furniture or floors).
Personal liability—say a guest slips on the stairs, breaks a leg,
and sues the homeowner for medical costs—also falls outside
most policies, leaving the renter, or host, on the hook for costs. To
date, State Farm has not developed a short-term rental policy to
respond to these changes.5
The rise of the gig or sharing economy signaled changes in
how policy holders (customers) behave. Climate change represents another challenge for P&C insurers. Rising oceans mean
that waterfront properties, and coastal cities in general, face
greater risk of weather-related damage. In humid climates, rising average temperatures spawn more powerful hurricanes,
tornadoes, and typhoons. In dry climates, warmer air increases
the risk of brush and forest fires. The net result for State Farm:
greater risk of property damage, both in the number of properties damaged and higher claim amounts. State Farm, and all
property insurers, continue to struggle with how to respond.
For example, in 2018 California experienced the worst fire in the
state’s history—the Mendocino Complex Fire—and 16 other fires
that caused extensive property damage and loss of life.6 For 2017
and 2018, loss claims for these wildfires exceeded $23 billion.
Some insurers refuse to cover at-risk homes, while others have
seen the claims rise by 20 percent.7 Strategy makers at State Farm
have to decide more than just prices for coverage; they have to
determine whether or not to compete in an increasingly risky
homeowners market.
As described in Chapter 1, strategy involves crafting a plan to
create competitive advantage—and superior profitability—in particular markets. This plan, however, is shaped by the landscape in
which the firm competes. A firm’s external environment provides
both opportunities—ways of taking advantage of conditions in
the environment to become more profitable—and threats—conditions in the competitive environment that endanger the profitability of the firm.8 Successful firms have a deep understanding of
their environment and constantly scan the horizon to see opportunities and threats as they emerge.9
One of the key threats a strategist must understand and
cope with is the environment in which their firm operates. In
this chapter you’ll learn about the forces that shape that environment, from the specific industry the firm competes in to the
larger, macroeconomic environment of competition. State Farm
competes in what has traditionally been a very stable industry;
however, changes among its customers, suppliers, competitors,
potential entrants, and substitute products all combine to create turbulence in its markets. Together, all five forces define an
industry’s structure and shape the competitive interactions—and
profitability—of companies within that industry. Even though
industries might appear to differ significantly, the principles that
determine the underlying drivers of profitability are often the
same. Outside forces, like a changing climate, help determine the
ultimate attractiveness of industries such as homeowners insurance. This chapter will help you to recognize the major threats
and opportunities that make up the competitive landscape,
both the industry forces and general macroeconomic forces that
drive industry attractiveness—and profitability.
As described in Chapter 1, strategy involves crafting a plan to create competitive advantage—
and superior profitability—in particular markets. This plan, however, is shaped by the landscape
in which the firm competes. A firm’s external environment provides both opportunities—ways of
taking advantage of conditions in the environment to become more profitable—and threats—
conditions in the competitive environment that endanger the profitability of the firm.10 Successful firms have a deep understanding of their environment and constantly scan the horizon
to see opportunities and threats as they emerge.11
One of the key threats a strategist must understand and cope with is competition. Often,
however, managers define competition too narrowly, as if it occurred only among today’s direct
Determining the Right Landscape: Defining a Firm’s Industry
competitors. Nokia was so focused on Microsoft as its key competitor in the 3G operating system
industry, and Motorola and Ericsson as its cell phone competitors, that it failed to effectively
prepare for Apple’s entry into the industry. Competition for profits goes beyond established
industry competitors to include four other forces that shape industry attractiveness and profitability: customers, suppliers, potential entrants, and substitute products. Together, all five forces
define an industry’s structure and shape the competitive interactions—and profitability—of
companies within that industry. Even though industries might appear to differ significantly, the
principles that determine the underlying drivers of profitability are often the same. The global
cell phone industry, for instance, appears to have nothing in common with the highly-profitable
soft drink industry or the low-cost airline industry (i.e., Southwest and JetBlue). But to understand industry competition and profitability in these and other industries we must analyze the
same five forces.
This chapter will help you to recognize the major threats and opportunities that make up
the competitive landscape, both the industry forces and general macroeconomic forces that
drive industry attractiveness—and profitability.
Determining the Right Landscape: Defining a
Firm’s Industry
The first strategic decision that most firms must make is to select the industry, and markets,
in which it will compete. The Strategy in Practice feature discusses the US government’s classification of industries.
A firm’s industry also determines which customers and which competitors will be part
of the firm’s landscape. The landscape is typically defined by: (1) the industry (or industries) in which a firm competes, and (2) the product and geographic markets within that
industry that the firm targets. For example, Nokia competes primarily in the cellular telephone manufacturing and operating system industries. Within the cellular telephone manufacturing industry, Nokia targets multiple product markets by selling a range of handsets,
from high-end smartphones to inexpensive basic phones. The company also targets multiple
geographic markets, focusing mainly on Europe and developing economies in the Middle
East and Africa.
Be careful about assuming that it is obvious which industry a company competes in. For
example, it seems obvious that Barnes & Noble competes in the book retailing industry and
Microsoft competes in the computer software industry. However, it may be less obvious that
those aren’t their only industries. In addition to operating systems, Microsoft also makes the
X-Box gaming system, so it competes in the gaming console industry as well as the PC operating
system industry. Barnes & Noble sells an e-reader, the Nook, that combines electronic books
with computer hardware. Amazon.com, Barnes & Nobles’ main book retailing competitor, not
only sells books and the Kindle e-Reader, but also sells web services competing with Microsoft
and a wide range of products online as a discount retailer competing with Walmart. Firms must
choose which markets to compete in, with many large firms choosing to compete in several at
the same time.
If managers do not properly define and understand their industry, they may be vulnerable to unseen competitors. For example, Nokia defined itself primarily as a mobile handset
manufacturer. As a result, managers failed to see computer hardware companies like Apple
and web search companies like Google becoming potential competitors—or potential partners.
(Nokia now uses Google’s Android operating system on its smartphones.) Their focus on preventing Microsoft from creating a dominant position in the mobile operating system industry
caused them to overlook Apple, a company that has consistently been the leader in innovative,
19
CH A PT E R 2
Analysis of the External Environment: Opportunities and Threats
Strategy in Practice
How the US Government Defines Industries
One tool that helps to define industries is the North American
Industry Classification System (NAICS), a series of codes
generated by the US government.12 These codes (formerly
referred to as SIC codes, for Standard Industrial Classification)
vary from two to seven digits, becoming more narrow with
increasing numbers of digits.
Table 2.1 provides the NAICS codes for State Farm. At the highest level the company competes in the Finance and Insurance sector, which includes banking, investment, and insurance companies.
It’s a broad industry, but the three-digit code narrows State Farm’s
industry to insurance. The four-digit level describes the extent of
State Farm’s business model. The five-digit level captures the company’s different product lines and the six-digit level provides more
detail about its casualty and property lines.
TA B L E 2 . 1
NAICS codes can be useful not just for helping to define an
industry but also for determining who the primary competitors and
stakeholders are, although in fast-changing industries, the NAICS
can sometimes lag behind changing technologies or changing customer demands. As we’ve seen, State Farm has to figure out a new
segment of buyers, people sharing their cars and homes with others, which is not yet reflected in the NAICS lines of business.
The choice of industries is important because not all industries
are created equal. The profits of an average firm in some industries
are substantially higher than profits of an average firm in other industries. Figure 2.1 shows the return on equity for a variety of industries
over a ten-year period. As you can see, the industry in which a firm
competes has a direct bearing on the profits earned by that firm.
NAICS Codes for State Farm
Code
Classification
52
Finance and Insurance
524
Insurance Carriers and Related Activities
5241
Insurance Carriers
52411
Direct Life, Health, and Medical Insurance Carriers
52412
Direct Insurance (except Life, Health, and Medical) Carriers
524126
Direct Property and Casualty Insurance
5242
Agencies, Brokerages and Other Insurance Activities
52421
Insurance Agencies and Brokerages
Varying Profitabilty of US Industries, 2018
60%
50%
40%
Return on Equity
30%
20%
10%
FIGURE 2.1
Tobacco
Renewable
Energy
Apparel
P&C
Insurers
Home
builders
Average
Soft Drinks
Airlines
Wireless
providers
–10%
Online
Retailers
0%
Railroads
20
Varying Attractiveness of US Industries, 2018
Source: Data from various sources, compiled by Aswan Damodoran, NYU Stern School of Business. Available at http://
pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html.
Five Forces that Shape Average Profitability Within Industries
21
user-friendly operating systems for a variety of platforms.13 At the time Apple didn’t make
phones, while Microsoft had announced plans to start making them. Because of how Nokia
defined their industry, it was easy for them to overlook Apple, a non-phone manufacturer.
Truly understanding an industry often begins by taking a customer-oriented view. Rather
than identifying the industry based on the product or service they produce (such as cell phone
handsets), firms should think carefully about the job that products do for customers. What
need does a product fill? Understanding customer needs can be very helpful in defining the
boundaries of an industry. If two firms have products that do the same job for customers—
that meet similar customer needs—then those two firms can be considered part of the same
industry. For instance, companies that meet the need for communication by manufacturing
mobile handsets, as opposed to mobile ham radios (long-range walkie talkies), compete in the
same industry.14 In the case of cell phones, changing customer needs broadened the boundaries of the industry, from primarily manufacturing hardware to including mobile operating systems and applications that allowed phones to do far more jobs for customers than just place a
phone call. This led to new competitors for Nokia, including Apple and Google.
Five Forces that Shape Average Profitability
Within Industries
Michael Porter, a well-known strategy professor at Harvard, identified five forces that shape the
profit-making potential of the average firm in an industry. As shown in Figure 2.2, those five
forces are (1) rivalry, (2) buyer power, (3) supplier power, (4) threat of new entrants, and
(5) threat of substitute products. The strength of each of these five forces (known as Porter’s five
forces15) varies widely from industry to industry. For instance, in the semiconductor industry,
the threat of substitutes is almost nonexistent, while in the carbonated soft drink industry it is
a significant threat. A careful analysis of the five forces is a powerful way for firms to discover
the threats and opportunities in their environments. We provide a tool at the end of this chapter to help you conduct a careful analysis of an industry’s five forces.
There are three basic steps involved in using the five forces analysis tool:
• Step 1: Identify the specific factors relevant to each of the five major forces. We describe
the factors that contribute to each of the five forces in the next five sections of this chapter.
• Step 2: Analyze the strength of each force. To what extent is it shaping the industry’s
attractiveness? The appendix at the end of the book lists several sources where you might
find the data you need to analyze each of the five forces.
• Step 3: Estimate the overall strength of the combined five forces to determine the general
attractiveness of the industry, the profit potential for an average firm in the industry.
Instructions for steps 2 and 3 are at the end of the chapter. Step 1, the factors relevant to
each of the five forces, is discussed next.
Rivalry: Competition Among Established Companies
Competition in an industry is sometimes referred to as war, with each company deploying as
many weapons in its arsenal as possible to gain greater profits. Because there are typically a limited number of buyers, each firm’s profits often come at the expense of other firms in the industry.
Each move by a firm provokes countermoves among competitors, resulting in a constantly shifting competitive landscape populated by winners and losers. (Chapter 11 explores how successful
firms manage that shifting landscape by planning for the countermoves of their rivals.)
Firms’ moves and countermoves can take many forms, including sales and promotions,
better quality or service, a wider variety of products, or lower prices. Not surprisingly, these
types of moves increase rivalry—the intensity with which companies compete with each other
rivalry Competition among firms
within an industry. Typically this
involves firms putting pressure
on each other and limiting
each other’s profit potential by
attempting to gain profits and/or
market share.
substitute A product that is
fundamentally different yet serves
the same function or purpose as
another product.
threats Conditions in the
competitive environment that
endanger the profitability
of a firm.
opportunities Ways of taking
advantage of conditions in the
environment to become more
profitable.
attractiveness of an industry
The degree to which an average
firm in the industry can earn
good profits.
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NEW
ENTRANTS
BUYER
POWER
COMPETITOR
RIVALRY
SUPPLIER
POWER
SUBSTITUTES
FIGURE 2.2
Analyzing Major Threats and Opportunities: The Five Forces Industry Analysis Tool
Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 86, 1
(January 2008), pp. 80–86.
for customers—which tends to squeeze the profit margins of most firms in an industry. Rivalry
among firms in an industry—for either rational or irrational reasons—is such an important
determinant of profitability that it is shown at the center of Figure 2.2.
The following seven factors are critical to understanding the intensity of rivalry in
an industry:
1. The number and size of competitors
2. Standardization of products
3. Costs to buyers of switching to another product
4. Growth in demand for products
5. Levels of unused production capacity
6. High fixed costs and highly perishable products
7. The difficulty for firms of leaving the industry
The Number and Relative Size of Competitors The more competitors there
are in an industry, the more likely that one or more of them will take action to gain profits at the
expense of others. Economists call an industry with a lot of competitors a fragmented industry.
In a fragmented industry, it is difficult to keep track of the pricing and competitive moves of
multiple players. The large number of firms responding to one another tend to create intense
rivalry. The same is true of the relative sizes of competitors. If firms are approximately the same
size, they tend to be able to respond, or retaliate, strongly to moves by rival firms.
Industries that are concentrated, as opposed to fragmented, have far fewer competitors
and tend to be dominated by a few large firms. In these industries, rivalry is typically much less
intense. Smaller competitors do not have the capability to respond to actions taken by large
firms, and the few large competitors are more aware of each other and less likely to risk actions
that may result in price wars.
Relatively Standardized Products Differentiated products, ones that boast different features or better quality, tend to engender loyalty in customers because they meet
Five Forces that Shape Average Profitability Within Industries
23
customer needs in unique ways. When products are standardized, or commodity-like, buyers are
less loyal to a particular brand and it is easier to convince them to switch brands. A rider may be
fiercely loyal to his or her Harley-Davidson motorcycle, for example, but willing to buy several
different brands of gas for the Harley. Firms that sell standardized products—manufactured products or materials that are interchangeable regardless of who makes them, like bolts and nuts,
rubber, plastics, or commodities such as coal, crude oil, salt, or sugar—often have to compete by
offering sales, rebates, or lowering prices. Price wars increase rivalry and decrease profits.
Low Switching Costs for Buyers Switching costs include any cost to the customer
for changing brands. Switching costs for buyers are related to the degree of product standardization. For a computer user, changing operating system or word processing software would
entail considerable switching costs because the user would need to (1) convert files to the new
software, and (2) learn how to use the new software. Switching from an iPod to another MP3
player might require music lovers to move all of their music files from iTunes to a different
music software. In contrast, most of us can change our brand of gum or candy bar without any
switching costs. The lower the switching costs, the easier it is for competitors to poach customers, thereby increasing industry rivalry.
Switching costs are a fundamental part of not just rivalry but also the other four forces:
1. Buyer power: If customers, or buyers, can easily switch firms, then buyers have increased
power.
2. Supplier power: If firms can’t switch suppliers easily, then suppliers have increased power.
3. New entrants: If buyers can easily switch to new companies attempting to enter the
industry, there is a greater threat of new entrants.
4. Substitutes: If buyers can switch to substitute products without much difficulty, firms face
an increased threat from those substitutes.
Slow Growth in Demand for Products or Services
When demand is increasing
rapidly, most firms can grow without taking existing customers from competitors. When growth
slows, however, firms can become desperate. They may try to increase their sales volume by
attracting customers from their competitors through sales promotions, price discounts, or
other tactics.16 Of course, competitors then respond with their own sales promotions and price
cuts, thereby increasing industry rivalry. Consider the flat-screen television industry. When
large, flat-panel displays were first introduced, prices were high. They remained that way for
years while industry growth exploded. As flat-panel manufacturers anticipated slower growth,
from 18 percent in 2010 to 4 percent in the first half of 2011, they dropped prices by more than
25 percent in the last quarter of 2010 in a bid to gain what market share they could from their
competitors.17
High Levels of Unused Production Capacity Unused production capacity is
expensive. Firms typically try to produce at or near their full production capacity so that they
can spread the fixed cost of factories, machinery, and other means of production across more
units. In fact, they may try to produce more product than the market demands, in order to use
their capacity completely. However, when more is produced than is demanded in the market,
firms often have to drop their price or risk having unsold product. This has frequently been the
case in the automobile industry. During an economic downturn, automakers offer price cuts,
rebates, and special sales incentives to buyers so that they don’t have significant unused production capacity or lots of older-model cars left to sell when new ones are produced.
High Fixed Costs, Highly Perishable Products, High Storage Costs Industries that produce or serve products in these three categories sometimes find themselves with
a supply of products that they have to sell quickly or take large losses on. For example, airlines
operate with high fixed costs. Most of the cost of a flight is in the airplane, the fuel, and the
pilot and flight attendants. It is not in the cost of serving an additional passenger. The marginal
switching costs Barriers that
help keep buyers using the same
supplier by imposing extra costs
for switching suppliers.
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cost of adding an additional passenger is truly only peanuts (and a drink). If it appears that a
scheduled flight is going to have few passengers, an airline may be tempted to discount steeply
in order to fill as many seats as possible. The variable cost of an additional passenger is very
little, so selling a seat for less would not cost the airline money, but leaving it empty would
mean the airline has fewer passengers over whom to spread its fixed costs.
Firms that sell highly perishable products, such as fruits or vegetables, face similar problems. As food nears the date when produce will spoil, grocery chains often steeply discount it
rather than lose the sale completely. Products with high storage costs exhibit the same characteristics. If firms have an oversupply and are forced to store the product, they may discount the
price to avoid storage costs. In all three cases, steep discounting leads to increased rivalry as
competitors are forced to respond with discounts of their own or be left with losses while others
recoup their production costs.
High Exit Barriers In some industries, companies don’t exit even when they aren’t
making a lot of money. Most often, they stay because they have made investments in specialized equipment that can’t be used in any other industry. For example, steel blast furnaces are
very expensive and cannot be used in any industry other than steelmaking. If the firm exits
the steel industry, its blast furnaces lose most of their value. Another barrier to exit is labor or
government agreements that make it difficult to close a plant. Emotional ties to employees or
a business can also lead to less than rational decisions by top management to stay in business.
Buyer Power: Bargaining Power and Price Sensitivity
supplier A firm that provides
products that are inputs to
another firm’s production process.
When buyers have sufficient power, they can demand either lower prices or better products
from their suppliers, thereby hurting average profitability of firms in the supplier industry. The
two primary situations in which buyers have high power are when buyers hold a stronger bargaining position than sellers and when buyers are price-sensitive. The strength of a buyer’s
bargaining power or price sensitivity can be affected by a number of factors. When firms understand what causes buyers to have power over their industry, they have a better chance of countering that power.
Buyer Bargaining Power Four key factors influence the degree to which buyers have
bargaining power over their suppliers. We already discussed two of these factors—buyers’
switching costs and demand—because they are also factors in rivalry among firms. The two
remaining factors are the concentration and size of buyers and the threat that buyers can
backward integrate:
• Number, or concentration, and size of buyers: Buyer concentration reflects the law of supply
and demand. If there are few buyers but many sellers, then the sellers must compete
more strongly for buyer business. Sellers in this situation are likely to give concessions to
make the sale. Likewise, the larger the number of buyers, compared to sellers, the more
likely sellers are to increase the level of competition in order to gain buyers’ business. For
example, farmers, as suppliers to the frozen-food industry, are not very concentrated. The
three largest farmers account for only about 1 percent of all food produced and sold. Frozenfood makers, however, are concentrated. The top four (Nestlé, Schwan, ConAgra, and H.J.
Heinz) accounted for nearly half (48.6 percent) of total market share in their industry in
2010.18 This means that frozen-food manufacturers, as buyers, have a great deal of power
over farmers. A farmer who needs the business of the big four frozen-food makers in order to
sell this year’s crop may be willing to accept a lower price in order to secure their business.
backward integration A firm
purchases one or more of its
suppliers in order to make a
product itself rather than buying it
from another firm.
• Credible threat of backward integration: In some cases, a buyer can exert pressure over
suppliers by threatening them with backward integration, meaning they will make the
product themselves. For example, one way Walmart keeps prices low for consumers is by
threatening to expand its Sam’s Choice store brand products into additional categories if
manufacturers of other branded products don’t meet Walmart’s pricing demands.
Five Forces that Shape Average Profitability Within Industries
Buyer Price Sensitivity In general, when buyers are more price-sensitive, they are
more likely to exert pressure on suppliers to keep prices low. Buyers exert pressure not just
through price negotiation but also through more comparison shopping and a greater willingness to switch suppliers. Buyer price sensitivity tends to increase in the following situations:
• Buyers are struggling financially: When companies, or consumers, are struggling financially, they are more likely to be price-conscious and to look for less expensive sources of
supply. If many of an industry’s buyers are in the same situation, there is a cap on what
suppliers can charge.
• Product is significant proportion of buyer’s costs: Buyers tend to care more about getting a
good price when the product they are buying creates a large part of the costs of their own
production (or their budget, if the buyers are the end consumers). If the product is only a
small part of their cost structure, buyers are less likely to bother negotiating or comparison
shopping. For instance, end consumers are less likely to do extensive comparison shopping
for a gallon of milk than they are for a home or car. Likewise, auto manufacturers are less
likely to pressure suppliers of electrical wiring for price cuts than suppliers of steel or
engine components.
• Buyers purchase in large volumes: When buyers purchase in large volumes, they typically
expect to get breaks in price. In essence, the buyer is taking a risk by being willing to buy
large amounts at once rather than smaller amounts over time.
• Product doesn’t affect buyers’ performance very much: If a product is very important to
the quality of the buyers’ end product, then buyers tend not to be very price conscious.
For instance, when Nokia had the most innovative handsets on the market, many cellular
phone carriers, like Verizon and T-Mobile, were willing to pay whatever Nokia charged in
order to be able to offer Nokia phones to their customers. However, if suppliers’ products don’t affect buyers’ quality or performance very much, then buyers are much more
likely to be price conscious. For instance, the plastic casing on tablet or laptop computers
doesn’t enhance the performance of the computers very much; it doesn’t drive sales to
the end consumer. As a consequence, PC manufacturers are likely to shop around for
price discounts on plastic casings in ways that they might not for the microprocessors
that run the computers.
• Product doesn’t save buyers money: If a product saves buyers money, they tend not to
be very price-conscious when purchasing it. These types of products can be anything
from machinery in manufacturing industries that replaces highly skilled, costly labor to
inexpensive, overseas labor that replaces more expensive labor or machinery in countries
such as the United States. If a product does not save buyers money, however, buyers are as
likely to be price conscious as they are with other types of products they buy.
Supplier Bargaining Power
The factors that increase the bargaining power of suppliers are very similar to those that
increase the bargaining power of buyers. In this case, however, the firms are not customers
but suppliers, those from whom your industry purchases inputs. When supplier industries have
strong bargaining power, they can charge higher prices, which tends to decrease average profitability in a buyer’s industry. As firms understand the factors that give suppliers power, they may
be able to make decisions that decrease that power.
Number, or Concentration, and Size of Suppliers As with buyer concentration,
supplier concentration also follows the law of supply and demand. If there are few sellers
but lots of buyers in an industry, then the buyers have to compete to get the products that
they want, often paying higher prices to get sufficient supply. Likewise, the larger the number
of sellers compared to the buyers, the less likely buyers are to pay the price that sellers are
demanding.
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For instance, ARM, a designer of semiconductor chips for smartphones, has, for years,
controlled upwards of 95 percent of the market for its product,19 resulting in a highly concentrated supplier industry dominated by one large firm. As a consequence, Nokia, or any other
smartphone handset manufacturer that wants a sufficient supply of chips, and wants the highquality chips that won ARM its market share in the first place, has to buy from chip manufacturers who license from ARM. ARM has sufficient power that it can, to a large degree, set the
price for its product. Suppliers who charge more often squeeze the profits of buyers, who may
not be able to pass additional costs through to their customers. In fact, ARM’s rise to power in
the mobile semiconductor chip industry is a major contributor to Nokia’s current difficulties.
Nokia cannot charge enough for its low-cost handsets to make a good profit after paying for
expensive ARM chips.
forward integration A firm goes
into the business of its former
buyers, rather than continuing to
sell to them.
Credible Threat of Forward Integration
In some cases, a supplier can exert
pressure over its buyers by threatening them with forward integration, doing what its buyers
do, if the buyers don’t offer price concessions. A good example of this is Google and its decision
to forward integrate into the smartphone handset industry by manufacturing its own phones.20
Google also licenses its Android operating system to other handset makers, such as HTC and
Samsung. Google’s ability to forward integrate, even if they don’t sell many phones, gives
Google power over those handset makers. When there is a credible threat of forward integration,
buyers are often willing to take a cut in profit by paying higher prices, rather than risk losing the
supply altogether and creating a new rival (if the supplier hasn’t already forward integrated).
Threat of New Entrants
barriers to entry The way
organizations make it more
difficult for potential entrants to
get a foothold in the industry.
As previously shown in Figure 2.1, not all industries are created equal. Industries in which the
average firm is making good profits can often be targets, enticing firms from outside those
industries to enter. Likewise, quickly growing industries are often attractive, which increases
the incentive for outside firms to enter those industries. One of the important tasks for strategists is to identify firms that might enter their industries. New entrants pose a double hazard.
First, they typically are anxious to gain market share.21 Unless the industry is growing quickly,
that market share must come at the expense of existing firms. Second, new entrants bring new
production capacity, which tends to drive prices down unless demand is growing faster than
the increase in supply.
New entrants mean greater rivalry, so existing firms often try to discourage new entrants
by building barriers to entry. The higher the barriers to entry, the more difficult it is for potential entrants to get a foothold in the industry, and the more likely that they are to quit or choose
to not enter in the first place. Likewise, incumbent firms, those already in the industry, often
signal new entrants that they are likely to retaliate by slashing prices, increasing advertising, or
other competitive moves that help the established firms hold on to their market share. If the
threats of retaliation are perceived as credible, potential entrants might decide to stay away.
It is essential for firms to understand the barriers to entry that already exist in their
industry and to consider ways of increasing them. Existing firms may also want to build new
barriers. Firms that are considering going into an industry can use an analysis of the barriers
to entry in the target industry to help them determine how likely they are to succeed if they
attempt to enter.
Economies of Scale, Experience, or Learning
These types of economies occur
when the cost per unit of production (the cost for producing each individual product or service)
decreases as a firm produces more. Typically, these economies come from mass manufacturing
methods, discounts through purchasing in high volumes, employees becoming quicker and
better at production, and being able to spread the fixed costs of production machinery, R&D,
advertising, and marketing across more units.22 Chapter 4 will explore these three types of cost
advantages in greater detail. In essence, lower costs allow the firm either to lower its price,
perhaps in retaliation for a new firm entering the market, or to maintain its price while earning
more profits than competitors.
Five Forces that Shape Average Profitability Within Industries
When economies of scale, experience, or learning exist in an industry, new firms will be at
a cost disadvantage. New firms are not likely to have as much market share as existing firms, so
they will not produce as much and can’t achieve the same economies as existing firms. Some
firms may not be able to lower their prices sufficiently to match incumbent firms’ prices. Other
new entrants may match incumbent prices, but earn smaller profit margins than the incumbents. The higher the economies of scale, the greater the barrier to entry and the easier it is for
the larger incumbent to pose a credible threat of retaliation.
If conditions change so that cost savings from these economies become smaller, the
barrier diminishes. For example, from the late 1980s until the early 2000s, the cell phone
handset manufacturing industry possessed high economies of scale. Nokia produced millions
of handsets per year during this time and had the lowest costs of its competitors. Consequently, the number of firms in the industry was relatively stable during this period. However,
the invention of flexible manufacturing processes, coupled with the rise of low-cost, highlyskilled labor in China in the mid-2000s, lowered the cost savings that could be achieved from
high levels of production and allowed thousands of new Shanzhai manufacturers to successfully enter the industry.
Other Cost Advantages Not Related to Scale
Incumbent firms might have cost
advantages relative to new entrants for a variety of reasons besides economies of scale. These
include the following:
1. Patents or proprietary technology, such as those that exist in the pharmaceutical industry
2. Better locations, a deterrent to firms wishing to enter markets where Starbucks is dominant, for example
3. Economies of scope, less expensive costs per unit created by bundling different types of
products. For example, Procter & Gamble has low-cost marketing and distribution costs,
compared to firms that manufacture only one type of product, because P&G ships dozens
of different types of products to the same retailers. (See Chapter 4 for a more detailed
explanation of economies of scope.)
4. Preferential access to critical resources, such as raw materials or access to distribution networks. For example, Chinese makers of lithium ion batteries have government-protected
access to sources of rare earth elements, raw materials that are necessary for battery production. In many industries, new entrants face high barriers in the cost of building a dealer
network or recruiting retailers to sell their products. With a limited number of potential
dealers and retailers, new entrants often find themselves having to cut prices, and profit
margins as well, to secure access to distribution.
As with economies of scale, it is important for firms to track whether barriers are rising or
falling. An expiring patent or the advent of an innovative distribution channel, such as the Internet, has the potential to radically change the strength of barriers related to cost advantages.
Capital Requirements
It costs money to enter a new industry. Not only do potential
entrants often need capital to build a factory or store, but they may also have to invest in R&D
to generate viable products, build inventory, undertake sufficient advertising and marketing to
take market share from incumbent firms, and have sufficient cash on hand to cover customer
credit. Anything that increases the start-up costs will reduce the pool of possible entrants. For
instance, the computer semiconductor chip industry, dominated by Intel, makes a very complex product. New entrants would need to spend years of R&D before they had a viable product and could make their first sale. The high capital requirements needed for long periods of
R&D limit the number of entrants to those with enough financial or other resources to enter.
However, firms that already have made R&D investments in similar products, such as semiconductor chips for mobile phones, could lower the capital costs associated with entering the
computer semiconductor industry. It is likely no coincidence that ARM, the maker of mobile
semiconductor chips, is one of only a few successful entrants into Intel’s industry in the last 30
or more years.
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Network Effects
network effects Growth in
demand for a firm’s product
that results from a growth in the
number of existing customers.
In some industries, network effects increase the switching costs for customers, making it more difficult for new entrants to take business from incumbent firms. When
network effects are in operation, the greater the number of people using products from a
given firm, the greater the demand grows for that firm’s product. For example, the more people
who use a particular social networking site, the more customers want to continue to use the
site, and the more new customers are likely to try it. A new entrant wanting to compete with
Facebook is at a distinct disadvantage, because most of their potential customers’ “friends” are
likely to be on Facebook, making it less likely that they will be willing to switch to a new social
media site. For new entrants to compete with a firm like Facebook they have to be innovative
enough to attract large numbers of users quickly, creating their own network effect.
Government Policy Restrictions
Finally, government policies may make it more
difficult to enter a market or even restrict a market completely to new entrants. For instance,
governments often raise the costs of entry by requiring bonding, licenses, insurance, or environmental studies before a firm can enter an industry. New entrants will have to use capital
that might have been used for R&D, production, or advertising to meet those requirements.
When competing across international borders, additional regulations, such as trade restrictions and local content requirements, may be applied to try to limit foreign competition. In
some industries, such as hairstyling, the requirements might be fairly minimal, but in others,
such as oil refining, they can become so onerous that most new firms cannot overcome
the barrier.
Threat of Substitute Products
A substitute is a product that is fundamentally different yet serves the same basic function
or purpose as another product. One of the primary problems for the strategist in assessing
substitutes is determining what is a substitute and what isn’t. It involves determining the
boundaries of an industry, as we addressed earlier in the chapter, and then scanning other
industries to find products that might serve the same basic functions. For instance, e-mail
is a substitute for telephone messages, faxed documents, or documents delivered via the
post office. All four are ways of delivering messages. Similarly, fruit juice is a substitute for
any number of other drink products, including coffee, wine, and soda. Generally, something
can be considered a substitute if it serves the same function, such as quenching thirst, but
does so with a different set of characteristics. If the product has the same basic characteristics and is made using the same general set of inputs, it would be considered part of rivalry,
rather than a substitute. For instance, competitor brands serving the same basic need, such
as Apple’s iPhones and Samsung’s smartphones running Google’s Android operating system,
are rivals, not substitutes.
In general, substitutes put downward pressure on the price that firms in an industry can
charge. For instance, streaming video across the Internet is a substitute for watching movies in
the theater. Even if you had the only movie theater in an area, you could not charge whatever
price you wanted to. As your price rose, more customers would switch to streaming video. If
the price difference is enough, customers will stream even though the quality is lower and they
have to wait weeks or months before the movie leaves the theater and is available online. For
some industries, such as newspapers, the low price of the substitute—in this case, free news
on the Internet—can be disastrous, creating such a low cap on the prices they can charge that
many firms go out of business. The factors that determine the intensity of a threat of substitutes
include the awareness and availability of substitutes and their price and performance compared to an industry’s products.
Awareness and Availability Sometimes customers aren’t readily aware that substitutes exist. The threat increases when substitute products are well known. This is particularly
true if there are strong brands among the substitute products. Likewise, if the substitute product is just as easy for customers to obtain as the industry’s products are, it is more of a threat. If
the substitute is difficult to find or acquire, the threat is diminished.
Overall Industry Attractiveness
Price and Performance
A significant part of the customer decision to switch to substitutes will concern the price and performance trade-offs. As we discussed earlier in the chapter,
customers are more likely to switch to a substitute if the costs of switching are low. The price
of the substitute itself also factors into customers’ decisions. If substitutes are cheaper than
products from another industry, the threat is higher. Likewise, if the performance of substitutes
is similar or better, the threat is higher. The closer the substitute is in performance, the less
flexible a seller can be with price. For instance, many newspapers have seen steep declines
in circulation as Internet news has gained in quality. The Wall Street Journal, however, has
not declined in circulation over the same time period because online substitutes for serious
business news have not increased in quality nearly as fast as for other types of news.
Overall Industry Attractiveness
Understanding the five forces that shape industry competition is useful as a starting point for
developing strategy. Indeed, managers often define competition too narrowly, as if it occurred
only among direct competitors. Yet competition for profits goes beyond direct rivals to include
buyers, suppliers, potential entrants, and substitute products. The extended rivalry that results
from all five forces defines an industry’s structure and shapes the nature of competitive interaction within an industry. Every company should know what the average profitability of its industry
is and how that has been changing over time. The five forces help explain why industry profitability is what it is—and why it might be changing. Attractive (profitable) industries are those where
firms have created power over buyers and suppliers, created barriers to entry to reduce the threat
of new entrants, and minimized the threat of substitutes while keeping rivalry to a minimum.
Even inefficient, relatively poorly run companies can earn superior profits under such conditions.
At the other extreme are unattractive industries. Firms in these industries are consistently
pressured by buyers and suppliers alike. They face high rivalry, easy entrance for new competitors, and many well-positioned substitute products. Under these conditions, only the most
efficient, well-run companies are able to turn a profit. Each of the five forces can be analyzed to
determine how, and the degree to which, it contributes to industry attractiveness.
We provide a strategy tool at the end of this chapter for analyzing each force. After doing an
analysis of each force, these can be combined to develop a detailed picture of what is driving
the overall profitability—the attractiveness—of the industry.
Few industries will rate high (attractive) or low (unattractive) on all forces. A significant
threat from just one or two of the five forces is often sufficient to destroy the attractiveness of
an industry. For example, many firms in the auto industry have struggled to be profitable over
the last decade. This industry, however, has relatively low buyer and supplier power, no real
threat of substitutes, and a moderate threat of new entrants. Rivalry, however, has been fierce,
with constant excess production capacity and price discounting. Sometimes, it only takes
one of the five forces to be unattractive to make an industry struggle. When many of the five
forces are unattractive, firms face great challenges maintaining profitability. However, understanding each force and how it is influencing profitability helps managers know where to focus
in dealing with those challenges. Moreover, a company strategist who understands that competition extends well beyond existing rivals will perceive wider competitive threats and be better
prepared to address them. At the same time, thinking comprehensively about an industry’s
structure can uncover opportunities to improve performance on each of the five forces, thereby
becoming the basis for distinct strategies that yield superior performance.
One thing to keep in mind is that the five forces are subject to change. Each of the five
forces can be altered by actions taken by firms inside or outside the industry. For instance,
Google built the Android operating system, even though it gives it away for free, to increase the
number of suppliers for its search engine, thus decreasing the supplier power that Apple might
have earned had it been able to dominate the smartphone industry. A good strategist always
has her eye on actions and trends that might change any of the five forces in her industry. Not
all of those trends come from actions taken by firms close to the industry. Some come from the
general environment. These are discussed in the next section.
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Where Should We Compete? New Thinking
About the Five Forces and Industry
Attractiveness
Strategists have long argued that where you compete is the starting point for strategic analysis.
The traditional answer to this question has been to use the five forces model we just studied to
compete in attractive (i.e., profitable) industries or markets characterized by high bargaining
power over suppliers and buyers, low threats of substitutes or new entry, and low rivalry. This
traditional argument is reflected in the recent best seller Playing to Win, by prominent strategists A. G. Lafley and Roger Martin, who argue, “Porter’s five forces help define the fundamental
attractiveness of an industry and its individual segments.”23 We agree that the five forces model
describes the kind of industry or market you’d like to create or compete in, and it remains an
excellent model that firms all over the world use to keep tabs on the industry and markets they
compete in and to get guidance about what tactical moves they can make to increase profitability in their industry.
Executives, however, have to choose markets to compete in before they enter. This is where
new thinking turns the five forces a bit upside down. Traditionally, you would give executives
the advice to enter industries or markets that are rated “attractive” by the five forces. But the
success of their choice to enter is determined almost completely by the unique value the firm
hopes to offer and the resources and capabilities (these concepts will be covered extensively in
Chapter 3) it has to deliver that unique value. Thus, whether a market is attractive may depend
more on what the entrant can offer to that market rather than the structural characteristics of
the market. To use a popular idiom: “Beauty is in the eye of the beholder.” Or, in other words,
unattractive markets according to traditional industry analysis may be quite attractive to the
right kind of entrant.
By almost any measure of attractiveness, the automobile industry is not an attractive
industry to enter. Entry barriers are enormous, bargaining power over customers is minimal,
rivalry is high, and average profitability is quite low. No wonder there hasn’t been a successful US-based company entrant since Chrysler in 1925. Yet in 2008, during the Great Recession
while the US government was bailing out GM and Chrysler to the tune of $80 billion24 Tesla,
a California-based firm, entered anyway. They entered an unattractive industry at the depths
of its unattractiveness—typically, a foolhardy strategic decision. Tesla entered the automobile market with the Roadster, a pricy, beautifully designed, battery electric (BEV) sports car.
They followed with the Model S and Model X—both targeted at wealthy individuals with a penchant for fast cars and a desire to reduce carbon emissions and US dependence on foreign oil.25
Within nine years of entry, by February 2017, Tesla had generated a market value of more than
$44.6 billion—double that of Chrysler and closing in on the 114-year-old Ford26—all in an “unattractive” industry.
Where successful companies choose to compete doesn’t depend so much on the historical profitability or structural attractiveness of the market. Rather, it is fundamentally tied to
what unique value they can offer, what capabilities they have, and whether they can prevent
imitation (all concepts covered more fully in Chapter 3). For industries that are not attractive
from a five-forces perspective, successful entry requires offering a unique value proposition
with unique resources and capabilities. If you use an approach that mimics what incumbents
are doing, your profits will be poor—just like incumbents. Nucor entered the unattractive steel
industry, but did so in a radically different way. It used Mini-Mill technology and sourced scrap
steel, rather than the traditional enormous steel production plants using iron and coke as their
raw materials. Nucor was, and is still, able to produce steel at a much lower cost and to be highly
profitable at a time when many US steel manufacturers have gone out of business.27 Markets
that are unattractive from a five-forces perspective can still be attractive to new entrants—but
only when they offer unique value.
How the General Environment Shapes Firm and Industry Profitability 31
On the flip side, it is also important to understand that attractive markets from a five-forces
perspective are typically unattractive for new entrants. In an article for Harvard Business Review
(see “Strategies to Crack Well Guarded Markets”), we reported that, on average, new entrants
into highly profitable (attractive) markets were 30 percent less profitable than new entrants into
unattractive markets (i.e., in general, it is easier for new entrants to make money in unattractive
industries than attractive ones).28 The reason? Barriers to entry made it difficult for the new
entrant to establish itself. So, on average, an attractive market (from a five-forces perspective)
is actually the least attractive market for a new entrant. But wait. We also found that when new
entrants did achieve profitability in the most attractive markets, they were four times as profitable
as the average profitable entrant elsewhere. For example, the beverage industry has historically
been a high-profit industry (indeed one of the most profitable)—but one with high barriers to
entry. So according to the logic we’ve been discussing, it should be an unattractive market for
new entrants. Walmart, however, decided to enter anyway—offering consistently low prices with
its Sam’s Choice brand. We won’t spell out exactly how Walmart did it because those barriers to
entry are part of the Coca-Cola and Pepsi case that is a companion to this chapter. Suffice it to
say that Walmart was able to overcome each element of the barriers to entry that Coca-Cola and
Pepsi had painstakingly erected over decades. By figuring out how to circumvent the entry barriers, Walmart was able to grab almost 5 percent share in an attractive market, indeed in one of
the most attractive markets from a five-forces perspective. The point is that if firms figure out how
to circumvent the barriers to entry into an attractive market, it can be profitable even if they aren’t
able to enter with a particularly unique value proposition (Sam’s Choice Cola isn’t all that unique).
Finally, we’ve learned that industries as we’ve historically defined them (e.g., automobiles,
medical equipment, computers, cell phones, etc.—think about the NAICS codes we covered at
the beginning of this chapter) are becoming somewhat irrelevant as it relates to finding attractive markets to compete in (it is not irrelevant to understanding the dynamics of an industry you
are already in). In deciding where to compete (i.e., which markets to enter), it is helpful to be as
specific as possible rather than using broad generalities such as industries as they have historically been defined. In fact, as Harvard business professor Clayton Christensen has suggested,
you compete at the “job to be done” level (if you truly understand the functional, emotional,
and social needs of your customer segment, the task of offering unique value becomes much
easier).29 Tesla started in the automobile industry by targeting wealthy individuals who loved
fast cars but also had a desire to be green. Customers purchased a Tesla not just because it
solved a functional need (transportation, rapid acceleration/speed) but also an emotional need
(“I want a green world”) and a social need (“I want to be part of the Tesla community and want
others to know about my social consciousness”). Now Tesla has added in-home battery charging stations and roof-mounted solar panels for homes. So from a historical perspective, Tesla
is now in the roofing segment of the home construction industry as well as being in the automobile industry. One could say that Tesla is in the energy industry at a very high level—which is
true. But it has expanded into roof tiles and battery-charging stations to do a particular job for
a very specific segment of customers: provide a convenient one-stop shop for clean energy at
home and on the road for individuals who want a green world.30 When the industry is defined
at the “job to be done” level, it then makes it easier to identify what other companies are also
trying to do at that specific job (competitors) and what substitutes exist for that job.
How the General Environment Shapes Firm
and Industry Profitability
To determine the landscape that a firm competes in, it isn’t enough to only understand the five
forces that directly affect an industry. The general environment also needs to be understood, as
it can affect firms in a variety of ways,31 including affecting the shape of each of the five industry forces. A simple way to think about the general environment is to break it down into eight
32
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Analysis of the External Environment: Opportunities and Threats
categories. Strategic managers in the best companies are focused on each of these categories,
looking for trends that might lead to new opportunities or threats. This is illustrated in Figure 2.3:
• Complementary products or services
• Technological change
• General economic conditions
• Population demographics
• Ecological/natural environment
• Global competitive forces
• Political, legal, and regulatory forces
• Social/cultural forces
Developments in each of the eight categories shown in the outer ring have the potential
to shape and change the general landscape for any specific industry. Each category can affect
an industry’s dynamics, which are shown by the area within the center circle, altering any or all
of the five forces. You should always keep in mind that an industry’s five forces are not static.
The five forces are subject to change and may change, even radically, if elements of the general
environment change. When you are examining the general environment, it is important, then,
to not just get a picture of what things look like today but to analyze trends and the direction
each category is headed toward tomorrow. Remember, as well, that this analysis is industry
specific. You want to know how each of the eight categories is going to affect the industry you
are studying, rather than how it might affect a single firm. Both levels of analysis can be useful.
But at this stage you want to know how the general environment might affect the five forces,
potentially giving you advance notice of what is going to change in your industry and a chance
to plan accordingly.
THE GENERAL ENVIRONMENT
Complimentary
Products/Services
NEW
ENTRANTS
Social/Cultural Forces
Political/Legal/
Regulatory
Forces
Global Forces
BUYER
POWER
COMPETITOR
RIVALRY
Technology Change
SUPPLIER
POWER
SUBSTITUTES
Ecological/Natural
Environment
FIGURE 2.3
Trends in Opportunities and Threats in the General Environment
General
Economic
Conditions
Demographics
How the General Environment Shapes Firm and Industry Profitability 33
The relative importance of each of the general environmental factors differs from industry
to industry. In the fast-food industry, social forces, such as a shift toward healthier eating, are
likely to significantly alter the threat of substitutes, but technological change doesn’t play as
large a role. In the motorcycle manufacturing industry, demographics play a key role, as many
industrialized nations experience an upward trend in the average age of the population, but
changes in societal perceptions of motorcycles don’t appear to be shifting quickly, resulting in
fewer people riding because of their age rather than a societal shift in the perception of motorcycles. Managers need to develop a deep sense of which environmental factors are strategically
relevant to their own industries.32 Managers need to understand not only which factors have
the largest impact on their industry right now, but also which factors are likely to change in the
future, so that they can adapt their firms’ strategies to changing conditions.
Complementary Products or Services
Complementary products or services are those that can be used in tandem with those in
another industry. For example, video gaming hardware and software, or smartphone operating
systems and Apps, are complementary sets of products. When two complements are used
together, they are worth more than when they are used apart. Complementary pairs or groups
(also called ecosystems) of products can be found in many places, not just in the technology
sector.33 Gas stations and roads are complements to automobiles, and piping is a complementary product to natural gas. Trends in complementary industries have the potential to radically
alter—for better or worse—the landscape in which firms compete.
Take the rise of application software (Apps), for instance. In the 1990s, Microsoft created
tools for software designers. By doing so, Microsoft lowered the barriers to entry in the application software industry, a complementary industry to operating systems. Apple made it even
easier to enter the App industry by releasing segments of its operating system code, creating
even more new entrants and sparking the rise of single-purpose, inexpensive Apps for mobile
computing devices. Now, customers at Apple’s App store can choose from hundreds of thousands of Apps for their iPhones.
The number of new entrants in the App industry is actually increasing the barriers to entry
in the smartphone operating system industry. It would be difficult for a new mobile operating
system to come on the scene and compete with Apple or Android. Even powerful Microsoft has
experienced challenges entering the mobile operating system business even though it had a
head start over Apple and Google.34 For many industries, changes in complementary products
are one of the most important trends to keep an eye on. Some consider them significant enough
that they even refer to them as a sixth force among the five industry forces.35
Technological Change
Technological change within an industry has the potential to radically reshape a firm’s landscape, and sometimes society with it. Technological changes can include new products, such
as smartphones; new processes, such as hydraulic fracturing (fracking), which has dramatically
increased the output of the natural gas industry; or new materials, such as lithium batteries,
which make electric automobiles possible. In many industries, the pace of technological change
has accelerated over the last couple of decades.36 Managers find it increasingly important to
consistently scan the environment to locate potential new technologies that might affect their
industries.37 Early adopters are often able to gain greater market share and earn higher profit
margins than those who are late to adopt, suggesting the importance of incorporating new
technologies early.
Not only can technology change the nature of rivalry in an industry by giving some firms
an upper hand in gaining market share, but it can sometimes lower barriers to entry. For instance, flexible manufacturing processes have allowed Shanzhai handset makers to nearly
match Nokia’s cost of manufacturing cell phones. Even in low-technology industries such as
steel, new technology can sometimes pave the way for new entrants. In the 1970s, a new technology for smelting steel called the electric arc oven allowed new firms, such as Nucor, to enter
complementary products or
services Products or services that
can be used in tandem with those
from another industry.
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the industry with only one-tenth the capital investment that would have been needed to start
a traditional steel firm. Perhaps the technological change that has affected the threat of new
entrants in the greatest number of industries in the last 20 years is the Internet. Some have suggested that the next giant wave of technology change, one we are in the middle of experiencing,
is wireless communication, like smartphones, which allow individuals to connect to and from
anywhere and anyone at any time; and the coming 5G wireless revolution, which promises to
allow those connections to occur at speeds that truly allow connection to and from anything
and anyone, at anytime, and from anywhere no matter how much data is being transmitted.38
General Economic Conditions
Changing macroeconomic forces can also have a large impact on industries. The state of an
economy can affect a region or nation and, subsequently, the ability of the average firm in an
industry to be profitable. Analyzing the economic environment typically involves measuring
the economic growth rate, interest rates, currency exchange rates, and the rate of inflation or
deflation. The appendix provides a list of sources where you can find information on these economic indicators.
Economic Growth
How quickly, or slowly, an economy is growing has a direct impact on
most firms’ bottom line. Economic expansion tends to improve customer balance sheets, lower
price sensitivity, and increase the growth rate in an industry, as customers purchase more, easing rivalry. For example, a number of African nations, such as Nigeria and Kenya, have experienced solid levels of economic growth in the last few years.39 As a consequence, a growing
percentage of the population has sufficient disposable income to afford products like automobiles and cell phones. Companies providing products like these in Africa have experienced a
boom in customer demand.40 The reverse is also true. When an economy slows down, industry
growth rates slow, customers are more price sensitive, and suppliers are also likely to be struggling and pursuing ways of increasing profits—at the expense of firms in your industry, if they
have the power to do so.
Interest Rates
Interest rates particularly affect rivalry by increasing or decreasing the
demand for an industry’s products. This is particularly true for expensive items like housing,
cars, and even education, which often require customers to take out loans to purchase. For
example, the housing boom experienced in the United States and Europe in the early 2000s
was fueled by low-interest-rate loans, sometimes below 4 percent, when the average mortgage
interest rate in the previous decade had been above 6 percent. When interest rates are low,
industry growth rates increase and rivalry decreases. When interest rates are high, the opposite
can occur. In addition, interest rates affect the cost of capital. When interest rates are low, many
firms can afford to invest in new assets. As interest rates increase, new investments become
more difficult. As a result, firms sometimes engage in price wars as a strategy for gaining market
share when rates are high, rather than investing in R&D and new product development.
Currency Exchange Rates Currency exchange rates reflect the value of one country’s
currency in relation to the currency from another country. Exchange rates can have a large
impact on the prices that customers pay for products from firms in other countries, directly
affecting profitability for those firms. For instance, from mid-2010 to mid-2011, the Swiss franc
appreciated 65 percent against the US dollar, making Swiss products 65 percent more costly
in the United States, even though the cost of production hadn’t changed at all. Nestlé, a Swiss
firm, was particularly hard hit. It either had to decrease its profit margin to cover the extra cost
or increase its prices substantially, risking fewer customers buying its products.
Inflation
A significant, consistent rise in prices, known as inflation, can create many
problems for firms. Inflation, or the opposite, deflation, means that the value of the dollar
doesn’t stay constant. Today, a product may cost $1. If inflation is at 2 percent a year (low
How the General Environment Shapes Firm and Industry Profitability 35
inflation), then next year that product will cost $1.02. If it is higher, though, say 30 percent,
which is not unheard of around the world, the product would cost $1.30 next year and $1.63
the year after that, doubling the cost in three years. Inflation or deflation, if they are high
enough, can make it hard for firms to plan investments. Inflation tends to decrease overall
economic growth, increasing rivalry and possibly buyer and supplier power and the threat of
substitutes. When firms can’t predict what price they will be able to get for a particular product, investments in new product development become riskier. When inflation is high, many
industries experience increases in price competition, rather than development, as a means
of gaining market share.
Demographic Forces
Demographic forces involve changes in the basic characteristics of a population, including
changes in the overall number of people, the average age, the number of each gender or ethnicity, or the income distribution of the population.41 Because demographic changes involve
basic shifts in the product and geographic markets that firms target, demographic changes are
always accompanied by opportunities and threats. Even though demographics often change
slowly, they fundamentally reshape the landscape, so good strategic managers have a firm
understanding of demographic trends. The appendix contains a list of readily available sources
for demographic information. Some sources, such as the World Bank, contain hundreds of different demographic indicators.
Over the last 50 years, the size of the world’s population has more than doubled, from
around 3 billion to more than 7 billion people. Projections suggest that the Earth’s population
could reach 9 billion by 2040.42 Each new individual is a potential new consumer, suggesting
that growth rates of many industries will increase over time. However, increases in consumption resulting from population growth also mean that supplies of raw materials (such as the
rare-earth metals terbium and europium currently used in flat-panel displays43) are likely to
decrease. Furthermore, the world population isn’t spread evenly over all nations. The enormous populations of China and India account, to a large degree, for the number of firms that
have set up operations in those countries.
The average age of the population within a nation can also have a tremendous effect on
some industries. In Japan, for instance, more than 20 percent of the population is over age 65.
In the United States, this won’t occur until around 2040.44 The robotics industry has already felt
this shift. Japanese companies like Honda have invested tens of millions of dollars in robots
for home use, including walk-assist robots that help seniors with weakened muscles remain
ambulatory when they would otherwise need to use a wheelchair.45
Ecological/Natural Environment
The natural environment can also be a source of change for many industries. In some cases,
this involves changes to the physical environment such as increasing shortages of key inputs
like rare earth metals or fluctuations in the amount and cost of energy (i.e., oil and gas). More
often, though, current trends in the natural environment involve changes in the public’s perception of how business affects the environment. From global warming to clean air and water,
the public in many countries—including developing economies like China—are demanding
that firms be more proactive in protecting the environment. Many firms have responded by
implementing green initiatives. Although some of these may be for public relations purposes
only many firms have established serious goals. For instance, Procter & Gamble has goals
to use 30 percent renewable energy to power its plants by 2020. By 2014, 7.5 percent of its
energy needs were already met by renewable energy. They have also promised to reduce
their energy consumption, water usage, greenhouse gas emissions, and waste by 20 percent
by 2020. They have already reduced them by 8 percent by 2014.46 If consumers truly care
about the environment, then actions like these increase rivalry as competitors are forced to
respond in kind.
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Global Forces
Global forces also play a large role in shaping many industries. Over the last 50 years, as communications and transportation technologies have undergone a revolution, trade barriers
among nations have fallen dramatically. Many countries, from South Korea and Taiwan, to
China and India, to Brazil and South Africa, have enjoyed remarkable economic growth and
a rising standard of living. These changes have caused firms from many countries to expand
operations and begin producing and selling across national borders. We will examine global
forces and strategies for capitalizing on them in greater detail in Chapter 9.
Political, Legal, and Regulatory Forces
Political, legal, and regulatory forces are those that arise from the use of government. When
new laws are passed, they may alter the shape of an industry and influence the strategic
actions that firms might take.47 For example, the federal Affordable Health Care Act, enacted in
2009, mandated that health insurance companies insure everyone, including those with preexisting conditions. This changed the cost structure of the insurance and healthcare industries,
resulting in consolidation and less rivalry, as inefficient firms either went out of business or
were acquired by more viable firms. In the United States, following the Great Recession of 2008–
2009, the Federal Reserve required banks to keep larger amounts of cash on hand to cover
potential mortgage-related losses. One consequence of this regulation was less lending to
small businesses, erecting entry barriers in many industries and changing the nature of rivalry
in industries with many small firms.
Because political processes, laws, and regulations have the potential to shape and constrain industries, managers should analyze and understand the impact of new laws and regulations and decide how to respond. The Affordable Health Care Act, for example, required firms
with over 50 employees to provide health insurance for their workers, or face fines. Because the
law also provided for health insurance exchanges through which uninsured people could buy
their own insurance, some firms dropped employee health insurance as a benefit. Their managers have determined that the fines their companies face would be cheaper than the current
premiums for health insurance.
Of course, laws can provide opportunities as well as threats. For instance, laws in many
countries and states in the United States that require electricity providers to obtain a percentage
of their electricity from renewable sources have resulted in a boom in demand for wind turbines and solar panels. Because of the potentially far-ranging effect of laws and regulations,
many firms and industries strategically lobby government in an attempt to influence the lawmakers to enact legislation favorable to their industries.
Social/Cultural Forces
Social forces refer to society’s cultural values and norms, or attitudes. Values and attitudes are
so fundamental that they often affect the other six general environmental forces, shaping the
overall landscape in which firms compete. For instance, changing cultural norms about health
have resulted in laws against sodas being sold in schools and lawsuits against fast-food retailers
such as McDonald’s for marketing “unhealthy” food to children.
Like the other environmental forces, however, social forces can create opportunities if
a firm happens to be among the first to act on changes in values and attitudes. For instance,
Facebook helped to change social norms about connecting to friends and family. It reaped
enormous profits for being among the first to capitalize on the change in social networking.
Social forces are different, sometimes radically so, in different countries. Firms that compete in a global industry must understand differences among consumers in each country they
serve. For example, the collectivist orientation of many people in China results in a general
belief that the well-being of the group is more important than that of the individual and a related
norm of open information sharing.48 This open-sharing norm allows a greater acceptance of
product knockoffs and software pirating than many people are comfortable with in countries
that tend to have individualist orientations, such as the United States.
Review Questions 37
Summary
• One of the primary decisions that firms need to make is which
industry, or environment, they are going to compete in. Defining a
firm’s industry correctly is important because it helps managers to
identify their competition. One tool for helping to define an industry
is the NAICS codes produced by the US government.
• Not all industries are equally attractive. Five major forces determine
the attractiveness of an industry, defined as the profitability of the
average firm in the industry. These forces are rivalry, buyer power, supplier power, threat of new entrants, and threat of substitute products.
• Good managers develop a deep understanding of the effect of each
of the Five Forces on industry attractiveness. Such an understanding
allows them to take strategic action to influence the five forces in
a positive way for their firm and industry. Misunderstanding the
nature of the five forces can lead to decisions that destroy industry
profitability.
• New thinking suggests that for potential entrants the conventional
wisdom needs to be re-examined. Rather than suggesting that new
entrants should always look for industries that are attractive, for
new entrants who possess unique value, entering an unattractive
industry can be much more profitable than entering an attractive
industry. But if you don’t possess that unique value you can still
enter attractive industries if you completely understand the barriers
to entry and can overcome each one.
• Eight general environmental factors can affect the profit potential of
a firm: complementary products or services; technological change;
general economic conditions; demographic forces; the ecological/
natural environment; global forces; political, legal, and regulatory
forces; and social/cultural forces. Changes in any of these eight
factors can create additional opportunities and threats and often
shape the five industry-specific forces.
Key Terms
attractiveness of an industry 21
backward integration 24
barriers to entry 26
complementary products or services 33
forward integration 26
network effects 28
opportunities 21
rivalry 21
substitute 21
supplier 24
switching costs 23
threats 21
Review Questions
1. Why is it important for a firm to accurately determine what industry it is in?
not hold? Besides the examples used in the book, can you think of any
other examples?
2. How should a firm decide what industry it is in?
11. Can you identify some of the eight general environmental factors
that might be important for the personal care industries that Procter &
Gamble participates in, such as shampoo, dish and laundry detergents, toothpaste, and cough medicine, to name a few? Please feel free
to use the Internet to get more information about Procter & Gamble.
The appendix also has a guide about how to gather information about
the eight general environmental trends. If your professor assigns this
question as part of a larger project, you may find the appendix to be
very useful as a starting point.
3. What are the five major industry forces? How do they shape average
profitability in an industry?
4. What factors determine the intensity of rivalry?
5. Which type of industry has more rivalry, fragmented or concentrated, and why?
6. Explain what happens to buyer power when buyers have increased
price sensitivity.
7. Explain what it means for suppliers to have a credible threat of forward integration.
8. What factors determine the intensity of the threat of new entrants?
9. What are substitutes? Can you name any substitutes for the laptop
most of your classmates are using? What about substitutes for watching your university play football on Saturdays?
10. Under what conditions does the traditional advice concerning
entering attractive markets and staying away from unattractive ones
12. How does each of the eight general environmental factors influence industry profitability? Take your time in answering this one and
examine how at least one general environmental factors affects each
of the five forces (you can use a different environmental factor for each
of the five forces).
13. What are the elements of a complete external analysis?
38
CH A PT E R 2
Analysis of the External Environment: Opportunities and Threats
Application Exercises
Exercise 1: Practice evaluating the industry five forces
using the strategy tools presented in this chapter and
using the cola industry case included in your textbook.
Read the case, Coca-Cola, Pepsi, and the Shifting Landscape of the
Carbonated Soft Drink Industry.
1. Use the strategy tool presented in this chapter, along with data from
the case, to evaluate:
a. The intensity of rivalry within the cola manufacturing industry
(where Coca-Cola and Pepsi are prominent firms). Is rivalry high,
medium, or low?
b. The intensity of supplier power within the cola bottling industry
(where Coca-Cola and Pepsi are prominent suppliers). Is supplier
power high, medium, or low?
2. Where sufficient data aren’t available, use qualitative evidence to
evaluate the strength of a particular factor. Whether there is sufficient
data or not, fill in the explanation/data line of each strategy tool where
the data can be found and/or a summary of your logic.
3. Which industry is likely to be more attractive: cola manufacturing or
bottling? Why? Use your analysis to back up your claim.
Exercise 2: Practice evaluating the five forces, using the
strategy tools presented in this chapter.
1. Use either an industry that your professor assigns to you or pick an
industry of your choice.
2. Use a five-forces tool that your professor assigns to you (or one
of your choice) to evaluate that force within the industry you are
analyzing. Be prepared to either hand in your completed analysis,
using the tools from Figures 2.3–2.9, or show and explain it in class.
Exercise 3: Analyze the effects of the general environment
on an industry of your choice.
1. Identify an industry you would like to learn more about. Ideally, you
should be able to gather sufficient information on this industry to thoroughly analyze the impact of the general environment on industry profitability. Although information is available for a wide variety of industries,
this exercise will be easier if you choose an industry that has been written about consistently in the business press. In order to manage the
volume of data required for a thorough analysis, your instructor might
want you to focus solely on the home country of the largest firms in the
industry (unless most firms earn a majority of their profits from abroad).
2. Use data from a variety of sources, including those listed in the
appendix, in your analysis.
3. Try to identify the major effects of each of the eight factors (complementary products; technological change; general economic conditions; demographic forces; ecological/natural environment forces;
global forces; political, legal, and regulatory forces; and social/cultural
forces) on industry profitability.
4. Identify and predict any short-term to medium-term changes in any
of the eight factors that might alter average profitability in the industry.
Address how those changes will affect industry profitability in the future.
5. As part of the analysis, consider how the general environmental
factors may affect each of the five industry forces (rivalry, buyer power,
supplier power, threat of new entrants, and threat of substitutes).
Strategy Tool
Evaluating Industry Attractiveness Using Porter’s Five
Forces Model
Understanding the five forces and their effect on the landscape that
a firm competes in is a cornerstone of successful strategic analysis.
Figures 2.4 through 2.9 are general analytical tools used by a number
of Fortune 500 firms to evaluate the intensity of the five forces in an
industry, either their own or one they are thinking about entering.48
These tools essentially help to quantify the ideas that we have already
discussed in this chapter. In practice, top management often implicitly
understands the dynamics of the five forces and might not personally
use the tools presented here to map out the strength of each force and
its overall effect on industry profitability. However, a number of Fortune 500 firms use these tools in their strategic planning departments
to provide rigor to the strategic analyses and recommendations they
present to top management. Although the tools might appear complicated, they distill the concepts from this chapter, allowing a relatively
simple, yet comprehensive and detailed analysis of the five forces.
You can look for the data to complete these analysis tools in the
sources listed in the appendix at the end of the book. Many of the
indicators in these analysis tools are objective numbers that you can
obtain from various data sources. Others are more subjective; they
require a logical argument for the level—low, medium, or high—that
you choose. Even for more subjective indicators, however, data from
various sources, for instance, articles in the business press, can take
the guesswork out of doing a five-forces analysis.
To use the tools, for each separate item, put an X in the box that
most accurately reflects the data you have gathered on your industry.
For some boxes this is a range of data, for instance, 60 to 70 percent
combined market share in the rivalry tool. If the correct number is
anywhere within the range, put an X in the appropriate box. Cite your
data source and/or explain the logic of your placement underneath
each item. Your answer for some rows of boxes will be an average of
more than one item. For instance, in the rivalry tool, the degree of
industry standardization is the average of the four items below it.
After filling out each item, you will use the columns. Each column
is assigned a number, 1 through 5. The columns will help you to find the
correct answer for elements that have subsets to them. For instance,
in the rivalry worksheet, you need to determine whether the degree
of industry product standardization is low, medium, or high. The low,
Strategy Tool
medium, and high are encased in boxes, letting you know that this is a
major concept, while the rows that are not in boxes will help determine
the answer to the major concept. You also should notice that each row
of boxes lines up with a number to the left. Each number is a major
concept that you will use to determine the overall level of whichever
force you are measuring, in this case, rivalry.
So, to determine the degree of standardization, you will use data
and/or logic to put an X on the right answer (according to your data) for
each of the four rows underneath Product Standardization. Now the
columns come into play. Notice that each X that you placed falls under
one of the columns. Each column has a number 1 through 5. Add up
the placement of your Xs and then divide by the number of rows you
were using (in this case there were four) to determine whether Product
Standardization is high, medium, or low.
For example, if the answer, according to your data and/or logic,
for the four rows under Product Standardization was (1) 5%–10%, (2)
50%, (3) Med, and (4) Med (each of these four items was in column
3), you would add these together (3+3+3+3), getting the number 12.
You would then divide by the number of rows you were using (4) and
end up with the number 3. That tells you to put an X in the row of
boxes for Product Standardization that is in column 3, which would
be medium. If the sum for the four rows doesn’t divide evenly by 4,
round the decimal to the nearest whole number to see which column
your X should go in. So, if instead of 12 our total was 15, we still would
FIGURE 2.4
divide by 4 rows, returning the number 3.75. This means we would
put our X under column 4, meaning that Product Standardization is
between medium and low.
To get the value for the overall intensity of each force, you will first
add the values from the boxes with Xs in them (the major concepts, i.e.,
that have a row of boxes and a number next to them on the left side of
the worksheet). The values come from the columns. So you would look
down each column and see if a box has an X in it. If all the boxes are in
Column 1, we would get a 6 for the rivalry worksheet because there are
six major concepts. If all of the boxes were in column 5, we would get a
30 (6 x 5 = 30). After you have a total from adding the numbers of each
box, which you obtained from the column it is in, you divide that number into the number of major concepts (6 for rivalry) times the number
of columns (5). For the rivalry worksheet, the total number possible is
30. Suppose the sum of all of the major concepts (found in the boxes,
each one under a numbered column) for your analysis is 15. Using those
two numbers, you have 30 divided by 15 = 2. You would then place your
answer for the Overall Intensity of Rivalry (the row at the very bottom)
under column 2, resulting in Rivalry that is relatively competitive (halfway between fiercely competitive and neutral). As with the subconcepts, always round your answer to the nearest whole number. If you
got a 1.6 or a 2.4, you still would put your final X under column 2.
And now that you know how to use the worksheets, go and do
great work!
Strategy Tool—Evaluating the Intensity of Rivalry (mark an × in the appropriate box
for each factor)
1. Number and Relative Size of Competitors
• Top 4 competitors’ combined industry market share
1
2
3
4
5
<40%
40–50%
50–60%
60–70%
>70%
Explanation/Source of Data:
2. Degree of Industry Product Standardization
High
Med.
Low
(take the average of the bullet points below)
• Difference between competitors in price of similar products
<2%
2–5%
5–10%
10–15%
>15%
100%
75%
50%
25%
0%
Explanation/Source of Data:
• What % of industry’s products are sold at discount?
Explanation/Source of Data:
• Customers’ ability to recognize brands from industry
Low
Med.
High
Low
Med.
High
Explanation/Source of Data:
• Degree of switching costs
Explanation/Source of Data:
3. Industry Growth Rate
Explanation/Source of Data:
<0%
0–1%
1–3%
3–5%
>5%
4. Unused Industry Production Capacity
• % of industry wide production capacity currently in use
Explanation/Source of Data:
5. Degree to which firms have high fixed costs or products have
high storage costs or are perishable
<70%
70–80% 80–90% 90–100%
>100%
High
Med.
Low
High
Med.
Low
Explanation/Source of Data:
6. Extent of Exit Barriers
Explanation/Source of Data:
Overall Intensity of Rivalry
(take the average of the major factors, items numbered 1 through 6)
39
Fiercely
Competitive
Neutral
Mildly
Competitive
40
CH A PT E R 2
Analysis of the External Environment: Opportunities and Threats
FIGURE 2.5 Strategy Tool—Evaluating the Intensity of Buyer Power (mark an × in the appropriate
box for each factor)
1. Buyer Industry Bargaining Power
(take the average of the bullet points below)
• Buyer concentration (top 4 buyers as a % of total industry
volume sold to buyers)
1
2
High
>70%
3
4
Med.
60–70%
50–60%
5
Low
40–50%
<40%
Explanation/Source of Data:
• Buyer switching costs
Low
Med.
High
Explanation/Source of Data:
• Demand (supplier industry growth rate)
<0%
0–1%
1–3%
3–5%
>5%
Explanation/Source of Data:
• Possibility of buyer backward integration
High
Med.
Low
High
Med.
Low
Explanation/Source of Data:
2. Buyer Industry Price Sensitivity
(take the average of the bullet points below)
• Profitability of average buyer
<0%
0–5%
5–10%
10–15%
>15%
>50%
30–50%
20–30%
5–20%
<5%
>50%
30–50%
15–30%
5–15%
<5%
Explanation/Source of Data:
• % of suppliers’ products which are sold at a discount
Explanation/Source of Data:
• Cost of supplier industry products as a % of total buyer costs
Explanation/Source of Data:
• Number of high volume purchases
Most
Half
Few
Low
Med.
High
Low
Med.
High
High
Power
Neutral
Low
Power
Explanation/Source of Data:
• Impact of suppliers’ products on buyer quality/performance
Explanation/Source of Data:
• Degree to which supplier products save buyers money
Explanation/Source of Data:
Overall Intensity of Buyer Power
(take the average of the major factors, items 1 and 2, above)
FIGURE 2.6 Strategy Tool—Evaluating the Intensity of Supplier Power (mark an × in the appropriate
box for each factor)
1. Number and Relative Size of Suppliers
• Top 4 suppliers combined volume of total supplier
industry sales to buyer industry
1
2
3
4
5
>70%
60–70%
50–60%
40–50%
<40%
Explanation/Source of Data:
2. Difficulty of Switching Suppliers
High
Med.
Low
(take the average of the bullet points below)
• Cost of switching suppliers as a % of total input costs (costs
include not just higher prices but all switching costs)
>30%
20–30%
10–20%
5–10%
>5%
<2%
2–5%
5–10%
10–15%
>5%
Explanation/Source of Data:
• Difference between suppliers in price of similar products
Explanation/Source of Data:
• Importance of suppliers’ brands to the end consumer
High
Med.
Low
High
Med.
Low
High
Power
Neutral
Low
Power
Explanation/Source of Data:
3. Possibility of Supplier Forward Integration
Explanation/Source of Data:
Overall Intensity of Supplier Power
(take the average of the major factors, items 1 through 3, above)
Strategy Tool
FIGURE 2.7 Strategy Tool—Evaluating the Intensity Threat of New Entrants (mark an × in the
appropriate box for each factor)
1. Incumbent Firms’ Cost Advantages
(take the average of the bullet points below)
• Size of scales economies: measured as the slope of the scale
curve (see Chapter 4 for how to calculate this)
1
2
Low
>95%
3
4
Med.
85–95%
80–85%
5
High
70–80%
>70%
Explanation/Source of Data:
• Size of investment in plant and machinery required to
enter industry
Small
Med.
Large
Small
Med.
Large
Low
Med.
High
Explanation/Source of Data:
• Size of investment in marketing needed to match incumbent
brand awareness
Explanation/Source of Data:
• Degree to which incumbents employ property rights, like
patents, to protect their market share
Explanation/Source of Data:
• Market share required to break even
<5%
5–15%
15–30%
30–40%
>40%
Explanation/Source of Data:
Low
Med.
High
Weak
Neutral
Strong
Low
Med.
High
• Degree to which network effects affect buying decision
Explanation/Source of Data:
Low
Med.
High
• Cost for entrants to comply with government regulations
Low
Med.
High
Low
Med.
High
2. Other Incumbent Firm Advantages
(take the average of the bullet points below)
• Strength of incumbents’ brands (how influential in
customer purchase decision?)
Explanation/Source of Data:
• Size of switching cost for incumbents’ customers
Explanation/Source of Data:
Explanation/Source of Data:
3. Additional Considerations
(take the average of the bullet points below)
• Profitability of average incumbent
>15%
10–15%
5–10%
0–5%
<0%
>5%
3–5%
1–3%
0–1%
<0%
Explanation/Source of Data:
• Incumbent industry growth rate
Explanation/Source of Data:
Overall Threat of New Entrants
(take the average of the major factors, items 1 through 3, above)
High
Threat
Neutral
Low
Threat
41
42
CH A PT E R 2
Analysis of the External Environment: Opportunities and Threats
FIGURE 2.8 Strategy Tool—Evaluating the Intensity of the Threat of Substitutes (mark an × in the
appropriate box of each factor)
1
1. Customer Awareness of Substitutes
• Customers’ ability to recognize brands from
substitute industry
2
3
4
5
High
Med.
Low
Better
Same
Worse
Lower
Same
Higher
Better
Same
Worse
Low
Med.
High
High
Power
Neutral
Explanation/Source of Data:
2. Availability of substitutes (compared to focal industry)
Explanation/Source of Data:
3. Price of substitutes (compared to focal industry)
Explanation/Source of Data:
4. Performance of substitutes (compared to focal industry)
Explanation/Source of Data:
5. Customer switching costs
Explanation/Source of Data:
Overall Threat of Substitutes
(take the average of factors, items 1–5 above)
FIGURE 2.9 Strategy Tool—Evaluating the Overall Attractiveness of an Industry (highlight the
appropriate box for each factor)
1
2
3
Low
Power
4
5
1. Competitor Rivalry
High
Med.
Low
2. Buyer Power
High
Med.
Low
3. Supplier Power
High
Med.
Low
4. Threat of New Entrants
High
Med.
Low
5. Threat of Substitutes
High
Med.
Low
Med. Avg.
Profits
High Avg.
Profits
Overall Industry Attractiveness
(take the average of boxes, 1–5)
Low Avg.
Profits
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N. Friedman, “California Homeowners Face Higher Prices for a Scarce
Commodity: Wildfire Insurance,” The Wall Street Journal (February 10,
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8
D. A. Bosse, R. A. Philips, and J. S. Harrison, “Stakeholders, Reciprocity, and Firm Performance,” Strategic Management Journal 30
(2009): 447–456.
P. Chattopadhyay, W. H. Glick, and G. P. Huber, “Organizational Actions
in Response to Threats and Opportunities,” Academy of Management
Journal 44 (2001): 937–955.
9
D. A. Bosse, R. A. Philips, and J. S. Harrison, “Stakeholders, Reciprocity, and Firm Performance,” Strategic Management Journal, 30
(2009): 447–456.
10
P. Chattopadhyay, W. H. Glick, and G. P. Huber, “Organizational Actions
in Response to Threats and Opportunities,” Academy of Management
Journal 44 (2001): 937–955.
11
These can be found at http://www.census.gov/eos/www/naics
/index.html.
12
B. Hunt and P. Abrahams, “Microsoft’s Battle with Symbian,” Financial
Times (February 25, 2003).
13
F. M. Scherer and D. Ross, Industrial Market Structure and Economic
Performance (Boston: Houghton Mifflin, 1990).
14
M. E. Porter, “The Five Competitive Forces that Shape Strategy,”
Harvard Business Review 86 (1) (2008): 78–93.
15
S. Nadkarni and V. K. Narayanan, “Strategic Schemas, Strategic Flexibility, and Firm Performance: The Moderating Role of Industry Clockspeed,” Strategic Management Journal 28 (2007): 243–270.
16
R. Tidwell, “2011 Flat Panel TV Growth Rate Projected to Fall Sharply,”
News Junky Journal (May 2, 2011).
17
“Frozen Food Production in the U.S.” IBISWorld. Accessed September 2011.
18
A. Gonsalves, “ARM Introduces 2.5 GHz Cortex A-15 Processor,” InformationWeek (September 10, 2010).
19
A. Efrati and S. E. Ante, “Google’s $12.5 Billion Gamble,” The Wall
Street Journal (August 16, 2011), pp. A1 and A4.
20
K. E. Kushida and J. Zysman, “The Services Transformation and
Network Policy: The New Logic of Value Creation,” Review of Policy
Research 26 (2009): 173–194.
21
R. Makadok, “Interfirm Differences in Scale Economies and the
Evolution of Market Shares,” Strategic Management Journal 20
(1999): 935–952.
22
A. Lafley and R. Martin, Playing to Win (Boston: Harvard Business
School Press, 2013).
23
J. McKinnon and J. Stoll, “U.S. Throws Lifeline to Detroit,” Wall Street
Journal (December 20, 2008), accessed February 20, 2017.
24
“Tesla’s Unique Position in the Car Market Is One of Its Greatest
Strengths.” www.Forbes.com (July 2, 2015), retrieved February 25, 2017.
25
“Our
Story,
History,”
February 20, 2017.
26
www.nucor.com/history,
accessed
J. Dyer and D. Bryce, “Strategies to Crack Well Guarded Markets,”
Harvard Business Review, 85 (5) (2007): 84–92, 144.
27
Clayton M. Christensen, Scott D. Anthony, Gerald Berstell, and Denise
Nitterhouse, “Finding the Right Job for Your Product,” MIT Sloan
Management Review 40 (3) (Spring 2007): 38.
28
29
https://www.tesla.com/presskit/teslaenergy, accessed February 25,
2017.
L. Fahey, Competitors (New York: John Wiley and Sons, 1999).
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J. A. Lamberg, H. Tikkanen, T. Nokelainen, and H. Suur-Inkeroinen,
“Competitive Dynamics, Strategic Consistency, and Organizational
Survival,” Strategic Management Journal 30 (2009): 45–60.
31
A. M. Brandenburger and B. J. Nalebuff, Co-opetition (New York:
Currency Doubleday, 1996).
32
T. Virki and S. Mukherjee, “Windows Phone Struggles to Break Catch22 as App Makers Hold Off,” Reuters (March 26, 2012).
33
A. S. Grove, Only the Paranoid Survive (New York: Doubleday, 1996).
34
R. K. Sinha and C. H. Noble, “The Adoption of Radical Manufacturing
Technologies and Firm Survival,” Strategic Management Journal 29
(2008): 943–962.
35
D. Lavie, “Capability Reconfiguration: An Analysis of Incumbent
Responses to Technological Change,” Academy of Management Review
31 (2006): 153–174.
36
S. A. Brown, “Household Technology Adoption, Use, and Impacts: Past,
Present, and Future,” Information Systems Frontiers 10 (2008): 397–402.
37
The World Bank, http://data.worldbank.org/indicator/NY.GDP.MKTP.CD
38
“Nigeria Gives Huawei a Place to Prove Itself,” The Wall Street Journal
(September 12, 2011), p. B2.
39
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in Practice: Review of Empirical Studies, Methodological Assessments,
and Agenda for Future Research,” Journal of Strategic Marketing 16
(2008): 223–265.
40
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41
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Metals Inspire Scientists to Seek Alternatives for Magnet Technologies,”
Science News (August 27, 2011), p. 20.
42
S. Moffett, “Fast-Aging Japan Keeps Its Elders on the Job Longer,” The
Wall Street Journal (June 15, 2005), pp. A1 and A8.
43
http://corporate.honda.com/innovation/walk-assist/.
44
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45
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46
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Knowledge Sharing: A Comparison of China and Russia,” Journal of
Management Studies 43 (2006): 384–405.
47
Roger McCarty is credited with the early versions of these tools. The
five forces tools presented here are generalized forms of specific tools
used in a number of Fortune 500 firms. While the tools presented here
are a good starting point, in actual practice they may need to be altered
to fit the circumstances of a particular industry. For instance, in the
operating systems industry, network effects play a bigger role than the
capital cost of plant and equipment.
48
CHAPTER 3
Internal Analysis: Strengths,
Weaknesses, and
Competitive Advantage
L EARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Identify the steps in the value chain a firm uses to
create competitive advantage.
3. Evaluate the strength and sustainability of internally
generated competitive advantages using the VRIO model.
2. Distinguish among the core concepts of strengths,
weaknesses, resources, capabilities, and
priorities.
4. Analyze a company and identify its strengths or
weaknesses, resources, capabilities, and priorities using
the competitive advantage pyramid tool.
WALT DISNEY PICTURES/Album/Superstock
Disney: No Mickey Mouse Company
When most of us think about the Disney Company, we think of
Mickey Mouse, Disney’s oldest and most important in a long line
of memorable characters. As the company’s spokesman, Mickey
appears prominently on the Walt Disney Company’s home page
44
(http://thewaltdisneycompany.com/about-disney.)1 Everyone knows
Mickey, but few know the story about how Mickey’s arrival in 1928
set off a chain of events that continues to drive profits for Disney
more than 85 years later.
In 1923, Walt Disney and his brother Roy settled in Burbank,
California. They created the Disney Brothers Cartoon Studio to capitalize on a series of Laugh-O-Gram animations Walt had produced
in their hometown of Kansas City, Missouri. Later that year, movie
distributor Margaret Winkler contracted with the new studio to
produce a series of single-reel cartoons based on a character from
Walt’s first movie, Alice’s Wonderland.2 After 56 successful episodes
of the Alice Comedies, Winkler’s husband, Charles Mintz, contracted
with the Disneys in 1927 to produce a new character, Oswald the
Lucky Rabbit.
Oswald quickly gained popularity, in large part because of the
Disneys’ insistence on quality drawing and animation sequences
that came to be described as the “illusion of life,” which enabled
characters to move smoothly, like real humans.3 In 1928, Walt and
his wife, Lilly, headed east to negotiate with Mintz for more money
to expand the successful series. The negotiations did not go well
for the Disneys. Not only would Mintz not pay more, he fired Walt!
Internal Analysis: Strengths, Weaknesses, and Competitive Advantage
Mintz held the rights to the Oswald character, and he set out to
produce Oswald without the Disney brothers.
Crushed at the loss of their main character and income source,
Walt and Lilly boarded the cross-country train to return to Hollywood. Lilly recalled, “Walt showed me some of his sketches on
the train coming home. They were cute little things; they could
do anything. I asked him what he was going to call the character.
“Mortimer Mouse,” he said. I said, “That doesn’t sound very good,
and then I came up with ‘Mickey Mouse.’”4 That mouse, conceived
in adversity, would soon lead his creator to prosperity.
Mickey’s public debut in Steamboat Willie in late 1928 introduced not only a memorable mouse performing laughable antics,
but also a company that incorporated the latest technology to
bring its stories to life. Sound was just beginning to make inroads
in Hollywood, and Steamboat Willie represented the first synchronous sound movie. Mickey’s motions and voice were perfectly
timed with the music and audio in the cartoon, a major advance in
motion pictures. The public, and critics, loved it, and the Disneys
were on their way to lasting success.
Walt and Roy Disney learned well from Charles Mintz the
importance of owning, not just creating, characters. Ownership of
their most important resources allowed the brothers to control the
use of characters by licensing the images to others. Walt entered his
first licensing agreement in 1929 with a stationery company that
produced Mickey Mouse emblazoned notecards. By 1942, when the
United States was entering its first full year of World War II, Disney
was earning 10 percent of its revenue from licensing.5
The cartoons featuring the lovable Mickey Mouse, and cuttingedge technology became a Disney hallmark. The company pioneered a series of firsts:
• Technicolor was used for the first time in a film in 1938’s Snow
White and the Seven Dwarfs.
• A multiplane camera enhanced the illusion-of-life artistry.
• In 1940, Fantasia introduced a precursor to modern surroundsound technology. This innovative technology would not spread
industry-wide for another two decades.6
Walt’s capability to innovate continued throughout his
career. He realized the potential of television in its infancy. The
first Disney television broadcast in 1950 was One Hour in Wonderland, a program Walt created to help promote his upcoming film
Alice in Wonderland. And on October 27, 1954, the first episode
of Disneyland aired. The show would later become Walt Disney’s
Wonderful World of Color to capitalize on the potential of color television. And, it would last. In some version, new Disney programming, from the original Mickey Mouse Club to today’s popular
Disney Channel, has been on weekly network television for more
than 60 years.
Walt entered the world of television in order to fund his grandest innovation of all: the country’s first destination theme park.
Disneyland opened in July of 1955 on 270 acres of land in Orange
County, California.7 Disneyland defied all skeptics and proved
to be a huge success from the day it opened. The park combined
the company’s skills in engineering and entertainment. Walt even
called his designers “imagineers.” Walt’s focus on creating a clean
setting also helped to set Disneyland apart from other amusement parks. Ferris wheels and roller coasters were no substitute
for Space Mountain or the Tea Cups, and the spotless and inviting
atmosphere proved a huge draw for families across the country.
Disneyland became one of America’s first destination resorts.
The Disney brothers chose to compete in a difficult industry. Their studio survived and
eventually flourished in spite of a harsh industry environment and intense competition. The
film industry featured several large studios such as Metro Goldwyn Mayer (MGM) and United
Artists. These industry powerhouses had access to the best actors and writers, and they had
distribution networks to ensure that their films played in theaters across the United States.
Competition in the industry was fierce—the industry produced more than 800 films a year
throughout the 1920s.8
The Disney story, from a strategic perspective, captures the essence and power of a
firm’s internal abilities—the resources and capabilities that can create and sustain a competitive advantage. The concepts and tools in this chapter will help you to evaluate a firm’s
internal abilities in order to answer the question: “How can a firm succeed, even in a very
difficult industry environment?” The first section of the chapter explains how firms create
competitive advantages over rivals, and the second section discusses the sustainability of
those advantages over time. Internal analysis seeks to facilitate informed and meaningful
judgments about a company’s ability to win in its market, both in time (during any year or
product cycle) and over time (as long as a decade or longer).9 Winning in time means that a
firm has a competitive advantage; winning over time requires that advantage to be sustainable. We end the chapter by describing how to use a tool called the competitive advantage
pyramid to create a helpful visual model of the internal attributes that are the basis for a
firm’s competitive advantages.
As we’ve mentioned, strategists assume that firms differ. How can we describe those differences in a clear way that highlights how they contribute to the overall strategy? The value chain
provides a logical way to divide the firm into important strategic activities.
45
46
CH A PT E R 3
Internal Analysis: Strengths, Weaknesses, and Competitive Advantage
The Value Chain
value chain A visual description
of the steps required to turn raw
materials into finished products
and/or services. The value chain
also describes key functions of the
company linked to each stage and
functions that span its productive
activities.
Figure 3.1 displays the value chain, or the steps in the process it takes to transform raw inputs
into finished outputs. Developed by Michael Porter, the value chain is a way to depict and evaluate the activities a company performs. The horizontal elements in Figure 3.1 capture the production process that a firm uses to acquire and import raw materials, transform them into
valuable outputs, and put them in the hands of customers. The vertical axis represents four
administrative elements—firm infrastructure, human resource management, technology
development, and procurement—that span all of the firm’s economic activities. Porter’s value
chain not only provides a framework to describe the activities a company performs, it also can
help to identify which activities represent the firm’s competitive strengths and weaknesses.
Walmart’s sophisticated information system shows how technology development adds
value by creating critical firm infrastructure. Its information systems give Walmart an advantage
in inbound logistics because it can find low-cost ways to move products from its suppliers to
warehouses, and in outbound logistics, when it uses the same systems to move products at low
cost to its retail stores. High-end retailer Nordstrom’s legendary return policy is part of its core
activities in marketing and sales as well as after-sales service. The ability to return virtually any
Nordstrom item with no receipt and no questions asked creates unique value for customers.
Apple’s dominance in its markets can be traced to its strengths in the support activities of
technology development and procurement. For example, the original iPhone featured a unique
raw material, Corning’s ultra-strong Gorilla Glass.10 Apple’s iTunes website and Apple Stores
showcase its strengths in operations. The company is also well-known for its strong marketing
and sales efforts, including its sleek logo and advertising campaigns that have made Apple
products a “must have” product for billions of customers across the globe.
Disney’s early strength, as the opening case indicated, came in operations, by way of its illusionof-life cartooning process and innovative film production, both of which were enabled by the company’s technological development. The company used its stable of memorable and unique characters
such as Mickey Mouse, Snow White, and the Little Mermaid to create and sustain its brand identity in
film and theme park entertainment. That identity contributes to Disney’s strength in marketing and
sales, theaters, theme parks, and retail operations such as the Disney Store.
Firm
Infrastructure
Support
(Enabling)
Activities
Human
Resource
Management
Technology
Development
Margin
Procurement
Inbound
Logistics
Operations
Outbound
Logistics
Marketing
and Sales
Primary (Core)
Activities
FIGURE 3.1
The Value Chain
Source: Adapted from Michael Porter, Competitive Advantage, 1985.
After-Sales
Services
The Resource-Based View
47
The value chain helps managers identify areas in which a firm has an absolute strength
but provides no guidance about strength relative to competitors. So, the value chain can
be used to answer the important question, “What is a firm good at?” However, it can’t be
used to answer the critical question, “What is the firm better at than relevant competitors?”
The second question can be answered through two processes. First, we’ll define a set of
concepts—resources, capabilities, and priorities—to help in understanding the sources of a
firm’s strengths. Second, we will introduce VRIO thinking, a way of measuring the magnitude
and durability of a firm’s strengths versus competitive rivals.
The Resource-Based View
Resources, capabilities, and priorities can be thought of as answers to basic questions that
firms face. Resources are what a firm employs to create value and competitive advantage.
Capabilities represent how firms do things—the processes they use. Priorities explain why
firms allocate critical resources to achieve key objectives.11
Resources
Resources provide the answer to the question, “What creates the firm’s strengths?” One definition states that “resources include all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc. controlled by a firm that enables the firm to conceive of and
implement strategies that improve its efficiency and effectiveness.”12 This definition clearly
identifies what could be a resource, but its breadth makes it difficult to identify and limit what
types of things count as a resource. Resources are the “what” of competitive advantage.
Most resources are, or could be, counted and quantified on a firm’s balance sheet as assets.
Accountants classify resources as tangible or intangible assets. Tangible resources are those
with physical presence, such as land, factories, machinery, equipment, or cash. Intangible
resources are economically valuable assets that “do not have physical presence,” and include
brands, licenses patents, knowledge, and reputation.13
Four categories of resources are important contributors to competitive advantage:
resources All assets, brands,
land, information, knowledge,
and so on, controlled by a firm
that enable it to conceive of and
implement strategies that improve
its efficiency and effectiveness.
capabilities The procedures,
processes, and routines firms
employ in their activities.
priorities A firm’s values
and rankings of what is most
important.
assets Tangible or intangible
resources or factors of production
that create economic value for the
firm when employed. This chapter
focuses on physical, financial,
human, and intangible assets.
1. Physical resources, such as plant or equipment
2. Financial resources, such as free cash flow
3. Human resources, including employee know-how, management skill, and talents
4. Intangible resources, such as brands and patents
These four types of resources enable both the core operational and important support/
administrative activities in the value chain. Nordstrom could not operate without the physical
resources of stores or a website for customers to visit, or without the financial resources of cash
or credit to purchase inventory. Similarly, without the human resources of salespeople there
would be no customer service, which gives Nordstrom its strength in marketing and sales. Finally,
without the intangible resource of Nordstrom’s elite brand and culture and training programs, the
shopping experience would provide little of the satisfaction that customers have come to expect.
Capabilities
Capabilities are processes that the firm has developed to coordinate human activity in order to
achieve specific goals. Capabilities represent the “how” of competitive advantage. McDonald’s
corporation holds a commanding 24 percent market share in the US fast-food industry, nearly
four times as large as rival Wendy’s.14 McDonald’s operates more than 34,000 stores worldwide,
many of them in highly accessible locations, such as freeway off-ramps, towns, and mall locations. Although the stores themselves are resources, McDonald’s has also developed a set of
operating capabilities, or processes, that are implemented in each of these stores. The process
of filling customers’ orders at industry-leading speed is a capability at the heart of what makes
operating capabilities
Procedures, processes, or routines
for delivering value to customers,
employees, suppliers, or investors.
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Internal Analysis: Strengths, Weaknesses, and Competitive Advantage
dynamic capabilities
Procedures, processes, and
routines that continuously expand
existing resources or improve
operating capabilities.
McDonald’s successful. Speedy customer service involves several steps: procuring customer
orders accurately and quickly, communicating the orders to the cooks, cooking the food, packaging it, and delivering it to the customer. This process is repeated hundreds of times a day at all
34,000 individual store locations, leading to high store-level capability for order turnaround.
Competitive advantage relies on a strong set of operating capabilities. A firm’s advantage
becomes stronger if it develops dynamic capabilities, processes that are designed to continuously expand existing resources or to improve or modify operating capabilities.15 Dynamic
capabilities are practiced and refined over time and through repetition. For example, Procter &
Gamble (P&G) has many brand resources, such as Crest, Tide, Pampers, Pantene, and Febreeze.
But it also has been through the process of creating a new brand many times. Through repetition, P&G has refined its capability to create new brands to the point that it now has a dynamic
capability that can help it expand its existing brand resources with new additions, such as the
Olay Pro-X skin cleaning system.
Dynamic capabilities can help firms modify and evolve processes to keep pace with environmental changes such as new competitors, shifting demographics, or emerging technologies.
They can also enable firms to incorporate learning into their processes. For example, Toyota
follows a method of continuous improvement of its processes, known as kaizen, in which ideas
from many different sources are used to eliminate waste of effort or materials.
Companies with strong dynamic capabilities have a more secure foundation for competitive advantage than those without them, for two reasons. First, dynamic capabilities entail
complex connections and coordination among different internal units within the firm. For
example, finding the optimal site for a restaurant requires input from marketing about demographic information and target customer segments; the corporate counsel about sales contracts and local regulations; and real estate professionals skilled at identifying, negotiating,
and closing on properties. These strong coordination processes contribute to the competitive
advantage of good restaurant locations.
Second, dynamic capabilities take time to develop and require significant learning.
Processes or routines represent deeply engrained habits of behavior that take years for companies to perfect. As firms and their managers master the ongoing process of learning and
adjusting in the face of competitor, customer, or market changes, they develop a formidable
set of dynamic capabilities.16 Read more about one of Disney’s critical dynamic capabilities, the
ability to protect its intellectual property, in the Strategy in Practice feature.
Strategy in Practice
Preserving Disney’s Capabilities: Don’t Mess
with the Mouse!
Walt and Roy Disney learned early on about the importance of copyrighting characters, and over the years, his company developed a
set of dynamic capabilities to protect those resources.17 Steamboat
Willie, also known as Mickey Mouse, debuted on the screen in 1928.
Under existing copyright law, Disney’s copyright protection on the
fabled mouse would expire in 2003, 75 years after the character’s
origination. In 1988, Disney led a group of Hollywood studios, music
labels, and other content owners in the entertainment business to
successfully lobby Congress to extend the copyright protection on
Mickey Mouse, and other characters created between 1923 and
1978, for another 20 years.18
With so much riding on the mouse and his friends, Disney
makes every effort to safeguard its property. The rise of YouTube and
other user-generated content (UGC) sites has presented yet another
challenge in the copyright wars. Users can upload content to these
sites without rights or permission to the material. Disney recognized
this threat early and realized the resulting legal battle would be
global, long-running, and very, very expensive. Rather than threaten
YouTube and other technology providers, Disney General Counsel Alan Braverman decided on a different strategy: Disney would
agree not to sue UGC sites as long as those sites worked to remove
copyrighted content on their own.19 The negotiations were delicate
and took more than a year, but industry giants Disney, Microsoft,
Viacom, Myspace, NBC, Dailymotion, and Chinese UGC site Youku
.com agreed to a set of rules to protect content copyrights.
Critics complain that Disney’s efforts to protect its copyrights
stifle creativity and innovation in film and entertainment, often
at the expense of small, independent filmmakers or retailers. The
company maintains its legal right to protect its brands and properties through copyright law. Its actions around UGC, however, have
allowed sites such as YouTube, Pinterest, and Facebook to grow
without the threat of costly and continuous lawsuits from content
providers such as Disney.20
Disney has acquired a number of new copyrighted assets in
recent years, from its acquisition of the Marvel Universe in 2009 to
the Lucasfilm acquisition in 2012. These assets provide many revenue opportunities for the company. They also provide protection
against the expiration of copyright protections on Mickey Mouse
and other Disney favorites.
Creating a Sustainable Competitive Advantage: The VRIO Model of Sustainability
Strategy in Practice
Values and Priorities at Pixar
When Steve Jobs bought Pixar Animation Studios in 1986, he refocused the company away from its founding focus on high-tech hardware, and toward creating computer-generated animated movies
that people would flock to. The refocus was critically, as well
as financially, successful and resulted in box-office hits such as Toy
Story 1, 2, and 3, A Bug’s Life, Monsters Inc., Finding Nemo, Cars,
and Up.22
Jobs valued innovation and creativity, and he felt they
were the keys to Pixar’s success. Jobs also believed that innovation is sparked when creative individuals spontaneously
get together and share ideas. Jobs oversaw the design of the
Pixar Studios building and made sure that the architecture
itself would reinforce his values, by making interaction among
employees a design priority. As Jobs’s biographer Walter Isaacson
recounts:
Because Jobs was fanatic about these unplanned collaborations, he envisioned a campus where these encounters
could take place, and his design included a great atrium
space that acts as a central hub for the campus.
Brad Bird, director of The Incredibles and Ratatouille, said
of the space, “The atrium initially might seem like a waste
of space . . . But Steve realized that when people run into
each other, when they make eye contact, things happen.”
And did it work? “Steve’s theory worked from day one,”
said John Lasseter, Pixar’s chief creative officer “. . . I’ve
never seen a building that promoted collaboration and
creativity as well as this one.”23
At Pixar, values favoring creative collaborations led to a design
priority: interaction. Building a workspace that promoted these
interactions maintains and enhances Pixar’s rich capabilities for
innovation in both technical design and storytelling.
Priorities
Resources and capabilities help firms create and deliver unique value. So what drives the
choices into which resources and capabilities a firm should invest money and time? The answer
is priorities, which are a firm’s rankings about what is most important. Priorities are driven by a
company’s underlying values, its leaders’ beliefs about what is right and wrong, good and bad,
desirable and undesirable.
Management guru Peter Drucker described values as the ultimate test for action.21
Drucker noted that corporate decisions about hiring from the inside or outside, a company’s
stance about the importance of R&D, marketing, or any other functions look like technical
questions of strategy; however, they are really questions about what companies and their
leaders truly value.
Values lead to priorities that help executives, managers, and employees make decisions.
Priorities drive the creation of resources and capabilities in two ways. First, priorities guide
resource allocation processes such as capital investment, human capital acquisition and
training, and brand development. Second, priorities maintain those allocations over time when
things get tough. Read in the Strategy in Practice feature how priorities influenced the design of
a new headquarters building for Pixar Studios, a Disney subsidiary.
Creating a Sustainable Competitive
Advantage: The VRIO Model of Sustainability
Walt Disney’s experiences with Oswald the Rabbit illustrate the difference between having a
competitive advantage and sustaining that advantage through time. Although the first cartoons were both profitable and promising of a strong future, the Oswald advantage was unsustainable because Disney didn’t own the rights to the character. Charles Mintz proved unable to
sustain the character Oswald because Mintz lacked the capability to keep Oswald “alive” the
way Disney kept Mickey Mouse alive through products, TV shows, and theme park. Oswald’s
life on film ended as Mintz’s team ran out of new ideas for the character in 1943, shortly after
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value Worth or utility.
rarity To be uncommon, or not
available to other competitors.
inimitability An attribute of
a resource that describes the
degree of difficulty a competitor
would face in copying, imitating,
or mimicking the value of
that resource.
Disney created Bambi, Dumbo, and Pinocchio.24 Walt Disney lost a valuable competitive asset
when Mintz enforced his ownership of the copyright on Walt’s fateful trip to New York, but Mintz
lacked the capability to sustain the character he had captured.
Competitive advantages arise when resources or capabilities possess two attributes:
Value and rarity. Two other principles determine the durability, or sustainability, of competitive advantage: Inimitability, the characteristics that make a resource or capability
difficult to imitate, and an organization’s ability to exploit profit returns generated by its
unique and valuable resources. Together, these four characteristics—value, rarity, inimitability, and organization to exploit profits—are often abbreviated as VRIO. We’ll examine each
one in turn.
Value
Mickey Mouse earned returns for Disney and allowed the company to grow because this character created value for film distributors and viewers. Value denotes worth for customers.
A resource creates value if its contributions allow a company to produce a product or service
that is of worth to end users. Products or services have value when they create direct pleasure,
satisfaction, or happiness for the end user, or when they create indirect opportunities for users
to experience pleasure and satisfaction. Users won’t pay for products or services unless they
create value in their lives. In fact, a fundamental premise of our economic system holds that
the price someone will pay for a good depends on the value that good produces. The higher the
value, the higher the price that buyers are willing to pay.
Although not an absolute rule, resources and capabilities that provide firms with the
opportunity to produce and sell at lower costs than their rivals create value for customers. Low
price itself may produce some direct pleasure for users, but its benefits are mostly indirect,
because purchasing products and services at a low cost usually leave users with more money
to spend on other things that provide them pleasure or satisfaction. Similarly, unique products
or services often create direct pleasure or satisfaction for customers. Resources that help a firm
bring such differentiated products and services to the market create value for customers. Of
course, those resources also create economic value for the firm, defined as profits. Chapter 4
includes a discussion about how firms can create cost leadership strategies and Chapter 5 considers differentiation.
Rarity
To be rare is to be uncommon, or not available to other competitors. Unique is often used as a
synonym for rare. McDonald’s tries to find unique locations for its restaurants, such as being the
only restaurant at a freeway exit, or the closest to the on-ramp, or its presence as the sole dining option inside many Walmart stores. Rare or unique resources create competitive advantage
through a basic principle of economics—scarcity. When products or services are scarce, users
are often willing to pay a higher price for them than they would if the same products or services
were more commonly available, leading to higher company profits.
Inimitability
Inimitability is the extent to which competitors cannot easily reproduce a product by employing
equal, or equivalent, sources of value in their own products and services. Think about attending a Major League Baseball, NBA, or NFL game. The histories of the teams, the star players,
the amenities of professional stadiums, and the rules adopted by each league to govern play
mean that other leagues simply can’t imitate the experience these leagues provide. In fact, the
last successful rival competitive league was the American Basketball Association (ABA), and it
merged with the NBA in 1976! Several factors drive inimitability, thereby acting as barriers to
imitation. We’ll describe each one below.
Creating a Sustainable Competitive Advantage: The VRIO Model of Sustainability
Path Dependence
Path dependence means that the process through which a resource
or capability came into being may make it difficult for competitors to imitate. During World
War II, British aerospace companies focused on building small fighter planes while Boeing,
an American company, built large bombers and tankers. After the war, Boeing leveraged its
learning and investments in large aircraft to introduce the first successful commercial jetliner,
the 707, in late 1957.25 A British company, De Havilland, actually developed the first commercial
jet aircraft, the Comet. However, the Comet failed because De Havilland wasn’t as far along
the learning curve on designing or building large aircraft that could safely fly passengers.
Path dependence helps to block imitation when resources or capabilities follow a sequential development path—for example, when previous investments enable later ones, or when
significant learning underlies the resource or capability.
Tacit Knowledge For many processes, such as cooking french fries at McDonald’s, the
actions needed to imitate the sequence can be codified, or written down, and easily learned
by others. Such easy-to-codify-and-learn knowledge is referred to as explicit knowledge. Tacit
knowledge is just the opposite. Many valuable skills and processes, such as Walt Disney’s knack
for choosing good stories or Steve Jobs’s ability to spot great design in a product, can’t be
learned easily, if they can be learned at all.27 These skills are difficult, maybe even impossible,
to learn, teach, or coach, because they are based on tacit knowledge. Tacit knowledge is sticky,
or immobile, and difficult to imitate by competitors.
Ethics and Strategy
Nondisclosure and Noncompete Agreements
Many companies have competitive resources in the form of proprietary business practices. These proprietary resources, also known
as trade secrets, may be a “formula, pattern, compilation, program,
device, method, technique, or process”26 that has been developed within a firm for its own use. One common trade secret is the
detailed information about the purchase preferences of customers
learned by salespeople over time. This leads to manufacturing
companies, for example, customizing machines or tools to fit their
own unique production demands. Similarly, many firms develop
unique software code that adapts “off the shelf” software packages
such as SAP or Microsoft Office to perform functions unique to the
firm. Trade secrets improve a firm’s ability to create a differentiated
offering or to lower costs. These trade secrets do not qualify for
legal protection through patents, copyrights, or trademarks, however, and challenges arise when other organizations gain access to
these “secrets.”
Trade secrets that create value for customers or other stakeholders and are unique to the firm can be a source of a sustained
advantage, as long as they do not “leak out” and become common
knowledge available to competitors. Companies use two legal contracts to protect trade secrets: nondisclosure agreements and noncompete agreements. Nondisclosure agreements, often referred to
as NDAs, prohibit employees, suppliers, investors, or others who have
knowledge about a trade secret from sharing it with others. Noncompete agreements prohibit employees from leaving the company and
taking a job with a firm that could exploit an employee’s knowledge
about trade secrets. A noncompete agreement usually covers
employee movement to firms that compete directly, but could also
include key suppliers or customers as well. The use of NDAs and noncompetes raises ethical issues for strategic managers.
From the firm’s perspective, these contracts offer protection
against the leakage of its valuable knowledge, processes, and
skills. Managers, however, can write NDAs so tightly that those
who sign them would be prohibited from using any knowledge,
skill, or process that is even remotely related to the actual trade
secret. Some entrepreneurs use the NDA as a weapon to keep
suppliers, customers, or investors from working on products or
projects that might be only loosely related to the trade secret.
NDAs that prohibit disclosure of particular lines of software code,
or particular programming languages, for example, might stifle
competition instead of protecting intellectual property. Ironically, many venture capitalists, suppliers, and large customers
routinely refuse to sign NDAs in order to avoid any restrictions on
their ability to pursue their own interests. Managers must balance
their economic interests in protecting their trade secrets with
stakeholders’ ethical rights to pursue their own goals without violating a contract.
Similarly, noncompete agreements can be written so broadly
that they unfairly penalize employees in their search for new
employment. First, noncompetes might be written in a way that
extends far beyond direct competitors, suppliers, or customers
and includes firms only distantly affected by the firm’s trade
secrets. Second, noncompetes might be of such a long duration
that even after a trade secret becomes obsolete it still prevents
employees from working for a competitor. Managers, in their
zeal to protect trade secrets, can create agreements that restrict
employees from using even their generalized skills to find other
employment.
Managers must strike an appropriate balance between the
strategic need of the firm to protect its valuable trade-secret-based
resources and the legitimate needs of other stakeholders to interact
with the firm and still pursue their own interests.
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Causal Ambiguity
Causality refers to the notion that one thing causes another: A leads
to B. Sometimes, however, the causal relationship is unclear or ambiguous, and the relationship between variable A and outcome B is difficult to disentangle.28 You might have learned in
statistics courses that correlation does not equal causation, and just because A and B appear
together does not mean that A causes B. One example is Steve Jobs, who studied calligraphy
at Reed College and yogic meditation from gurus in India. Jobs credited these two experiences
as highly influential in shaping his aesthetic sense, but most entrepreneurs will not find that
calligraphy classes or meditation trips to India bestow upon them the same aesthetic eye
that Jobs possessed. In similar fashion, General Motors tried to imitate Toyota’s production
methods—the Toyota Production System—to produce cars at the same cost and quality. But
even after its engineers spent weeks and months watching Toyota build cars in a joint-venture
plant, GM still wasn’t able to achieve equal productivity. The cause of Toyota’s productivity
was not easy to determine because it was spread throughout the organization, including
hiring and training systems, the layout of its plants, and fundamental priorities and culture
of the company.
Complexity
Resources, capabilities, and priorities become difficult for competitors to imitate when they span the organization or contain many interrelated elements and exhibit substantial complexity. Creating synchronous sound for Steamboat Willie, for example, proved a
complex task in 1927. Walt Disney learned that the key was to time the cartoon framing and
motion with the beat of the music (12 frames and beats per minute). Today, much of Disney’s
competitive advantage rests on the complex interplay between film production, distribution in theaters and television, branding, merchandising, and theme park management. NBC
Universal has similar resources, but its profit rate is only about one-fourth of Disney’s. Disney
mastered the complex art of managing multiple, interrelated businesses over several decades,
while NBC Universal combined these resources through a merger and has yet to prove the same
ability to manage a complex and interrelated set of business processes.
Time Compression Diseconomies
Diseconomies happen when an action
increases, rather than decreases, cost and inefficiency. Timing is crucial in the development
or deployment of many resources, capabilities, or priorities and can become a diseconomy in
many cases.29 If a project requires a $20 million investment per year for the next two years, time
compression diseconomies mean that you can’t get the same results by spending $40 million
in one year. Resources that come from natural or physical processes, such as biological growth
limits in biotechnology, pharmaceutical research, or forestry, cannot be rushed. Similarly,
resources that come from differences in individual or organizational abilities to learn require
adequate time for lessons to be deciphered and processed.30
positive network externalities
When the value of a product
increases with the number
of users.
virtuous circle When more sellers
attract more buyers, who, in turn,
attract more sellers.
Network Effects and First-Mover Advantages Much of the reason eBay is so
successful has to do with network effects, which economists call positive network externalities. eBay wins because of its network effect. If you want to sell your old stuff, where do you
want to sell? Some place where there are lots of potential buyers. If you want to buy stuff, where
would you look? In a place with lots of sellers! More sellers attract more buyers, who in turn
attract more sellers. It’s a virtuous circle. As eBay grows in popularity, other online auction
sites such as Yahoo! have a hard time competing because it’s difficult to attract buyers and
sellers. Everyone wants to be where they have the greatest exposure or selection.
Network effects represent a specific form of a first-mover advantage.31 For example, eBay
has been able to lock up the best sellers and most active buyers for its site because it was the
first mover in the market. Being the second to enter is difficult, as eBay learned in Japan, where
it exited the market because Yahoo!’s auction site had captured the first-mover advantage.32
First movers establish a number of advantages. In addition to customers, they can lock up other
resources such as locations, patents, or scarce raw material inputs. They can also establish
long-term contracts with customers and set industry standards that favor their products. These
actions make it difficult for rivals to profitably imitate the first mover.
Creating a Sustainable Competitive Advantage: The VRIO Model of Sustainability
53
Organized to Exploit
A firm may employ valuable, rare, and difficult-to-imitate resources and yet still lack a sustainable competitive advantage because the firm may not be organized to exploit or have the
contracts and systems in place to capture the profits that resources create.33 Consider National
Football League (NFL) players. Revenues paid to the NFL from television networks for the
exclusive right to broadcast NFL games have grown from $47 million per year in 1970 to just
over $4 billion each year in 2012, a compound annual growth rate of an impressive 12 percent.
Over that same period, the players’ share of revenue has jumped from 35 percent in 1970 to 57
percent in 2011.34 How were players able to increase their share of the pie by more than
60 percent?
Before 1970, the NFL Players Association (NFLPA) had been a weak collection of player representatives. During the 1970s, however, the NFLPA emerged as a true, well-organized union,
capable of engaging owners in meaningful contract negotiations backed up by credible threats
of strikes and legal action. The contracts that the NFLPA negotiated for its members have garnered an increasing percentage of the NFL’s growing revenue. The NFLPA’s stronger organization enhanced its legal standing and administrative abilities, allowing players to capture the
value from their rare and inimitable resources.
organized to exploit The degree
to which the legal, administrative,
and operating structure of the
firm allows it to capture the rents
generated by resources.
Assessing Competitive Advantage with VRIO
Figure 3.2 shows the relationships between VRIO attributes of resources or capabilities and
competitive advantage. You can assess the strength and durability of a company’s position by
answering a yes or no question for each element in the matrix. Both resources and capabilities
should be subjected to the VRIO questions to determine the strength of a company’s competitive advantage.
As Figure 3.2 shows, in the real world, firms that can’t create value for their stakeholders
don’t survive. These businesses experience competitive failure. Many companies, especially
new start-ups, introduce valuable products that are also unique and rare and enjoy a period of
competitive advantage. The combination of value and uniqueness creates a short-run competitive advantage in time for a firm. Over time, however, competitors can imitate these resources
and create competitive parity in the industry. Parity means that a company survives but has
no real competitive advantage over rivals.
Is the
resource
Valuable?
Is the
resource
Rare?
Is the
resource
Inimitable?
Is the company
Organized to
exploit?
No
No
No
No
Competitive
Failure
Yes
No
No
No
Competitive
Parity
Yes
Yes
No
No
Competitive
Advantage
Yes
Yes
Yes
No
Durable
Competitive
Advantage
Yes
Yes
Yes
Yes
Sustained
Competitive
Advantage
FIGURE 3.2
Resources and Competitive Advantage
Source: Adapted from Jay Barnery, “Firm Resources and Sustained Competitive Advantage,” Journal of Management
17, no. 1 (March 1, 1991): 99–120 and Jay Barney and Bill Hesterly, Strategic Management and Competitive Advantage,
4e, Pearson.
competitive failure When
firms can’t create value for their
stakeholders, they don’t survive.
competitive parity When a
company survives but has no real
competitive advantage over rivals.
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Strategy in Practice
Disney Responds to a Competitive Threat
Disney’s initial competitive advantage arose from the company’s
ability to combine illusion-of-life animation and the latest technological advances with classic stories in the 1920s. Steamboat Willie,
which pioneered synchronous-sound, Fantasia, which debuted
Technicolor, and Snow White, the first full-length animated feature
film, all still stand as classics. Modern classics, including The Little
Mermaid, The Lion King, and Beauty and the Beast, built on and reinforced Disney’s valuable, rare, and difficult-to-imitate brand and
character resources, as well as its storytelling capabilities.
Eventually, however, a leapfrog technological innovation
threatened Disney’s core source of competitive advantage. In 1986,
Pixar Animation Studios secured its first Oscar nomination for its
animated short film Luxo, Jr. The wonderful, family-friendly story of
a small lamp signaled that computer-generated animation (CGA),
coupled with a great story line, could prove a viable competitor to
Disney’s illusion-of-life capability.
With the development of its RenderMan software in 1987,35
Pixar “could produce settings that looked absolutely real,” said
Pixar director John Lasseter.36 Pixar used this new technology to
produce a series of blockbuster hits, including Toy Story, Toy Story 2,
Monsters Inc., The Incredibles, and Wall-E. Wired magazine would
sustained competitive advantage
When firms combine the legal
elements, intellectual property
rights, administrative elements,
and cultural elements, allowing
them to capture high profits
that come from their valuable,
rare, and inimitable resources,
capabilities, or priorities.
later peg Lasseter as “the next Walt Disney.”37 Disney had used CGA
since the production of Tron in 1982, but only as a complement to,
never a substitute for, hand-drawn animation.
Disney lacked the in-house skill or software to compete with
Pixar. The company also found itself boxed in strategically. Mickey
Mouse turned 60 in 1987, and the Disney brand evoked images of
family-oriented entertainment but not cutting-edge technology.
Furthermore, the look and feel of its animated character family
appealed more to children than to teenagers or adults. CGA posed
a threat to Disney’s brand, character resources, and illusion-of-life
and storytelling capabilities.
How did Disney respond? At first, the company partnered
with Pixar and provided distribution for Pixar films, as well as
financial resources for production and marketing. In return, Disney
received a percentage of the films’ profits. The partnership prospered through six movies, including Ratatouille, Up, Toy Story 3, and
Monsters University.
During the time it partnered with Pixar, Disney’s own films,
built around its illusion-of-life animation, such as Treasure Planet,
were mostly unsuccessful. Eventually, Disney decided it needed to
own Pixar’s cutting-edge CGA capabilities. In 2006, Disney bought
Pixar for $7.5 billion, adding Pixar’s capabilities to its own pool of
Disney capabilities.
To create competitive advantage in the long run—an advantage that endures over several
years—a firm must create barriers to imitation. Barriers make it difficult for competitors to offer
similar products or services, drive prices down, and dissipate the firm’s superior profits. Barriers to imitation provide a durable competitive advantage, one a company is able to sustain.
Durable advantages dissipate over time, and moving from durable to sustainable potential
advantage into an actual one requires an organizational structure and design that captures the
value from resources and capabilities. Companies that realize sustained competitive advantage
combine the legal elements, such as contracts or intellectual property rights; administrative
elements, including organizational structure; and cultural elements, such as norms regarding
rewards and what constitutes equity, that allow them to capture high profits that come from
their valuable, rare and inimitable resources, capabilities, or priorities.
Managers may work hard to create resources and capabilities that are VRIO, only to then
witness changes in technology, consumer tastes and preferences, government regulations, or
other forces that imperil their source of competitive advantage. The Strategy in Practice feature
describes how Disney responded when a new technology for cartooning presented a threat to
its sources of competitive advantage.
The Competitive Advantage Pyramid: A Tool
for Assessing Competitive Advantage
We’ve introduced some important concepts to help you understand how a company’s internal
resources and capabilities may allow it to deliver unique value and achieve superior performance. Internal analysis depends on more than concepts, however, and so now we present
an analytical process and tool that allow you to identify and catalog a firm’s potential for sustained competitive advantage. The competitive advantage pyramid tool will help you in the
The Competitive Advantage Pyramid: A Tool for Assessing Competitive Advantage
academic work of this course, but it will prove even more valuable as you decide whether to
invest in or work for a particular company. You can also use the pyramid after you take a job,
when you work on teams assigned to create strategy for your company or to understand the
strategic strengths of your competitors. This tool will prove particularly helpful should you
want to start your own company.
The pyramid also invokes a powerful metaphor about internal sources of competitive
advantage. The stability and beauty of the top of the pyramid depends on the solidness of the
base below. Just as each brick of a pyramid relies on the one below it for strength, support, and
orientation, each level of competitive advantage depends on the one below. A company’s valuecreating activities will only be as strong as the resources and capabilities that support them.
The strength of those resources and capabilities, in turn, relies on a company’s core values and
priorities to sustain the investments over time that build VRIO resources and capabilities.
Figure 3.3 illustrates the competitive advantage pyramid. The shape helps you to integrate
the different internal elements that create layers of competitive advantage.38 In the top layer
are the activities that create strengths and weaknesses. Resources and capabilities lie below, in
the center layer, because they lay the foundation for and fuel the activities in the top layer. The
bottom of the pyramid—the deepest driver of competitive advantage—captures the values and
priorities that guide the development of resources and capabilities.
The numbered questions can be answered in order to help you move down the pyramid to
discover the different sources of competitive advantage for a company. When you are finished
gathering and analyzing data to answer them, you should be able to draw a pyramid or create
a table for the company that provides a robust and detailed picture of the company’s strategic
advantages.
Gathering Data for the Competitive Advantage
Pyramid Analysis
Data to complete a pyramid come from a number of sources. You can use three main
types of data:
1. Archival data: Written or numeric information can be found in the library or on the Internet.
2. Interviews: Interviews can range from personal questions to impersonal surveys.
3. Observation: Your own experiences, such as visits or use of products or services, are
also valuable.
1. What is the company good at? What
activities create value for customers?
2. What resources and capabilities drive those
activities? How rare are they? How difficult
to imitate?
3. In what ways is the organization designed
to capture the value created?
4. What priorities and values support and
sustain resources and capabilities? How
committed is the company to these
priorities and values?
FIGURE 3.3
The Competitive Advantage Pyramid
Activities
Resources,
Capabilities, and
Organization
Values and Priorities
55
56
CH A PT E R 3
Internal Analysis: Strengths, Weaknesses, and Competitive Advantage
Strategy and Your Career
The competitive advantage pyramid provides a way for you to
quickly document and understand a company’s sources of competitive advantage, and it allows you to make some judgment
about how durable and sustainable that advantage might be. As
you approach decisions about where to work, you would be wise to
invest the time and effort into creating a pyramid for each company
you might like to work for. If you use the rigorous research methods described earlier in the chapter, you should be able to create an
accurate and useful picture of the company. If you can do interviews
or site visits, you may be able to create personal relationships that
will give you good information and some positive recommenders
within the company. The pyramid can help you prepare for interviews as well, as you’ll be able to couch your answers in terms the
company will value, and the pyramid tells you where to focus your
research so you learn more about the company.
The real value of the competitive advantage pyramid
model in your job search, however, comes when you create one
for yourself, or You, Inc. There is an end-of-chapter exercise
that describes how you can create a personal pyramid. Take
the time to collect data on your own activities, strengths, and
weaknesses. You may get some uncomfortable feedback, but
it will help you identify where you can add value. Catalog your
resources and capabilities and think deeply about your core
values and priorities. This deep level of the pyramid should
help you clarify what you care about most, in your work and
throughout your career.
With a thoughtful personal pyramid, you can compare
yours with those of target companies. You can identify areas, and
jobs, where you may be able to create value for a company, and
see where you can add to their resource base as well as grow your
own. Finally, and most importantly, you can make sure that potential employers share your priorities and align with your values.
These pyramids, both company and personal, can help you make
better choices about where to work.
If you want to create a pyramid profile for a private company, you might find very little
archival data, but you may identify people willing to grant interviews or to directly observe the
company’s operations. For public companies, the reverse often proves true. Abundant archival
data exist, but companies often create barriers, or firewalls, that make interviews difficult. The
size of the company means that observations provide only a limited view of the company. The
appendix helps you know what to look for as you perform a pyramid analysis and describes in
detail different data sources you can use to do the analysis.
As you gather data and use the questions to sort and categorize the information you find,
remember the GIGO principle from computer programming: garbage in, garbage out. Stated
more elegantly, the more attention you pay to gathering, verifying, and comparing the data, the
richer, more robust, and more insightful your finished product will be. You should always rely
on at least two types of data (e.g., archival records and interviews) and use multiple sources
of data within each type. For each strength, weakness, resource, capability, value, or priority
that you identify, include the source from which you drew your data. If your data all come
from a single source such as a website or a Bloomberg Businessweek, Fortune, or Wall Street
Journal article, then your pyramid will be weaker than if the information is drawn from multiple
sources. Tapping other data sources, such as doing an interview or scheduling a plant visit, may
seem daunting, but doing so will pay great dividends in creating a richer, more complete profile
of the company.
Be very careful to balance your data sources. Don’t rely exclusively on data provided by the
company or solely on data that come from the company’s detractors. Both have a point of view
that differs from the real company. If you are thinking about accepting a job with a company,
or one of its competitors, you’ll want to dedicate significant time and energy to developing the
most accurate pyramid you can.
Using the Competitive Advantage Pyramid
You can use the pyramid to focus on a company’s strengths or its weaknesses. It is often simpler
to create a separate analysis for strengths and weaknesses as a first step.
Table 3.1 shows the results of a simple pyramid analysis to compare the strengths of
two national retailers: Walmart and Nordstrom. As you can see from the table, both Walmart
and Nordstrom have clearly identifiable strengths that customers, suppliers, and others can
readily see.
The Competitive Advantage Pyramid: A Tool for Assessing Competitive Advantage
TA BL E 3 . 1
57
Using the Pyramid Model to Identify Strengths
Company
Questions
Walmart
Nordstrom
What is company good at?
Low prices
Customer service
What activities create value for customers?
Low prices enable customers to purchase
more total items
Pleasure and satisfaction through
the shopping experience and the
goods purchased
What resources and capabilities drive
those activities?
Rural locations
Posh stores
Large number of stores
Upscale locations
Logistics/planning
Talented staff
Huge distribution centers
In-store merchandizing
Sophisticated IT systems
Compensation system for staff
Pricing policies
How rare are these resources and
capabilities?
Rare due to size and scale
Rare due to brand and reputation
How difficult are they to imitate?
Organizational complexity makes resources
difficult to imitate
Causal ambiguity and path dependence
make resources difficult to imitate
In what ways is the company organized
to capture value?
Centralized decision authority ensures consistency across stores
Decentralized structure allows each store
to customize to meet customer needs
What priorities support and sustain those
resources and capabilities?
Frugality
Outstanding service
Striving for excellence
Empowered employees
Sources: Author interviews with selected organizational members, store visits and tours, various articles in popular
press such as The New York Times, Wall Street Journal, Business Week, Fortune, and Forbes.
TA BL E 3 . 2
Using the Pyramid Model to Identify Weaknesses
Questions
Sears Holdings
What is company good at?
Limited selection of goods; Sears sold off many
valuable brands such as Craftsman Tools and
Lands End
What activities fail to create value for customers?
Outmoded stores
Poor merchandizing
Unmotivated employees
What resources and capabilities are lacking and
contribute to those weaknesses?
Lack of financial resources for reinvestment
How rare are these resources and capabilities?
Diminishing through asset sales, most valuable
real estate sold off and stores closed
How difficult are they to imitate?
Not difficult: Specialty retailers offer better
products, services; low-cost retailers offer
better prices
In what ways is the company organized to
capture value?
2018 bankruptcy means all profits go to
creditors; shareholders lost all value
What values support/sustain those resources
and capabilities?
Survival. As the bankruptcy proceeds, the only
value will be maximizing liquidation value
Lack of strategic consistency to support training,
merchandizing
58
CH A PT E R 3
Internal Analysis: Strengths, Weaknesses, and Competitive Advantage
What if you wanted to create a pyramid to describe a company’s weaknesses? Consider
Sears Holdings, the company created by the 2004 merger of Sears and Kmart. Kmart began
operations in the late nineteenth century and was a competitor of Walmart until Walmart drove
them into bankruptcy. Sears opened its first retail store in 1925 and enjoyed a run as America’s
largest retailer through most of the twentieth century. Sears filed for Chapter 11 bankruptcy
on October 15, 2018. Whether Sears will survive as a retailer will depend on the company’s
ability to turn its weaknesses into strengths. A pyramid analysis for Sears reveals how difficult
that will be.
A visit to a Sears store would allow you to observe both the company’s strengths and weaknesses. Sears stores now carry a limited line of major national brands and some of their own
branded merchandise, offered at multiple price points.39 However, while you would see a broad
selection, you would also likely see a store with outmoded lighting, worn carpeting or tile, and
a merchandising and product mix that lacks excitement. Articles in the popular press indicate
that the company’s strategy centers on store closings and layoffs, rather than on investing in
new capabilities.40 Table 3.2 details this analysis.
Summary
• Strategy tools can be used to better understand how companies create and sustain competitive advantages through their own efforts,
as opposed to merely relying on the industry’s structure.
• The value chain provides a broad and comprehensive roadmap for
identifying the sources of a firm’s strengths and weaknesses among
its different value-creating functions and infrastructure elements.
• Valuable and rare resources and capabilities create competitive advantages for firms. The durability or sustainability of those
resources depends on inimitability—how difficult it would be for a
competitor to imitate the resource. Finally, the firm must be organized in legal and administrative ways that capture the returns created by those resources.
• The factors of production that a firm uses to create competitive advantages can be divided into three categories: resources, capabilities, and
priorities. Priorities support the development of capabilities, and they
enable the creation and deployment of unique and valuable resources.
• The competitive advantage pyramid is a tool to help identify, categorize, and assess the overall strategic advantages of a firm. The
diamond allows depth of analysis and understanding about the root
causes of a firm’s competitive advantages.
Key Terms
assets 47
capabilities 47
competitive failure 53
competitive parity 53
dynamic capabilities 48
inimitability 50
operating capabilities 47
organized to exploit 53
positive network externalities
priorities 47
rarity 50
resources 47
52
sustained competitive advantage
value 50
value chain 46
virtuous circle 52
54
Review Questions
1. Identify and describe the two major elements of the value chain.
How can the value chain help you do internal analysis?
5. Under what conditions will resources lead to competitive advantages? When will those advantages be sustainable?
2. What is a resource? What types of resources can firms employ in
their search for competitive advantage?
6. Identify three situations in which a competitive advantage pyramid
analysis would be useful to you. What two rules about data collecting
should you remember when you do a pyramid analysis?
3. What is a capability? How do capabilities work together with
resources to enable companies to create value?
4. How is a resource different from a capability? How are the two similar? How do different types of resources work together to create competitive advantage?
References 59
Application Exercises
Exercise 1: Identifying the value chain.
1. Go to your local grocery store and walk down the cereal aisle, the
soda and snack foods aisle, and the meat aisle. How many different
brands do you see on each aisle? Which companies produce those
brands? Research two companies from your search and use the value
chain to describe each company. As you compare them, what key differences do you see in their value chain strengths and weaknesses?
How do their financial results differ?
information? How would you evaluate the company’s prospects for
future performance?
Exercise 2: Understanding and using the competitive advantage
pyramid.
2. Identify two companies in the same industry. Using their 10-K filing or other available data, determine the operating performance
(market share, customer satisfaction, new product introductions, etc.)
and financial performance (return on sales, return on assets or equity,
free cash flow) of both companies. Using the data in the 10-K or annual
report, create a list of resources and capabilities for each company.
How do the differences in the strength of competitive advantages correlate with firm performance?
1. Choose a company you would like to work for. Using the competitive advantage pyramid, analyze the strength (or weakness) of
competitive advantage for your target company and for the two rival
firms. Begin your research by looking at news reports, company filings, and press releases to create a working model of the competitive advantage pyramid. Then, identify and interview someone who
works at that company. Find out what elements they would include in
the pyramid. How did the pyramid differ when you included “inside”
1. Create a competitive advantage pyramid. Collect data from those
around you to identify activities that create strengths and weaknesses. List what you, and others, see as your resources and capabilities that underlie your activities. Catalog your priorities and values.
How do the different elements in your pyramid work together? What
changes do you need to make to improve alignment throughout
the pyramid?
Exercise 3: Personalizing the competitive advantage pyramid.
References
See http://thewaltdisneycompany.com/, accessed December 10, 2012.
You’ll find Mickey displayed in the “latest news” section and on the
flash video images that dominate the home page.
1
B. Thomas, Building a Company: Roy O. Disney and the Creation of
an Entertainment Empire (New York: Hyperion, 1998), pp. 46–47.
2
J. P. Telotte, The Mouse Machine Disney and Technology (Urbana:
University of Illinois Press, 2008). p. 27.
3
4
Thomas, pp. 57–58.
5
R. Grover, The Disney Touch (Homewood, IL: Irwin, 1991), p. 7.
6
Telotte, p. 15.
7
Thomas, pp. 178–187.
8
http://www.1920-30.com/movies/, accessed November 28, 2012.
9
W. D. Miller, Value Maps Valuation Tools that Unlock Business Wealth
(Hoboken, NJ: Wiley, 2010), http://site.ebrary.com/id/10388356.,
pp. 35–36.
S. Weintraub, “Apple Acknowledges Use of Corning Gorilla Glass
on iPhone,” 9t05MAC, available at http://9to5mac.com/2012/03/02
/apple-acknowledges-use-of-corning-gorilla-glass-on-iphone-means
-gorilla-glass-2-likely-for-iphone-5/, accessed November 6, 2013.
10
C. Christensen, K. Dillon, and J. Allworth, How Will You Measure Your
Life? (New York: Harper Business, 2012).
11
J. Barney, “Firm Resources and Sustained Competitive Advantage,”
Journal of Management 17 (1) (March 1, 1991): 99–120, doi:10.1177
/014920639101700108., quotation from p. 101.
12
E. K. Stice and J. D. Stice, Financial Accounting, 7th ed. (Independence,
KY: Thomson/Southwestern, 2006), p. 357.
13
Research firm IBIS World has data on the major competitors in the fast
food industry as of 2012. See http://www.ibisworld.com/#MP347824,
accessed December 5, 2012.
14
For a discussion and definition of dynamic capabilities, see D. J.
Teece, G. Pisano, and A. Shuen, “Dynamic Capabilities and Strategic
Management,” Strategic Management Journal 18 (7) (August 1, 1997):
509–533, doi:10.2307/3088148.
15
Ibid.
16
J. Wasko. Understanding Disney (Malden, MA: Policy Press in
association with Blackwell Publishers, 2001), pp. 85–86.
17
See also C. Sprigman, The Mouse that Ate the Public Domain: Disney,
the Copyright Extension Act, and Eldred v. Ashcroft (2002). Available at
http://writ.news.findlaw.com/commentary/20020305_sprigman.html,
accessed November 17, 2012.
18
J. Mullich, “Disney’s GC Works His Magic,” Super Lawyers Business
Edition. Available at http://business.superlawyers.com/california
-southern/article/Disneys-GC-Works-His-Magic/83da6d0f-3047-4a9e
-8464-36710c6be140.html, accessed November 17, 2012.
19
Ibid.
20
P. F. Drucker, “Managing Oneself,” Harvard Business Review 83 (1)
(January 2005): 100–109.
21
“The Inside Story: 5 Secrets to Pixar’s Success,” Fast Company (September 14, 2011). See http://www.fastcodesign.com/1665008/the
-inside-story-5-secrets-to-pixar-s-success,
accessed
November 3, 2013.
22
W. Isaacson, Steve Jobs (New York: Simon & Schuster, 2011),
pp. 430–431.
23
24
A list of Disney movies, by year, can be found at http://d23.disney.go.com
/archives/a-complete-list-of-disney-films/, accessed December 6, 2012.
The Boeing 707 was not the first jet aircraft, but the first one to hold
the jet-transport formula right. See http://www.boeing.com/stories
/timeline.html, accessed December 7, 2012.
25
60
CH A PT E R 3
Internal Analysis: Strengths, Weaknesses, and Competitive Advantage
Definition found at http://www.law.cornell.edu/wex/trade_secret,
accessed January 24, 2014.
26
R. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic
Change (Cambridge, MA: Harvard University Press, 1982).
27
R. Reed and R. J. Defillippi, “Causal Ambiguity, Barriers to Imitation,
and Sustainable Competitive Advantage,” The Academy of Management
Review 15 (1) (January 1, 1990): 88–102.
28
I. Dierickx and K. Cool, “Asset Stock Accumulation and Sustainability
of Competitive Advantage,” Management Science 35 (12) (December 1,
1989): 1504–1511.
29
W. M. Cohen and D. A. Levinthal, “Absorptive Capacity: A New Perspective on Learning and Innovation,” Administrative Science Quarterly
35 (1) (March 1990): 128.
30
M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,”
Strategic Management Journal 9 (July 1, 1988): 41–58; M. B. Lieberman and D. B. Montgomery, “First-Mover (Dis)Advantages: Retrospective and Link with the Resource-Based View,” Strategic Management
Journal 19 (12) (December 1, 1998): 1111–1125.
31
C. Gaither, “Internet: eBay Exits Japan for Taiwan,” New York Times,
February 27, 2002. Available at http://www.nytimes.com/2002/02/27
/business/technology-briefing-internet-ebay-exits-japan-for-taiwan
.html, accessed December 7, 2012.
32
R. W. Coff, “When Competitive Advantage Doesn’t Lead to Performance: The Resource-Based View and Stakeholder Bargaining Power,”
Organization Science 10 (2) (March 1, 1999): 119–133.
33
Data compiled from P. Ghemawat, Commitment: The Dynamic of
Strategy (New York: Free Press, 2001), pp. 96–98, and J. Vrooman,
“The Economic Structure of the NFL,” in The Economics of the National
Football League: The State of the Art, ed. K. G. Quinn (New York: Springer
Science + Business, 2012), p. 335.
34
Information drawn from Pixar Animation Studios History, available
at http://www.fundinguniverse.com/company-histories/pixar-animation
-studios-history/, accessed November 19, 2012.
35
Wasko, Understanding Disney, p. 160.
36
J. Daly et al., “Hollywood 2.0,” Wired 5 (11) (1997): 200–215. Cited in
Wasko, p. 163.
37
For example, the Activity Map used by Harvard’s M. E Porter, What Is
Strategy? (Boston: Harvard Business School Press, 1996), or the Strategy
Canvas suggested by W. C. Kim and R. Mauborgne, Blue Ocean Strategy:
How to Create Uncontested Market Space and Make the Competition Irrelevant (Boston: Harvard Business School Press, 2005).
38
Author visits to local Sears stores, 2011–2012.
39
D. Mattioli and K. Talley, “Pared-Down Sears Posts Profit on Asset
Sales,” Wall Street Journal, May 17, 2012. Available at http://online.wsj
.com/article/SB10001424052702303360504577409722818223112.html,
accessed January 4, 2013.
40
CHAPTER 4
Cost Advantage
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Differentiate between economies of scale and scope and
describe how both produce cost advantages.
3. Discuss sources of lower input costs and how they
provide the basis of a cost advantage strategy.
2. Describe what an experience curve is and how it can be
used to make effective business decisions.
4. Explain two changes in a firm’s business model that can
enable a cost advantage strategy.
travelib environment/Alamy Stock Photo
The World’s Cheapest Car
One rainy day in Mumbai, India, in 2003, Ratan Tata, former
chairman of the Tata Group, noticed a man riding a scooter with
an older child standing in the front, behind the handlebars.
The man’s wife sat sidesaddle on the back of the scooter with
another child on her lap. All four were soaked to the bone. As Tata
watched, he asked himself, “Why can’t this family own a car and
avoid the rain?” Then he realized that, like over 700 million Indians who made less than $10,000 a year, they probably couldn’t
afford one. Tata could not get the sight of that family out of his
mind. He began to dwell on the possibility of creating an affordable “people’s car.”
“The two-wheeler observation [with the family of four piled on
the scooter] got me thinking that we needed to create a safer form of
transport,” Tata recalls. “My first doodle was to rebuild cars around
the scooter, so that those using them could be safer if it fell. Could
there be a four-wheel vehicle made of scooter parts?” Tata gathered
a small group of engineers to design a low-cost vehicle with four
wheels. The initial design had two soft doors with vinyl windows,
a cloth roof, and a metal bar as a safety measure. But after seeing
the initial designs, Tata and his group concluded that the market
wouldn’t want a “half car.” So Tata and his team spent the next several years designing a “real” car that would use the least expensive
materials and the least expensive components, and could be assembled with minimal skill in the fewest possible labor hours.
Tata’s dream became a reality in 2009, with the launch of the
Tata Nano. Priced at $2,500, Nano was launched as the world’s
cheapest car. Designed to only weigh 1,320 pounds and get 50 miles
per gallon, the Nano is powered by a rear-mounted 35-horsepower
engine. Yes, that’s not a typo; only 35 horsepower.2 Compare that
to the 170 horsepower standard engine in the base-model Honda
Accord, or even the 70 horsepower engine in a tiny US. Smart car.
The Nano also sported numerous innovations (including 34 inventions for which Tata filed patent applications) that made it India’s
Car of the Year in 2010.3
Beyond designing a car that could be manufactured at low
cost, Tata also thought about how these cars could be distributed at low cost. The Nano is designed to be assembled from kits
at dealerships, much like motorcycles are in the United States.
This approach alone could disrupt the automobile distribution
61
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CH A PT E R 4
Cost Advantage
system in India. Tata needed a way to reach customers in the
smaller villages in India, where Indians primarily drove scooters.
To be able to sell its cars as inexpensively as possible in the
smaller villages in India, Tata decided against building dealerships; there simply wasn’t a large enough market. Instead Tata
imitated the strategy of companies that sold scooters. Scooter
dealers arrived on Sunday at farmers’ markets or flea markets with
big trucks filled with scooters and set out the scooters in rows for
people to buy immediately. The Tata team brought 40 Nanos at a
time to each open-air market and provided services so customers
could see the car, learn how to operate it, get a license, buy insurance, and drive it home the same day.4
The Tata Nano case illustrates how a company can attempt
to develop and compete with a low-cost offering. (For an update
on the Tata Nano, see “Revisiting Tata” at the end of the chapter.)
Companies typically choose between one of two “generic” strategies for offering unique value
to customers: cost advantage or differentiation advantage (the focus of Chapter 5). By designing
cars to be manufactured at the lowest cost possible, and by designing a distribution system
to get the cars to customers at the lowest cost possible, Tata has a cost advantage over every
other carmaker in India, which allows it to sell the Nano at the lowest price. Like Tata, a firm
that chooses a cost advantage strategy wins with customers by reducing its prices below all
of its competitors, thereby allowing it to gain market share. Alternatively, a firm with a cost
advantage may choose the same price as competitors, which results in greater profits rather
than higher market share.
Adopting a cost advantage strategy does not mean that the company focuses on cost to
the exclusion of everything else. Having a single-minded focus on making a low-cost product
or service can result in an offering that no one wants to buy. Although Tata attracts customers
with a low price offering, it must still worry about producing a car that works and is at least
somewhat reliable. In fact, some of the early Nanos caught fire, which scared off many buyers
until Tata fixed the problem by beefing up the heat shield in the exhaust system.
However, a company that wins by providing low-cost products or services must focus most
of its resources and capabilities on keeping its costs as low as possible. In this chapter, we’ll
explore the five potential sources of cost advantage summarized in Table 4.1: economies of
TABLE 4 .1
Sources of Cost Advantage
Economies of Scale or Scope
Greater unit volume allows firms to have lower costs by:
• spreading fixed costs across more units
• specialization of equipment and people
Learning and Experience
Greater cumulative volume drives cost differences due to greater learning and experience within companies with more cumulative experience
in production.
Proprietary Knowledge
Some companies develop proprietary knowledge in the production of their product or service, which leads to a cost advantage.
Input Costs
Some companies may have lower input costs than others due to:
• greater bargaining power over suppliers or labor
• superior cooperation with suppliers (including lower transaction costs)
• sourcing from low-cost locations (e.g., country comparative advantage)
• preferred access to inputs
Different Business Model
Eliminating activities or steps in the value chain or using a different set of activities altogether may allow a firm to deliver a product or service
at lower cost.
Economies of Scale and Scope
63
scale or scope, learning or experience effects, proprietary know-how, lower-cost inputs, and
using a different business model.
Economies of Scale and Scope
One of the primary reasons large companies dominate many manufacturing and service industries is because of economies of scale. Economies of scale exist when an increase in company
size (measured as volume of production) lowers the company’s average cost per unit produced.5
For example, if Tata can sell a volume of 100,000 cars instead of 10,000 cars, the cost to produce
each car will fall as the total volume or scale of production increases. When there are significant
economies of scale in manufacturing, research and development (R&D), marketing, distribution, or service, large firms have a cost advantage over smaller firms.
Economies of scale arise from four principal sources: the ability to spread fixed costs
of production, the ability to spread nonproduction costs, specialization of equipment, and
specialization of people.
economies of scale A reduction
in costs per unit due to increases
in efficiency of production as the
number of goods being produced
increases.
Ability to Spread Fixed Costs of Production
High volumes of production enable firms to spread the fixed cost of production, such as the
costs of plant and equipment, thereby lowering their cost per unit. A simple way to think
about this is to imagine two roommates who decide to share the $3,000 cost of purchasing a
big-screen TV. In this case, the cost per roommate is $1,500. If, however, another roommate
joins in on the purchase, the cost per roommate will decrease to $1,000, because there are
now three roommates. If there were five roommates, the cost would drop still more, to $600
per roommate. The more roommates with whom to spread the cost of the TV, the lower the
cost per roommate.
In similar fashion, companies can spread the costs of their plant and equipment when they
have more customers to share the cost. For example, it might cost a company $1 million to purchase equipment and a plant with the capacity to produce one thousand units of a particular
product; but it might cost that company only $2 million to build a plant with the capacity to produce five thousand units. This happens because, in many activities, increases in output do not
require proportionate increases in input. For example, building an auto plant that can produce
100,000 cars does not cost Tata five times the cost of a 20,000-car plant. The larger plant would
typically only cost two to three times as much as the smaller one.6
Ability to Spread Nonproduction Costs
High volumes of production also enable firms to spread the cost of nonproduction functions
across more units, thereby lowering the cost per unit. Large volumes enable companies to
spread the cost of R&D, advertising, and general and administrative expenses.
Research and Development Firms that incur high R&D expenses—such as in the
pharmaceutical industry—have a strong incentive to expand operations globally to as many
customers as possible. Once a pharmaceutical company has made the R&D investment to
develop a new drug, those costs essentially become a fixed cost to spread across as many consumers as possible. In fact, some research has shown that the best predictor of whether an
industry is global (meaning that firms in the industry expand to compete on a global basis) is
the company’s R&D costs as a percentage of sales. The higher a firm’s R&D costs as a percentage
of sales, the more incentive the firm has to expand globally to spread those costs across more
customers.7
fixed cost of production Costs
such as plant and equipment,
which are relatively fixed, meaning
that they do not increase with
an increase in the number of
units produced.
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CH A PT E R 4
Cost Advantage
Advertising
In similar fashion, advertising is also subject to economies of scale. The fixed
cost of putting an advertisement in the local city newspaper is the same for a grocery chain
with one store in a particular market as it is for a chain with three stores in the same market.
By spreading the advertising cost across three stores, the larger chain will have one-third the
advertising costs per store, with the same level of advertising.
general and administrative
costs (G&A) Expenses and taxes
that are directly related to the
general operation of the company,
and executive salaries, general
support, and taxes related to
the overall administration of
the company.
General and Administrative Costs General and administrative costs (G&A)
include the costs of accounting, finance, human resource management, and the chief executive
and her staff. A company with high sales volume can spread its G&A costs across more units,
thereby creating a cost advantage. Walmart’s general and administrative costs are only about
0.5 percent of sales, for example. This is a much lower proportion than its struggling competitor
Sears Holding Company, which has had G&A costs of roughly 2 percent of sales.8 Walmart actually spends, on an absolute basis, more than three times as much on G&A as Sears Holdings
Company does. It is because Walmart’s sales volume is more than 10 times greater that G&A is
a much smaller percentage of its sales.9
Specialization of Machines and Equipment
Companies with large volumes are also able to produce at low cost because they can invest in
specialized machines and equipment. A firm that has high volumes of production is often able
to purchase and use specialized equipment or tools that small firms simply cannot afford, due
to their lower production volumes. For example, in the ball bearing industry, the lowest-cost
way to produce fewer than 100 rings is to do it on general-purpose lathes. Producing between
100 and 1 million rings is done most efficiently with a specialized screw machine. Companies
that produce more than 1 million rings can afford to purchase an even more specialized highspeed, continuous-process machine that further lowers the cost per unit. As volumes increase,
firms have the ability to use specialized (often automated) machines to do work at lower cost
per unit.10
Specialization of Tasks and People
High volumes of production also permit greater task specialization, thereby leading to greater
employee specialization.
task specialization Breaking
a large process into smaller
tasks that require specialized
knowledge.
Task Specialization
employee specialization
Increased efficiency that results
when employees perform a
narrow range of tasks over and
over again, leading them to
acquire specialized knowledge
that helps them complete the task
more efficiently.
Employee Specialization Employees who specialize in accomplishing a particular
task, such as accounting, legal, or tax work, often bring high levels of skills to their tasks. The
value of employee specialization occurs not just in manufacturing environments, but also in
knowledge industries such as management consulting, investment banking, and the legal profession, where specialization of labor permits larger firms to offer a wider range and depth of
expertise to potential clients.
Smaller firms often do not have the volume necessary to justify high levels of employee
specialization—and when they do hire specialized employees, there might not be enough work
to keep them busy all of the time. This is why small firms are more likely to have employees who
are required to perform multiple business functions and why they often outsource to subcontractors specialized work, such as accounting, legal, or taxes.
When work tasks are specialized, workers can become more and
more efficient at the particular task and avoid the loss of time that occurs from workers switching between jobs. For example, Henry Ford’s big breakthrough in the mass production in automobiles involved breaking down the production process into a series of separate tasks that
could be performed by highly trained and specialized workers. Some workers specialized on
design, others on specific parts, and others on testing.
Economies of Scale and Scope
65
Evaluating Economies of Scale: The Scale Curve
Cost per Unit of Production
As we’ve seen, due to economies of scale, we expect cost per unit of output to decrease as unit
volumes increase. This relationship can be shown in a graph, the scale curve pictured in
Figure 4.1. Service businesses do not produce “units” of products like manufacturing businesses. Instead, in most cases, companies use some version of “number of customers served”
as their unit of analysis. Service companies can typically create scale curves that show how the
cost to serve customers decreases as the number of customers served increases.
At some point, however, the costs per unit no longer decrease with increases in volume.
This point, shown at Q1 in Figure 4.1, is called the minimum efficient scale. It is the optimal
quantity for a company to produce.
If a company continues to increase its volume beyond the minimum efficient scale, the
cost per unit actually starts to increase, due to diseconomies of scale. In large organizations,
diseconomies of scale can happen because large plants become very complex to manage. This
increase in size and complexity tends to lead to increased waste and lower employee motivation, which, in turn, leads to increased supervision costs.
Moreover, while large firms typically have an advantage in economic upturns, they are
sometimes at a disadvantage during downturns because they have more difficulty spreading
fixed costs when demand declines, as described in Strategy in Practice: The Downside of Size
and Scale in the Airline Industry.
scale curve A graphic
representation of the relationship
between cost per unit and scale
(volume) of production in a given
time period.
minimum efficient scale The
smallest level of output (unit
volume) that a plant or firm can
produce to minimize its longrun average costs. In a graphic
presentation of output/unit
volume (x-axis) and cost per unit
(y-axis), it is the output level
where costs per unit flatten and
no longer continue going down
with increased output.
diseconomies of scale An
increase in marginal cost when
output is increased.
Economies of Scale
Minimum Efficient
Diseconomies of Scale
Scale
(optimal quantity)
Q1
Low
High
Volume of Production
FIGURE 4.1
Economies of Scale
Strategy in Practice
The Downside of Size and Scale in the
Airline Industry
After the terrorist attacks on September 11, 2001, airlines in the
United States experienced a dramatic decrease in passengers
because people were worried about flying.11 During the prior
10-year period, American, Delta, and Northwest—the largest carriers in the United States—had been among the most profitable, in
large part because of their economies of scale. But during the threeyear period immediately following 9/11, these three airlines were
among the least profitable.
So how did being a large airline become a liability? There
were many contributing factors. One of the most important
reasons was that these large airlines had heavy fixed costs. Prior
to the attacks, they had spread those costs across a lot of passengers. After the attacks, American, Delta, and Northwest still
had the same fixed costs, but they had a much smaller volume
of passengers. These airlines suddenly had too many planes, too
many gates, and too many employees for the smaller number
of passengers they were serving. Combined with the economic
downturn following 9/11, the airlines’ inability to spread their
fixed costs over a large number of passengers cut deeply into
their profits.
Although economies of scale can be an advantage during
an economic boom, they can be an anchor weight during an economic bust.
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CH A PT E R 4
Cost Advantage
Some firms with heavy fixed costs have moved to reduce the risks of large fixed costs
by shifting more of their cost structure from fixed cost to variable cost. One way they do this
is by outsourcing more of their activities, which will be discussed in depth in Chapter 7. For
example, rather than invest in information technology personnel or equipment, they may
outsource these services to a low-cost provider, perhaps in India. For these firms, the cost of
information technology now varies according to how much the firm uses the subcontractor’s
services. During a downturn, the company does not have to continue paying for people or
equipment it is not using. Another way they may convert fixed to variable costs is by leasing equipment on a short-term basis, allowing them to turn equipment back to the lessor if
demand is low. The key point to remember is that size and scale do not always guarantee a
cost advantage.
Economies of scale are more relevant in some industries than others, meaning that costs
per unit fall more rapidly with increases in volume in those industries. Scale curve slopes in
these industries are described as “steeper” than those in other industries. One such industry
is the mobile (cell) phone service industry. Figure 4.2 shows data for a wireless carrier, which
estimates a scale curve. This scale curve suggests that costs per subscriber (shown on the
vertical axis) drop by roughly 18 percent with each doubling of the number of subscribers
(shown on the horizontal axis). For mobile phone companies, volume brings significant benefits. The relatively steep scale curve of the mobile phone service industry is a primary reason
for mergers and acquisitions in that industry, as companies try to grow larger and get more
subscribers. Today, a small number of large companies dominate the market. For AT&T,
Verizon, and Sprint, the fixed costs per subscriber drop by 10 percent to 25 percent with every
doubling of the number of subscribers, because these companies can spread across more subscribers the fixed costs of the cell phone towers required to route calls and the retail stores
required to serve customers.
Economies of Scope
Economies of scope differ from economies of scale in that the company does not reduce costs
by increasing the volume of a specific activity but by expanding the scope of its operations to
related activities, so that some costs can be shared.12 Economies of scope exist when the cost
of conducting two business activities within the same company is less than the cost of
those same two businesses operated separately. To illustrate, when PVH, parent company to
Calvin Klein, Tommy Hilfiger, IZOD, Speedo, and Van Heusen, opens up a Calvin Klein store,
$40.00
Average Cost per Subscriber
(Constant Dollars)
economies of scope The
average total cost of production
decreases as a result of increasing
the number of different
goods produced.
$35.00
$30.00
$25.00
$20.00
$15.00
5,000,000 15,000,000 25,000,000 35,000,000 45,000,000 55,000,000 65,000,000
Number of Subscribers
Scale Curve: y = 3184.8x–0.271
Average Slope: 2a = 2(–0.272) = 0.83
Cost per subscriber falls (1 – 0.83) = 17 percent with each doubling of cumulative subscribers.
FIGURE 4.2
Wireless Scale Curve
Source: Wireless Experience Curve (Constant Dollars).
Learning and Experience
67
a Tommy Hilfiger store, and an IZOD store all in the same outlet mall, the company is looking for
economies of scope. Each of these stores sells different kinds of products and therefore they
perform different activities in terms of product design, product mix, suppliers, and marketing.
However, the activities required to run these three separate stores are not completely unrelated. All three stores need to find—and sign leases for—optimal locations in the mall. All three
stores also need to have their products shipped to the mall.
When these stores are part of the same company, the company can lower the costs of
securing retail space by (1) using the same people to identify, and negotiate the lease for, all
three stores, and (2) using the bargaining power of leasing space for three stores rather than
one to negotiate a better deal. PVH can also lower distribution and shipping costs by using the
same warehouses and trucks to ship products to the mall. The company might engage in joint
store promotions to boost sales, perhaps distributing promotional offers good for IZOD at the
Calvin Klein stores, or vice versa.
The greater scope of its operations is what allows PVH to share some of the costs of operation across its three stores. We discuss economies of scope in greater depth in Chapter 6:
Corporate Strategy.
Learning and Experience
Some companies use the basic premise of “practice makes perfect” to help them pursue a
cost advantage strategy. These companies are relying on the fact that humans can perform
tasks more efficiently—more quickly, with greater dexterity—the more a task is repeated. Doing
a task a lot of times also often helps people become more effective, that is, they find better ways
to complete the task. Researchers and strategists measure the effects of learning and experience using the learning curve and the experience curve.
cost advantage strategy A
strategy in which the unique value
offered to customers is lowerpriced products or services.
The Learning Curve
The learning curve is a tool that managers can use to determine the contribution of human
learning on the part of employees to reductions in costs per unit. During World War II, researchers first noticed a labor costs per unit decrease with an increase in cumulative output. The
researchers studied an aircraft manufacturing firm. They calculated that the number of labor
hours required to build each aircraft fell by roughly 20 percent each time the cumulative volume
of production doubled.13 Since that initial discovery, a similar pattern has been found in many
other industries, including the manufacture of ships, computers, and TVs.14
Learning curve advantages are also relevant in service industries such as accounting, consulting, legal services, and even personal services such as hair styling. As an accountant completes a greater number of tax returns, she learns how to do it more quickly. The same can be
said for a lawyer who repeatedly handles divorces or hair stylists repeatedly giving clients a
particular hairstyle.
The learning curve is more complex than a scale curve to calculate because it requires
gathering data on the cumulative volume of a given product or service produced, the total
amount since the company started making the product or providing the service. In contrast, the
scale curve, described earlier in this chapter, shows how costs per unit change with increases of
volume of production during a given time period, such as a quarter, half-year, or year. It is easier
for companies to obtain cost information from specific time periods.
The Experience Curve
In 1968, the Boston Consulting Group (BCG) generalized the concept of the learning curve to
encompass not just direct labor hours but all costs incurred to produce a product or service.15
BCG conducted a series of studies on a variety of products and services ranging from bottle caps to refrigerators to long-distance telephone calls, and they found that costs per unit
learning curve The concept that
labor costs per unit decrease
with increases in volume due to
learning. New skills or knowledge
can be quickly acquired initially,
but subsequent learning becomes
much slower.
Cost Advantage
The cost per unit of a standard product or service declines by a constant percentage
(typically between 10 percent and 30 percent) each time cumulative output doubles.16
Although the law of experience is phrased in terms of cost reductions, the slope of an
experience curve is described according to the percentage of costs that remain after doubling
cumulative volume, rather than by the reduction in costs. For example, Figure 4.3 shows an
80 percent experience curve slope for semiconductors. This means that with each doubling of
cumulative volume, the cost has dropped by 20 percent, which means that costs are 80 percent
of what they were before volume doubled. If the thousandth semiconductor produced costs
a company $100 to make, then the two-thousandth semiconductor costs $80, and the fourthousandth semiconductor will cost $64, or 80 percent of $80.
60.00
Average Slope = 0.798
Average Decrease in Cost with Doubling
of Volume = 20.2%
50.00
40.00
30.00
20.00
10.00
FIGURE 4.3
Semiconductor Industry Experience Curve
00
00
,0
00
5,
0
00
,0
00
Cumulative Volume of Production (units)
4,
5
00
,0
00
4,
0
00
,0
00
3,
5
00
,0
00
3,
0
00
,0
00
2,
5
00
,0
00
2,
0
00
,0
1,
5
00
0.00
00
,0
law of experience Costs per
unit decrease with increases in
cumulative volume of production.
1,
0
experience curve A
representation of the relationship
between cumulative volume and
product cost.
(and prices) fall in a predictable way with increases in cumulative volume. Costs drop with
increases in cumulative volume due to a combination of factors, including economies of scale,
but also due to learning.
The experience curve shows how costs per unit change with increases in cumulative
volume produced. Like the learning curve, calculating an experience curve requires cumulative
volume data. An experience curve does a better job of capturing learning effects than a scale
curve, because it is based on cumulative volume, like the learning curve. But it also does a
better job of capturing the effects of economies of scale than a learning curve does, because it
includes all costs, not just labor. However, if data from the same time period are used to calculate a scale curve and experience curve, both analyses produce the same result. For detailed
instructions on how to calculate a scale or experience curve using Microsoft Excel, see the
Strategy Tool at the end of the chapter.
Like scale curves, experience curves are applicable to service, as well as manufacturing,
industries. Recall that, for service industries, the unit of analysis is generally “number of people
served.” For example, one of the authors of this book consulted with a bank that was providing
credit card services (a store-brand credit card) to Fry’s Electronics, a retail chain that competes
with Best Buy. The bank was trying to decide whether to invest more money in marketing to
convince more of Fry’s customers to apply for, and use, a Fry’s credit card. Our question to the
company was: How much do your costs decrease as you add credit card subscribers? What is
the slope of your experience curve? By understanding how much costs would decrease if the
company doubled its number of credit card subscribers, the company would know how much
it could afford to spend in marketing to get additional customers.
Since BCG’s early studies, literally hundreds of studies have shown that production costs
usually decline by 10 percent to 30 percent with each doubling of cumulative output. All of this
research is summarized in the law of experience:
0
50
0,
00
0
CH A PT E R 4
Cost per Unit of Production ($)
68
Learning and Experience
Learning and experience curve slopes tend to be steeper in the early stages of production
because learning occurs more rapidly in the early stages of production. This is because the
most obvious opportunities to reduce costs will present themselves early in the experience of a
company, but after those easy changes are adopted, gains from learning come in smaller increments. Both scale curves and experience curves tend to be steeper in manufacturing industries
than they are in service businesses—which means volume tends to be more important for success in manufacturing industries.
Experience Curves and Market Share
To a strategist, the logic of the experience curve suggests that the company with the highest
volume in an industry—the highest share of an industry’s output—will also be the lowest-cost
producer. In fact, early work by the Boston Consulting Group showed that a company’s relative
market share was a key indicator of competitive advantage and profit performance.17 This finding was corroborated by the PIMS studies (an acronym for Profit Impact of Marketshare Studies), which showed a consistent positive correlation between a company’s market share and its
profitability in most industries.18 As discussed in Strategy in Practice: The Relationship Between
Market Share and Profitability in Retail Industries, the correlation can sometimes be seen in
retail as well as manufacturing industries. The logic was as follows: the higher the company’s
volume (its market share), the lower the costs per unit, and the better the profit performance.
A company’s market share was seen as a key driver of firm profitability.
Strategy in Practice
The Relationship Between Market Share and
Profitability in Retail Industries
Food retailers such as Albertsons and Pathmark sell thousands of
products, as do home improvement retailers such as The Home
Depot and Lowe’s. In retail industries, where companies sell multiple products, it is not possible to analyze an experience curve,
because retailers do not have a “cost per unit,” as manufacturers do.
Another way for firms in these industries to answer the question, “Do I need to be big to be profitable?” is to plot each company’s
market share (its share of industry revenues) on the x-axis and each
company’s profit margins (operating profit as a percent of revenues)
on the y-axis. Figure 4.4 shows an example of such a graph for the
home improvement industry. This graph shows a clear positive
relationship between national market share and profit margins. The
Home Depot and Lowe’s have high market share in the United States
and are much more profitable than Sears, Ace Hardware, or True
Value hardware. In this particular industry, it appears that national
market share contributes to lower costs and higher profitability.
However, we conducted this same analysis in the food retailing industry, using companies such as Albertsons, Kroger, Safeway,
Pathmark, A&P, Giant Food, Wegmans, and Food Lion. That graph
showed that national market share was not a good predictor of
firm profit margins. Many regional supermarket chains, including
Wegmans and Giant Food, were more profitable than larger national
chains, such as Albertsons and Safeway. We can conclude that it is
not critical to have high national market share to be successful in
food retailing.
8.0%
7.0%
Lowe’s
Net Profit Margin
6.0%
Home Depot
5.0%
4.0%
Walmart
3.0%
2.0%
1.0%
True Value
Sears
Ace Hardware
0.0%
0.0% 2.0% 4.0%
FIGURE 4.4
6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Market Share in Revenue
The Market Share-Profit Relationship: Home Improvement Retailing
Note: Market share figures are for 2004; profit figures are an average of 2000–2005.
69
70
CH A PT E R 4
Cost Advantage
The initial conclusion from studies on the market share/profitability relationship was that
if a company wants to increase its profitability, it should increase its market share. This had a
clear implication for pricing strategy: A company should set its price based on its anticipated
costs per unit (at the higher market share), not at current costs per unit. This kind of anticipatory pricing strategy would presumably trigger actual increases in market share, along with
lower costs per unit and higher overall profitability.
Does this strategy work? Not usually, and here’s why: Imagine that you compete in an
industry with five other companies that all hold the view that market share is the key to profitability. To acquire market share from each other, each organization will have to drop its
prices or increase its advertising and marketing costs. If all companies in a market adopt this
approach, it seems clear that none of the firms will be particularly successful at either gaining market share or increasing profitability.19 The general consensus of strategists now is that
market share cannot be easily purchased. Rather, it is most often earned, through a low-cost
strategy or by offering a differentiated product. For example, Air Asia is currently the low-cost
airline in Asia—and perhaps the world—because it has very low labor costs and provides fewer
amenities to customers than its competitors do.20 In fact, to keep costs low it doesn’t even
rent gates at airports, but instead buses its passengers out to the tarmac where they board
the plane. Air Asia consistently prices lower than competitors who realize they cannot afford
to match the low prices. As a result, Air Asia is rapidly growing its market share by offering
lower prices.
Most strategists today acknowledge that there is a correlation between market share and
profitability and appreciate that greater market share will lead to lower costs per unit. As Air
Asia grows its market share in the airline industry, for example, its cost per unit will decrease,
which will further improve Air Asia’s profitability. However, in most cases the cause of both
market share and profitability is some common underlying factor, such as a lower-cost method
of production or an innovative product that allows a firm to simultaneously grow market share
and profitability. In Air Asia’s case, its low-cost position is what allows it to grow market share
and profitability simultaneously. In the case of Apple, its ability to simultaneously grow market
share in music players (with iPod) and phones (with iPhone) while increasing profits is due to
its ability to create an innovative product.
How Strategists Use the Scale and Experience
Curves to Make Decisions
Scale and experience curves are useful tools for making practical strategic decisions about
growth and investment strategies, pricing strategies, strategies for managing costs, and acquisition strategies.
Growth/Investment Strategy
As we’ve mentioned, experience curves tend to be
steeper in fast-growing industries. A scale or experience curve slope in a particular industry that
is quite steep (a slope less than 85 percent is quite steep, meaning that with each doubling of
volume, costs drop by 15 percent or more) indicates that first movers in a fast-growing market
will secure a widening cost advantage. Firms in an industry with a steep curve have an imperative to grow as fast, or faster, than their rivals, so they do not end up at a cost disadvantage.
Moreover, a steep curve also suggests that a firm should take whatever action is necessary to
become a market-share leader. Some strategists have advocated for the philosophy, “Be #1 or
#2, or exit.” This philosophy may make sense in industries with steep experience curves, where
it is difficult to be profitable if the business is not #1 or #2 in unit volume.21
Pricing Strategy A scale or experience curve can also be useful as a basis for pricing
strategy. A company can use the curve to anticipate future costs at different levels of volume.
If higher unit volumes will produce lower costs per unit, the company may want to price its
product or service aggressively low now, so that it can gain enough market share to reach
those higher volumes and make more money. For example, Hyundai has been described as
Learning and Experience
71
a company that is pricing very aggressively to gain market share in order to lower its future
costs per unit.22 The strategy seems to be working, as evidenced by the fact that share has
tripled in the United States in the last 10 years. Of course, as we pointed out earlier, if all firms
in an industry attempt to price for market-share gains without a sustainable cost advantage,
the strategy may not work for any of them.
Cost-Management Strategy
A scale or experience curve can also be used as way to
assess a company’s relative cost position. For example, it is possible to plot scale or experience
curves for a company and for its competitors, allowing company leaders to assess how well
each company is managing its costs. For many years, General Motors produced more cars than
any other automaker in the world. An industry-wide analysis of several companies’ cost per
unit produced (each car) showed, however, that while General Motors produced the most units,
it did not have the lowest cost per unit.23 Toyota, Honda, and Hyundai all had lower costs per
unit. This type of analysis suggests that General Motors was not managing its costs well. Given
its high production volumes, it should have lower costs per car. There is probably much GM can
learn from its lower-cost competitors.
Acquisition Strategy
Finally, a scale curve can be useful to predict cost synergies: the
amount by which costs will likely decrease if two firms combine their volume/scale. For example,
Guest Tek, a company that delivers Internet service to hotel rooms, saw an opportunity to lower
its cost per room with the purchase of its competitor Golden Tree. Guest Tek had a volume of
200,000 rooms, and Golden Tree also provided Internet service to roughly 200,000 rooms.
Acquisitions are often based on such synergies, which is why acquiring firms must pay
a premium to the shareholders of the target firm. How much was Golden Tree worth to
Guest Tek? An experience curve analysis allowed Guest Tek to see that its total operating
cost per room per day was decreasing by 29 percent with each doubling of rooms (a 71 percent slope, as shown in Figure 4.5). The acquisition of Golden Tree would almost double the
number of rooms serviced, so Guest Tek could expect costs to drop by close to 29 percent.
The actual drop would probably be somewhat less, due to the costs associated with integrating the operations of the two separate companies, but at least Guest Tek had some idea
of the cost synergies that it would likely generate as the result of acquiring Golden Tree. Guest
Total Operating Cost per Room per Day
$0.80
$0.75
$0.70
Guest Tek costs fall by
an average of 29
percent with every
doubling of room count1
$0.65
$0.60
$0.55
$0.50
$0.45
$0.40
$0.35
$0.30
$0.25
Acquisition of
Golden Tree
(200,000 rooms)
$0.20
$0.15
$0.10
0
70,000
140,000
210,000
280,000
350,000
420,000
490,000
560,000
Number of Rooms (Installed Base)
1Power
function (based on trend-fit) is C = 154.13 Q–.4955. Doubling volume (2–0.4955) delivers a
cost that is 71 percent of previous level.
FIGURE 4.5
The Value of Scale in Delivering Internet Service to Hotel Rooms
Note: Guest Tek Operating Cost per Room, 2003–2006
relative cost The costs incurred
by one company compared to the
costs paid by a competitor.
72
CH A PT E R 4
Cost Advantage
Tek went ahead with the acquisition and achieved the expected cost synergies, leading to
record profits.
In summary, scale curve or experience curve analysis can be an extremely useful tool for
the strategist in making a number of key strategic decisions.
Proprietary Knowledge
proprietary knowledge
Information that is not public and
that is viewed as the property of
the holder.
In some cases companies are able to achieve a cost advantage due to proprietary knowledge
that is independent of scale or output. As described in the opening case, Tata designed the
Nano in a unique way, for example, using a specially designed 35-horsepower, rear-mounted
engine. Tata developed some important proprietary knowledge in designing the low-cost vehicle, some of which is protected by the 34 patents it applied for when it completed the design.24
Patents are often important sources of proprietary intellectual property. Another auto manufacturer, Toyota, has long been known to have lower production costs than its US competitors
in the auto industry—GM, Ford, and Chrysler—because it has pioneered flexible production
techniques (sometimes called the Toyota Production System, or TPS), while US firms have historically used mass production techniques.25 These techniques are not protected by patents
but by trade secrets.
The architect of the Toyota Production System was Taiichi Ohno, a Toyota engineer who
realized that Toyota simply didn’t have the volume of production required to compete with
US automakers on the basis of economies of scale. So, Ohno invented a set of processes that
allowed Toyota the flexibility to make three to four different car models within the same plant.
US automakers, in comparison, could typically only make one or two different car models within
the same plant. A key principle of the Toyota Production System is “just-in-time” delivery of
components, both from outside suppliers and from different manufacturing stations within the
plant. Delivering components close to the time they will be used keeps inventories at plants
low and minimizes waste.
Studies have shown that the Toyota Production System comprises roughly 30 key
processes, including its “just-in-time” delivery. Although US automakers have tried to imitate
many of the practices of TPS, they have been relatively unsuccessful at understanding the
full proprietary system and how it works. As a result, Toyota has been able to maintain a cost
advantage and quality advantage over many competitors.
Lower Input Costs
inputs Resources such as
people, raw materials, energy,
information, or financing that
are put into a system (such as an
economy, manufacturing plant,
computer system, etc.) to obtain a
desired output.
Inputs are any purchases that are made by a firm in the course of conducting business activities. The term inputs is broad. It includes raw materials, supplies, parts, and equipment. Inputs
also include labor, capital, and land. When companies in a particular industry purchase their
inputs as commodities from the same competitive input markets, we can expect every company to pay the same price for identical inputs.
In some situations, however, companies can achieve a cost advantage through lower-cost
inputs. There are four primary ways that companies achieve cost advantage through lower-cost
inputs: (1) exercising strong bargaining power over suppliers, (2) cooperating especially well
with suppliers, (3) getting inputs from low-cost locations, and (4) arranging better access to
inputs than other companies have.
Bargaining Power over Suppliers
Perhaps the most important way that companies get lower-cost inputs is by having greater bargaining power over suppliers than their competitors do. There are two main sources of bargaining power: buying a lot from the supplier and using successful negotiating tactics.
Lower Input Costs 73
Purchasing Volume Perhaps not surprisingly, suppliers can be expected to drop prices
when buyers increase their volume of purchases. Indeed, as a rule of thumb, suppliers are
known to drop prices by 5 percent to 10 percent with a doubling of purchased volume. At high
volumes, suppliers experience economies of scale and the law of experience, so they can lower
their prices. Walmart, for example, is known to get lower cost per unit prices from suppliers
because it can guarantee significantly higher volumes than its brick-and-mortar competitors,
Target and Sears Holdings Company.
Purchasing and Negotiating Tactics Even when two firms purchase similar volumes of inputs, one of the firms may have negotiation skills and purchasing tactics that allow it
to get inputs at lower prices. Once again, Walmart is well-known for its purchasing strategy and
tough negotiating tactics. Walmart spreads its purchases across numerous suppliers, so that no
one supplier has a dominant market share in any particular product category. The company’s
willingness to drop a supplier’s product if another supplier comes in with a lower price is widely
known. These practices let suppliers know that they are expendable, which creates an incentive
for suppliers to always give Walmart their lowest prices.26
Cooperation with Suppliers
Rather than strong-arm suppliers into offering lower prices as a result of bargaining power,
some companies achieve cost advantages by working cooperatively with suppliers. Toyota is
known for working cooperatively with suppliers to get lower-cost and higher-quality inputs.
Rather than spread purchases across multiple suppliers, Toyota has a two-vendor policy; it
typically works with only two partner suppliers of a particular input. By working with a smaller
number of suppliers, Toyota is able to devote resources to make sure it coordinates very effectively with these particular suppliers.27 Toyota will even send its own engineers, who are manufacturing experts in TPS, to help suppliers implement more efficient manufacturing processes
to lower their costs. As a result of their close, highly cooperative relationship with Toyota, many
suppliers will build their manufacturing plants close to Toyota’s automobile assembly plants,
thereby lowering the costs of transportation, logistics, and face-to-face communications.
Toyota is often able to get lower input costs from suppliers by developing relationships that
are highly cooperative.
Location Advantages
Another way to achieve cost advantage through low-cost inputs is to source inputs from the
lowest-cost location or country. The price of inputs can vary significantly between locations
because of differences in wage rates, exchange rates, or raw material or energy costs.
• Wage rates. When Nike entered the athletic footwear industry in the late 1970s, Adidas
was the world leader. Adidas produced high-quality shoes primarily in Europe, where
labor rates were quite high. Textile workers were paid approximately $20 per hour in 1990.
Nike decided to source all of its shoes from Asia, starting in Korea (where wage rates were
roughly $2.50 per hour in 1990) and then later mainly in China and Indonesia (where wage
rates were roughly $0.50 an hour in 1990).28 Because high-quality athletic shoes require a
lot of hand-stitching labor, Nike was able to get shoes at far lower cost than Adidas. Nike
used these cost savings to invest in marketing, athlete endorsers, and shoe design—a
strategy of differentiation.
• Exchange rates. In the late 1990s, the value of the Indonesian rupiah fell from 4,000 rupiah
per dollar to more than 10,000 rupiah per dollar. This meant that Nike could buy more
rupiahs with each dollar. It also meant Nike could buy shoes manufactured in Indonesia
for less than it could purchase shoes made in countries, such as China, where the currency
had more value compared to the dollar.
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CH A PT E R 4
Cost Advantage
• Raw material and energy costs. The production of aluminum requires significant energy,
which is why much of the production is done in countries with low-cost hydroelectric
power, such as Canada.29 Pulp and paper producers have typically come from countries
such as Canada and Scandinavia that have access to forests and hydroelectric power.30
Preferred Access to Inputs
In some instances, a company may have a cost advantage because it has preferred access to
particular inputs—it can get them more easily than other companies can. For example, drilling
oil in Saudi Arabia requires only the simplest drilling technologies, because drilling is less complicated in the desert and oil is more frequently found relatively close to the surface. For this
reason, Saudi Arabian oil companies, like Saudi Aramco, can access oil more cheaply than most
oil companies in the world can. Not surprisingly, Saudi Aramco is reportedly the most profitable
oil company in the world. In similar fashion, the diamond company De Beers has historically
had preferred access to diamonds because De Beers owns and controls the output of a large
percentage of the world’s diamond mines.31
Companies gain a cost advantage only through preferred access to inputs when those
inputs are raw materials (such as oil or diamonds) that are rare and difficult to imitate.
Different Business Model or Value Chain
business model The plan and
set of activities implemented by
a company to offer unique value
and generate revenue and make a
profit from operations.
value chain The sequence of all
activities that are performed by
a firm to turn raw materials into
the finished product that is sold
to a buyer.
A final way to achieve a cost advantage is to use an entirely different business model, or set of
activities, to deliver a product or service. There are two basic ways to create a new business
model: to eliminate activities or steps in the value chain or to perform different activities altogether.32 The value chain refers to the sequence of all activities that are performed by a firm to
turn raw materials into the finished product that is sold to a buyer.33 Each activity is designed to
add value to the prior activity, which is why it is referred to as the value chain.
Eliminating Steps in the Value Chain
One reason Ryanair has a cost advantage over other airlines in Europe is because it does not
offer any in-flight meals, pillows, blankets, or even air-sick bags. By not offering these items,
Ryanair not only doesn’t have to purchase the items itself, but it also is able to significantly
reduce the labor costs associated with getting meals on and off its airplanes or laundering blankets and pillows.
In similar fashion, Panasonic has long had a cost advantage over competitor Sony, because
it opts to spend only one-half as much as Sony spends for research and development each year.
Rather than lead in product development, Panasonic follows, largely by imitating Sony’s technologies. Panasonic also spends less than Sony does on advertising, because it does not lead
in launching new product designs. Eliminating some R&D and advertising allows Panasonic to
have lower costs, and lower prices, for comparable products sold in electronics stores.
Performing Completely New Activities
Book retailer Barnes & Noble sells books through large superstores. Each store costs
millions of dollars to build. The company also has thousands of employees working in those
bookstores and millions of dollars of books on its store shelves. In 1995, Amazon.com began
to sell books in a completely different way—over the Internet. It was much cheaper for
Amazon to build a few large warehouses, take orders online, and ship books directly to the
customers’ homes than to do the things Barnes & Noble was doing: building superstores,
hiring employees to staff the stores, and buying and storing inventory.34 We provide a more
Summary
75
comprehensive treatment of strategies based on different business models and disruptive
innovations in Chapter 10. Some firms such as Ryanair and Amazon achieve a cost advantage by deploying a different business model, meaning that they either eliminate activities
or steps in the value chain, or they deliver their product or services using entirely different
activities from their competitors.
Revisiting Tata
At the beginning of the chapter, we described how Tata entered the motor vehicle industry with
the Tata Nano, which was heralded as “the world’s cheapest car.” Indeed, the Tata Nano was
the lowest-priced car in the world and was expected to appeal to very price-sensitive Indian
customers. Yet it hasn’t sold as expected. Between 2009 and 2014, Tata sold 229,000 vehicles—
a number far lower than expected. So what happened? Most observers point to the fact that
the Nano was marketed as the most affordable car available. But in the Indian market where
car purchases are hugely aspirational, people don’t want to buy “the world’s cheapest car.”
Purchasing a Nano makes the Indian consumer feel cheap and doesn’t give the impression that
they want to give to friends and family. Says Haritha Saranga, a professor at the Indian Institute
of Management in Bangalore, “It is important to change the current image of Nano as a cheap
car.”35 Tata has responded by trying to reposition the Nano from a cheap microcar to a “smart
city car” with the launch of the Nano Twist in 2014. With power steering, Bluetooth stereo, and
keyless entry, the Nano Twist targets a younger, more affluent customer. So Tata represents a
cautionary tale about how you position a low-cost product. For some products that are hard to
differentiate, such as sugar, salt, wheat, oil, coal, and aluminum, offering the lowest price may
be all you need to win customer business. However, for many other products, such as a car,
customers consider a broader set of factors beyond price. In Chapter 5, we turn our attention to
the ways that firms differentiate their offerings in ways other than price.
Summary
• Companies that consistently offer lower prices due to lower costs rely
on one or more of five primary sources of cost advantage: economies
of scale or scope, learning and experience, proprietary knowledge,
low cost inputs, or a different business model.
• Economies of scale produce cost advantages by allowing firms to
(1) better spread the fixed costs of production across more units, (2)
spread nonfixed costs across more units, and/or (3) invest in the specialization of machines and employees that lower the per-unit costs
of production.
• Learning produces cost advantages by improving employees’
efficiency and effectiveness. A learning curve shows reductions in
labor costs per unit as cumulative volumes of production increase. A
similar analysis that considers all costs produces an experience curve.
• A scale curve shows how cost per unit decreases with increases in
volume of production. An experience curve shows how cost per unit
decreases with increases in cumulative volume of production. Scale
and experience curve analysis are useful for:
making investment/growth decisions,
making pricing decisions,
analyzing a company’s relative cost position and looking for
opportunities to reduce costs, and
making acquisition decisions.
• To a strategist, experience-curve logic suggests that the company
with the highest share of an industry’s cumulated output will also
be the lowest-cost producer. However, a strategy to simply buy
market share, or grow volume, through increases in advertising
or lowering prices does not typically result in higher profits. The
correlation between high market share and high profitability is
the result of some underlying factor, such as low-cost production methods or an innovative product that causes both to grow
simultaneously.
• Even when producing similar volumes, some companies are able to
achieve a cost advantage as a result of proprietary knowledge about
how to produce a product or service.
• Lower input costs are possible due to (1) bargaining power over suppliers or labor, (2) superior cooperation with suppliers, (3) sourcing
from low-cost locations, or (4) preferred access to inputs (e.g., ownership of key raw materials).
• Some firms achieve a cost advantage by deploying a different
business model, meaning that they either eliminate activities or
steps in the value chain, or they deliver their product or service using
entirely different activities than competitors.
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CH A PT E R 4
Cost Advantage
Key Terms
business model 74
cost advantage strategy 67
diseconomies of scale 65
economies of scale 63
economies of scope 66
employee specialization 64
experience curve 68
fixed cost of production 63
general and administrative costs (G&A)
inputs 72
law of experience 68
learning curve 67
64
minimum efficient scale 65
proprietary knowledge 72
relative cost 71
scale curve 65
task specialization 64
value chain 74
Review Questions
1. What are the five sources of cost advantage?
2. Which of the five major sources of cost advantage contributed to the
Tata Nano being the world’s least expensive car?
3. Explain three ways that economies of scale produce cost advantages.
4. What is a scale curve, and how is it different from an experience curve?
5. What data would you need to calculate a scale curve or experience curve?
6. Why do companies have difficulty increasing their profitability
by simply buying market share (e.g., lowering prices to increase
market share)?
7. Identify at least two ways that companies can achieve a cost
advantage through lower-cost inputs.
8. Give an example of a company that has a cost advantage because
it uses a different business model or shorter value chain than its
competitors.
Application Exercises
Exercise 1: Find the sources of cost advantage of a
successful company with low prices.
1. Identify a company you would like to learn more about that seems
to have a cost advantage—it consistently has the lowest prices in
the market.
Exercise 2: Airbnb and Uber are companies that have
successfully entered the lodging and ride-hailing markets,
respectively. Both provide offerings that are typically less
expensive than their incumbent competitors, hotel chains
and taxis.
2. Use your own experience and public sources, including the company
website or annual reports and public articles, to gather data about the
activities of that company. Based on your data, what are the primary
sources of the company’s cost advantage?
1. What are the sources of cost advantage for Airbnb and Uber? How
are their strategies similar?
3. Try to identify any resources or capabilities the company has that
enable it to achieve low costs.
3. How would you respond if you were running a hotel chain or a
taxi company?
2. Why is it difficult for hotel chains or taxis to imitate their cost
structure?
4. What, if anything, do you think prevents other companies from
easily imitating this company’s strategy? For example, is it difficult to
imitate the company’s source (or sources) of cost advantage? Why?
Strategy Tool
How To Calculate a Scale Curve or Experience Curve
Imagine that you work for a wireless phone carrier that is trying to
decide how much money it should invest in marketing and advertising in order to grow its number of subscribers. Calculating a scale
curve will let you determine the extent to which increases in the
number of subscribers result in corresponding decreases in the cost
per subscriber. The faster that costs per subscriber drop with increases
in the number of subscribers, the more money the company can afford
to spend to acquire new subscribers.
To calculate a scale curve for a particular product or service, you
need the following data: Cost per unit (in this case, the unit = one subscriber) at different levels of company volume (in this case, volume =
total number of subscribers).
References 77
You can determine the cost per unit with the following formula:
Company’s costs ÷ Number of units
Many strategists use numbers from several different years to calculate the cost per unit. Here, we provide disguised data for a wireless company’s total costs (expressed in constant dollars with inflation
taken out),36 number of subscribers, and average cost per subscriber
over 12 years.
To provide a visual summary of the relationship between number of subscribers and the cost per subscriber, create a graph that
plots the number of subscribers for each year on the horizontal (x)
axis and the cost per subscriber on the vertical (y) axis, using a piece
of graph paper or an Excel spreadsheet. To quickly estimate a scale
curve—the extent to which costs decrease with each doubling of the
volume of subscribers—select an initial year and then select a later
year with twice the number of subscribers. Divide the cost per subscriber in the later year by the cost per subscriber in the earlier year.
For example, in Year 5, the number of subscribers was twice that of Year
1, so we can divide the cost per subscriber in Year 5 ($29.85) by the
cost per subscriber in Year 1 ($36.40) to estimate the extent to which
costs drop with every doubling in volume. In this case, $29.85/$36.40
= $0.82, which suggests that after the doubling of volume, costs per
subscriber were 0.82, or 82 percent of what they were before volume doubled. This result is called a scale curve slope or experience
curve slope of 0.82, or 82 percent.
Year
Total Costs
To learn by how much, in percentage terms, unit costs drop with
every doubling of volume, subtract the average slope of the experience
curve from 1 (1 − slope). In this case, costs drop by roughly 18 percent
as the number of subscribers doubles (1 − 0.82 = 0.18, or 18 percent).
The approach we have shown here provides only a rough approximation of the scale curve. You can calculate a scale curve more accurately using spreadsheet software such as Excel. The basic way to
do this is to use a power curve to calculate a regression or trend line
through the points on a graph. The formula for a regression line that
expresses the relationship between unit cost and production volume is:
Cn = C1n−a
where:
C1 is the cost of the first unit of production
Cn is the cost of the nth unit of production
n is the volume of production
a is the elasticity of cost with regard to output
(Here, elasticity is the relationship between how changes in output
translate into changes in cost).
This analysis has been done and is shown in Figure 4.2. The
slope for the data provided above is actually 17 percent, rather than
the 18 percent we roughly estimated. Costs per unit drop by 17 percent with each doubling of volume. Detailed instructions for how to
calculate a scale or experience curve in Excel are available through
WileyPlus.
Number of Subscribers
Cost per Subscriber
1
$553,571
15,102
$36.40
2
$605,823
17,255
$35.11
3
$726,653
21,940
$33.12
4
$809,650
25,992
$31.15
5
$901,022
30,185
$29.85
6
$977,227
34,026
$28.72
7
$1,127,115
39,912
$28.24
8
$1,238,115
44,843
$27.61
9
$1,318,457
49,325
$26.73
10
$1,373,314
52,257
$26.28
11
$1,453,207
57,439
$25.30
12
$1,538,182
61,429
$25.04
References
J. Dyer, H. B. Gregersen, and C. M. Christensen, The Innovator’s DNA
(Boston: Harvard Business Review Press, 2011).
1
A. Taylor III, “The World’s Cheapest Car,” Fortune (May 2, 2011), p. 86.
2
Ibid.
3
Dyer, Gregersen, and Christensen.
4
For more on economies of scale, see S. M. Sheffrin, Economics: Principles in Action (Upper Saddle River, NJ: Pearson Prentice Hall, 2003),
p. 157; G. M. Gelles and D. W. Mitchell, “Returns to Scale and Economies
5
78
CH A PT E R 4
Cost Advantage
of Scale: Further Observations,” Journal of Economic Education 27
(Summer 1996): 259–261.
See Air Asia, “Fourth Quarter 2010 Results,” (February 24, 2011),
http://www.airasia.com/iwov-resources/my/common/pdf/AirAsia/IR
/AA_4Q10_Analyst_Presentation.pdf.
20
M. B. Lieberman, “Market Growth, Economies of Scale, and Plant Size
in the Chemical Processing Industry,” Journal of Industrial Economics
36 (2) (1987): 175–191.
21
7
See “DHL Global Connectedness Index 2012,” http://www.dp-dhl
.com/content/dam/presse/specials/gci/2012/dhl-gci-2012-chapter3
.pdf, p. 48.
22
See V. Courtenay, “Hyundai Aiming High on Several Fronts,”
WardsAuto (March 20, 2013), http://wardsauto.com/management-amp
-strategy/hyundai-aiming-high-several-fronts-2013.
See U.S. Securities and Exchange Commission, “Sears Holdings Corporation,” http://www.sec.gov/Archives/edgar/data/1310067/000131006
713000013/shld201210k.htm, p. 24.
23
9
See U.S. Securities and Exchange Commission, “Exhibit 13.3
Annual Report to Shareholders,” http://www.sec.gov/Archives/edgar/
data/104169/000010416913000011/annualreporttoshareholders
.htm, p. 26.
25
10
K. Junias, “Economies of Scale: A Survey of the Empirical Literature,”
Kiel working paper 813, Kiel Institute of World Economics (1997).
26
See http://traveltips.usatoday.com/effects-911-airline-industry-63890
.html; E. Goldschein, “13 Ways the U.S. Airline Industry Has Changed
Since 9/11,” Business Insider (September 8, 2011), http://www
.businessinsider.com/how-the-us-airline-industry-has-changedsince-911-2011-9?op=1.
27
6
8
11
“How Jack Welch Runs GE,” http://www.businessweek.com/1998/23
/b3581001.htm.
J. H. Dyer, “Dedicated Assets: Japan’s Manufacturing Edge,” Harvard
Business Review (November–December 1994): 174–178.
A. Taylor III, “The World’s Cheapest Car,” Fortune (May 2, 2011), p. 86.
24
J. P. MacDuffie, “Human Resource Bundles and Manufacturing
Performance: Organizational Logic and Flexible Production Systems in
the World Auto Industry,” Industrial and Labor Relations Review 48 (2)
(1995): 197–221.
P. Ghemewat, S. Bradley, and K. Mark, Wal-Mart Stores in 2003
(Cambridge, MA: Harvard Business School Press, 2003).
J. H. Dyer and N. Hatch, “Using Supplier Networks to Learn Faster,”
Sloan Management Review 45 (3) (2004): 57–63.
P. Rosenzweig, “International Sourcing in Athletic Footwear,” HBS
Case 9-394-184.
28
P. Chevalier, “Aluminum,” The Canadian Encyclopedia, 2012, http://
www.thecanadianencyclopedia.com/articles/aluminum, accessed
April 8, 2013.
29
For more on economies of scope see J. C. Panzar and R. D. Willig,
“Economies of Scale in Multi-Output Production,” Quarterly Journal
of Economics 91 (3) (1977): 481–493; “Economies of Scope,” American
Economic Review 71 (2) (1981): 268–272; D. J. Teece, “Economies of
Scope and the Scope of the Enterprise,” Journal of Economic Behavior
& Organization 1 (3) (1980): 223.
30
L. E. Yelle, “The Learning Curve: Historical Review and Comprehensive Survey,” Decision Sciences 10 (1979): 302–328.
32
12
13
M. Gottfredsen and S. Shaubert, The Breakthrough Imperative (New
York: HarperCollins, 2008).
14
Perspectives on Experience (Boston: Boston Consulting Group, 1968).
15
Ibid.; also see G. Hall and S. Howell, “The Experience Curve from the
Economist’s Perspective,” Strategic Management Journal 6 (1985):
197–212.
16
G. S. Hansen and B. Wernerfelt, “Determinants of Firm Performance:
The Relative Importance of Economic and Organizational Factors,”
Strategic Management Journal 10 (5) (1989).
17
P. W. Farris and M. J. Moore, The Profit Impact of Marketing Strategy
Project: Retrospect and Prospects (Cambridge, England: Cambridge
University Press, 2004); R. D. Buzzell and B. T. Gale, The PIMS Principles: Linking Strategy to Performance (New York: Free Press, 1987).
18
R. P. Rumelt and R. Wensley, “In Search of the Market Share Effect,”
Proceedings of the Academy of Management (1981): 2–6.
19
See C. Campbell, Global Forest, Paper & Packaging Industry Survey:
2009 Edition—Survey of 2008 Results. PricewaterhouseCoopers, 2009.
T. Kretschmer, De Beers and Beyond: The History of the International
Diamond Cartel (New York: New York University, 2003).
31
G. Hamel, “Strategy as Revolution,” Harvard Business Review (1996).
M. Porter, Competitive Advantage (New York: Free Press, 1983).
33
“Barnes & Noble versus Amazon.com.” (A) Harvard Business School
Press.
34
S. Philip, “Tata’s Nano, the World’s Cheapest Car, Is Sputtering,”
Bloomberg Businessweek (April 11, 2013), http://www.businessweek
.com/articles/2013-04-11/tatas-nano-the-worlds-cheapest-car-is
-sputtering. Also, S. Nolen, “India’s Nano Hits Bumps on the Road,” The
Globe and Mail (November 8, 2011), http://www.theglobeandmail.com
/globe-drive/news/indias-nano-hits-bumps-on-the-road/article4252239/.
35
Scale and experience curves should be calculating using costs in
constant dollars to eliminate the effects of inflation. This can be done
using a GDP deflator where a year is selected as the base year and the
nominal costs for subsequent years are adjusted down based on inflation for each subsequent year. To convert nominal/current US dollars to
constant dollars using a GDP deflator, see http://www.measuringworth
.com/uscompare/.
36
CHAPTER 5
Differentiation Advantage
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Define product differentiation.
3. Explain how to find sources of product differentiation.
2. Describe the four major categories or sources of product
or service differentiation.
4. Discuss how to build the resources and capabilities to
differentiate.
Erkan Mehmet/Alamy Stock Photo
The Rise of Facebook
In 2004, it seemed that the social media niche had been filled. The
two largest social networks were MySpace, with 86 million users,
and Friendster, with fewer than 10 million users.1 MySpace was
open to anybody over the age of 13, while Friendster was open to
those 18 years or older. MySpace, in particular, was growing rapidly and was designed to be easily customizable to the interests of
its users. It followed the example of Friendster by having user profiles, blogs, and friendship connections, but it also made it easy to
share music and videos and was particularly popular with emerging music performers. When Facebook first launched, it wasn’t
clear that it would be successful at competing with these two social
media sites and their already-large networks of users. However, it
didn’t take long before it became clear that Facebook was offering
users things they could not get on MySpace or Friendster, and that
those things could make Facebook extraordinarily successful.
Facebook was launched by Mark Zuckerberg and his computer
science roommates at Harvard, Eduardo Saverin, Dustin Moskowitz,
and Dustin Hughes. Access to Facebook was initially limited to
Harvard students. Although membership was later expanded to
anyone with an .edu e-mail address, Facebook’s exclusivity created
a sense of privacy, security, and elitism.2 Like Friendster, Facebook
was not necessarily intended to build new friendships online, but
rather, to perpetuate real-world friendships through the Internet.
It required its users to request friends and wait for a friendship
confirmation. Only after a friendship had been established could a
user view another person’s information and photos.
MySpace, on the other hand, had a significantly more open
interface, allowing greater access to information and photos of
MySpace users. This increased the user’s ability to create online
friendships but decreased security. Numerous news stories exposed
sexual predators who sought out victims through MySpace, and
many parents would not allow their children to use MySpace
because of safety concerns.3
In addition to enhancing real-world friendships, Facebook
was the first social media site to offer a “relationship status”
option, allowing users to link their profiles to those of significant
others. Although this feature was later easily replicated by other
social media sites, Facebook was the first to offer it.
Facebook also had a different approach to customization.
MySpace offered a high degree of customizability, allowing users
to change the color and layout of their page. In contrast, Facebook
had a simple, clean, and standard appearance. Interestingly, most
users of social network sites reported that Facebook was much
easier to navigate because it didn’t allow the customizability of
MySpace.4 The standard appearance made it easier to find the
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information they were looking for. A final key difference between
MySpace and Facebook was that MySpace had several advertisements on each page, which cluttered the website and increased
the wait time for the page to load. When Facebook launched, Mark
Zuckerberg insisted that it have no advertisements, thereby adding to the minimalist appearance of the site. This approach made it
quicker and easier for users to navigate the site.
These differences quickly propelled Facebook past both
MySpace and Friendster. By 2018, Facebook had more than 1.8 billion
total active users, and on any given day, 1.1 billion of them used the
site.5 MySpace, on the other hand, had only 50 million users, 15 million of whom used MySpace daily.6 Friendster trailed far behind at
8.2 million users. Facebook’s unique features allowed it to become
the largest social networking site in the United States.
Facebook was launched at the same price as MySpace and
Friendster: Free. Thus, it wasn’t possible for Facebook to succeed
through a low-cost strategy. Instead, Facebook needed to offer something different—a product differentiation strategy—to attract users.
Why did users flock to Facebook over other social networks? The primary reasons were that
Facebook offered greater exclusivity, privacy, and simplicity; the ability to share relationship
status; and zero advertising. These were features that simply weren’t available on the other
social networking sites. These features allowed Facebook to offer unique value in a way that the
other sites did not.
Professor Clayton Christensen has argued that customers—people and companies—have
“jobs” that arise regularly that need to get done. When customers become aware of a job that
they need to get done in their lives, they look around for a product or service they can “hire” to
get the job done. As well-known marketing professor Theodore Levitt once observed, “People
don’t want to buy a quarter-inch drill. They want a quarter-inch hole!”7 A drill is one way to
do that job. Customers hire movies, concerts, or Cirque du Soleil tickets to provide an entertainment experience. They hire an iron and ironing board to help them iron the wrinkles out
of clothing, but they could also purchase clothing with wrinkle-free fabric to do the same job.
When customers go to purchase a product (or service—we will use “product” in this chapter to
refer to both products and services) to get a job done, they tend to consider two factors:
1. The way a product is differentiated from other products to perform the job (or jobs)
they want done
2. The price of the product
What Is Product Differentiation?
product differentiation A
strategy whereby companies
attempt to gain competitive
advantage by offering value that
is not available in other products
or services or that other products
don’t do as well.
Some companies decide to offer customers low-priced products and thus pursue a low-cost
strategy as described in Chapter 4. In effect, they don’t try to do a different job from competing
products; they just try to do the same job at a lower price. Other companies, such as Facebook,
choose a product differentiation strategy. Product differentiation is a strategy whereby companies attempt to gain competitive advantage by offering value that is not available in other
products or services or that other products don’t do as well.8 This value may come in the form
of different product features, product quality or reliability, convenience, or brand image.
It is important to remember that product differentiation is always a matter of customer perception.9 The actual products of two different companies may be similar or even identical in
terms of technical features (think of generic vs. branded drugs), but if one product is perceived as
being different in a way that is valued by customers, then product differentiation exists. Not surprisingly, when the perceived value of the product increases in the mind of the customer, it also
increases the customer’s willingness to pay a higher price. Thus, companies that invest resources
to create unique features in their products often charge a premium price. A higher price is typically necessary because attempts to differentiate products usually require companies to invest
resources that increase the cost of their offering.
Apple virtually always charges higher prices for its products because it invests heavily in R&D
and design in order to develop products that “wow” customers by offering unique features. However, even Apple must keep its cost structure under control so that it can offer its differentiated
Sources of Product Differentiation
products at a competitive price. If the price of an iPhone or iPad were $1,500, far fewer customers
would be willing to buy them. Thus, there is a clear trade-off companies must make between cost
and differentiation. Greater differentiation typically requires greater costs (though not always,
as we shall discuss at the end of the chapter). So, in order to make a differentiation strategy successful, customers must typically be willing to pay for greater product differentiation.
Sources of Product Differentiation
Identifying the sources of product differentiation is challenging. It seems as though there are
dozens of ways that products or services are differentiated from each other to offer unique
value. However, we have found four major categories of differentiation. As shown in Figure 5.1,
products typically offer unique value because they offer (1) different product/service features,
(2) superior quality or reliability, (3) convenience, or (4) brand image.10
Different Product/Service Features
Offering different product features is perhaps the most frequently used source of differentiation. We have found that it is useful to think about offering different product features in
three ways:
1. The product does a “better job” of meeting a customer need on existing product features.
2. The product does “more jobs” for the customer than other products.
3. The product does a “unique job” that nothing else does.
Does a Better Job on Existing Features
Some companies differentiate their products by focusing on one particular feature and doing a better functional job than other products
of providing value on that particular feature. For example, Dyson vacuums have gained market
share by claiming the CycloneTM technology in their vacuums provides better “sucking” capability. Dyson’s tagline: “The strongest suction at the cleaner head.” It doesn’t necessarily claim
that its vacuums are more reliable or lighter and easier to use—other features that customers
might care about. The key differentiator is suction capability, which is supposed to do a better
job of getting carpets clean.
Does a better job on existing
features
Superior Product
Features
Better
Quality/Reliability
What is the source of
differentiation
advantage?
More convenient to
find, purchase, use
Brand/Image
FIGURE 5.1
Sources of Differentiation Advantage
Does more “jobs” than other
products
Does a “unique” job that nothing else
does
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Before 2001, when Apple launched the iPod, Sony was the market leader11 in portable
music players, based on the success of its portable cassette-tape player, the Walkman, and
the follow-up portable CD player, the Discman. The Apple iPod beat the Sony Discman on two
key features. The iPod, which customers could fit into a pocket, was more portable than the
Discman, a key feature that many customers were looking for. Not only was the iPod more
portable, but it also had the feature of being able to store and play 500 songs, far more than
the Discman, which could play only one CD at a time. By providing better performance on key
features—portability and menu of songs available to listen to—iPod quickly came to dominate
the market. Companies can identify key features by identifying customer needs and the “jobs”
that customers are hiring products to do for them.
Some companies succeed by doing a better job of providing service to customers. Of course,
every company must provide service to customers, but some just figure out ways to exceed customer expectations. Nordstrom is an example of a company that is often lauded by customers
for providing exceptional customer service. One of the most well-known Nordstrom customer
service stories is about a man who went into the Nordstrom in Anchorage, Alaska, to return a set
of tires. Nordstrom does not sell tires. But to be responsive, the Nordstrom store manager still
decided to allow the customer to return the tires there.12 In another instance, a member of the
housekeeping staff at a Nordstrom in Connecticut noticed a customer had left her bags, along
with her receipt and a flight itinerary, in the parking lot. After Nordstrom was unsuccessful at
contacting the customer by phone, the employee drove to the airport, paged the customer, and
returned her bags.13 Nordstrom provides extensive training to employees about how to provide
great customer service, and these stories serve to create a culture that encourages extraordinary customer service. Nordstrom’s great service not only meets a functional job for customers,
it also does an emotional job for customers–it makes them feel special.
Does More Jobs In some cases, a product might not do a better functional job but simply
does more jobs, or meets more needs, for customers than competitor offerings. For example,
Facebook did a job that the other social networking sites did not do when it gave users the
ability to alert their friends about their “relationship status,” a particularly important piece of
information for teenagers and college students.
When Apple launched the iPhone, the differentiating factor was not that the iPhone made it
easier to do the same jobs as other phones, such as place a phone call or get good reception. In
fact, many users say that the iPhone is a worse “phone” than competing products. Instead, Apple
differentiated the iPhone by having it do more “jobs” for customers, beyond making calls. iPhone
users are able to easily make FaceTime video calls and use their phone to take HD videos. A second
camera is built in to make it easy for users to take self-portraits in front of the White House or the
Eiffel Tower. The many apps that were available only on the iPhone (Remember “there’s an App
for that”?) did a host of other jobs for users that no other phones had the capability to perform.14
In similar fashion, 35-millimeter cameras lost the market to digital cameras because digital
cameras could do more jobs for customers. According to most professional photographers, the
early digital cameras were technologically limited and actually took pictures that were not
as clear as pictures taken by 35-millimeter cameras. However, clarity in the photo was only
one dimension of getting a “good” picture. Consumers also wanted to see the picture at the
moment it was taken to know whether it had turned out the way they liked. Digital cameras
made it possible to instantly see the picture. Because the picture was captured on a digital
file, it was much easier to post a picture on your Facebook page, or e-mail it to friends and
family. Finally, a digital camera lowered the cost of taking each picture because customers only
printed the pictures they liked and wanted to use—as opposed to having to print the whole
roll of film. Digital cameras ultimately came to dominate the market because they simply did
more jobs for customers than their 35-millimeter predecessors.
Does a Unique Job
Some products do a completely unique job that other products
simply do not do. Rather than simply doing existing jobs better or doing more of jobs than
other products, they offer a completely new feature to the market. For example, Propecia was
the first pharmaceutical pill that was clinically proven to grow hair. No other pill could do that
Sources of Product Differentiation
unique job. Disney theme parks are the only places you can go to see Mickey Mouse or ride the
Pirates of the Caribbean to see Captain Jack Sparrow.
Products that are designed to be customizable by customers do a unique job because they
can be created expressly to meet one particular customer’s unique need. In many cases, the
customer does the customization. For example, Nike allows customers to design their own
athletic shoes by selecting from a variety of design, color, and print options. Similarly, Timbuk2
allows buyers to customize their bag or purse by selecting from a variety of modules or options.
One of the most successful companies of this type is Build-a-Bear, a company that allows you to
“build” your own stuffed animal. You choose what the animal looks like and then select various
sounds that your animal can make. The company also has a variety of different types of clothes
that you can put on your animal. This approach has often been referred to as mass customization,
meaning that a company mass-produces the various modules of the product and then allows
the customer to select which modules will be combined together.15 Companies that choose this
approach must develop the resources and capabilities necessary to create their products in
modules and to accurately combine those modules as customers request.
Quality or Reliability
Some products are differentiated because of the quality or reliability of the product. The product doesn’t necessarily do a better job as far as performance on existing features. It doesn’t do
more jobs than other products, and it doesn’t do a unique job. It simply lasts longer.
Of course, it is possible to argue that a product with superior reliability actually does do a
better job on an existing feature, as already suggested. However, it is important to note that a
product differentiated based on quality or reliability offers essentially the same features and
functionality of other products, but lasts longer. Unlike the Dyson vacuum, a product that wins
because of superior reliability would not offer “better sucking power.” Instead, the vacuum
might suck just as much, but continue to display the same sucking power for months or years
longer. A music player might not offer better portability, as was the case with the Apple iPod,
but it might be more durable. For customers who don’t like the hassle of products breaking
down, this can be an important differentiator.
Historically, Honda and Toyota have succeeded, and differentiated their products, based
on superior reliability. Their vehicles have typically been at the top of various quality ratings
because they have the fewest defects. Customers don’t necessarily purchase Honda or Toyota
vehicles because of superior styling, more comfortable seats, or more power. They buy them
because they are reliable and don’t often break down.16 This is particularly important to people or families who have only one car, or do not have alternative transportation or a support
system available to help them when their car breaks down.
For years, Energizer has used the “Energizer Bunny,” an advertising character, to promote
the reliability of its batteries. Energizer batteries don’t do anything different from other batteries,
so Energizer has emphasized their reliability, with its claim that they “last, and last, and last.”
Convenience
Another differentiator used by companies is making their products more convenient to find and
purchase.17 The product itself might actually be identical to other products on the market, but
the seller has figured out a way to make it easier for customers to buy. Starbucks is an example
of a company that succeeds, in part, through convenience. Starbucks does attempt to differentiate its coffee through branding and by offering different blends and taste. But perhaps just as
important, the company makes its coffees very easy to find. Go into downtown Seattle or San
Francisco and it seems you will find a Starbucks on every other corner. When you have a hankering for coffee, Starbucks makes it convenient to find. Convenience is also one of the reasons
why Coke and Pepsi are so successful. Although brand image (described in the next section) is
their most important differentiator, by investing in enormous vending machine networks, they
ensure that when you are thirsty, there is likely to be a Coke or Pepsi product nearby. We often
mass customization When a
company mass-produces the
various modules of the product
and then allows the customer
to select which modules will be
combined together.
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network effects When some
products or services are more
convenient to use because there is
a large network of other users.
buy Coke or Pepsi products because it is less convenient to find another place that offers a
wider array of beverages.
Convenience also includes making a product easier to purchase. Amazon.com was the
pioneer of one-click purchase on the Internet, differentiating its services and contributing to
its ability to outsell other Internet retailers. In related fashion, because Amazon provides such a
broad array of products, it essentially provides a “one-stop shop” for customers looking to buy
products on the Internet. In the brick-and-mortar world, Walmart provides convenience in its
stores by offering a broad array of products from groceries to electronics to flowers and shrubs
in the nursery. Beyond offering low prices, Walmart makes it more convenient for customers to
purchase what they want by putting it all under one roof.
A special case of convenience involves the size of the network or ecosystem of the firm
offering a product or service. Some products or services are more convenient to use because
there is a large network of other users; these products benefit from network effects.18 Now
that Facebook is the largest social network site, it is more convenient for new users to
join Facebook to connect with friends than to choose another site, because most friends
probably already have a profile on Facebook. This advantage keeps users going to Facebook,
even though competitors may have imitated many of Facebook’s other features. Similarly,
eBay dominates the online auction market because buyers find it more convenient to go
to an auction website where there are more sellers and, thus, a broader selection of
goods. Interestingly, while eBay is the dominant auction site in the United States, Yahoo! is
the dominant auction site in Japan. Yahoo! launched in Japan before eBay, and network
effects (e.g., more sellers attract more buyers) allowed it quickly to become the largest
auction site in Japan.
Ethics and Strategy
At What Point Does Marketing Become Lying?
The shoe company Skechers claims that its rocker-bottom Shape-ups
sneakers help tone and shape your body. Hall of Fame quarterback
Joe Montana said they improved his strength and posture, and
celebrity Kim Kardashian boasted that they allowed her to ditch
her personal trainer. Olay Regenerist, a line of anti-aging products made by Procter & Gamble, claims that its creams will reduce
wrinkles and help you look younger. And then there is Dannon,
claiming that its Activa and DanActive yogurts have health benefits,
including boosting immunity and regulating digestion. Are these
claims true? Can companies advertise these benefits if they haven’t
been proven?
Companies that pursue a differentiation strategy are motivated to accentuate the features of their products and services
that provide unique value. Indeed, that is the job of the marketing
function—to create advertisements and promotional materials that
differentiate a product in the minds of customers. This can create
challenges for leaders in companies because they have an incentive
to exaggerate product claims in an attempt to convince customers
that their product offers specific benefits.
To illustrate the fine line that marketers often walk, consider
the case of Kirstie Alley, the actress who touted the benefits of the
Organic Liaison weight loss program that resulted in her dramatic
weight loss as she prepared to participate in Dancing with the Stars.
But according to a “false and misleading advertising” lawsuit filed
by Marina Abramyan, a dieter that used the program, Alley didn’t
achieve all of her weight loss by using the Organic Liaison program.
Abramyan’s suit against both Alley and Organic Liaison claims that
the celebrity’s weight loss was augmented with an extreme diet and
exercise regimen. Now it is up to the court to decide if the Organic
Liaison program works as advertised.
To avoid these types of lawsuits, companies have become
increasingly cautious and are making sure their claims are backed
by data. For example, if Verizon claims it is “America’s most reliable
network,” or AT&T says that it has “more bars in more places,” the
companies must use specific measures of “reliability” or “bars in
more places” to back their statements. Of course, it’s possible that
the data supporting Verizon or AT&T’s claims may be technically
correct but are actually misleading. For example, if a company’s
network is most “reliable” for a very limited time period—say, a
week or month—is it misleading to use the most reliable label all
the time? These are just a few examples of issues and decisions that
pose ethical dilemmas for the strategist.
One clear standard of wrongdoing is whether claims will be
supported in a court of law. In the case of Skechers and Dannon,
the answer appears to be no. Skechers was forced to pay $50 million and Dannon $35 million to settle claims of false advertising
when it was determined in a court of law that their product claims
didn’t hold up. These lawsuits show that false product claims can
be very costly—and they highlight the importance of making sure
that product claims can be verified. Moreover, even if a company’s
claims are partially true but misleading, this can lead to negative
publicity that can tarnish a company’s brand. The bottom line
is that differentiators must be careful to ensure that the claimed
benefits actually exist.
How to Find Sources of Product Differentiation
85
As a final example, one reason people use Microsoft’s operating system or Office suite of
products is because a large network of other individuals uses the same products. Using the
same software makes it more convenient for users to trade and exchange files, because the files
are compatible.
Brand Image
A final source of differentiation advantage is brand image.19 Companies often turn to this
source of advantage when they have difficulty differentiating their products based on features, reliability, or convenience. Brand image is typically developed through marketing, via
advertisements, promotions, and other marketing activities. Interestingly, numerous studies
have shown that the more people are exposed to something, be it a brand, company, or product, the more they come to trust it.20 Indeed, the “mere exposure effect” is a psychological
phenomenon by which people tend to develop a preference for things merely because
they are familiar with them.21 In social psychology, this effect is sometimes called the “familiarity principle.” Studies of interpersonal attraction suggest that the more often we see a person,
the more pleasing and likable that person appears to us.22
To fully appreciate and understand the value of brand image, consider the following questions: Is Jell-O really better than other gelatins? Is Kleenex really better than other tissues?
These brands are extremely well-known because they essentially pioneered their product categories. We have been exposed to these brands many times over many years, through commercials and other forms of marketing. Consequently, when we reach out to buy gelatin or tissue,
we tend to reach for the brands with the best brand image—even if it isn’t clear that the product
is different in features, reliability, or convenience.
Beyond mere exposure, companies also attempt to actively associate their products
with positive qualities in the minds of customers. This is a particularly important source of
differentiation for products we consider as prestige brands.23 Sometimes, the job we hire a
product to do is to help us feel part of an elite group or “club.” For example, this is why many
people hire a brand such as Louis Vuitton, Versace, Rolex, or Chanel even when functionally
equivalent products can be purchased at a much lower price. Customers may choose to purchase a Lexus or Infiniti even when a functionally equivalent Toyota or Nissan is available with
the same or longer warranty. In fact, Toyota makes Lexus and manufactures both Toyota and
Lexus brand cars in the same manufacturing plants with the same workers. The same is true for
Nissan, which produces Infiniti vehicles. But brand doesn’t have to signal prestige. The Toyota
Prius is a brand that appeals to the environmentally conscious. People may want to be associated with a brand that differentiates itself as low-brow, environmentally conscious, manly, or
some other distinguishing characteristic. There are a variety of ways that brand image can be a
powerful source of differentiation in the mind of the customer.24
How to Find Sources of Product
Differentiation
There are two major ways that companies attempt to find sources of product differentiation—
customer segmentation and mapping the consumption chain. We’ll discuss some of the details
of each method.
Customer Segmentation
As mentioned earlier in the chapter, customers hire products or services to do jobs for them—to
satisfy particular needs or wants. Individual customers have different needs that they want satisfied. They also differ in the amount of money they have to purchase products or services to satisfy
brand image When products are
differentiated through marketing,
via advertisements, promotions,
and other marketing activities.
prestige brands When products
are differentiated by being
associated with positive qualities
in the minds of customers.
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customer segmentation
Grouping customers based on
similar needs.
customer segments Groups of
people who share similar needs
and thus are likely to desire the
same features in a product.
those needs. For example, some car buyers want power, speed, and torque in a car so that it can
go from zero to 60 miles per hour in 3 or 4 seconds. They look for turbo-charged vehicles with lots
of horsepower. Those buyers who like power but are more price-sensitive look at turbo-charged
vehicles that sell for less than $30,000, such as the Mitsubishi Evo, Subaru STI, or Hyundai Genesis
Coupe. Buyers looking for power who have more financial resources will look to purchase a Tesla,
Porsche 911, BMW M-6, or Mercedes McLaren—or an even higher-priced Ferrari or Lamborghini.
These cars are all designed to do the job of providing speed and excitement to buyers.
Other car buyers need a car that can comfortably seat five people when they carpool or
carry their kids and friends to the soccer match. These buyers look for roomy vehicles that are
easy to get in and out of, such as minivans. Still other car buyers are simply looking for reliable transportation—a car that isn’t expensive but won’t break down and if it does is relatively
cheap to fix. Those buyers will tend to opt for vehicles such as the Hyundai Elantra, Honda Civic,
or Toyota Corolla that are specifically designed for that job.
Companies are more successful when they can offer the exact value that each customer is
looking for. However, the cost of designing a specific product for each customer is usually prohibitively high. The next best solution is to group customers based on similar needs and then
create products that meet the needs of a particular group. This process of grouping customers
based on similar needs is often called customer segmentation. Customer segments are groups
of people who share similar needs and thus are likely to desire the same features in a product.
Along with defining customer segments, a company must choose which segments are
actually in its target market. Strategy involves making trade-offs, and companies often have
to make decisions about where to deploy scarce resources to get their best return. This means
they often have to decide which customer segments they think they can best serve—and which
segments deserve little (or no) attention. Facebook started by focusing on the college student
segment because the founders—as college students themselves—had a deep understanding of
the needs of college students and designed Facebook to meet their needs.
Companies find customer segmentation extremely helpful if they can define segments
appropriately. When companies do not effectively segment customers into similar need-based
groups, then they are likely to run into one of two problems. The first problem is that they may
add features, and costs, to their products that some groups of customers don’t really want and
don’t want to pay for. The second problem is that they may not add features that certain groups
care about and would be willing to pay for, potentially losing market share to rival firms that do
offer those features.
The marketing function within companies is typically charged with the challenge of market
segmentation. Marketers typically segment markets in one of three ways:
1. Based on various attributes or the price of products
2. Based on attributes of the individuals or companies who are customers, including demographics or psychographics
3. Based on attributes of the customer’s circumstance, or what is called the job-to-be-done
view, an alternative way of segmenting customers that has emerged recently
Product Attributes
One way to segment customers is based on product attributes. For
example, customers looking to buy motorcycles may place different value on different attributes, such as power (speed), reliability, ease of handling, gas consumption, or customizability.
By assessing the relative importance that customers put on different attributes, and grouping
customers based on what they want in those attributes, it may be possible to design products
to meet the needs of that customer segment. For example, Honda tends to design motorcycles
that appeal to customers who want reliable, easy-to-handle transportation vehicles. In contrast, Harley-Davidson designs rugged motorcycles that are loud, showy, and highly customizable. Customizability is an important attribute for customers who prefer Harley-Davidson; the
average Harley-Davidson buyer spends an additional 50 percent over the price of the motorcycle to make it completely unique. Discovering groups of customers who want similar product
attributes has enabled Honda and Harley to design their products to better meet the needs of
those customer segments.
How to Find Sources of Product Differentiation
Demographics/Customer Attributes
Another way to segment customers is based
on the demographics of customers. Popular ways to segment the consumer market include
by age, socioeconomic status (e.g., income), education, profession, and ethnic group. For
example, teenagers might be considered one segment of the market because they are viewed
to be similar in terms of what they want from certain types of products or services. Their needs
and wants are often quite different from college students, 30- to 50-year-old parents, and retired
people. Not surprisingly, high-income, middle-income, and low-income families are often put
into different segments, as are people with differing levels of education.
A popular way to segment the business market is based on size of companies, as measured
in revenues, assets, or employees. Large companies are often perceived to have needs that differ considerably from those of small companies and, consequently, businesses that sell to large
companies view them as a different customer segment.
Segmenting based on demographics has the advantage25 that it is relatively easy to do,
once you have data to place customers into different demographic categories. The disadvantage is that not all individuals (or companies) within a particular demographic category share
the same needs and wants.
Job to Be Done As we’ve mentioned, Clayton Christensen suggests that customers “hire”
products to do “jobs” for them. He further argues that, “What this means is that the job, not the
customer or the product, should be the fundamental unit of market segmentation analysis.”26
When people have a “job” to do, they set out to hire something to help them do the job as effectively, conveniently, and inexpensively as possible. Observing someone in a particular circumstance can lead to insights about a job to be done—and a better way to do the job.
According to Christensen, every job has a functional, a social, and an emotional dimension.
The relative importance of these dimensions varies from job to job. For example, “I need to feel
like I belong to an elite, exclusive group” is a job for which luxury brand products such as Gucci
and Versace are hired. In this case, the functional dimension of the job isn’t nearly as important
as its social and emotional dimensions. In contrast, the jobs for which a delivery truck might be
hired are dominated by functional requirements, such as the size of the truck or ease of loading.
Understanding the functional, social, and emotional dimensions of a “job to be done” can
be quite complex—but might be key to differentiating your product or service. For example,
Harley-Davidson customers often purchase a Harley-Davidson motorcycle because they view
themselves as rugged individualists. This is one reason why customizability is so important—
each Harley rider wants the motorcycle to reflect his or her unique identity and not be like
anyone else’s. Beyond that, they want to find others with a similar life view with whom they can
ride, which is why the Harley Owners Group (HOG) is important to many riders. Thus, for most
Harley-Davidson buyers, the job to be done goes well beyond the functional capabilities of the
motorcycle, such as acceleration, comfort, ease of handling, or reliability. The job to be done is
related to helping the buyer express his or her identity (an emotional job) and be part of an elite
group of rugged individualists (a social job).
Segmenting a market in different ways can provide different insights as to how to differentiate a product. Table 5.1 shows all three ways of segmenting the mobile handheld device market.27
Each segmentation approach might lead a company to develop different features and consider
different competitors. For example, a company that segments the market using the product attribute view may focus on providing the best camera, best phone features, best organizer, and so on.
A company that takes a demographic approach to segmenting the handheld market might use
occupation as a way to segment customers. Such a company might conclude that traveling sales
representatives want different things in a handheld device than college students do. A company
that uses the job-to-be-done view might discover that one segment sees the job to be done as
using small snippets of time productively. That segment might be different from those who “hire”
their handheld device to provide entertainment. When most companies in an industry segment
customers in a particular way, there may be an opportunity for a company to segment the market
in a different way, thereby identifying groups of customers whose needs are not met by the typical method of segmentation. This might allow a company to offer a different value proposition,
thereby creating a competitive advantage with a particular group of customers.
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TABLE 5 .1
Differentiation Advantage
How You Segment the Market for Handheld Devices Will Influence the Product Features
You Consider to Be Relevant
Product Attribute View
Customer Attribute View
Job-to-Be-Done View
Market Definition
Market Definition
Market Definition
The handheld wireless device
The traveling salesman
Use small snippets of time productively
Competitors
Competitors
Competitors
Tablets including the Apple iPad, Microsoft Surface, Amazon Fire, and Samsung
Galaxy Tab A
Notebook computers, wireline Internet
access, wireless and wireline telephones
Wireless telephones, Wall Street Journal,
CNN Airport News, listening to boring
presentations, doing nothing
Features to consider
Features to consider
Features to consider
Voice phone
Wireless Internet access; bandwidth for data
E-mail
Digital Camera
Downloadable CRM data/functionality
Voice mail
Work productivity software (Word, Excel,
Outlook, etc.)
Wireless access to online travel agencies
Voice phone
Video/computer games
Online stock trading
Headline news, frequent updates
Calendar
E-book and e-technical manuals
Simple, single-player games
Social media/networking tools
E-mail
Entertaining “top-ten” lists
Voice phone
Always on
Source: Adapted from Christensen and Raynor, The Innovator’s Solution, p. 83.
Mapping the Consumption Chain
mapping the consumption
chain Identifying all the steps
through which customers pass,
from the time they first become
aware of your product to the time
when they finally have to dispose
of it or discontinue using it.
Another process that can be used to look for differentiation opportunities is to map the consumption chain, which involves tracing your customer’s entire experience with your product or
service.28 Professors Ian McMillan and Rita McGrath, who developed and advocate the technique, suggest that companies perform this exercise for each important customer segment.
Mapping the consumption chain involves identifying all the steps through which customers
pass from the time they first become aware of a need for a product to the time when they finally
have to dispose of it or discontinue using it, as shown in Table 5.2. Although products or services
may have somewhat different consumption chains, a few activities are common to most chains.
To understand the consumption chain, MacMillan and McGrath suggest asking the following
questions, in the following order.
How Do Consumers Become Aware of Their Need for a Product or Service? The first step in the consumption chain occurs when customers become aware that
they need a product or service. A company may be able to differentiate its product if it can
find a unique way to make consumers aware of a need. For example, consider the problem of
differentiating an everyday consumer product, such as a toothbrush. For most of us, brushing
is an everyday ritual to which we pay relatively little attention. As a result, many people use a
toothbrush for too long, until its bristles become worn and no longer effective at cleaning teeth.
Toothbrush maker Oral-B discovered a way to capitalize on this widespread habit by inventing a way for the toothbrush to communicate to the customer that it needs to be replaced.
Oral-B introduced a patented blue dye in the center bristles of its toothbrushes. The dye gradually fades as the brush is used. When the dye completely disappears, it signals the user that
the brush is no longer effective and needs to be replaced. Thus, customers are made aware
of a need that previously had gone unrecognized. One could imagine that makers of tires or
other products that wear out could create a similar advantage. By providing a way to make
customers aware that they may need a particular product, companies can find a way to differentiate their product.
How to Find Sources of Product Differentiation
TA BL E 5 . 2
Mapping the Consumption Chain
How do consumers become aware of a need for your product/service?
How do consumers find your offering?
How do consumers make their final selections (priority of attributes)?
How do consumers order and purchase your product?
How is your product/service delivered?
How is your product/service paid for?
How is your product stored/moved around?
What do consumers need help with when they use the product?
What if customers aren’t satisfied and need to return or exchange?
How is your product repaired, serviced, disposed of?
Source: MacMillan and McGrath, “Discovering New Sources of Differentiation.”
How Do Consumers Find Your Offering?
After potential customers are aware
that they have a need for a product, they then must find it. Companies can differentiate their
offering if they can make the search process easier for customers by making it less complicated,
more convenient, or less expensive. Starbucks has made finding high-quality coffee simpler
by opening up so many stores that a latte is nearly always within easy reach. Many companies
help consumers find their product by paying to be at the top of a Google search. For example,
if a consumer types “snowboard” in a Google search, sporting goods retailer REI pops to the
top of the list because it pays Google for that premium space. Convenient placement of REI’s
listing makes it easier for consumers to find, and eventually buy, snowboards from REI. Other
ways to make a product easier to find include making it available when others are not, as companies that have 24-hour telephone-order lines do, or offering it in places where competitors
do not offer theirs. For example, some credit card companies set up booths on college campuses to put credit cards within easy reach of college students. In similar fashion, Coke puts
vending machines in university buildings, at gymnasiums, and in workplaces to make it easy
for someone to find a Coke. Thus, some companies can differentiate their offering simply by
making it easier to find.
How Do Consumers Make Their Final Selections?
After a consumer has
narrowed down the possibilities, they must make a choice. This is the time when product
attributes typically dominate, and it is critical to ensure that consumers are aware of features
that differentiate a product. Some companies assist in product selection by providing customers
with side-by-side comparisons of their products with those of competitors. A comparison list
makes it easier for consumers to see which product has more features, or has the features they
care about the most. Alternatively, a company can select the one feature that customers might
care about and trumpet how their product beats others on that particular feature. Bose does
this with its “noise canceling” headphones, emphasizing that its headphones cancel out more
noise and give you better sound quality than other headphones. Anything that can be done to
make the product selection process more comfortable, less irritating, or more convenient has
the potential to be a differentiator.
How Do Customers Order and Purchase Your Product or Service?
Another way to differentiate a product is to make the process of ordering and purchasing more
convenient. Amazon.com has made the process of purchasing a product online easier by storing all of your relevant personal and credit information and allowing you to use their “one-click”
purchase option. Similarly, Starbucks has created a “Starbucks Card” that is essentially a credit
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or debit card that allows you to quickly swipe your way to a coffee. In addition to buying the
coffee faster, customers who use a Starbucks Card also accumulate points that can be applied
to future purchases at Starbucks.
American Hospital Supply revolutionized how disposable medical products, such as bandages, tongue depressors, syringes, and disinfectants, are sold to hospitals by simplifying the
ordering and restocking process. The company did this by installing computer terminals for purchasing its products at each of its customer hospitals. The terminals connect those customers
directly to the company’s system, allowing direct-drop shipment and automatic restocking
whenever supplies fall below a certain level.
One potential benefit of making your product more convenient to order is your company
can create a switching cost, especially for repeat customers. After customers have signed on to
a purchasing system such as American Hospital Supply’s terminals, it can be costly or inconvenient for them to switch to another supplier. As we described in Chapter 2, switching costs
create a barrier that can prevent competitors from getting access to your customers.
How Is Your Product or Service Delivered and/or Installed?
Customers
sometimes need to have products that they purchase delivered, installed, or assembled. Transporting and assembling products are stumbling blocks for customers, so these services can be
a source of differentiation. RC Willey, a successful retailer of furniture, appliances, and televisions, guarantees delivery within 48 hours for those who want it. Quick delivery is especially
important to customers whose refrigerator has quit working or who need a new bed.
If a product requires assembly or installation, companies may differentiate themselves by
making it easier to install. For example, before software was downloaded via the Internet, Apple
let your computer software self-install. All you had to do was insert a disc it into the computer
and everything else was taken care of. When consumers need to install parts or equipment,
some companies try to make installation easier by providing a poster with the product that
clearly illustrates the installation steps. Color-coding cords and cables or other devices involved
in an installation can further simplify the process and make a product easier to set up and use.
How Is Your Product Stored? When it is expensive, inconvenient, or even dangerous
for customers to have a product simply sitting around, a company has the potential to differentiate the product by providing better or easier storage options. Air Products and Chemicals, a
maker of industrial gases, became the leader in its market segments by addressing the problem
of storage. Air Products realized that most of its customers—chemical companies—would
rather avoid the burden of having to store vast quantities of high-pressure gases. So it built
small industrial-gas plants next to its customers’ sites. This created an important differentiator
by making gas storage more convenient. Even better, after an Air Products plant was built next
to a customer, competitors had little opportunity to move in.
In similar fashion, NordicTrack, a maker of workout equipment including cross-country ski
machines and treadmills, has designed many of its workout machines to easily fold up and slide
under a bed or into a closet. Customers with little room for a workout machine, but a strong
desire to work out at home, have been attracted to NordicTrack’s easy-to-store machines.
What Do Customers Need Help With When They Use Your Product?
Sometimes a customer will need assistance when using a product or service. A company can
differentiate on that dimension if it understands what kind of help customers need and can
provide that assistance more effectively than other companies. For example, each year during Thanksgiving in the United States, millions of home chefs cook a turkey. Many of these
people are making a turkey for the first time and have questions about the process. Butterball’s 24-hour Turkey Talk-Line fields questions from thousands of these customers every
Thanksgiving. Butterball also has a turkey-cooking guide that its customers can download.
One frequent, and very important, question people ask when cooking a turkey is how to tell
when it is done. Poultry must reach a certain internal temperature to be safe to eat. Nobody
wants to give their family and friends food poisoning on Thanksgiving. To answer this question
easily and definitively for cooks who don’t have or have trouble reading a food thermometer,
Building the Resources and Capabilities to Differentiate
Butterball (and some other turkey providers) install a “pop-up button” on the turkey that
springs outward when the turkey is done. Its help line and pop-up signals help differentiate
Butterball as the best turkey choice for inexperienced cooks.
What If Customers Aren’t Satisfied and Need a Return or Exchange?
While many companies focus on the customer through the sale and installation of a product,
others realize that long-term loyalty requires attention to customers’ needs throughout their
experience with a product. Handling problems well when the product doesn’t work out for a
customer can be as important as meeting the need that motivated the initial purchase.
Nordstrom is an excellent example of a company that has focused on succeeding through
superior service—including after-sale service. As previously described, Nordstrom captured
national publicity when one of its store managers “took back” a set of tires from a customer
despite the fact that Nordstrom did not sell tires. By focusing on and aggressively promoting
its no-questions-asked return policy, Nordstrom has developed a reputation as a company that
provides unique customer service. Customers may be unhappy with a particular product that
they return, but they are not unhappy with the store if it does everything possible to make sure
that the return is easy to do.
How Is Your Product Repaired, Serviced, or Disposed Of? As many users
of technologically sophisticated products will attest, repair experiences—both good and bad—
can influence a lifetime of subsequent purchases. This is particularly true if you are highly
inconvenienced because the product fails to work properly, as is the case of an elevator (nobody
wants to get stuck in an elevator). Otis Elevator uses remote diagnostics to prevent service interruptions on its elevators. In high-traffic office buildings, where servicing elevators is a major
inconvenience to occupants and visitors alike, Otis uses its remote-diagnostic capabilities to
predict possible service interruptions. It also sends employees to carry out preventive maintenance in the evening, when traffic is light. Thus, companies can find opportunities to differentiate by ensuring that products are quickly and easily repaired when they fail to work properly.
Finally, customers might find the need to dispose of a product when it is no longer usable.
Most people don’t have a truck—or enough time and interest—to haul an old mattress or oven
off to a landfill or recycling center. But RC Willey, a successful seller of mattresses and appliances, will haul away your old mattress or oven for free when you buy a new one. By disposing
of obsolete or broken appliances, mattresses, and furniture for customers when they purchase
a product, RC Willey meets a customer need that may be unrelated to the new product, but still
differentiates the product because it comes with a service that makes the customer’s life easier.
In summary, by analyzing the consumption chain—the series of steps experienced by a
customer from becoming aware of a need for a product to disposing of it—companies can find
opportunities to differentiate. After an opportunity to offer unique value has been identified,
the company must then figure out how to deliver that unique value better than its competitors.
Building the Resources and Capabilities
to Differentiate
Customer segmentation and mapping the consumption chain are useful tools for identifying
what unique value to offer a customer. However, it is just as important for a company to figure
out how to deliver that unique value.29 For example, how does a company consistently offer different features in its products? How does a company deliver high quality and reliability? How
does a company build a brand image?
Building the capacity to deliver unique value requires acquiring and allocating resources.
For example, as discussed in Chapter 1, Howard Schultz, founder of Starbucks, got the idea for
Starbucks Coffee Bars during a visit to Italy. There, he observed “espresso bars” that offered
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Strategy in Practice
How Starbucks Built the Resources
to Differentiate
Starbucks’s ability to deliver on a differentiation strategy of offering
high-quality coffee at convenient locations required that the company build its resources and capabilities.
One capability that proved essential in order for Starbucks to
differentiate itself with high-quality coffee and multiple blends was
the ability to roast and blend coffee beans. Most coffee shops in the
United States did not roast their own coffee beans and therefore
couldn’t match the quality of coffee that Starbucks offered. Roasting its own beans also allowed Starbucks to create signature blends,
experimenting with different beans and different ways of roasting
to offer a variety of flavors. Then, it built capabilities to highly train
baristas to peddle its gourmet blends in a way that added to the
feeling that Starbucks was a trendy hangout.
Starbucks also learned—through analysis and trial and error—
to identify the optimal locations within a city in order to make each
shop as conveniently accessible to as many customers as possible. To
prevent imitation of its coffee shops, Starbucks built stores as quickly
as possible so that would-be imitators would find that the best locations for similar coffee shops within a city already were taken.
As we examined in Chapter 3, there are numerous types of
resources and capabilities that a firm can build and deploy to deliver
unique value better than competitors. For Starbucks, two of the key
capabilities have been the ability to effectively roast and blend coffee
beans and the ability to identify optimal store locations and quickly
fill those locations with Starbucks shops and highly trained baristas.
customers their choice among multiple blends of coffees—far more than the typical coffee shop
in the United States—and were conveniently located at several places throughout major cities.
Schultz also realized that many people in the United States would also want to purchase
high-quality coffee at convenient locations where they could sit and enjoy their drinks with
friends in a comfortable atmosphere. Schultz had identified a unique value. Now, he needed
to build the resources and capabilities to deliver that value, as described in the Strategy in
Practice box.
New Thinking: Achieving Low Cost and Differentiation
The traditional answer to creating unique value is to be either a low-cost (price) provider or a
differentiator. Low cost is achieved by deeply understanding the economics of the supply and
value-added chain. This allows the company to drive down production costs through proprietary processes, lower cost inputs, or moving to low-cost locations overseas. In contrast, differentiation is best achieved by deeply understanding customer needs and then developing
and configuring unique sets of product features that increase customers’ willingness to pay.
According to Professor Michael Porter, the generic business strategies of cost and differentiation represent “a fundamentally different approach to creating and sustaining a competitive
advantage . . . Usually a firm must make a choice between them or it will become ‘stuck in
the middle.’”30 Moreover, Porter stressed that “achieving cost leadership and differentiation are
usually inconsistent, because differentiation is usually costly.”31
Despite the concern that Porter expresses about being “stuck in the middle,” some companies have found ways to succeed through differentiation and cost leadership.32 In a study of
69 business units, Professor Roderick White found that 27 percent of the 69 units had a competitive advantage based on a combination of both low cost and differentiation. Moreover, the
results showed that business units that successfully combined both low cost and differentiation
advantage had the highest return on investment.33 Professor Charles Hill has argued that
differentiation can be a means for firms to achieve a low-cost position.34 For example, Intel was
able to successfully differentiate its microprocessors through superior processing speed and
with its “Intel Inside” and “Pentium” branding. This allowed Intel to develop a dominant position in the marketplace which allowed it to generate larger volumes than competitors, thereby
resulting in lower costs per unit because of a steep experience curve. Thus, Intel offered both
a differentiated product and produced it at low cost, which resulted in a very high return on
investment. The same could be said for Apple’s iPod. The iPod came to dominate the market
due to superior features (as described in Chapter 1) which subsequently led to large production volumes and low cost per unit. When a superior, differentiated product allows a firm to
Building the Resources and Capabilities to Differentiate
dominate a segment of the market and drive to low cost, it is not surprising that this strategy will
result in high profitability. It is important to note, however, that neither Intel nor Apple chose to
be low price in the market. In other words, they won with customers by offering a differentiated
product. But they didn’t pass on their low costs to customers in the form of low prices. Instead,
they kept the difference which resulted in higher profits.
Increasingly, however, companies are finding ways to deliver both differentiation and low
price (not just cost) simultaneously. Consider the case of Uber. Uber delivers car rides at a lower
price than a taxi but also delivers those rides in a differentiated way by allowing customers to
summon their ride on the Uber App and know the price and type of vehicle before it arrives.
Customers avoid the time and expense of paying the bill, or a tip, and Uber has also added
other differentiating services, such as UberEATS (an app that allows you to order food from
area restaurants, which is delivered by drivers in the Uber fleet). In similar fashion, Amazon
succeeds with both low price and convenience in ordering (one-click ordering from home)
relative to traditional brick-and-mortar retailers. Finally, Google Maps beat Garmin, TomTom,
and Magellan in navigation because of low price (what’s lower than FREE?) and superior features such as estimating the time to complete a route based on current traffic. These companies
and many others defy neat categorization into a cost or differentiation strategy.
How are companies able to compete on both price and differentiation simultaneously? The
basic argument is that by offering a combination of low price and differentiation the company
is able to attract so many customers that they are able to lower their cost (and price) per customer (through economies of scale and scope) and generate enough profits to invest in new
differentiated offerings that bring in even more customers. This leads to a virtuous cycle of
creating new layers of unique value (at relatively low cost by leveraging existing resources
and capabilities) that bring in more customers that in turn allow the firm to lower costs and
prices.35 If successful, the company simultaneously offers low price and a differentiated
product—a combination of unique value that is extremely difficult for any competitor to match.
There is simply no reason for a customer to switch to a competitor offering. If Uber offers both
lower price and more convenience (and now the ability to order your dinner on the ride home
through UberEats), why would anyone want to use a taxi? This explains why taxis have lost
more than 80 percent share in some markets like San Francisco. Similarly, if Google Maps is
free and offers features that no other navigation program offers (such as estimating the arrival
time via a specific route), why would anyone choose a competing offering? More research is
needed to understand the conditions under which companies should consider simultaneously
pursuing a strategy of low price and differentiation. However, the ability to offer both a differentiated and low-price offering appears to be a powerful new way to offer unique value—and
dominate a particular market.
Assessing Differentiation Performance
We have heard many executives ask, “What metric can I use to assess how well my differentiation
strategy is working?” According to Bain & Company consultant and researcher Fred Reichheld,
the answer to that question lies in whether you can satisfy customers to such a degree that they
are willing to recommend your company (or product) to a friend or colleague.36 Companies that
do an exceptional job of providing unique value to customers get their customers to promote
the product to others. In effect, they turn their customers into salespeople. Naturally, this has a
dramatic, positive effect on a company’s growth.
Reichheld and his colleagues at Bain & Company conducted a great deal of research, surveying consumers across multiple industries, to find a way to measure how much companies
inspire their customers to promote them. Their research resulted in the net promoter score, a
useful tool for assessing customer satisfaction (see the Appendix for a description of how to
calculate a net promoter score). Reichheld claims that tracking net promoters is a powerful way
to measure customer loyalty.
We compared the net promoter scores of the iPhone versus the Blackberry among a
sample of college students during the spring of 2011. In this sample, the iPhone had a net promoter score of more than 70 percent. Most students who used an iPhone ranked it a 9 or 10,
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and few ranked it at 6 or below. In contrast, the Blackberry had a net promoter score of only 10
percent, with almost as many detractors as promoters. Not surprisingly, during the subsequent
years sales of the iPhone continued to grow while sales of the Blackberry are now almost nonexistent among college students.
Our informal net promoter score survey highlights an important dimension of any analysis using the net promoter score or any other customer satisfaction metric: You must have a
representative sample of customers. If we had sampled a different customer segment, such
as business people, we might have seen different net promoter scores for the iPhone and
Blackberry because some older business people still use the Blackberry. To get an overall picture of a company or product’s net promoter score, choose a customer sample that represents
all of the company or products’ different market segments. To gather targeted information
about how well a product or service is differentiated to meet the needs of customers in a
particular segment, your sample should include only customers in that segment of the market.
Strategy in Your Career: What Is Your Unique Value?
As you contemplate what career path is best for you, ask yourself: What is my unique value? Hopefully it’s clear that you don’t want to be a cost leader—you don’t want to convince a business to
hire you because you will work for less money than anyone else. You want to be a differentiator.
So what differentiates you? What skills (capabilities) do you have (or can you develop) that will
convince a company that you are the best person for the job? Of course, the first step is to see if
there is a fit between your skills and a particular career. For example, if you want to get a job in
management consulting, with a focus in strategy, you will need to have strong critical thinking
skills and be good at case analysis and structured problem solving. Most management consulting firms ask job candidates to solve a business problem during the interview. Candidates who
perform well on case interviews typically do a lot of practice solving business problems before
the interview. Moreover, junior consultants are asked to do a lot of data analysis. As a result, job
applicants that are experts at Excel and other data analysis software programs like Tableau, R,
Stata, or Sequel can use those capabilities as a differentiator in an interview. In addition, management consultants must interact with clients and give presentations—so interpersonal and
linguistic skills are also important for success. By understanding the skills that are important
for success in a particular career (this is your choice of “where to compete” for a job), you can
determine whether your skill set will allow you to differentiate yourself. Some business careers
(such as in Accounting and Finance) require you to be organized, good with numbers, and skilled
at paying attention to detail. Other business careers (for example, in advertising, marketing, or
product development) require that you have creative ideas and a flair for experimenting and trying new things. Still others (for example, sales) place a premium on interpersonal skills, extraversion, empathy, and persistence. If you apply the strategy principles you are learning in this book
to your career, you are more likely to secure a job in a career that is a good fit for you.
Summary
• In this chapter, we examined differentiation as an alternative
to low cost as a way to offer unique value to a customer. Product
differentiation is a strategy whereby companies attempt to gain
competitive advantage by offering value that is not available in other
products or services.
• Companies have four main options for creating product
differentiation:
Different features. The product does a better job on features available
in other products, does more “jobs” than other products, or does a
“unique job” not done by any other product.
Quality or reliability. The product does the same job as other products, but does it for longer.
Convenience. The product is easily available when the customer
needs or wants it.
Brand image. The product gives customers a certain feeling or idea.
• Strategists often use two tools to discover differentiation opportunities: customer segmentation and mapping the consumption chain.
Customer segmentation is a process used to segment the market
into customer groups who share similar needs. The consumption
chain is the set of activities a customer goes through in the process
Strategy Tool
of realizing a need and then acting on it to purchase a product or
service. Each step in the chain can present ways to differentiate a
product or service.
• Discovering sources of differentiation is just one half of the equation.
In order for a differentiation strategy to be successful, a company
95
must then develop or acquire the resources and capabilities to
deliver that unique value better than competitors.
• The net promoter score is a tool that can be used to assess how
well a differentiation strategy is working to turn customers into
promoters of a company’s offering.
Key Terms
brand image 85
customer segmentation 86
customer segments 86
mapping the consumption chain
mass customization 83
network effects 84
88
prestige brands 85
product differentiation
80
Review Questions
1. Define a differentiation strategy.
2. What are the four major categories or sources of product differentiation?
3. What are two processes that companies can use to search for
differentiation opportunities?
4. What is customer segmentation? Describe three different ways that
customer segmentation can be done.
5. What is the consumption chain? Describe as many stages of the
consumption chain as you can.
6. What is a net promoter score, and how is it calculated? Why is the
net promoter score a useful indicator of how successful a company is
at differentiating its product?
Application Exercises
Exercise: Understanding Sources of Differentiation
1. What product do you use because of differentiation? What do you
buy because it is awesome, rather than because it is the lowest-price
alternative? What causes you to have such strong feelings about the
product or experience?
2. In what ways can a company differentiate a product that is a commodity? What is an example of a differentiated product that was previously commoditized?
3. Harley-Davidson gets hired by customers for social and emotional
reasons (jobs) that go well beyond the functional characteristics of
the motorcycle and its ability to provide transportation or comfortable leisure riding. Identify at least two other products or services that
seem to attract customers for largely social or emotional reasons?
4. What is an example of a product class that lost its differentiation?
How and why did it happen?
Strategy Tool
The Net Promoter Score
Fred Reichheld and his Bain & Company colleagues tried numerous
survey questions with consumers across multiple industries to see
which questions were best correlated with customer loyalty (repeat
purchases) and company growth. The following question was the best
indicator of whether a customer was loyal and enthusiastic about a
company or product.
How likely is it that you would recommend [company X; product Y]
to a friend or colleague?
Respondents answer on a 10-point scale, with 1 meaning “not at
all likely,” 5 “neutral,” and 10 “extremely likely.”
As illustrated in Figure 5.2, Reichheld classifies a customer who
responds with a 9 or 10 on the question above as a promoter. Anyone
who scores 6 or below is a detractor, who is likely to steer others away
from your company or product. Those scoring 7 or 8 are passives. To
calculate a net promoter score, subtract the percentage of detractors
from the percentage of promoters.
Net promoter score = Percentage of customers who answer 9 or
10 − Percentage who answer 6 or below.
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Products (companies) with high net promoter scores consistently
grow much faster than competitors. Generally speaking, products
(companies) with net promoter scores above 70, like iPhone, are
excellent differentiators. Products with net promoter scores between
50 and 70 are good differentiators. Products with net promoter scores
between 30 and 50 are average differentiators, and those with net
promoter scores below 30 are struggling to get customers to promote
their product.
DETRACTORS
0
1
2
3
PASSIVES
4
NET PROMOTER SCORE
FIGURE 5.2
6
5
% PROMOTERS
7
8
PROMOTERS
9
10
% DETRACTORS
How to Calculate a Net Promoter Score
References
1
M. J. Piskorski and C. I. Knoop, Friendster (A). Harvard Business School
Case (2007).
M. J. Piskorski, T. R. Eisenmann, and A. Smith, Facebook. Harvard
Business School Case (2013), p. 2.
2
A. Viejo, “Social Shield Offers Help for Parents Struggling with Children
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3
Piskorski, Eisenmann, and Smith, p. 7.
4
Ibid., p. 8.
5
A. Savar, “54% of US Internet Users on Facebook, 27% on MySpace,”
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-internet-users-on-facebook-27-on-myspace.
6
C. Christensen, “Integrating Around the Job to Be Done,” Harvard
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7
A. Shaked and J. Sutton, “Relaxing Price Competition Through Product
Differentiation,” The Review of Economic Studies (1982): 3–13.
8
V. A. Zeithaml, “Consumer Perceptions of Price, Quality, and Value: A
Means-End Model and Synthesis of Evidence,” The Journal of Marketing
(1988): 2–22.
9
M. E. Porter, Competitive Strategy (New York: Free Press, 1980).
10
M. Haire, “A Brief History of the Walkman,” Time (2009), http://
content.time.com/time/nation/article/0,8599,1907884,00.html,
accessed September 14, 2013.
11
C. Conte, “Nordstrom Customer Service Tales Not Just Legend,”
Jacksonville Business Journal (September 7, 2012), http://www
.bizjournals.com/jacksonville/blog/retail_radar/2012/09/nordstrom
-tales-of-legendary-customer.html?page=all.
12
Ibid.
13
“There’s an App for That—Top Advertising Campaigns for the Wireless
Industry,” FierceMobileIT (May 5, 2011), http://www.fiercemobile
content.com/special-reports/theres-ad-top-advertising-campaigns
-wireless-industry/theres-app-top-advertising-cam.
14
Joseph Pine II, Mass Customization: The New Frontier in Business Competition (Cambridge, MA: Harvard Business Press, 1999).
15
Quality Is the Lifeline of Toyota Industries. Company white paper,
Social and Environmental Report, 2005.
16
J. Beath and Y. Katsoulacos, The Economic Theory of Product Differentiation
(Cambridge, Massachusetts: Cambridge University Press, 1991).
17
M. L. Katz and C. Shapiro, “Systems Competition and Network Effects,”
The Journal of Economic Perspectives 8 (2) (1994): 93–115.
18
R. Schmalensee, “Product Differentiation Advantages of Pioneering
Brands,” The American Economic Review 72 (3) (1982): 349–365.
19
20
R. B. Zajonc, “Attitudinal Effects of Mere Exposure,” Journal of Personality and Social Psychology 9 (2) (1968): 1.
Ibid., pp. 1–27.
21
R. F. Bornstein, “Exposure and Affect: Overview and Meta-analysis
of Research, 1968–1987,” Psychological Bulletin 106 (1989): 265–289.
X. Fang, S. Singh, and R. Ahluwalia, “An Examination of Different
Explanations for the Mere Exposure Effect,” Journal of Consumer
Research 34 (2007): 97–103.
22
K. L. Keller, “Managing the Growth Tradeoff: Challenges and Opportunities in Luxury Branding,” Journal of Brand Management 16 (5)
(2009): 290–301.
23
C. Fombrun and M. Shanley, “What’s in a Name? Reputation Building
and Corporate Strategy,” The Academy of Management Journal 33 (2)
(1990): 233.
24
References 97
25
A. Weinstein, Market Segmentation: Using Demographics, Psychographics and Other Niche Marketing Techniques to Predict and Model
Customer Behavior (Chicago: Probus, 1994).
Ibid., p. 1.
26
C. Christensen and M. Raynor, The Innovator’s Solution (Boston:
Harvard Business School Press, 2003).
27
I. McMillan and R. McGrath, “Discovering New Sources of Differentiation,” Harvard Business Review (July 1997): 133–145.
28
M. Swink and W. H. Hegarty, “Core Manufacturing Capabilities and
Their Links to Product Differentiation,” International Journal of Operations & Production Management 18 (4) (1998): 374–396.
29
M. E. Porter, Competitive Advantage (New York: Free Press, 1985), p. 17.
30
Ibid., p. 19.
31
R. E. White, “Generic Business Strategies, Organizational Context and
Performance: An Empirical Investigation,” Strategic Management
Journal 7 (1985): 217–231. C. L. Hill, “Differentiation Versus Low
Cost or Differentiation and Low Cost: A Contingency Framework,”
Academy of Management Review 13 (3) (1988): 401–412. L. Downes and
P. Nunes, “Big Bang Disruption,” Harvard Business Review (2013, March).
32
White.
33
Hill.
34
For more on how firms can succeed by simultaneously offering differentiated and low price products, see J. Dyer, B. David, and P. Godfrey,
“Strategy 2.0: New Answers to Strategy’s Big Questions.” Brigham
Young University Working Paper (2017).
35
F. Reichheld, “The One Number You Need to Grow,” Harvard Business
Review (December 2003).
36
CHAPTER 6
Corporate Strategy
L EARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Describe how a corporate strategy differs from a
business unit level strategy.
2. Identify the eight ways in which a company may create
value through diversification, and the advantages
of each source. Be able to evaluate a diversified
company’s ability to create value using one or more of
these sources.
3. Use a portfolio management tool to characterize a
company’s different business units and to evaluate how
well a company manages its portfolio.
4. Explain how a company would choose whether to
diversify by greenfield entry or by acquisition. Explain
how a company should decide how tightly to integrate
an acquisition into its current business portfolio.
Justin Sullivan/Getty Images News/Getty Images
Cisco Systems: Growth Through Diversification and Acquisition
In 1984, Len Bosack managed the computer science department at
Stanford University, and his wife, Sandra Lerner, worked with the
computer network at the Graduate School of Business, located 500
yards from her husband’s building. The two wanted to connect the
computer networks of their respective departments to each other.
Because the networks used different protocols (commands and
languages), the two developed the first multi-protocol router, a
device that lets different networks communicate and share data.
The husband and wife team decided to commercialize their invention, the AGS router, and, during a drive over San Francisco’s Golden
Gate Bridge, they chose to name the company Cisco Systems.1
98
Cisco entered the market just as Apple Computer introduced
the Macintosh and the personal computer industry began to grow
rapidly. Cisco’s initial customers were large corporations with multiple, extensive computer networks. By 1989, Cisco had one patent,
three products on the market, 11 employees, and $27 million in
revenue.2 The company went public in 1990 (ticker symbol CSCO)
with revenue of $69 million, and an initial market capitalization of
$224 million. By 1992, sales had grown 550 percent to $381 million
and Cisco began to enter new markets for its products and services;
Cisco expanded into the market for networked servers and began
writing and selling software.3
In 1993, the company made its first acquisition, a $94.5 million all-stock deal for Crescendo Communications, a manufacturer of desktop computing workgroup solutions. The acquisition
broadened Cisco’s product line and expanded its resources and
capabilities in the emerging market of networked computers. CEO
John Morgridge touted the acquisition’s ability to “permit us even
greater responsiveness” to customer needs.4 Over the next three
years, Cisco would make a dozen acquisitions, each designed to
help the company enter new product and customer segments or to
expand and solidify its presence in existing markets. In 1997, Cisco
entered the training and education market by opening 64 “network
academies” to train high school and college students to design,
install, and maintain computer networks.5
1998 was a watershed year for Cisco. The company, using a
mix of acquired and internally developed technology, entered
Corporate Versus Business Unit Strategy
the telephone market and introduced Voice over Internet Protocol (VOIP) communications. The fast-growing company realized
revenue of $8.5 billion and saw its market capitalization rise to
$100 billion. Since going public, revenue had grown almost 1,200
percent, and Cisco’s market cap had grown almost 450 percent! The
company’s acquisition capabilities grew as well; Cisco completed
nine acquisitions that year, averaging one every six weeks. Cisco
also expanded its training academies to a total of 580 locations.
Cisco’s growth continued over the next two years. The company entered a new market for its products and services in 1999:
the home computer and consumer market. By late 1999, 42 percent
of American homes had Internet connections, up from almost
none five years earlier. The company quickened its acquisition
pace, announcing 18 deals—a deal every three weeks. In 2000,
Cisco bought 23 companies, two a month. The market for Internet
connectivity and computer networking continued to evolve, and
Cisco’s products enabled that growth and evolution. Research and
development efforts resulted in patents and products that established Cisco in wireless network technology, a major growth sector of the industry during the early twenty-first century. On March
27, 2000, Cisco became the world’s most valuable company, with a
market capitalization of $569 billion.6
With 46 acquisitions completed since 1993, Cisco had developed a clear and consistent process for bringing acquisitions into
the Cisco family.7 The process began with the identification of
attractive targets, typically companies with new and emerging technologies or ones whose products would enhance Cisco’s current
99
offerings to customers. The newly acquired company’s products
would appear in the Cisco catalog—with Cisco part numbers—the
day the acquisition closed. This ensured immediate revenue and
profit growth from the acquisition. Integration specialists from Cisco
worked onsite with the newly acquired company during the first
90 days after the deal closed. These specialists helped the new organization adapt to and navigate within Cisco’s internal systems; they
also introduced new members to the Cisco culture. Other integration
specialists installed Cisco accounting and purchasing systems.
Cisco fell from its perch as America’s most valuable company
when the Internet stock bubble burst in 2002. That didn’t stop
the company from pursuing its strategy of acquisition and diversification to maintain and enhance its status as the backbone of
the Internet. At the end of the new century’s first decade, Cisco
held leading market positions in most router and networking categories, including over 30 percent of the market for routers and
switches.8 That year, the company shipped its 30 millionth IP phone
to customers around the world.9 Internal growth and acquisitions
helped Cisco maintain and extend its lead in cutting-edge communication and network markets. Cisco received 913 patents during
2010. The August 2011 purchase of Versly, a software tool for collaboration within Microsoft applications, represented Cisco’s 150th
acquisition, and its deal for machine learning company Perspica in
October 2017 brought the total to 200. In 2018 the company bought
another eight companies, and 2019 looked to continue the trend.
Cisco had proven the value of using acquisitions to grow and maintain industry leadership.10
Cisco Systems is a leading business in the tech economy of the twenty-first century. The
company uses its intellectual property and brand resources, along with its innovation and
acquisition capabilities, to create competitive advantages through the methods you’ve learned
about in previous chapters. The concepts and models discussed in Chapters 2 through 5 presume that a company operates in one definable industry, such as healthcare or home appliances. This chapter discusses how strategy changes when a firm competes in multiple markets.
Corporate Versus Business Unit Strategy
The tools of industry analysis, low cost or differentiation strategies, and innovation help managers devise business unit strategy, or an approach for creating competitive advantage within
a single industry, market, or line of business. Cisco, when viewed as a collection or portfolio of
businesses, competes in a different, but related, way than its individual business units. Cisco
managers have a clear corporate strategy, or an approach for creating value and competitive
advantages through participation in several different industries and markets.
Corporate strategy entails competing in a core industry or business and also operating in
adjacent businesses or markets. When those adjacent markets can be mapped along the value
chain, then a firm vertically integrates. For example, when Apple made the decision in the early
1980s to develop its own computer operating system in-house, it vertically integrated backward
by producing the inputs to its computers. Vertical integration represents such an important
and unique form of diversification that Chapter 7 deals specifically with this topic.
When a firm moves to an adjacent business or enters a new industry value chain, it engages
in horizontal diversification, most commonly referred to simply as diversification. The adjacent market may mean selling the firm’s existing products to new customer groups, bringing
new products and services to existing customers, or selling new products and services to new
customers. Managers diversify their firms through one of three methods: greenfield or organic
business unit strategy The
search for competitive advantage
within a single industry, market, or
line of business.
corporate strategy The search
for value and competitive
advantages through participation
in several different industries
and markets.
vertical integration Movement
into adjacent markets by a
firm along its own value chain.
Movement in the direction of raw
materials is backward integration.
Movement in the direction
of sales, service, or warranty
operations is forward integration.
horizontal diversification The
movement into an adjacent
market, one that is not along a
firm’s current value chain.
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entry, alliance, or acquisition. Alliances, like vertical integration, present the firm with a unique
set of opportunities and challenges, so we’ll discuss them separately in Chapter 8. This chapter
describes both greenfield entry and acquisition as mechanisms of diversification.
In this chapter, you’ll learn how companies can create value by competing in several industries instead of just one, and how companies can diversify through greenfield entry or acquisition. Should a company choose to diversify through acquisition, you’ll learn about the process
of acquisition and understand how tightly a newly acquired business should be integrated into
the company.
Creating Value Through Diversification
Early research by strategy scholars into corporate diversification identified an inverted curvilinear (an upside-down, U-shaped) relationship between corporate diversification and profitability. Firms that compete in a few, related industries or markets outperform firms focused on a
single industry. More is not always better, however, because firms that compete in many, unrelated industries perform worse than those in a few, related ones. A number of studies over the
last three decades have come to the same general conclusion: Moderate diversification pays
off, but very high levels of diversification lead to lower levels of performance.11
Levels of Diversification
single business A firm earning
more than 95 percent of revenues
from a single line of business.
dominant vertical business A
firm that earns more than
70 percent of revenues from its
main line of business and the rest
from businesses located along the
value chain.
dominant business A firm that
earns more than 70 percent of
revenue from its main line of
business and the remainder
from other lines across different
value chains.
related-constrained
diversification A firm that earns
less than 70 percent of its revenue
from its main line of business,
and its other lines of business
share product, technological,
and distribution linkages with the
main business.
related-linked diversification A
firm that operates in related
markets, but fewer linkages exist
between the new and existing
markets than the elements create
separately.
unrelated diversified
firm Competes in product
categories and markets with
few, if any, commonalities
between them.
Firms have several choices about how to diversify, and they have a range of options about how
much to diversify. Strategy scholar Richard Rumelt created a continuum of diversification strategies based on the product market similarity of the firm’s businesses. Firms range from related
to unrelated diversifiers.12 A single business is one where more than 95 percent of the revenues
come from a single line of business, most often measured in terms of the four-digit NAICS codes
you learned about in Chapter 2. The dominant vertical business earns more than 70 percent
of its revenue from its main line of business and the rest from businesses located along the
value chain, either upstream (backward integration) or downstream (forward integration) from
the core activity. A dominant business earns more than 70 percent of revenue from its main
line of business and the remainder from other lines across different value chains.
A related-constrained firm earns less than 70 percent of its revenue from its main line of
business and its other lines of business share product, technological, and distribution linkages with the main business. Amazon Marketplace represents related-constrained diversification; Marketplace sells a similar product (used rather than new books) and uses the same
technology (the Amazon website) and distribution network (UPS) as the parent company.
Related-linked diversification occurs when the businesses are still related but fewer linkages
exist between the new and existing business. Amazon Fresh, started in 2007, sells groceries
(a different product group) over the web (same technology) for rapid home delivery (but not
through UPS).
Finally, an unrelated diversified firm competes in product categories and markets with
few, if any, links between them. Unrelated firms are also called conglomerates and include
firms such as General Electric and the 3M Company, also known as Minnesota Mining and Manufacturing. You might recognize 3M for its famous Post-It Notes and line of tapes, but the
company sells a variety of products, from surgical materials for abdominal support to its dental
restorative product ESPE Z100.13
For diversification to add value in the real world, managers must answer the following acid
test questions: (1) Why will the existing businesses be more valuable because we’ve entered
an adjacent business? and (2) Why will the new business activity be more valuable inside our
corporation than operating alone? The simplest answers to these questions are the same as
the answers to the fundamental strategy questions we raised in Chapter 1. Diversification adds
value when it allows the combined businesses to deliver greater value and utility to new or
Creating Value Through Diversification
existing customers than the firm could without being diversified. Diversification also adds value
if the combined businesses reduce the firm’s overall cost of producing goods or services.
Value Creation: Exploit and Expand Resources
and Capabilities
Diversification adds value when expansion into an adjacent business either exploits the firm’s
valuable resources and capabilities or diversification enhances and grows the resource base. To
provide more clarity to the notion of exploiting and expanding, you can divide a firm’s resources
and capabilities into two broad categories: a “front end,” or customer-facing resources and
capabilities, and a technological and operational “back end.” Procter & Gamble’s resources
such as brands, product lines, distribution channels, and capabilities in uncovering deep customer needs represent the customer-facing part of the business. Walmart’s resources in terms
of regional distribution centers and information systems and its capabilities in global supply
chain management and cost reduction belong in the “back-end” group.
Diversification allows companies to exploit their existing customer-facing resources by
adding new operational resources and capabilities. General Electric’s entry into the finance
business in the early part of the twentieth century allowed it to solve a core problem for cities and towns: how to defray the huge upfront costs of electrification. Similarly, a business
can exploit its existing technological and operational strengths to reach out to new customer
groups. General Electric used its original skills in light bulb and electrical equipment manufacturing to enter a new, high-technology market at the end of the nineteenth century: X-ray
machines. GE leveraged its knowledge and skill toward a new set of customers including doctors, hospitals, and patients.
Diversification also creates value when it helps a company expand its existing set of
resources and capabilities or diversification enables it to prepare for the future. Cisco has made
a number of acquisitions designed to expand both its technology platforms and product lines.
Cisco introduced its first Internet Protocol (IP) phone in 1998. In 1999, the company made three
acquisitions, Sentient Networks, GeoTel Communications, and Amteva Technologies, that
brought patents and products that Cisco needed to expand its business.14 Figure 6.1 illustrates
the basic logic of value creation through exploiting or expanding resources and from either
front- or back-end resources or capabilities.
The logic of exploiting or expanding resources and capabilities provides you with a deeper
understanding of what it means for a firm to enter an adjacent market. Adjacent means “next
to,” and we might think of adjacent markets as ones with products or services right next to each
other. Starbucks sells food and mugs along with its premium coffee, but the company also sells
CDs or other products. Food and mugs are naturally adjacent to coffee (people eat food with
coffee and drink coffee in mugs), but music isn’t. When we speak of an adjacent market,
Value Through
Exploiting Resources
“Front-end,”
customer-facing part
of the business
Value From
“Back-end,”
operational parts of
the business
FIGURE 6.1
Expanding Resources
• Expand customer base
• Gain new market knowledge
• Better serve existing
customers through more,
better products
• Add new brands
• Create economies of scope
or increased scale
• Improve quality, productivity,
or other best practices
• Broaden existing
production capacity
• Access innovative process or
product technologies
• Adopt new technology
platforms
• Enhance R&D capabilities or
outputs
Adding Value Through Diversification
• Identify new trends earlier
adjacent market A market or
industry that is closely related
to markets or industries a firm
currently competes in.
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C H A PT E R 6
Corporate Strategy
we mean a closely related market for creating value and utility for customers. Starbucks
provides customers with a cup of coffee but also a relaxing place to hang out or meet up with
others. Part of that environment entails music to set the mood. Starbucks captures the value of
that music by offering CDs and other ambience products to customers.
The notions of expanding and exploiting resources help you understand why companies
can create sustainable competitive advantages. In the next section, you’ll learn how companies
actually create competitive advantage and business value through diversification.
The Eight Ss
Exploiting and/or expanding the resources and capabilities usually come through one of eight
mechanisms. To help you remember these important elements, we’ve created a mnemonic
device, the eight Ss: employing slack, creating synergy, leveraging shared knowledge, utilizing
similar models for success, spreading human and financial capital to its best use, providing a
stepping stone for the company to a completely new business sector, stopping or slowing competitors, and staying even with of technological change. As you read through each S, try to think
about how each would help a company exploit or expand its resources and capabilities. Each of
the Ss can work through the customer-facing front end of the business or the operational and
technological back end.
slack Unused resource capacity.
economy of scope Activities
where the average cost of
producing two different products
is less when delivered together
than separately.
management skill The individual
and collective abilities of a firm’s
management team to engage in
value-creating activities.
synergy Action between different
elements of a system that creates
more value together than the
elements create separately.
Employing Slack Slack means unused resource capacity. Delta Airlines generated
almost $37.7 billion in revenue in 2012 through its combined operation, almost $1 billion
carrying cargo and freight.15 Why would Delta, whose primary customers are people, be involved
in the back-end freight business? The top half of the aircraft carries people, the bottom half
carries the luggage. There’s often extra room in the bottom of the plane that Delta can fill with
freight cargo at almost no cost! Transporting cargo adds value because it captures slack in the
form of an economy of scope. An economy of scope arises when the average cost of producing
two different products is less when delivered together than separately.
Management skill often represents another unused resource. Firms can only grow as
fast as they have knowledgeable and skilled managers to guide that growth.16 This has an
important corollary: As managers learn their jobs and develop skill, they are able to effectively handle an increased number of activities. Marriott, the upscale hotel operator, competed for many years to service business travelers in hotels noted for excellent service. In the
late 1980s, the company started its economy chain of Fairfield Inns and the extended-stay
Marriott Suites hotel. Marriott became the first major hotelier to offer a portfolio of brands.17
In the mid-1990s, Marriott moved into the adjacent but upscale hotel segment with its purchase of the fabled Ritz-Carlton brand.18 Employing slack usually creates value through
exploitation, although sometimes during an acquisition a company may acquire redundant
resources that expand slack.19
Creating Synergy
Synergy occurs when different elements of a system interact in a way
that creates more value together than the elements create separately. Simply put, the whole
exceeds the sum of its parts.
Disney competes in two adjacent entertainment markets, films and theme parks. The
two businesses create more brand value for Disney together than either would separately. For
example, customers’ emotional connection with Disney deepens when they interact with the
same characters at a distance in movies and then up close through attractions at the parks.
Procter & Gamble gains operational leverage with retailers when it negotiates for shelf space
because the company offers retailers a portfolio of important products and can bundle different products to maximize potential revenue for retailers. P&G saves on distribution and logistics costs as trucks carry multiple products to each retail location. Synergy clearly exploits
the resources and capabilities to offer customers better products and services. Synergy also
increases the number and ways a company interacts with its customers, and that can expand
its capabilities to meet customer needs in the future.
Creating Value Through Diversification
103
Shared Knowledge
Think of a diversified company as a tree: the leaves, twigs, and
branches represent different product markets and industries, but the competitive advantage
comes from the common roots, processes, or knowledge. These roots are often called core
competencies, “the collective learning in the organization, especially how to coordinate
diverse production skills and integrate multiple streams of technologies.”20 Core competencies
represent a set of resources or capabilities at the center of the diversified corporation that are
distributed to individual businesses to adapt for their particular markets. Honda parlays operational and technological knowledge and ability in engine design and performance into several
diverse downstream markets, including automobiles, lawnmowers, and consumer generators.
ESPN’s ability to extend its brand and reputation for serious and engaging sports coverage creates competitive advantage across its 70 different brand platforms.21 These include the flagship
broadcast properties and websites, as well as the magazine, apparel, and restaurant businesses. Honda’s core competencies at high-quality engine design attract a broad set of customers to its products, while ESPN’s core competencies (or shared knowledge) allow the
company to service sports fans over a variety of technological platforms. Shared knowledge
helps you understand why some very unrelated product markets can represent valuable adjacent markets.
Similar Business Models A business model is a method for enabling value to be created and exchanged between companies and their customers. General Motors’ business model
involves transforming raw materials such as steel, rubber, and plastic into automobiles, all
done at very large scale. eBay’s business model is to provide an electronic venue, or market,
where buyers and sellers can come together. Strategy scholars note that some business models
have common elements or keys to success. They describe these commonalities as a dominant
logic or “the way managers conceptualize the business and make critical resource allocation
decisions—be it in technologies, product development, distribution, advertising, or human
resource management.”22 A dominant logic implies that some businesses may look very different at the level of products or services but may share a set of management principles and skills,
such as managing a workforce filled with skilled labor, or be subject to the same economic
processes such as stage in the life cycle, similar barriers to entry, or economies of scale.
core competencies (or shared
knowledge) Collective
knowledge that can be distributed
throughout the organization to
create value.
business model A method to
enable the creation and exchange
of value between companies and
their customers.
dominant logic A
conceptualization of a business, or
a set of rules for competition, that
applies to seemingly unrelated
product markets or industries.
Strategy in Practice
Creating Value at Newell Rubbermaid
Newell Rubbermaid (Symbol NWL, 2015 Revenues: $5.91 billion)
traces its origin to 1903, when Edgar A. Newell purchased the assets
of curtain rod manufacturer W. F. Linton. Newell’s original focus lay
in improving curtain rods through technology, production improvements, and cost reduction. In 1912, the company began selling its
products through mass merchandizer Woolworth, and business
took off. As the company grew over the years, it broadened the
product line to include other low-technology window treatment
products such as extension rods, drapery pin hooks, and curtain
holdbacks.23
In 1965, new CEO Dan Ferguson decided on a new strategy;
rather than focus solely on window treatments, the company
would use mergers and acquisitions to become a major player in
housewares and hardware goods, specifically low-technology
products marketed through mass retailers. Increasing the product
line would create better leverage with the company’s target customers: chains such as Woolworth and K-Mart. With the purchase
of the EZ Paintr Corporation in 1974, the company made its first
substantial jump outside its traditional markets. Ferguson would
make 70 acquisitions during his 30-year tenure as CEO, including
glass maker Anchor Hocking, cookware manufacturer WearEver,
and later Calphalon, and Levelor window blinds.
Newell’s acquisition formula exhibits a dominant logic. Each
of the target companies mass produce relatively low-technology
consumer goods in different grades (good, better, best), and each
company distributes its products through mass retailers.
After taking control of its targets, the company follows a rigorous process of “Newellizing” its new acquisition.24 Newell uses
its deep and extensive knowledge of its customers, mass retailers,
to help its acquisitions reconfigure product lines and categories
to satisfy the needs of its customers. Newell eliminates duplicate
product lines and makes sure that the company’s offerings fit
into the “good, better, best” quality logic that lies at the core of
its success.
Newell creates back-end synergies by eliminating duplicate
functions such as separate sales staffs or headquarters expenses,
as well as sharing production technologies and processes. Newell
uses its dominant logic knowledge to help the acquired company
reduce costs, improve manufacturing to find efficiencies, improve
financial controls and metrics, and improve cash flow.
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The Japanese company Sumitomo Heavy Industries competes in a number of different
industries. The company has business divisions in power generation, plastics machinery (like
injection molding tools and dyes), industrial equipment, precision instruments (such as extreme
cryogenic refrigeration), defense systems, ship building, and others. These don’t seem adjacent
at all, but a closer look reveals that each business shares two back-end commonalities: advanced
engineering and huge fixed costs. Success in each business area depends on the ability to attract
and retain scientific talent that will drive innovation and on managing a set of very sophisticated
physical assets that require substantial capital investments. The Strategy in Practice feature
details a company with a customer-facing dominant logic.
internal capital market The
movement of funds, talent, or
knowledge from unit to unit
directed by the leaders of the firm.
Spreading Capital Some companies create value through diversification by acting as an
internal capital market.25 They create value across business units by moving funds, talent, or
knowledge from unit to unit. Rather than leaving resources within a business unit for its own
growth, these strategic investments work to increase the corporate value by investing in
business units with greater potential growth in the future.
Spreading capital depends on detailed performance information for each unit, as well as an
intuitive sense about the value of future investments. As a consequence, these managers can fund
business growth at a lower cost of capital than if units relied on external sources such as banks
or capital markets.26 Companies creating value through an internal capital market look like the
definition of conglomerates—business units with little in common in the products or processes.
Executives keep these businesses as separate units in order to accurately assess and reward
performance. Since there is no sharing of resources, managers have no other divisions to blame
if their units perform poorly. Keeping business units separate also allows corporate executives to
sell units to willing buyers. Spreading capital exploits the management team’s unique abilities
to invest for value, and each new investment enhances the team’s collective learning. Read the
Strategy in Practice feature to learn about the challenges of the spreading capital strategy at ITT.
Provide a Stepping Stone to a New Industry
While the other Ss all exploit a
company’s current resources and capabilities, the stepping-stone mechanism explicitly works
to enhance capabilities. Executives may survey the landscape of the industry and its future
Strategy in Practice
The Challenges of a Conglomerate: The Fall of
General Electric
Thomas Edison formed General Electric in an 1892 merger of his
Edison General Electric Company and the Thomson-Houston
Electric Company. GE initially focused on lighting products for the
electrification of New York City. In 1895 the company leveraged its
expertise in building larger electrical generators to build its first
locomotives and electrical transformers. Medicine entered a new
age in 1895 when German physicist Wilhelm Roentgen discovered
the X-ray; a year later GE scientist Elihu Thomson built an electrical
machine to produce X-rays for use in identifying fractured bones.
In 1902 GE brought the electric fan to market, followed by the
electric toaster in 1905; thus GE entered the home appliance business. In 1905, the company formed the “Electric Bond and Share
Co” to help smaller communities and utilities afford electrical
power systems. GE Aviation began in 1917 when the U.S. government awarded the company a contract to produce a “turbosupercharger” to help the emerging Army Air Corps win World War I.
GE later designed and built the first jet engine. GE Capital, which
would later generate a third of the conglomerate’s revenue, began
in 1932 as GE Credit, a retail finance operation designed to help
cash-strapped consumers purchase appliances during the Great
Depression.27
By 2001, GE would become the most valuable company in the
world with a market capitalization of over $400 billion. Executives
like Reginald Jones and Jack Welch leveraged knowledge, learning,
expertise, and cash flow to create value across the portfolio.28 By
2009, however, GE began to unravel. GE Capital, which contributed
just shy of one-third of the consolidated profit the previous year,
suffered through the financial crisis. GE would sell most of GE Capital over the next several years. To replace the earnings and growth,
CEO Jeff Immelt planned to pivot the company toward energy
(oil and gas), infrastructure, and technology.29 Each of those bets
turned sour, and when Immelt retired in 2017, new CEO John Flannery inherited a company in deep trouble.
Flannery hoped to retool GE by selling off its investments in
energy and creating a smaller, more nimble and focused company. The
board pushed Flannery out in October 2018, and the company continues its process of turning from a conglomerate into a more related set
of businesses. A share of stock at GE’s peak in 2000 cost $57.31. That
same share cost on $7.51 in December 2018.30 GE’s recent performance
continues a long-running debate about the value of unrelated diversification for companies, their shareholders, and society at large.
Creating Value Through Diversification
105
trends and decide that their competitive position will not be sustainable and their money
would be best invested in some other business segment.
Successfully shifting the firm’s position through diversification usually entails migration,
creating a path so the company can avoid “long leaps” from its core into a segment where its
resources and capabilities create little value. The path involves a set of “short leaps” executed
over time that allows the company to acquire new resources and capabilities. Adjacent markets
have two characteristics: (1) They allow the firm to exploit some of its resources and capabilities to create value, and (2) they allow the firm to acquire related resources and capabilities to
prepare for the next step.31
Consider the case of Safeguard Scientific in the 1990s.32 In 1991, the company’s major line of
business was computer peripherals, an industry that includes keyboards, printers, and storage
devices. By 2003, the company had shifted its major line of business to the optical instruments
business, products such as advanced lenses, scopes, and optical scanning equipment. Safeguard
didn’t just jump from keyboards to scientific equipment; it migrated through adjacent industries
to acquire skills and capabilities. In 1993, the company moved into producing telephone equipment, and then, in 1995, into electrical instruments. The company exited computer peripherals
in 1996, the same year it entered optical instruments. It exited the telephone business in 1999.
Instead of one “long leap” from computer equipment to optical devices, Safeguard took
a number of “short hops” through industries where it could leverage existing capabilities and
build new ones. The stepping-stone path allowed the company to acquire a new set of backend operational skills and technology. The company also had to acquire a new set of customerfacing elements, as well.
Stopping Competitors
While exploiting and expanding the resources base is the general rule of diversification, sometimes it makes sense for a company to enter a market, either
through greenfield or acquisition, to keep a competitor from occupying that market space. In
markets with fierce competition and evenly matched competitors, strategic managers might
choose to diversify to forestall a competitor from entering, rather than to clearly exploit or
expand a current resource or capability.
The tech sector often sees a major company acquiring a new, unproven startup to keep the
technology and/or market out of the hands of a potential competitor. Google’s 2013 purchase
of the Israeli startup Waze for almost $1 billion seemed overpriced, given that Google Maps was
already used by more than half of smartphone users. Google wanted to keep Waze out of the
hands of Apple, however, as Tim Cook had made improving Apple’s mapping app a high priority. With Waze out of the market, Apple had to invest in internal development that took much
longer to complete. Google did add some features developed by its target, but the real value
for Google came from slowing, if not stopping, Apple’s progress.33 The primary goal of stopping
competitors, however, remains keeping valuable assets out of the hands of competitors and
forcing them to keep even with of your firm.
Staying Ahead of Technology
If a company competes in an industry where technology changes rapidly, such as the life sciences or information technology, then diversification, primarily through acquisition, can shorten lead times and reduce the overall costs
of technology development. Cisco’s acquisition activity is driven as much by its desire to
buy emerging technology as it is in buying a revenue stream; acquisitions allow companies
to buy fully developed, and sometimes market tested, technologies rather than developing
them in-house.
Many firms, particularly in the technology sector, operate corporate venture capital (CVC)
businesses to keep even with emerging technologies. These units operate like independent VC
firms in that they manage an active portfolio of startup companies. Like regular VCs, CVC units
are judged on returns, and managers win when portfolio companies go public (IPO) or get
acquired. Unlike independent VCs, however, corporate venture capital units win when the technology available in a startup can be transferred to the corporate parent.34 CVC firms use their
position on a startup’s board of directors to learn about new technologies, both within the
startup and among the startup’s competitors or industry. In 2015, CVC activity surpassed
corporate venture capital A
venture capital fund owned and
managed by a corporation instead
of independent investors.
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C H A PT E R 6
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$28 billion, and established companies such as Caterpillar and Airbus have joined the likes of
Intel and Cisco in CVC activity.35
Destroying Value Through Diversification
The eight Ss show how and where managers can create value for shareholders of a diversified
firm; however, one relatively robust finding from scholars in corporate finance is that diversified firms often trade at a discount versus undiversified rivals and that increasing diversification
(entering additional new lines of business) tends to destroy shareholder value.36
If you think of the acid test for value we presented earlier, diversification destroys value
when the new line of business fails to exploit or expand the company’s resources and capabilities in meaningful ways. Value usually gets destroyed in one of five ways: excessive pride, sunk
cost fallacy, imitative diversification, poor governance and incentives, or the lack of resource
commonality between the lines of business.
hubris Excessive pride,
arrogance, or overconfidence.
sunk cost fallacy The belief of
managers that investment in a
failed acquisition must continue
because significant amounts have
already been invested.
Hubris Managers may diversify based on their own beliefs about the potential of their company’s ability to create value in the adjacent market. Hubris is an ancient Greek word for excessive pride, arrogance, or overconfidence.37 Managers act with hubris when they diversify or
make acquisitions based on their own experience or their “gut feelings” rather than on solid
data and research. Researchers have argued for, and demonstrated, the hubris hypothesis as
an explanation for the poor performance of so many acquisitions.38
Sunk Cost Fallacy
Closely related to hubris as a reason why diversification fails is the
sunk cost fallacy, whereby managers believe that their investment in a failed acquisition just
needs more incremental investment in order to succeed. Executives are often reluctant to
abandon a project in which they have already invested so much time and capital; they often move
forward under the assumption that “things will turn around with a little more investment.” The
sunk cost fallacy leads managers on a path of escalating commitment to invest resources in
failed, or failing, diversification efforts.
Imitation
Managers sometimes feel pressure to diversify their corporation when a competitor diversifies first. The competitor has done due diligence and selected an attractive target
for acquisition, or made a greenfield entry after careful research and planning. Caught offguard, a firm might quickly look for a similar acquisition target or hurry to create a similar line
of business. In their rush to respond, managers fail to consider how attractive the target really
is, or if they have the resources and capabilities that make the new market a value adding adjacency. In 2001, shipping leader UPS bought Mailboxes, Etc. for $191 million to give the company
4,300 new drop-off locations. FedEx responded by paying $2.4 billion for 1,200 Kinko’s copy
centers. FedEx bought fewer stores for more money and had to figure out how to incorporate
Kinko’s huge copy business into its operations.39 While both companies sought to expand into
an attractive adjacent market, by being the first mover UPS found the more attractive target.
FedEx struggled because it had to integrate a set of resources that aligned poorly with the company’s core. Kinko’s resources and capabilities were not oriented to truly exploit FedEx’s.
Poor Governance and Incentives
Managers receive compensation based on
how their companies perform. The threat of failure and the thrill of profit-based rewards create a set of high-powered incentives for managers to run their businesses effectively.40 When
they become part of a diversified corporation, however, those managers sometimes move to
salary-based compensation that divorces their pay from their performance. Further, within a
diversified firm, managers’ decisions must account for internal politics, resource allocation constraints, or mandatory transfers with other divisions. The division becomes less valuable inside
the corporation because managers have weak incentives to focus on exploiting and expanding
resources and capabilities and stronger incentives to focus their energy in other areas.
Creating Value Through Diversification
Poor Management How do managers, given their limited time, energy, and mental
resources, guide and direct the diversified firm? Sometimes they use models that relegate
their different investments to simplified categories and then provide a management rule for
each category. The Boston Consulting Group’s growth share matrix represents one such tool.
Figure 6.2 illustrates the growth share matrix.
In the growth share matrix, units contribute to corporate value creation in one of two ways;
they either serve as engines of revenue growth or they generate cash flows for the firm to reinvest or distribute to shareholders. Executives classified business units as high or low on each
dimension and applied a set of rules for managing each different quadrant. Cash cows have
high share but low growth and can generate large cash flows that can be used to fund growth
businesses. Companies typically like to minimize investments in cash cows because the goal
is to milk the cow. Stars combine high share with high growth, and smart managers should
invest heavily in these units to maintain or improve their position over time. These businesses
typically represent the future of the company. Question marks, as their name implies, present
a conundrum for management because they require significant investment and effective strategic management if they are to become stars. But if not managed correctly, the significant
investments may not move them into the star quadrant, and instead they may move into the
dog quadrant when growth slows. Dogs have low share and low growth and add little profitability to a company’s overall portfolio businesses. The general rule is to divest the dogs.
As you can easily see, the growth share matrix says almost nothing about whether cash
cows, dogs, question marks, or stars help the corporation exploit or expand a company’s
resources and capabilities. Companies that slavishly follow tools such as this will often miss
important sources of value available in their portfolio. For example, a dog business may have
low growth because it competes in an emerging industry using cutting-edge technology.
Divesting the dog may prevent the company from understanding a new technology platform
at its inception.
Lack of Resources
Think back to our feature on ITT. A single management system that
operates 2,000 different business units relies on very high level financial measures, such as
return on invested capital, to make decisions about which businesses will grow and which will
stagnate. What ITT lacked, and why it eventually broke itself apart, was the ability to understand and respond to the unique strategic needs of each market, customer group, and line of
business. Most of ITT’s business units would offer very negative answers to the questions of
value at the beginning of the chapter. Each business gained little of value by membership in the
corporation, and each added little value in return.
In this section, you’ve learned why and when diversification adds value. In the next section, we’ll introduce a set of tools that strategic managers can use to evaluate the different
business units in their portfolio.
Growth Rate
High
Low
Low
High
Relative Market Share
FIGURE 6.2
The BCG Matrix
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Methods of Diversification
greenfield entry Entry into an
adjacent market by a firm that
opens its own operation.
acquisition The purchase of
another company, or its assets.
TABLE 6 .1
Once firms decide to diversify their operations, the next question they must answer concerns
how to diversify: Should they use greenfield entry by opening their own operations, or should
they acquire a company already in the target market or industry? Moreover, if they do decide to
enter via acquisition, how do they select a target, get the deal done, and successfully integrate
the new company into the portfolio?
Table 6.1 displays some criteria that managers should consider when choosing their mode of
entry. The table aids analysis by dividing resources into front- and back-end categories, and also
includes the important criteria of scale-based advantages and timing issues for market entry.
Greenfield entry makes sense, first and foremost, when companies have the front-end and backend resources and capabilities they can immediately exploit to create value. For example, GE’s
entry into medical products in the early 1900s drew on its core technical expertise in designing
and manufacturing electrical equipment. GE opened its own finance unit to effectively exploit its
deep knowledge of the buying process for electrification systems and customer characteristics.
Greenfield also makes sense when companies can afford to enter new arenas slowly and at
small to moderate investment. Conversely, acquisition, the outright purchase of another
company, becomes the preferred mode of entry when the firm needs to quickly expand its own
resources and capabilities to effectively compete. Acquisitions make sense when delay proves
costly. In many technology businesses with sophisticated technologies and long lead times for
development, companies that enter through greenfield may be too far behind to ever catch up.
Acquisition also makes sense if the industry favors competitors with large scale or is characterized by a steep learning or experience curve.
You may be tempted to think that greenfield entry represents value through exploitation
and acquisitions through expansion. That oversimplifies the analysis; acquisition may prove
the preferred choice when any one of the target markets meets any one of the criteria outlined above. GE’s 2012 purchase of Italian aerospace company Avio may look like just another
addition to a large conglomerate, but this acquisition both exploited and enabled GE’s position in the aircraft industry.41 GE’s 2015 divestiture of most of its GE Capital unit was designed
to retain only those financing operations that would directly benefit customers of GE’s other
divisions.42 Once managers decide to acquire another business, firms that have developed an
Greenfield Entry Versus Acquisition
Competitive Dimension
Greenfield Entry
Acquisition
Brands
Brands well-known in the new markets and little
advertising needed
Brands not well-known in the new market and
heavy advertising will be required
Customers
Customers in new market similar to existing
customers
Customers in new market very different from
existing ones
Channels
Many channels available that the firm can
easily access
Few channels available or access to channels
difficult and expensive
Human Capital
Standardized knowledge and skills that can be
easily gained
Unique or tacit knowledge and skill
Technology
New technology integrates easily with existing
processes
New technology does not integrate easily with
existing processes
Scale
Economies of scale add few, if any, advantages
Significant economies of scale or learning effects
that confer strategic advantage
Speed
Slow, deliberate entry enables growth of solid
market position
Rapid entry needed to capture opportunity
Front-End Resources
Back-End Resources
The Acquisition and Integration Process
acquisition capability initiate a well-defined process to examine, purchase, and then bring the
new entity into the corporate fold. In this section we’ll explain the four essential steps in that
process: identifying potential targets, selecting which of these to purchase, doing the deal, and
integrating the acquisition after the deal closes.
The Acquisition and Integration Process
Acquisitions represent an opportunity to create, or destroy, value for the firm. In 2015, for example, the American economy witnessed over 12,000 mergers or acquisitions, with almost 300
valued in excess of $1 billion.43 In spite of its prevalence in the US economy, most mergers or
acquisitions fail to create value for shareholders. Estimates vary, but between 70 percent and
90 percent of mergers don’t work out.44
Making the Acquisition
Before searching for a firm to purchase, managers must understand the real, value-creating need
behind the move. Good reasons to diversify center on both the acquiring and target firms’ resources
and capabilities. Value creating acquisitions will either exploit the value of a firm’s current stock
of resources or the acquisition will enhance the firm’s resources and capabilities. Poor reasons for
acquisitions include simply adding top line revenue growth or doing a deal just because a competitor recently did one. These reasons make clear how the acquisition makes the current corporation more valuable; however, managers must also answer other questions: Why and how will
the target firm be more valuable because we own it? The answer to these questions comes from
the eight Ss above. The best acquisitions create value for both the acquiring and acquired firm.
After making a list of potential targets that pass the first screen, the next phase requires the
firm to perform a due diligence audit on each potential target. Due diligence means to closely
examine the target firm to understand its core processes, strengths, and weaknesses.
Newell Corporation’s 1999 purchase of Rubbermaid illustrates the problems that inattention to due diligence can create. Newell essentially bought Rubbermaid’s revenues and profits;
it had little to offer Rubbermaid in terms of resources and capabilities, and the same held true
for Rubbermaid.45 Newell rushed its financial due diligence and failed to see that, within legal
bounds, Rubbermaid created a picture of a business in better condition than the actual corporation. Rubbermaid proved to be what one analyst termed, “a perfumed pig,” and Newell
overpaid as a result. Newell Chairman Daniel Ferguson stated, “We should have paid $31 per
share but we paid $38.”46 Failure to follow these steps required Newell to write off $500 million
of merger-related goodwill in 2002.
Once a potential candidate passes the value screen and survives the due diligence process,
managers at the acquiring firm must decide how much they are willing to pay for the target.
A number of tools exist to help with the valuation; firms often hire investment bankers or advisors to help them.47
Acquirers must pay a premium to acquire a target; the premium represents a bet by the
acquirer on its ability to create value through the acquisition. In the United States, the average
premium that the acquiring firm pays for a target firm is roughly 30 percent. For example,
Newell originally offered just over $34/share for Rubbermaid, which was then trading at about
$26/share, but eventually paid $38 per share.48 The process of acquisition plays an important strategic role for firms, and it represents a source of ethical challenges for managers and
executives. Our Ethics and Strategy feature invites you to think through one such dilemma.
Integrating the Target
The acquisition premium creates two challenges for the acquiring firm. First, the larger the premium, the more value they must actually create to justify the acquisition. Second, given the
time value of money, the larger the premium, the quicker the acquirer must create that value.
due diligence The process
whereby managers closely
examine the target firm to
understand its core processes,
strengths, and weaknesses.
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C H A PT E R 6
Corporate Strategy
Source of
Value
Creation
Degree of
Integration
Reason
Employing
Creating
Slack/Stopping
Synergy/
Competitors
Staying Ahead
of Technology
Tightly
Integrated
Best exploit
economies of
scope,
knowledge,
and skills.
Increase market
reach of core
brand, leverage
and grow share
to thwart
competitors.
FIGURE 6.3
Stepping
Stones
Shared
Knowledge
Similar
Models
Spread Capital/
Stopping
Competitors
Integrated
Moderately
Integrated
Loosely
Integrated
Not Integrated
Building new
knowledge and
skill requires
close proximity
and exchange
but also freedom
of action by the
acquired firm.
Sharing
overlapping
knowledge, but
allowing each
business to
exploit unique
knowledge.
Only those
areas with
common
model will
gain through
shared
practices.
Keep units
separate to
monitor
performance and
create
accountability.
Well Integrated
Cost sharing
requires
integrated
operations.
Innovation builds
on common
resources.
Mere ownership
and control of
valuable assets
and resources
forestalls
competitors.
Integrate new
knowledge and
technology
throughout each
business unit.
Determining the Proper Degree of Integration
For example, a hefty premium, coupled with large debt to close the deal, strongly encourages
(forces) managers of the acquiring firm to create real value in order to pay off the debt.49 Strategy and management researchers suggest that acquisition represents a risky strategy for value
creation with failure rates as high as 90 percent in some industries.50 Acquisitions may fail to
create value because of poor strategic fit, incomplete due diligence, or a high acquisition price,
but also because the acquiring firm fails to properly integrate the firm into its portfolio.
Proper integration, like everything else, depends on the firm’s overall strategy and, more
specifically, on which of the eight Ss the corporation uses to create value through diversification. Integration means the degree to which the two companies share facilities, operating procedures, compensation systems, organizational structures, and even cultural norms. Sometimes,
an acquiring firm will need to tightly integrate the acquired firm into its own organization, but
other strategies require the two firms to operate relatively (or completely) separate. Figure 6.3
illustrates the link between the degree of integration and the source of value creation.
Managers in the firm tasked with integrating the new acquisition must decide which activities or operations to integrate and how completely or tightly the target and company will be
linked together. The tighter the degree of integration, the more the combined entity looks and
acts like a single firm. Conversely, loose integration allows each company autonomy in its
business operations. Firms may follow one of four general integration strategies: They can bury
the target through complete integration, build a brand new entity with the combined entities
through tight integration, blend in the target to the corporation using best practices from each,
or bolt on the target to the existing company only where it makes sense. Table 6.2 summarizes
each approach; we will describe each in more detail.
TABLE 6 .2
General Integration Strategies
Element/Strategy
Bury
Build
Blend
Bolt On
Integration
Complete
Tight
Moderate—loose
None
Brand and Identity
Acquirer maintains, Target loses
New, combined
Target maintains front end
Target retains
Back-End Operations
Acquirer imposed
Best of breed
Acquirer dominates
Separate
Customer-Facing Operations
Acquirer imposed
Combined, Best of Breed
Separate
Separate
The Acquisition and Integration Process
111
Ethics and Strategy
Transparency During the Acquisition Process
When a company makes an acquisition, how much should it disclose about its true intentions to the employees of the acquired
firm? Cisco Systems CEO John Chambers talks about the importance of treating employees of the acquired firm well, as he believes
“you’re only acquiring employees.”51 Cisco has acquired almost
200 companies, and its core values reflect Chambers’s concern for
employees: integrity, respect for individuals, and open communication. These core values have led to many successful acquisitions
by Cisco as target companies have been successfully integrated into
the Cisco family.
Open communication and respect for individuals seem to be
straightforward values, but each of these raise ethical issues for strategic managers during the integration process. Strategists usually
have several objectives in mind when making an acquisition. The
firm might buy the ability to offer certain products or services; it may
purchase another firm for access to production processes, plants, or
favorable locations; managers may target intellectual property such
as patents and trademarks in an acquisition; or strategists may seek
to lock up unique and valuable human capital. The point is that when
an acquiring firm considers a target, it might have multiple objectives
in mind. The firm might fully integrate some divisions or elements,
allow others to run as a separate business, and close down or sell off
others. The ethical issue involves the trade-off between the acquirer’s desires to move efficiently and effectively versus stakeholders’
(primarily employees but also customers and suppliers) needs for
information in making their own plan.
Here’s an example. Consider two regional nursing home operators, Blue Heron and White Swan.52 Each company uses acquisitions to grow and expand into new regions. In this case, Blue
Heron and White Swan each purchased a family-owned, local set
of nursing homes to gain entry into the Southwestern region of
the United States. Both acquirers follow a prescribed list of 90-day
objectives integration plan to bury the acquired firm. The objectives include implementing the corporate technology platform,
migrating purchases to the acquirer’s preferred vendors, assessing
the need for capital investments in the newly acquired units, and
training employees on Blue Heron or White Swan procedures and
protocols. At the end of the 90 days, both acquirers always replace
the unit’s existing general manager to bring in their own staff who
are familiar with the existing culture, processes, and strategies.
The ethical challenge for Blue Heron and White Swan is
that during the 90-day transition period, the acquired unit’s
manager-in-place can play a key role in the efficiency and effectiveness of the transition. How much information should leaders of the
acquiring firm share with the unit managers about their ultimate
plans? If they tell the managers of their impending termination, they
run the risk of losing a valuable player during the transition process.
However, withholding that information raises fairness concerns for
the unit managers; they could have used that 90-day period to find
and secure new employment. How would you resolve this dilemma?
Blue Heron operates as a business first and foremost. Its
belief is that the most important goal is to ensure efficiency and
effectiveness during the transition. Managers are interchangeable,
and Blue Heron does not disclose its true intentions to the unit
managers until they receive termination notices at the end of the
90 days. White Swan, also deeply committed to creating value for
shareholders, opts for a different, open approach. Its managers sit
down with the unit managers at the beginning of the process and
disclose their ultimate plans. White Swan offers those managers
increased pay and a bonus for the transition period, outplacement
help in finding a new position, and the promise of a very positive
reference if the job is well done. White Swan refuses to trade off its
obligations to owners and employees. The owners get a smooth
and effective transition, and employees are treated with dignity,
fairness, and respect.
Bury
Another term for bury is takeover, where the acquiring firm breaks up the target firm
and weaves its individual elements (e.g., product lines, employees, manufacturing facilities) into
the fabric of the acquiring firm. The target’s brand, culture, and identity all disappear; both the
back-end operations and customer-facing aspects of the acquirer remain unchanged, although
supplemented by the addition of the target’s assets. Apple’s acquisitions of more than 40 start-up
firms have followed this pattern, including NeXT, eMagic, and Siri (yes, it used the Siri name for
the personal digital assistant on the iPhone). The target firm ceases to exist as Apple assimilates
and disperses the valuable elements of the firm throughout its existing organization.53
takeover An acquisition where
the acquiring firm absorbs the
target firm. The target firm
ceases to exist.
Build
merger An acquisition with the
goal of creating a new firm from
the components of the two preacquisition firms.
The traditional term merger represents what companies do when they build one new
firm from the components of the two. The degree of integration is not as high as in the bury
strategy, but a new identity, culture, and corporate brand emerge when the deal closes. Backend and customer-facing aspects of the business use the best in class processes of either
company.
In 1998, auto giants Daimler-Benz and Chrysler merged, resulting in DaimlerChrysler AG,
with a stated goal of increasing global customer share by sharing best operating practices between the two businesses. This bold strategy required the companies to truly build a new organization, on both the customer front end and operational back end. Unfortunately, the companies
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split in 2007 after it became apparent that the “merger of equals” was really an acquisition of
Chrysler by Daimler. Building a new company may be the hardest integration strategy of all.
Blend
A blended acquisition results in a moderate degree of integration. The target firm
retains its own identity, brand, and much of its culture and operating autonomy. Acquirers
may transfer many back-end practices to the acquired firm, as Newell does when it “Newellizes” an acquisition; the company may choose to share fewer processes and practices, such as
GE’s management of many of its acquisitions. Customer-facing aspects of the business remain
largely separate to capitalize on the strength of each company in its market. When companies
add value through synergy, shared knowledge, or similar processes, a blending strategy helps
create new value while preserving the strengths of each company.
Bolt On
integration team A group
of individuals from different
functional areas of an acquiring
firm that coordinate and manage
the integration of the target
company after the acquisition
has closed.
The metaphor of bolting on an acquisition implies two separate entities joined at
a single point through a very strong link. In a bolt-on acquisition, the two entities remain deliberately separate in order to monitor the performance of each unit. The link between the two
businesses usually lies in the transfer of cash between divisions, either in the form of capital
investment from the acquirer to the acquired or the payment of a dividend in the reverse
direction.
ITT exemplifies the bolt-on model; each business unit was connected with the corporate
center only through financial reporting. Because the goal of each unit was to contribute cash
and operating profit rather than knowledge or strategically valuable assets, the bolt-on model
was the only appropriate integration choice for ITT to create any value. The different business
units could make no excuses that achieving larger corporate goals had influenced their
individual earnings; the bolt-on model preserved operating transparency among the many different businesses.
Regardless of the integration template managers in the acquiring firm choose, attention to
a number of integration processes works to create a smooth and successful acquisition. These
processes begin with the creation of a dedicated integration team as soon as the deal is
announced.
The most successful integration teams are jointly led by high-profile executives from both
the acquiring and acquired firm; the credibility and authority of these teams helps break down
barriers to change and integration in both companies. The team should be composed of subject
area experts within each business function, such as human resources, marketing, operations,
and finance/accounting.54 Each element of the new business that will be integrated needs its
own specialist on the integration team to lead and monitor the effort. Finally, members of the
best integrations work full time in these roles. Full-time status allows these individuals to supplement their functional knowledge with expertise specific to the acquisition process.
This team makes several key decisions that create a successful acquisition. The first
decision involves which company culture will dominate the new entity. Culture, norms, and
values that define “how things are done around here” are the most important elements in the
process. The acquiring firm usually wants its culture to dominate the new company, but people
in the acquired firm often want their culture to persist. The resulting cultural clash can sabotage
the entire integration process. A more difficult option entails building a new culture that combines
the best elements of each company’s culture.55
Speed matters in the integration process. When people see that the new company creates value for its stakeholders, including themselves, they become willing to change their own
behaviors and truly join the new organization. The quicker the integration team can create
clear successes, the more quickly members of the acquired firm dedicate their energy to making the venture succeed. This principle underlies Cisco’s practice of having the acquired company’s products for sale by Cisco employees on day one of the new relationship.
The team decides which tactical elements and operational functions of the two firms will
be integrated and implements whichever strategic integration template the firm chooses. Several other processes ensure that the merger, once finalized, creates value as soon as possible.
These include determining a clear day-one set of priorities and tasks to realize immediate
value from the deal; establishing a clear set of measures or key performance indicators (KPIs)
Summary
113
Strategy in Practice
Questions Every Acquirer Should Ask
The buying and selling of businesses can add strategic as well as
financial value to companies and their shareholders. However,
research over a number of decades indicates that mergers and
acquisitions fail to create value for the acquiring company about
70 percent of the time. How can executives increase the odds of
being in the 30 percent that succeed? Successful acquirers have
answers to the following five questions:
1. What strategic gap is our company trying to close? Strategic
gaps occur when changes in the external landscape or internal
situation call for new answers to strategy’s four critical questions: Where will we compete? Why will we win with customers?
How will we create that value? What keeps competitors from
copying us? Strategic gaps fall into two major classes: (1) a
company is missing something—assets or processes—that
keep them from winning with existing customers, or (2) they
are missing out on winning with new customers because they
lack critical assets and processes.
2. Why is an acquisition the best way to close the gap? Acquirers
pay, on average, a 35 percent premium over market to acquire
a target. That’s expensive! Companies almost always overpay,
and many times they didn’t need to pay a premium at all.
There are many ways to close strategic gaps: organic growth
and entry into new markets, strategic partnerships and
long-term contracts, and alliances or joint ventures. Winning
teams know what acquisition is essential to success.
3. What’s the cultural fit between our company and the target?
Poor cultural fit results in the loss of key stakeholders (customers leave, employees quit, or suppliers reduce their
commitment to the firm). Cultural mismatches mean that integrating processes takes longer, or that knowledge and intellectual capital won’t flow across boundaries in the new firm.
4. How will the acquisition create new value? Will new value
(profits) come from revenue synergies? These come from
cross-selling existing products, or by developing new products
for existing or new markets. Or, will the combined company
create cost synergies? Cost synergies come from eliminating
duplicate functions in the combined firm, or by using one company’s knowledge, processes, or technologies to drive down
costs in the other one.
5. How will we integrate the target into our operations? Integration
determines whether or not the combination will create the
synergies described above. Acquirers have four options: Bury,
Bolt-on, Blend, or Build? How the acquired company will
be integrated follows question four and leads to the actual
creation of value. In general, Bury and Blend create cost synergies, and Bolt-on or Build lead to revenue synergies.
Successful acquisition pass the “acid test” of synergy: Both the
acquirer and acquired companies are more valuable together than
they would be separately. Teams that think through and give solid
answers to these five questions can create valuable synergies that
put them in the 30 percent of successful acquisitions.
to monitor progress; a clear path for implementing new systems in operations, marketing, or
information systems; and a commitment to clearly communicate, in fact over communicate,
the rationale and goals for the acquisition and the measurable progress toward those goals.
We close this chapter by looking at General Electric to see how the company has mastered the
acquisition integration process.
Summary
• Diversification creates value when firms exploit or enhance their
resource base by entering a new line of business, market, or industry.
Managers should ask two questions when considering entering a
new line of business: (1) Why will the existing businesses be more
valuable because we’ve entered an adjacent business? and (2) why
will the new business activity be more valuable inside our corporation than operating alone? When managers choose to diversify, they
face a choice about whether to enter a new line of business through
greenfield entry or through acquisition. Greenfield entry proves
a preferred strategy when the firm can readily exploit its existing
resources and capabilities, is not pressed for speed, and can enter
a new line of business at a small or moderate scale. Diversification
through acquisition becomes the preferred strategy when firms
must expand their resources and capabilities to compete effectively,
enter a market quickly, or operate at large scale.
• Successful diversification relies on one of the Eight Ss to create value:
managerial slack—the ability of managers to handle more work
effectively over time
synergy—the combination of two businesses creates more value
than either could separately
shared knowledge—diversification allows valuable knowledge
and skill to be shared between business units
business models—when business unit success depends on
common characteristics, such as knowledge management, or
scale economies
spreading capital—the headquarters of the corporation quickly
allocates capital and other resources to their best use among
business units
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C H A PT E R 6
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a stepping stone to new markets—where a firm moves to a new
industry through a set of small jumps and each jump allows the
acquisition of key resources and skills
poor governance and incentives—simply running the new
business poorly or failing to incentivize managers to attend to
the business
stopping (or slowing competitors)—pre–emptively moving into
a new market space, or acquiring another firm, to deny a competitor access to that space
the lack of resource commonality between the lines of
business—moving into lines of business that fail to create value
based on any of the eight
staying ahead of technology—expanding into a new technology
arena, or buying a company in that arena, in order to learn about
new technologies
• Successful integration ensures that acquisitions add value to the
organization. The four Bs provide a template for thinking about how
a firm should integrate an acquisition:
• When done poorly, diversification destroys value through
excessive pride or hubris—making diversification decisions based
on biased thinking or emotional reasoning rather than facts and
data
sunk cost fallacy—focusing on past resources expended, which
cannot be recovered, as a criteria for decision making
imitative diversification—choosing to copy a competitor’s moves
rather than having a compelling strategic logic
bury—completely absorb the acquired company into the
acquirer
blend—retaining and combining the best elements of both companies to compete more effectively
build—craft an entirely new organization
bolt on—run the acquired company independently of the
acquiring company
Key Terms
acquisition 108
adjacent market 101
business model 103
business unit strategy 99
core competencies (or shared
knowledge) 103
corporate strategy 99
corporate venture capital 105
dominant business 100
dominant logic 103
dominant vertical business 100
due diligence 109
economy of scope 102
greenfield entry 108
horizontal diversification 99
hubris 106
integration team 112
internal capital market 104
management skill 102
merger 111
related-constrained diversification 100
related-linked diversification 100
single business 100
slack 102
sunk cost fallacy 106
synergy 102
takeover 111
unrelated diversified firm 100
vertical integration 99
Review Questions
1. Why and when do firms create value through diversification?
2. Apple is primarily an electronics company, creating products for
business and consumer markets. Apple also operates its own chain of
retail outlets. In terms of Richard Rumelt’s categories of the level of
diversification, where does Apple fit?
5. How can acquiring firms increase the likelihood of a successful
integration of an acquired firm?
6. Why do acquiring companies have to pay a premium when they
acquire another firm? How does that premium create challenges for
the acquiring firm?
3. List the reasons why diversification fails to add value. Which one do
you believe is most common? Which is least?
4. What factors should executives consider when making a decision
on entering a new market through greenfield entry versus making an
acquisition?
Application Exercises
Exercise 1: Understanding Diversification
1. Look in The Wall Street Journal, Businessweek, or other business
publication and find a company looking to expand through diversification—either greenfield entry or acquisition. What type of diversification does this represent?
2. For the example you selected in Exercise 1, how do managers claim
they will create value through diversification? Using the eight Ss described
in the chapter, evaluate how well you believe the company will do in its
value creation strategy. For example, are there real synergies or core competencies to create? Do the businesses share a similar dominant logic?
References 115
Exercise 2: Understanding Acquisitions
1. Choose a diversification move that entails acquisition. Using the
company diamond from Chapter 3, identify areas where you believe
the acquisition can add value for shareholders. Also identify three to
five issues that you believe will create challenges for the acquiring
company’s management team.
2. Through a friend, mentor, colleague, relative, or recruiter, identify
someone who has experienced an acquisition or merger, either as a
buyer or seller. Which integration strategy did he or she experience?
What worked well and helped create value during this process? What
did not work well? What would the person change if he or she went
through this situation again?
References
See “Cisco Systems, Inc. History,” Funding Universe, http://www
.fundinguniverse.com/company-histories/cisco-systems-inc-history/.
1
2
“Cisco Systems Silicon Valley Historical Association,” http://www
.siliconvalleyhistorical.org/#!cisco-systems/c1vg0.
“Cisco Systems Corporate Timeline,” http://newsroom.cisco.com
/dlls/corporate_timeline.pdf, accessed 12 February 2014.
3
Data on 3M’s very large product catalog can be found at https://
www.3m.com/3M/en_US/company-us/all-3m-products/~/All-3M-Prod
ucts/?N=5002385+8711017+3294857497&rt=r3
13
See Cisco Systems Acquisitions, http://www.cisco.com/web/about
/doing_business/corporate_development/acquisitions/ac_year
/about_cisco_acquisition_years_list.html.
14
Data from Delta’s 2012 SEC filing form 10-K. Found at http://
www.delta.com/content/dam/delta-www/pdfs/about-financial
/DeltaAirLines_10K_2012.pdf.
Data on the Crescendo acquisition taken from “Cisco Systems Finalizes
Agreement to Acquire Crescendo Communications,” company press
release, http://newsroom.cisco.com/dlls/1993/corp_092493.html.
15
See Cisco Systems Timeline for the data contained in the following
two paragraphs.
16
4
5
Ibid.
6
E. Paulson, Inside Cisco: The Real Story of Sustained M & A Growth
(New York: John Wiley & Sons, 2001).
7
8
Data from “Cisco Loses Market Share as Router/Switch Market Up,” Infonetics Research report (August 26, 2011), http://www.telecomreseller.
com/2011/08/26/cisco-loses-market-share-as-routerswitchmarket-up/.
B. O’Sullivan, “30 Millionth Cisco IP Phone!” blog (October 27, 2010).
https://blogs.cisco.com/news/30-millionth-cisco-ip-phone/.
9
A list of Cisco acquisitions can be found at http://www.cisco.com/c
/en/us/about/corporate-strategy-office/acquisitions/acquisitions-list
-years.html, accessed 19 February 2019.
10
The original work is R. P. Rumelt, Strategy, Structure, and Economic
Performance (Cambridge: Harvard Business School Press, 1986). See
also R. P. Rumelt, “Diversification Strategy and Profitability,” Strategic Management Journal 3 (4) (October 1, 1982): 359–369. A metaanalytic study can be found in S. R. Perry, A Meta-Analytic Review
of the Diversification-Performance Relationship: Aggregating Findings in Strategic Management (Florida Atlantic University, 1998),
http://digitool.fcla.edu/R/UFVFAL2DR3T6X2N1AMIJG32TMKA7
XYMRG8TGT1E8ITXANM1NHL-02231?func=dbin-jump-full&object
_id=12566&local_base=GEN01&pds_handle=GUEST. L. H. P. Lang and
R. M. Stulz, “Tobin’s Q, Corporate Diversification, and Firm Performance,”
Journal of Political Economy 102 (6) (December 1, 1994): 1248–1280.
See also D. J. Miller, “Technological Diversity, Related Diversification,
and Firm Performance,” Strategic Management Journal 27 (7) (July 1,
2006): 601–619. Researchers have also considered international diversification as a measure of relatedness. See G. Qian et al., “Regional
Diversification and Firm Performance,” Journal of International Business
Studies 39 (2) (March 1, 2008): 197–214. G. Qian et al., “The Performance
Implications of Intra- and Inter-Regional Geographic Diversification,”
Strategic Management Journal 31 (9) (September 1, 2010): 1018–1030.
11
Rumelt, “Diversification Strategy and Profitability.” See also Rumelt,
Strategy, Structure, and Economic Performance.
12
See E. T. Penrose, The Theory of the Growth of the Firm (Cambridge,
England: Oxford University Press, 1959). For a recent treatment of the
Penrose effect in strategic management, see J. T. Mahoney and D. Tan,
“Examining the Penrose Effect in an International Business Context:
The Dynamics of Japanese Firm Growth in U. S. Industries.,” Managerial and Decision Economics 26 (n.d.): 11–127.
Information taken from http://timeline.marriott.com/#/?era=3
&milestone=1.
17
E. McDowell, “Marriott to Acquire a Ritz-Carlton Stake,” New York Times
(business day, March 7, 1995), http://www.nytimes.com/1995/03/07
/business/company-news-marriott-to-acquire-a-ritz-carlton-stake.html.
18
C. Zook and J. Allen, “Growth Outside the Core,” Harvard Business
Review 81 (12) (December 2003): 66–73.
19
C. K. Prahalad and G. Hamel, The Core Competence of Corporation
(Canada: Harvard Business School Reprint, 1990).
20
G. Bodenheimer, “Growing Up with ESPN,” Marriott School Alumni
Magazine (Winter 2013): 14–16.
21
C. K. Prahalad and R. A. Bettis, “The Dominant Logic: A New Linkage
Between Diversity and Performance,” Strategic Management Journal
7 (6) (1986): 490.
22
Information on the Newell Corporate history taken from http://www
.newellrubbermaid.com/OurCompany/Pages/OurHistory.aspx.
23
The Newellization process is summarized in William Rouse, Enterprise
Transformation: Understanding and Enabling Fundamental Change
(Hoboken: John Wiley & Sons, 2006).
24
J. P. Liebeskind, “Internal Capital Markets: Benefits, Costs, and Organizational Arrangements,” Organization Science 11 (1) (January 1,
2000): 58–76.
25
R. H. Gertner, David S. Scharfstein, and Jeremy C. Stein, “Internal
Versus External Capital Markets,” The Quarterly Journal of Economics
109 (4) (November 1, 1994): 1211–1230. J. C. Stein, “Internal Capital
Markets and the Competition for Corporate Resources,” The Journal of
Finance 52 (1) (March 1, 1997): 111–133.
26
Data taken from a variety of sources, including Eric Owles, “G.E.’s
History of Innovation,” New York Times, June 12, 2017, https://www
27
116
C H A PT E R 6
Corporate Strategy
.nytimes.com/2017/06/12/business/general-electric-history-ofinnovation.html, accessed February 20, 2019.
Jeff Desjardins, “The largest companies by market cap over 15 years,”
Visual Capitalist (August 12, 2016), https://www.visualcapitalist.com/
chart-largest-companies-market-cap-15-years/ accessed February 20,
2019.
28
J. Werdigier, “General Electric to Buy Avio for $4.3 billion,” New York Times
(December 12, 2012), http://dealbook.nytimes.com/2012/12/21/general
-electric-to-buy-avio-for-4-3-billion/.
41
Jen Wieczner, “Last Big Chunk of GE Capital Sold to Wells Fargo,”
Fortune, (October 13, 2015), http://fortune.com/2015/10/13/ge
-capital-wells-fargo/, accessed January 13, 2017.
42
Data on 2015 acquisitions available at https://www.statista.com
/statistics/245977/number-of-munda-deals-in-the-united-states/,
accessed January 13, 2017.
29
GE Annual Report and 10-K filing, 2008 and 2009, https://www
.ge.com/ar2008/pdf/ge_ar_2008.pdf and https://www.ge.com/ar2009
/pdf/ge_ar_2009.pdf.
43
Stock price data available at https://www.google.com/search
?rlz=1C1GGRV_enNL751NL751&tbm=fin&q=NYSE:+GE&stick=H4sIAAAAA
AAAAONgecRoyi3w8sc9YSmdSWtOXmNU4-IKzsgvd80rySypFJLgYoOy-KR
4uLj0c_UNzKtyCg0LeBaxcvhFBrtaKbi7AgA1ngknRQAAAA&biw=1497&bi
h=807#scso=_lnRtXNHdGei7jwS_x4-gBQ2:0, accessed February 20, 2019.
44
30
D. J. Bryce and S. G. Winter, “A General Interindustry Relatedness
Index,” Management Science 55 (9) (September 1, 2009): 1570–1585.
C. Christensen, R. Alton, C. Rising, and A. Waldeck, “The Big Idea: The
New M&A Playbook,” Harvard Business Review (March 2011), p. 46.
A. Corbett, C. Lemire, and D. Harding, “Deals Done Right,” Ivey Business
Journal (January/February 2007), http://www.iveybusinessjournal
.com/topics/strategy/deals-done-right#.UWg7RLXCZ8E.
45
31
46
32
D. J. Bryce, “Firm Performance and the Rate of Change in Capabilities,” Strategic Management Society (October 2012).
47
Conner Forest, “The Top 7 Acquisitions of All-Time in Social Media, and
Why They Matter.” Tech Republic, March 12, 2014. Available at http://
www.techrepublic.com/article/the-top-7-acquisitions-of-all-time-in
-social-media-and-why-they-matter/, accessed January 12, 2017.
48
33
Gary Dushnitsky and Michael Lenox, “When Do Incumbents Learn
from Entrepreneurial Ventures? Corporate Venture Capital and Investing Firm Innovation Rates.” Research Policy 34 (5): 615–639.
34
Data taken from Kerry Wu, “CBInsights,” https://www.cbinsights.com
/research-cvc-trends-mar2016, accessed January 12, 2017.
35
R. Rajan, H. Servaes, and L. Zingales, “The Cost of Diversity: The
Diversification Discount and Inefficient Investment,” The Journal of
Finance 55 (1) (February 1, 2000): 35–80. See also J. Hund, D. Monk, and
S. Tice, “Uncertainty About Average Profitability and the Diversification
Discount,” Journal of Financial Economics 96 (3) (June 2010): 463–484.
36
See http://dictionary.reference.com/browse/hubris
37
M. L. A. Hayward and D. C. Hambrick, “Explaining the Premiums Paid
for Large Acquisitions: Evidence of CEO Hubris,” Administrative Science
Quarterly (1997): 103–127. R. Roll, “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business (1986): 197–216. P. R. Rau and
T. Vermaelen, “Glamour, Value and the Post-Acquisition Performance of
Acquiring Firms,” Journal of Financial Economics 49 (2) (1998): 223–253.
38
For UPS, see A. Doan, “UPS Picks Up Mail Boxes, Etc.,” Forbes (March 5,
2001), http://www.forbes.com/2001/03/05/0305ups.html. For FedEx,
see C. Deutsch, “FedEx Moves to Expand with Purchase of Kinko’s,”
New York Times (Dec. 31, 2003), http://www.nytimes.com/2003/12/31
/business/market-place-fedex-moves-to-expand-with-purchase-of
-kinko-s.html.
39
O. E. Williamson, The Economic Institutions of Capitalism: Firms,
Markets, Relational Contracting (New York, London: Free Press; Collier
Macmillan, 1985).
40
D. Harding and S. Rovit, Mastering the Merger: Four Critical Decisions
That Make or Break the Deal (Harvard Business School Press, 2004), p. 27.
W. D. Miller, Value Maps Valuation Tools That Unlock Business Wealth
(Hoboken: Wiley, 2010), http://site.ebrary.com/id/10388356.
C. Deutsch, “Newell Buying Rubbermaid in $5.8 Billion Deal,” New
York Times (October 22, 1998), http://www.nytimes.com/1998/10/22
/business/newell-buying-rubbermaid-in-5.8-billion-deal.html.
M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance,
and Takeovers,” The American Economic Review 76 (2) (May 1, 1986):
323–329.
49
M. E. Graebner, K. M. Eisenhardt, and P. T. Roundy, “Success and
Failure in Technology Acquisitions: Lessons for Buyers and Sellers,” The
Academy of Management Perspectives 24 (3) (August 1, 2010): 73–92.
50
E. Paulson, Inside Cisco: The Real Story of Sustained M & A Growth
(New York: John Wiley & Sons, 2001). Information on Cisco’s core
values found at http://csr.cisco.com/pages/governance-and-ethics.
51
Blue Heron and White Swan are fictitious companies drawn from actual
author experiences with different companies facing similar issues.
52
53
A nice summary of these 40 acquisitions, plus citations to verify
each one, can be found at https://en.wikipedia.org/wiki/List_of_mergers
_and_acquisitions_by_Apple.
G. Knilans, “Mergers and Acquisitions: Best Practices for Successful Integration,” Employment Relations Today (Winter 2009), 9 pages.
http://www.tgcpinc.com/SiteData/doc/MergersAcquisitions-MBrenner
-071409/976ceba14c4fae75a4bbcb514bb34762/MergersAcquisitions
-MBrenner-071409.pdf.
54
T. Rouse and T. Frame, “The 10 Steps to Successful M&A Integration,
Insights,” Bain and Company (November 4, 2009), http://www
.bain.com/publications/articles/10-steps-to-successful-ma
-integration.aspx.
55
CHAPTER 7
Vertical Integration and
Outsourcing
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Define vertical integration, forward vertical integration,
and backward integration.
2. Describe the three Cs that represent the primary
reasons that firms choose to vertically integrate (make)
and perform an activity internally versus outsource
(buy) the activity to (from) a supplier.
4. Explain the advantages of outsourcing and the
conditions under which it might be advantageous to
outsource an activity to an external supplier.
5. Discuss the actions a manager could take to prevent a
subcontractor from becoming a competitor.
3. Describe the two Fs, which examine the potential
dangers of vertical integration.
Ed Lallo/Bloomberg/Getty Images
Dell and ASUS: A Tale of Two Companies
Dell began in 1984 with a simple idea in mind: Create and deliver
custom personal computers (PCs) directly to customers within 48
hours. What started in Michael Dell’s dorm room at the University of
Texas, Austin, grew to a Fortune 500 company in less than a decade.1
Moving inventory quickly without the costs of storefronts or distributors made these computers affordable, and also provided customers
with the latest technology within days. The company became a powerful player in the PC market in just a few years.
From the early 1990s until 2006, Dell was a darling of stock
analysts. In fact, Dell’s market value (market cap) jumped from $2.5
billion in 1995 to $100 billion in 2005.2 Dell was rewarded by Wall
Street with a higher stock price for its growth and ability to generate high profits with relatively few assets. The company’s ability to
generate high profits with only a few assets was possible because
it outsourced most of the components and operations associated
with making its PCs to outside suppliers. This allowed it to focus on
computer design, final assembly, sales and distribution, and service. Over time, Dell streamlined its business model by outsourcing
more and more of its low-value manufacturing operations, eliminating expensive equipment and competencies. For example, by
outsourcing motherboards and the final assembly of its computers, Dell cut the cost of those activities by roughly 20 percent.3
Outsourcing low-value-added manufacturing tasks reduced
assets on Dell’s balance sheet and provided the freedom to focus
on higher-profit-margin products and services. Both Dell and Wall
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Vertical Integration and Outsourcing
Street loved the change. As Dell moved upmarket selling more
powerful PCs and servers, it continued to outsource more of its
lower-value components and processes, mostly to suppliers in
China. Eventually, Dell outsourced the management of much of
its supply chain, and more of the final assembly of the entire computer.4 It got to the point where some Dell computers were almost
completely designed and manufactured by other companies.
Although Dell outsourced to increase efficiency and improve
its performance, other companies in the industry chose the opposite approach. ASUS, a Chinese company that was the recipient
of much of Dell’s outsourcing, began making circuits and motherboards for Dell (and other PC manufacturers) cheaper than Dell
could. ASUS had a cost advantage from manufacturing circuits
and motherboards in China and soon became the world’s largest
manufacturer of PC motherboards.5
As ASUS produced more and more of Dell’s components, it
increased both sales and profits. Over time, ASUS continued to
build new manufacturing knowledge and capabilities, moving
upmarket behind Dell, from circuits and motherboards to supply
chain management, computer assembly, and computer design.
Eventually, in 2007 ASUS launched its own inexpensive Eee PC in
Taiwan at a price tag of $340, and the computer quickly sold out.
ASUS stock increased by 4.9 percent the day it launched.6 This led
to a worldwide launch of the Eee PC, which is now sold through
BestBuy and Amazon.com.7 Analysts appreciated ASUS’s vertical
integration strategy (bringing more activities inside the firm), just
as they appreciated Dell’s outsourcing strategy (sending more
activities to suppliers). By 2018 Dell was the world’s third largest PC
maker with 15 percent share (behind HP and Lenovo) and ASUS had
risen to number six with 6.5 percent share.
Dell and ASUS prospered with opposite strategies: one outsourcing, the other integrating.
Dell improved its profit returns on net assets (RONA) by outsourcing manufacturing processes
and their associated physical assets while focusing on higher-value-added activities such as
design, marketing, and service.8 ASUS increased revenues and profits by moving upmarket
behind Dell, gradually developing more sophisticated manufacturing capabilities and eventually launching its own PC. Dell and ASUS’s different approaches to vertical integration raise
the following questions: How can two companies in the same industry each find success with
opposite vertical integration strategies? Are both strategies appropriate, or did analysts overlook weaknesses in one or both of these strategies? Finally, did Dell or ASUS management set
up their respective companies for greater future success or failure?
What Is Vertical Integration?
outsourcing The process
where a firm contracts out a
business process or activity to an
external supplier.
vertical integration (or
insourcing) Bringing business
processes or activities
previously conducted by outside
companies in-house.
Dell and ASUS made different decisions about the extent to which they wanted to perform
activities related to developing, designing, manufacturing, selling, and servicing their computers. Dell decided to outsource some of the activities that it had previously conducted internally
to ASUS and other suppliers. Outsourcing refers to a firm contracting out a business process or
activity to an external supplier.
Dell’s leaders made this decision because they believed that other firms could perform
these activities more efficiently than Dell could. So they outsourced what they perceived as
lower value-added activities—or those activities on which they made lower profit margins. At
the same time, ASUS decided to enter into an increasing number of activities related to making
a computer—from making components and motherboards to fully designing and manufacturing its own Eee personal computer. This is referred to as vertical integration (or insourcing)—
bringing business processes or activities previously conducted by outside companies in-house.
ASUS developed the capabilities to perform these additional functions efficiently and improved
the company’s overall performance. Moreover, by adding activities, ASUS’s leaders believed
that they could build additional manufacturing capabilities for the company that would be
useful in the future.
This case illustrates the classic “make” (ASUS) versus “buy” (Dell) choice that leaders face
as they try to offer unique value to the market. Two firms can look at the same activity and one
might decide that it makes sense to make it, or conduct the function internally within the firm,
while another firm might decide to outsource it. As shown in the Dell–ASUS case, this choice
can have real impact on a firm’s ability to succeed. Consequently, it is important to understand
when to make and when to buy.
What Is Vertical Integration?
119
This chapter will examine why companies choose to conduct an activity within the firm;
the benefits of outsourcing, and the conditions when it might be advantageous; and the dangers of outsourcing as well as the risks of vertical integration. In the Strategy Tool at the end of
the chapter, we provide a tool, the “Make Versus Buy Assessment,” that can be used to decide
whether to make versus buy.
The Value Chain
The different aspects of the value chain have been covered in earlier chapters, but they warrant
a more in-depth discussion here as a clear understanding of the value chain is critical to the
“make versus buy” decision. The value chain for an industry is the sequence of activities that
transforms raw materials into finished products. Each key activity “adds value” to the prior
activity—hence the term value chain.9
To illustrate, let’s walk through the industry value chain for gasoline. To get gasoline
to the consumer, we first need to explore for crude oil, then drill, then ship, then refine the
crude into gasoline, then ship again, then finally sell gasoline to the end consumer, as outlined
in Figure 7.1.
Companies have their own value chains that are usually distinct from an industry value
chain. Companies that participate in many or all stages of the industry value chain from exploration to final sale are highly vertically integrated.10 Companies that participate in only one
activity (such as shipping crude oil) are vertically specialized.11 Activities closer to the beginning
of the industry value chain, or the raw materials used to create a product, are referred to as
upstream activities and those toward the end, or final products that consumers purchase, are
downstream activities.12
Forward Integration and Backward Integration
If a company wants to grow by moving forward in the value chain—that is, downstream—we
say that company engages in forward integration.13 This might be an oil-refining company that
wants to open its own gas stations to sell gas. Or it might be an oil-exploration company that
decides to refine the crude oil that it finds. In contrast, if a company wants to grow by moving
backward in the value chain—that is, upstream—we say that company is backward integrating.14 This might be a drilling or refining company that wants to do its own exploration.
For any given activity in the value chain, an organization’s leaders must answer this key
question: Do we make it or do we buy it? In other words, do we do it ourselves, or do we have
some other company do it? The answer to this question hinges on whether the firm can build a
Exploring for Crude Oil
Drilling for Crude Oil
Shipping Crude Oil
Refining Crude Oil
Shipping Refined Products
Selling Refined Products to Final Customer
FIGURE 7.1
The Oil Industry Value Chain
value chain The sequence of all
activities that are performed by
a firm to turn raw materials into
the finished product that is sold
to a buyer.
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C H A PT E R 7
Vertical Integration and Outsourcing
capability that will allow it to do a better job of offering unique value by conducting the activity
itself rather than having another company do it.
In some cases, a firm’s leaders will decide that being vertically integrated into more activities will allow it to better deliver either a low-cost or differentiated product to the customer. In
other cases, a firm might think it is better off by being vertically specialized.
To illustrate, Walt Disney is vertically integrated into many vertically linked activities in the
value chain. It produces its own movies and TV shows with its own studio and its wholly owned
subsidiary Pixar. Disney also distributes its TV shows and movies through its own TV networks
(ABC and Disney Channel) and to movie theaters through a worldwide distribution network.
Disney doesn’t own movie theaters, but many years ago most of the movie studios such as
Paramount and Fox did own their own theaters.15
In contrast, Nike is much more vertically specialized than Disney. Nike designs and markets its athletic footwear, equipment, and apparel, but outsources many other activities in its
value chain.16 It does not manufacture its shoes, equipment, or apparel, and for the most part,
it sells its products through stores owned by other companies, such as Foot Locker. When Nike
started selling its shoes and apparel through its own Niketown stores, it forward integrated by
conducting activities within the firm that are downstream and closer to the end customer. Likewise, ASUS engaged in forward integration as it continued to take on more activities for Dell in
the final assembly of a computer. If Nike were to start to manufacture its own shoes or apparel,
it would be engaging in backward integration by incorporating more activities that combine
materials and components into a final product. When Netflix started to create its own originally
produced shows—such as political drama House of Cards and comedy Arrested Development—
this was a form of backward integration designed to allow it to differentiate its service from
competitors.
The success of firms such as Nike, Disney, Netflix, and ASUS has been strongly influenced
by the choices of organizational leaders regarding which activities along the value chain should
be conducted within the firm and developed as core competencies, and which activities should
be outsourced to other companies. This choice of whether to “make” or “buy” hinges on a
variety of factors that we address in the next section.
Three Key Reasons to Vertically Integrate
There are three primary reasons that companies choose to make versus buy. We refer to these
reasons as the three Cs of vertical integration: capabilities, coordination, and control, as outlined in Table 7.1.
Capabilities
The first C is capabilities, which refers to the question of whether the firm has—or can build—
the capabilities to perform the activity better than other firms.17 The firm’s leaders should
ask this question: To what extent are we, or could we be, the best in the world at conducting
this activity?
TA B L E 7. 1
3-C Reasons to Vertically Integrate
Capabilities
Conduct the activity internally when the firm has or can develop better capabilities
to perform it than other firms.
Coordination
Conduct the activity internally when effective coordination and tight integration of
the activity with other firm activities provides performance advantages—such as
speed to market or improved quality.
Control
Conduct the activity internally to control scarce inputs or inputs created through
specialized assets in order to reduce transaction costs.
Three Key Reasons to Vertically Integrate
If the firm can be one of the best in the world, then it is probably an activity it should do.
But, if it cannot be one of the best in the world, then the firm is probably better off outsourcing
the function to a company that has stronger capabilities.18
To illustrate, Nike designs and markets its own shoes, but outsources the manufacturing
of its shoes to other companies. Suppliers that manufacture shoes for Nike and other athletic
shoe companies have developed capabilities to manufacture shoes at very low cost. This
requires managing low-wage workers in emerging economies, such as China and Indonesia,
where the majority of the world’s athletic shoes are manufactured. Since Nike differentiates
its shoes based on its internal activities of design and marketing, it is content to let suppliers
manufacture its products.
Nike understands that low-cost manufacturing capabilities are very different from design
and marketing capabilities and has decided that it doesn’t need to manufacture its own shoes
in order to differentiate them in the marketplace. It saves considerable capital investment by
not having to invest in large manufacturing plants and building manufacturing capabilities.
This allows Nike to focus its capital and full attention on building a capability to design athletic
shoes that deliver the best performance possible.
Nike also focuses on developing the world’s best marketing capabilities to build a brand
that will differentiate its products.
Finally, through its design and marketing capabilities Nike creates barriers to imitation to
prevent subcontractors of its shoes from becoming competitors (see Strategy in Practice: How
to Prevent a Subcontractor from Becoming a Competitor).
Coordination
The second C is coordination, which refers to the question of whether a firm is better able to
effectively coordinate the activity with other activities in the firm when both are conducted
internally. In this case, the firm isn’t necessarily more capable of performing a particular activity, but it lowers the coordination costs associated with two interdependent activities. A firm’s
leaders should ask: To what extent will we improve our ability to coordinate our business activities—and offer unique value—by conducting this activity ourselves?
The fact is that some activities or tasks require more coordination than others to be successful because of greater interdependence with other activities. The greater the interdependence between activities, the more it makes sense to vertically integrate and have these done
within a company where the team members can effectively coordinate their work.19
For example, Apple’s integration of chip design activities illustrates a company vertically
integrating to achieve better coordination.20 For years, Apple outsourced the design and manufacture of most of the microprocessors (chips) used to power its products to companies such as
Motorola, Intel, and AMD. However, Apple executives decided that they could better coordinate
product development activities if Apple designed its own chips.21 They believed that doing so—
even if they didn’t have better chip development capabilities than Intel or AMD—would lower
coordination costs and enhance the speed of new product development. Additionally, designing
their own chips would make it more difficult for competitors to imitate Apple technology because
competitors wouldn’t have access to Apple-designed chips. So, Apple hired chip experts, some
who had worked for AMD and Intel,22 and now designs many of the chips that power its products.
Being able to better coordinate all of the activities associated with developing new products was
a key reason that Apple decided to backward integrate and bring chip design in house.
So how do managers know if two activities require high levels of coordination and therefore are better conducted within the firm? The answer is to understand the nature of the interdependence of the activities—with less interdependent activities being outsourced and more
interdependent activities being conducted within the firm.
We will now describe three types of interdependence—modular, sequential, and
reciprocal—and how they influence the make versus buy decision as outlined in Figure 7.2.
Modular Interdependence Some activities require low levels of coordination
because the activities are modular in nature. This means the results are pooled together, but
the individual activities can be conducted without coordinating with other activities.
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subcontractor A supplier that
provides an input to a local firm;
the term subcontractor is often
used to describe suppliers that are
contracted to create customized
inputs for a firm.
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Low Teamwork
(Modular
Interdependence)
Moderate Teamwork
(Sequential
Interdependence)
Low
Medium
Outsourcing
FIGURE 7.2
High Teamwork
(Reciprocal
Interdependence)
High
Vertical
Integration
How Interdependence Influences Vertical Integration and Outsourcing
To illustrate modular interdependence, consider the activities that are important to the
performance of a golf team. Members of a golf team might share information about the golf
course with each other, but the game is played by the individual golfer. In this case, team
performance is based on individual performances or activities that are pooled together. This
is typically referred to as modular or pooled interdependence,23 which means that the degree of
coordination required is relatively low.
In similar fashion, when an automaker purchases certain standardized nuts and bolts to
assemble its cars, everything else in the car can be designed without regard for the nuts and
bolts. As a result, automakers feel no need to make their own nuts and bolts because, while
these inputs are necessary, they don’t require a high level of coordination with other inputs.
The task of designing and manufacturing nuts and bolts is completely independent of the tasks
of designing and manufacturing other automobile components. Moreover, nuts and bolts do
not differentiate the final product. The same is true for other automotive inputs, such as batteries and oil filters, which are fairly standard across vehicles and are therefore characterized
by modular interdependence.
Sequential Interdependence
Activities are sequentially interdependent when one
firm (or set of individuals) cannot perform its (their) tasks until another firm has completed
its tasks and passed on the results. Under these circumstances, team members must meet
together more regularly and consistently to coordinate their work.24
A baseball team is an example of a team that requires a moderate amount of coordination.
All nine players must be on the field at once, but all the players are not involved in every
play. However, whether a batter bunts or tries to hit to the opposite field depends on what
the previous hitters have done. Relay throws from outfield to shortstop to home base, and
double plays from the third baseman to second to first, are activities that require sequential
coordination.
Likewise, with an automobile, whoever creates the air conditioning system cannot design it
until the overall vehicle has been designed. In contrast, bolts and nuts can be produced without
regard for the car design. Before the activity of creating an air conditioning system can begin,
the amount of geometric space allocated for the air conditioning system in the dashboard must
be identified. Moreover, the location of the vents in the vehicle and lines for carrying air to the
vents must also be designed. The work of designing and manufacturing an air conditioning
system cannot begin until the vehicle body and geometric dimensions of the car have been
designed, which means these activities are characterized by sequential interdependence. As
a result, automakers either make the air conditioning system internally or work closely with a
supplier—often in partnership fashion—to achieve the coordination required.
Reciprocal Interdependence Some activities or tasks require a high degree
of coordination because tasks are reciprocally interdependent. In these activities, good
performance is achieved through work done in a simultaneous and repetitive process in which
each individual must work in close coordination with other team members because they
can complete their tasks only through a process of iterative knowledge sharing.25 Individuals
performing certain activities must communicate their own requirements frequently and be
responsive to the needs of those performing related activities.
Three Key Reasons to Vertically Integrate
123
To illustrate, members of a basketball team must coordinate constantly as they run their
offensive plays and play “team” defense. Every member interacts with every other member.
It could be predicted that a basketball team would suffer more from the lack of teamwork
(coordination) than would a golf team or a baseball team. Indeed, this seems to be the case, as
evidenced by the fact that major league baseball teams that acquire a few free agent stars will
occasionally come from a low ranking the prior year to win the World Series. For example, the
2012 Boston Red Sox placed last in their division—and third-worst in the American League—but
won the World Series in 2013. This rarely happens with NBA basketball teams, which must learn
how to coordinate and work together to be successful. Experience has shown that even having
the best individual basketball talent on one team is no guarantee of team success. The United
States basketball team experienced a historic failure when it failed to win the 2004 Olympics
and the 2006 World championships, even with star players such as Tim Duncan, Dwayne Wade,
and Carmelo Anthony. The need for better teamwork prompted the United States to require a
three-year commitment from NBA players so that they could learn to work together as a team.
Since then, the US basketball team has won every world championship, including gold medals
at the 2008, 2012, and 2016 Olympics.26
Product development teams for complex products such as automobiles, aircraft, robotics,
consumer electronics, and so on work together in a reciprocally interdependent fashion. For
example, the design of an engine for an automobile is reciprocally interdependent with many
of the other activities of designing and creating an automobile. The engine design must change
along with modifications in the vehicle’s overall body design because a heavier or lighter vehicle
requires different engine requirements. The engine also influences, and is influenced by, the
transmission system in the vehicle. Because of all of these reciprocal interdependencies among
the engine, overall vehicle design, and other key vehicle systems such as the transmission, automakers almost always make their own engines rather than outsourcing them to suppliers. The
need to coordinate these activities effectively leads to vertical integration of these activities.
Control
The third C is control, which refers to a firm’s desire to maintain control over a valuable activity
or input in the value chain. In other words, an organization’s leaders must ask: To what extent
should we maintain control over a crucial step in the value chain by conducting this activity
ourselves?
A company might want to vertically integrate in order to control some scarce and valuable
resource, particularly if it is a differentiator of its final product.27 The choice to backward integrate might be made in order to control access to important raw materials or inputs that are
highly customized to downstream activities. Some producers of aluminum have purchased
land that is rich in bauxite—a key raw material that is necessary to make aluminum. They want
to ensure that they have control of that key input so they developed bauxite-mining operations.
In a similar vein, it might make sense to maintain control over investments in assets or
equipment that provide key inputs at lower cost. For example, suppose that crude oil is best
shipped to an oil refinery through a pipeline. Let’s say the cost of shipping a barrel of crude oil
by truck is $1.00 per barrel, whereas transporting by pipeline would be only $0.50 per barrel.
Once built, the owner of the pipeline could opportunistically raise the shipping price up to $0.99
since the only real alternative is to ship the crude in trucks. Likewise, the owner of the refinery
could refuse to pay a fair price to the pipeline owner—or any price, for that matter—if there is no
other alternative use for the pipeline.
In this case, the pipeline is a transaction-specific asset, meaning it is specialized or customized to a particular transaction (transporting oil to the refinery) and has little value when
redeployed to its next-best use.28 In fact, a technique that can be used to determine if an asset
is specialized is to estimate the value of an asset (equipment, process, etc.) in its current (or
intended) use divided by the value of the asset/process in its next-best use. What is the nextbest use of a pipeline? Is it redeployable to other uses without a loss in value? While it might be
fun to think that it could be used as an underground waterslide, practically speaking, it has little value if it isn’t transporting oil. The value of a pipeline in its intended use as a pipeline is
high, but in its next-best use the value is very low. In contrast, trucks used to transport oil could
transaction-specific asset An
asset, such as equipment (oil
pipeline) or a facility (bowling
alley), that is customized or
specialized to a particular use.
Assets are more specialized when
the value of the asset in its current
or intended use is high compared
to its next-best use.
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Strategy in Practice
A Classic “Make vs. Buy” Mistake
Imagine that you work for a company that makes a kitchen appliance product that costs $50 to manufacture. You have to decide
whether to make or buy a component that is an input for the product. Your analysis shows that, based on the estimated volume of
parts, your costs to manufacture the part internally will be $0.98
per unit. A quick bid in the market suggests that you can buy the
same part from two suppliers for $1.00 (another supplier bid $1.01).
There are no real quality differences between what you can make
and what you can buy from suppliers. What should you do? Make
the part for $0.98 or buy it for $1.00?
For many, the answer seems easy. Of course you make the part
for $0.98 because it will save you $0.02 per unit over buying it from
an outside supplier. But this is typically the wrong answer—and
here’s why. You want to conduct an activity internally if you can do
it at lower cost or with better quality than the competition. In this
case, it appears that your costs per unit are lower than the competition. However, the price of the part from the supplier includes a
profit margin—and profit margins for most products sold are typically in the 10 to 20 percent range or higher. This means that the
supplier’s cost to produce the part is likely to be 10 to 20 cents less
per unit than your company’s costs.
In fact, you don’t have an absolute cost advantage in making this part. Multiple suppliers produce this same component and
offer a similar price. This means you might have some bargaining
power over these suppliers and could get at least one of them to
drop their price to $0.98 or lower. In addition, outsourcing will allow
you to focus the company’s capital resources and the attention of
the management team on higher-value activities. A part that costs
$1.00 out of $50.00 total is not a significant contributor to cost.
Even if you save $0.02 per unit, it won’t contribute much to your
cost advantage. Of course, if this part allows you to differentiate
your product—or if you could make it with higher quality—then you
still might want to do it internally. But in this case, there are no real
quality differences between the product that you can make internally and the one you can buy from a supplier.
The bottom line is that a classic mistake with make versus
buy is assuming that you are better off making a part or conducting an activity internally when the internal cost is equal to—or even
slightly lower—than the price from a supplier. You need to compare
your costs with the supplier costs (not the supplier’s price) to know
whether your capabilities at conducting the activity are really better
than a supplier’s. Of course, if you have the capabilities to produce
a higher-quality input, or there are advantages associated with having better coordination or control, you still might want to conduct
the activity internally even if your costs are higher. For guidance in
making the “make versus buy” decision, see the Strategy Tool: Make
Versus Buy Assessment at the end of the chapter.
be used to transport things other than oil, such as chemicals or natural gas. They are a far less
specialized asset than a pipeline.
Managers ultimately want to control assets or inputs that are specialized to each other.
By doing so, they avoid the transaction costs associated with negotiating and writing a legal
contract to ensure that the transaction takes place.29 The cost of hold-up, which is what can
happen when one firm tries to take advantage of a firm that has made a transaction-specific
investment such as a pipeline, is also avoided.30 The refinery could hold up the pipeline firm by
failing to pay a fair price because the pipeline has no alternative use.
In the previous example, the pipeline has high value only if it is transporting oil to the
refinery; so the same firm would want to own both the pipeline and refinery. This way, the firm
avoids the possibility of one firm trying to hold up another firm, and it also reduces transaction
costs. This is the same reason homeowners like to own the land that surrounds their home. If
they didn’t, the person owning the land could charge an unfair price to cross the land to access
the home. This would be another example of hold-up.
Dangers of Vertical Integration
Even though there are some very good reasons to vertically integrate, there are two important
dangers—a loss of flexibility and loss of focus—the two Fs.
Loss of Flexibility
First, when many activities are managed in the value chain, the flexibility to quickly make
changes to the business is lost.31 This might be important when there are major technological
changes. In fact, research has shown that companies that are more vertically integrated take a
bigger hit to performance when there is a technological change.32
Dangers of Vertical Integration
This happened to computer workstation manufacturers DEC and Data General—companies
that had vertically integrated into making CISC microprocessors that powered the workstation—when the faster and simpler RISC microprocessors were introduced. Competitor Silicon
Graphics did not make its own CISC microprocessors, so it was able to quickly move to RISC
microprocessors, which gave it an advantage in the marketplace. Silicon Graphics also didn’t
need to sell off any now-obsolete CISC microprocessor manufacturing equipment. Similar
things happened to the more vertically integrated makers of CD players and Discman—such as
Sony and Panasonic—when MP3 players hit the market. Companies simply have greater flexibility to switch to another supplier when they outsource.
Having more flexibility—that is, being less vertically integrated—is particularly valuable
when new technologies are being developed or if the cost to perform an activity can change
quickly. For example, one of the reasons that Nike chooses to outsource the production of its
shoes is because it likes the ability to switch suppliers depending on which supplier is lowest
cost at the moment.
To illustrate, in the late 1990s, the Asian financial crises had a dramatic effect on the currencies and exchange rates of some Asian countries, but not others. Indonesia’s currency, the
rupiah, was trading at roughly 4,000 to the dollar before the crises, but a dollar would fetch
more than 10,000 rupiahs at the crises’ height. This meant that Nike could buy shoes from
Indonesian subcontractors for less than half the prices they were paying before the change in
exchange rates. At the same time, China decided to keep its currency stable with the dollar so
Nike’s prices on shoes from Chinese shoe suppliers didn’t change much. Because Nike didn’t
own any of the manufacturing plants, it had the flexibility to shift production to the low-cost
location—which, for a period of time, favored Indonesia over China. As a result of changing
wages and exchange rates across countries where shoes are produced, Nike likes the flexibility
to source the manufacturing of its new products to the lowest cost producer.
Loss of Focus
A loss of focus refers to the fact that the greater the number and variety of activities a firm needs
to manage, the harder it is to be world class in all of those activities. It is just too difficult for
managers to focus on many different activities at once and be world class at all of them.
To illustrate, for many years General Motors (GM) made almost 70 percent of its parts internally including spark plugs, batteries, brakes, and a host of other automotive parts. In contrast, Toyota makes only about 25 percent of its parts. Toyota outsources to companies that
specialize in various parts—such as spark plugs, batteries, and brakes—and therefore provides
the best possible parts at reasonable costs. While GM made its own brakes, Toyota outsourced
them to companies such as Akebono and Kayabe Brake that specialized in brakes. General
Motors cars have cost more than Toyota’s, in part because it just couldn’t make parts cheaper
than Toyota could buy them.
Why did General Motors have higher costs for producing automotive components such
as spark plugs, batteries, and brakes? The primary reason was a lack of focus—suppliers were
able to have lower costs by focusing on a narrow product line and producing those products in large scale for multiple automakers. Akebono Brake made braking systems not only
for Toyota but also for Nissan and many other automakers. This allowed Akebono to make
products in larger volumes and with greater economies of scale, thereby lowering costs per
unit. GM’s lack of focus made it difficult for its internal brake divisions to compete with these
focused suppliers. Moreover, even though GM could buy cheaper brakes from outside suppliers such as Akebono and Kayabe, it refused to do so because GM didn’t want to incur the
costs to fire its union workers and close its plants. Both a lack of focus and flexibility hurt GM’s
overall performance. General Motors finally realized that too much vertical integration was a
liability, and it eventually created an automotive components division it spun off as a separate company that would have to compete on its own. Now GM has more flexibility to buy from
other suppliers and buys from its former in-house suppliers only if they offer the best product
at the lowest price.
One more dimension is worth mentioning. When firms are vertically specialized, they stay
in business only when they can make profits to cover their cost of capital. If they can’t make
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enough profits, they go out of business. However, when an activity is conducted within a firm, it
can often stay in business even if it isn’t performing well and making profits—just like some of
GM’s automotive parts divisions. This is possible because it gets subsidized by other parts of a
company’s business that are profitable. Sometimes you lose the discipline of the marketplace
and a focus on making profits when you conduct an activity internally. Keeping employees
motivated to perform is critical if an organization hopes to be world class in any activity.
Advantages of Outsourcing
The two Fs, as already described, are dangers of vertical integration—which also means they
are advantages to outsourcing. Outsourcing gives firms more flexibility to quickly move activities to whatever company is the best at performing that particular activity. As previously
mentioned, Nike has the flexibility to move its shoe production to the world’s lowest-cost supplier. This flexibility is particularly valuable when economic conditions or technologies change
rapidly. When there is high technological uncertainty in an industry with lots of new leapfrog
technologies being developed, flexibility is valuable, and outsourcing is often preferred to vertical integration.
Outsourcing also allows firms to focus their attention on being good at a narrower range
of activities. Along with this benefit, outsourcing also minimizes the capital investment
required to grow. Nike would have needed to raise a lot more capital during its rapid growth
phase of the 1980s and 1990s if it had not outsourced the manufacturing of its shoes. The cost
of building and running new plants would have been significant. Instead, it was able to focus
its attention on the capabilities that were most critical to differentiating its shoes: shoe design
and marketing.33
There is one final advantage of outsourcing. Imagine that Nike had decided to build plants
to manufacture its athletic shoes. In order to achieve greater economies of scale, Nike’s manufacturing plants would have to be able to acquire shoe-manufacturing contracts from other
shoe companies—like Adidas, Reebok, New Balance, or Skechers. Do you think Adidas would let
a Nike manufacturing plant produce its shoes? Probably not. Adidas would not want to share its
designs or help Nike in any way. Without those economies of scale, Nike shoes manufactured by
Ethics and Strategy
Should You Outsource to Subcontractors that Use
Child Labor?
The CEO of a popular clothing business discovers that two of her
company’s sewing subcontractors in Bangladesh are using child
labor. She also learns that if the child workers lose their jobs, most
of them will just find work with another company—or worse, some
might turn to prostitution to survive. What’s the right thing to do?
Fire the children and live with the fact that you’ve eliminated a
viable option for their survival, or keep them working in the factory?
This is the type of ethical dilemma faced by many companies that
outsource jobs to subcontractors.
When Levi Strauss & Co., which outsources its production to
subcontractors, confronted this problem, it came up with an innovative solution: Take the children out of the factory; continue paying their wages on the condition they attend school full time; and
guarantee them employment in the factory when they are 14 years
old, the local age of maturity. Because the pay of these underage
workers was less than $0.40 per hour, the cost to Levi and the subcontractors was relatively low. The benefit was a cadre of more
educated and productive—and more loyal—workers.
Levi’s approach to this difficult situation earned the praise of
Bangladeshi and US government officials and several nongovernmental organizations (NGOs). Not only did Levi help meet the needs
of factory workers, but it did so without necessarily sacrificing
returns to its shareholders. Subsequently, the Bangladesh Garment
Manufacturers and Exporters Association, along with other groups,
set aside more than $1 million for the education of approximately
75,000 underage girls who had previously worked in Bangladesh
factories. Levi’s initiative shows that an innovative solution can
resolve even the most challenging problems.
Advantages of Outsourcing
127
Strategy in Practice
Outsourcing via Crowdsourcing
Companies are increasingly turning over outsourcing tasks to
crowds—individuals or organizations outside the company who
might be better suited to perform a particular task. Crowdsourcing
refers to the phenomenon of outsourcing tasks to individuals or
organizations that are outside of your organization.34 One example is Wikipedia.35 Rather than follow Encyclopedia Britannica’s
model of hiring experts to provide all of the information necessary for an encyclopedia, Wikipedia enlists crowds of individual
contributors. Wikipedia is the product of thousands of individuals
contributing their knowledge and information. Unlike most cases
of crowdsourcing, Wikipedia contributors don’t get paid but are
energized by intrinsic motivations, such as the desire to learn or
build a reputation for being an expert in a community of peers.
In most cases, however, the crowd is paid to perform a task for
the company.
While crowdsourcing is the term used to refer to the practice
of outsourcing tasks to a crowd outside the organization, there are
actually several types of crowdsourcing, including crowdtasking,
crowdvoting, crowdcreating, and crowdinnovation.
Crowdtasking refers to enlisting a crowd to complete a simple,
repetitive task. For example, CardMunch, founded in 2009 by a group
of Carnegie Mellon University engineering graduates, has a simple
mission—storage of business cards and how they are managed.
Using the company’s free App, customers start by taking a picture of
a business card. For a small fee, the content is digitized by a crowd
of individuals, put into the user’s contacts, and then CardMunch
reaches out to the contact via email or a LinkedIn request.36
CardMunch can vary the amount they pay for data input
depending on the supply of workers—which can be quite large
because they can tap into large pools of labor in India willing to
work for very low wages. They also use a different member of the
crowd to compare the information on the business card with what
was input into CardMunch. Another example is Amazon, which has
turned crowdtasking into a business with its Mechanical Turk, an
online marketplace for work. Companies that want to crowdsource
tasks can go to Mechanical Turk to request workers for human
intelligence tasks (HIT), and individuals can go to Mechanical Turk
to find a task to work on. Crowdtasking works particularly well for
tasks that don’t take a lot of specialized skill and can be accomplished by people sitting at their computer.
Crowdcreating refers to turning to the crowd to create
content or complete a task that requires specific knowledge or
expertise on the part of the crowd member. Threadless, an online
community of artists and an e-commerce website, is a company
that uses crowdcreating. Rather than hire T-shirt designers,
Threadless enlists members to submit ideas for T-shirt slogans
and designs.37 This allows it to constantly tap into new artists and
ideas, and sell its T-shirts without professional designers, advertising, modeling agencies, photographers, a sales force, or retail
distribution.38 The company typically pays $2,000 for a T-shirt
design that it takes to market and has sold T-shirts from more
than 1,500 different designers.39 Threadless uses another form of
crowdsourcing—called crowdvoting—to select the designs to take
to market.
Crowdvoting or crowdsorting refers to using a crowd to evaluate an offering or to make predictions about uncertain events.
Crowdvoting is particularly good for gathering information about
a market that is widely dispersed. For example, after Threadless
receives submissions for T-shirt designs, it goes to a crowd of
customers and designers and asks for their vote on which T-shirt
designs they like the best. By using the crowd to choose the winners
of the design contests, Threadless is able to better predict which
T-shirts will sell. Threadless has developed an enviable track record
of having never produced a flop—every T-shirt it has ever produced
has sold out.40
Crowdinnovation refers to using the crowd to solve a challenging problem that requires an innovative solution. For example,
Netflix offered a $1 million prize to the software programmer(s)
who could create an algorithm that would provide the best recommendations about movies for specific customers. Netflix provided
a dataset of more than 100 million movie ratings from users to the
crowd to analyze. In explaining why Netflix chose to go this route,
Netflix CEO Reed Hastings said the company wanted to get hundreds—if not thousands—of software programmers to work on the
algorithm. “You’re getting PhDs [to work on your problem] for a dollar an hour,” said Hastings.41 Netflix got its best movie ranking algorithm from the BelKor Pragmatic Chaos team—a group of software
programmers who worked on complex programming problems for
AT&T wireless.42 Crowdinnovation using contests works well when
it isn’t obvious what combination of skills or technologies will lead
to the best solution to a problem.
The bottom line is that new digital technologies have turbocharged crowdsourcing as a way to outsource activities to a crowd.
And crowdsourcing has resulted in companies outsourcing more
activities than ever before.
a Nike manufacturing plant would cost substantially more to make than they do in outsourced
manufacturing plants.
In a similar vein, during the time period that General Motors made most of its own automotive parts, its in-house suppliers were limited in their total volumes because GM’s competitors would not buy parts from GM’s suppliers. In fact, Ford had an explicit policy prohibiting
it. Outside suppliers can often produce at much greater scale than in-house suppliers because
in-house suppliers often have difficulty getting outside customers.
128
C H A PT E R 7
Vertical Integration and Outsourcing
Dangers of Outsourcing
While outsourcing has its advantages, it also has its dangers. There are two major dangers of
outsourcing: a loss of capabilities (particularly the capability to innovate) and a lack of control
over critical assets or activities. Dell’s experience of outsourcing the majority of components,
supply chain management, and final assembly of its computers is instructive. Although Dell’s
outsourcing strategy lowered its asset base and increased its profits in the short run, it also
resulted in Dell having fewer capabilities to innovate and create competitive advantage in
the future. Dell’s market value soared to a high of $103 billion in 2005, but at the beginning
of 2012, Dell’s market value had dropped to $26 billion. One reason for Dell’s fall is the emergence of new, low-cost PC makers such as ASUS—a competitor that Dell helped create (see
Strategy in Practice: How to Prevent a Subcontractor from Becoming a Competitor). However,
and perhaps more importantly, Dell has had a difficult time designing and building differentiated PCs, laptops, and tablets to compete effectively with Apple. More vertically integrated
than Dell, Apple makes much of the software that runs its products as well as some of the
key components. By having a larger portfolio of capabilities, Apple is better able to innovate
and create new products. Outsourcing can also be dangerous because it can lead to a loss of
capabilities to do new things.43
In addition to leading to a loss of innovation capabilities, outsourcing can lead to a loss of
control as suppliers that provide key inputs gain bargaining power. To illustrate, when IBM first
launched a micro-computer—the PC—it decided to outsource two of the key components of the
computer: the microprocessor (to Intel) and the operating system (to Microsoft). The microprocessor was the single most expensive component of the PC, and the DOS operating system was
the software that users had to learn in order to navigate the computer. IBM believed that if the
PC turned out to be successful, it would eventually make its own microprocessors and create
its own operating system.
Strategy in Practice
How to Prevent a Subcontractor from Becoming a
Competitor
Companies that outsource face a substantial challenge. They must
make sure that they don’t end up creating a competitor—which was
essentially what Dell did by outsourcing so much to ASUS. What
steps can companies take to prevent this from happening?
1. Build barriers to imitation. One of the most important things
a company can do to prevent a supplier from becoming a
competitor is to build barriers to imitation. As described in
Chapter 2, a barrier to entry prevents new entrants from
easily entering a particular industry. A barrier to imitation is
something that prevents other companies from imitating what
a particular company can do.
To illustrate, Nike outsources the manufacturing of
its athletic shoes to subcontractors—so they know how to
make Nike-quality shoes. Why don’t these suppliers enter
the athletic footwear business and compete with Nike? The
answer is that Nike has built a number of barriers to imitation that make reproduction of their footwear difficult. The
first barrier is brand. Nike’s brand is so well known that a
no-name brand would have a hard time competing, even if
it is good quality. But beyond that, Nike’s shoes go through
annual design changes. This means suppliers would soon be
developing shoes using “old” design technology. Of course,
Nike also writes contracts with suppliers that prohibit them
from making shoes based on Nike’s designs or intellectual
property. These practices all make it difficult for suppliers to
become a competitor to Nike.
2. Limit knowledge of the full product. Another way to stop a
supplier from becoming a competitor is by preventing the
supplier from knowing everything about making a product. Some companies will outsource some of the components of a product to suppliers but will manufacture one or
more key components internally and manage final assembly of the product internally. That way, no one supplier has
all of the knowledge necessary to easily produce a competing product.
3. Take an equity stake in the supplier. A final way to prevent
a supplier from becoming a competitor—or from becoming
too powerful—is by taking an equity stake in the supplier. For
example, when IBM launched its PC, back in the early 1980s, it
could have looked at its key suppliers—for example, Intel and
Microsoft—and decided to take an equity stake in those suppliers. If IBM had taken an equity stake in Intel and Microsoft
it would have given itself more control over their activities.
Moreover, IBM would have at least been rewarded for helping
Intel and Microsoft grow and become powerful suppliers in the
industry. Imagine how much more successful IBM would be
today if it had only thought to take a 40 percent equity stake in
Intel and Microsoft—something it could have easily done when
it launched the first IBM PC.
Review Questions
129
As it turned out, IBM PCs were very successful, and so the company decided to make its own
microprocessors and operating systems. However, Intel launched the “Intel Inside” campaign,
telling customers that the microprocessor was the “heart” of the computer and alerting customers to look for “Intel Inside.” As a result, IBM was not successful at getting customers to buy
IBM PCs that didn’t have Intel chips in them. In fact, in the halls of IBM’s headquarters, some of
the executives were heard asking the question: “Who let Intel Inside?”44 Many believed that IBM
should have purchased Intel early on or should have launched the first PC with an IBM-built
microprocessor because it was a key input that the company should have controlled. IBM had
traded speed to market (flexibility) for control of a critical input.
In similar fashion, IBM decided that it no longer wanted to rely on Microsoft for the
operating system, so it launched its own OS/2 operating system and tried to get customers to
switch. Microsoft responded with its Windows 3 operating system. IBM’s customers were so well
acquainted with Microsoft’s operating system that they didn’t want to switch to OS/2. IBM eventually abandoned OS/2 in 2004. At the end, IBM had outsourced the two key components that it
later realized it wanted to control. Without making its own operating system or microprocessor,
IBM had few options for differentiating its PCs. IBM eventually sold off its PC division to Chinese
firm Lenovo in 2004. IBM and Dell’s experiences provide a cautionary tale for companies that
choose to outsource.
Summary
• Vertical integration is defined as a decision about whether to conduct an activity within the firm (make) or outsource it to an outside
supplier (buy).
activity internally if it believes that by doing so it will help it build
its internal resources and capabilities so that it is better able to offer
unique value.
• Companies choose to conduct an activity within the firm and use the
3-C framework as a way to evaluate whether it makes sense to make
versus buy.
• Two dangers of vertical integration are a loss of flexibility and a loss
of focus. These are also the key benefits to outsourcing an activity to
a supplier that is vertically specialized.
• Firms want to conduct an activity internally if they think they have,
or can develop, the capabilities necessary to be among the best in
the world at conducting that activity. Firms also choose to conduct
an activity internally if they believe it will help them better coordinate with other activities or if they want to have more control over
a particular activity or input. An organization should conduct an
• Outsourcing can eventually put an organization at a disadvantage,
as suppliers develop bargaining power or potentially become competitors.
• A manager can receive guidance in making an effective “make”
versus “buy” decision by using a Strategy Tool we call the Make
versus Buy Assessment.
Key Terms
outsourcing 118
subcontractor 121
transaction-specific asset 123
value chain 119
vertical integration (or insourcing)
118
Review Questions
1. Define vertical integration, forward vertical integration, and
backward integration.
2. What are the three Cs, and how do they explain why companies
choose to perform an activity internally (make) versus outsource (buy)
the activity to a supplier?
3. Describe what the chapter describes as a “classic mistake” that
firms make when deciding whether to make versus buy.
4. Describe the advantages of outsourcing and the conditions under
which it might be advantageous to outsource an activity to an
external supplier.
5. Define crowdsourcing and explain the different ways that companies
can use an external crowd to do their work (e.g., types of crowdsourcing).
6. Explain what actions you could take to prevent a subcontractor from
becoming a competitor.
130
C H A PT E R 7
Vertical Integration and Outsourcing
Application Exercises
Exercise 1: Contact an executive at a company that performs multiple activities. Ask her to identify at least five activities that she is not
sure whether the company should be doing internally or outsourcing
to a supplier. Apply the make versus buy strategy tool to each activity,
asking her to answer the survey for each activity. Using the output from
the survey, assess whether there are any activities that the company
should probably be outsourcing instead of conducting internally.
Exercise 2: Identify a company that has increased its level of vertical
integration, such as Apple forward integrating into Apple Stores or
Netflix backward integrating into its own originally produced shows
and programming. Evaluate the impact of that decision on the
company by answering the following questions.
a. What new resources or capabilities, if any, did the firm have to
develop in order to enter that new activity?
b. What impact did the decision to enter that activity have on its ability
to coordinate with other related activities within the firm?
c. What impact did this decision have on its suppliers or customers?
Strategy Tool
Make Versus Buy Assessment
conduct our other activities; we don’t need to work on this simultaneously and iterate.
With regard to a specific activity, the question for the manager is: Do
we make (conduct activity internally) or buy (outsource activity to a
supplier)? For example, most companies need to design and build
a website. Should the company hire people to build and maintain
the company website, or should it outsource? Here is a short survey
that can be taken to provide important guidance as to whether to
make or buy.
C. Not interdependent at all. We merely pool our processes/products with those of other suppliers.
1. To what extent are you, or could you be, the best in the world at
conducting this activity?
A. We are, or fairly easily could be, as good as the best in the world
at conducting this activity.
B. We are not, and are not likely to become, as good as the best in
the world at conducting this activity.
2. To what extent does this activity differentiate your offering (product
or service) in the mind of the customer?
A. This activity does provide some differentiation in the mind of
the customer (it provides unique value and influences the purchase decision).
B. This activity provides little differentiation in the mind of the
customer (it doesn’t really provide unique value).
3. What is your cost of performing the activity (with similar quality)
compared to an outside supplier?
A. 5% or more lower.
B. About the same or higher.
4. How many outside suppliers can conduct the activity (with similar
quality) at a cost that is about the same or lower than your firm?
A. 0 or 1
B. 2 or more
5. To what extent is this activity highly interdependent and require
coordination with other activities you perform in the firm?
A. Highly interdependent (reciprocal interdependence), meaning
that in order to do this and other activities well, we need to tightly
coordinate this activity with other activities (simultaneously
iterate when conducting the activities).
B. Somewhat interdependent (sequential interdependence),
meaning that this activity must be done before (or after) we
6. Does performing this activity allow you to maintain control over
information or resources that are important for either offering unique
value or preventing imitation of what you do?
A. Yes
B. No
7. Does performing this activity create a barrier to competitors imitating the unique value you are attempting to offer?
A. Yes
B. No
If you answered A to six or seven of these questions, you should
conduct the activity internally. If you answered A to four or five of these
questions (including questions 2 or 3), you should probably conduct
the activity internally. If you answered B to six or seven of these questions, you should outsource this activity. If you answered B to four
or five of these questions, you should probably conduct this activity externally (unless your answers to questions 1 and 2 are both A,
meaning that you think you can be the best in the world at this activity
and you think it is a differentiator).
Career Readiness: Building Personal Alliances
How do you get a job? Or move up in a company? Or find the resources
to do almost anything you are trying to accomplish? The answer?
People. Yes, when we build relationships with people we have the
potential to accomplish amazing things. As Albert Einstein once
observed, “What a person does on his own, without being stimulated
by the thoughts and experiences of others, is even in the best of cases
rather paltry and monotonous.”45 This is particularly true when you
start working for a company. If you want to succeed, it makes a big
difference if you can develop strong relationships with mentors, ideally leaders in the organization. They can advise, coach, and bring
resources to bear to help you accomplish things. They can recommend
you for promotions or desirable new positions. They can be your ally.
That’s what companies try to do when they initiate alliance relationships with other resource-rich companies. They want to ally with other
companies so they can access new resources and accomplish things
References 131
that just would not be possible on their own. You can follow the same
principles we’ve discussed in this chapter to build your own network
of alliances.
The first step to building relationships with potential mentors
in a company is to “be interesting.” What makes someone interesting? Two things seem to help. First, breadth of experience matters in
a big way. If you’ve traveled widely (China, Australia, Italy), experienced widely (Broadway shows, scuba diving), read widely (novels,
history, different subjects), or networked widely (“Yes, I know so and
so; we met when . . .”), then you increase your chances of being interesting to someone. Second, make sure you find ways to help your
allies—because networking is a two way street. You must be willing
to give in order to receive. Of course, being able to tell short, interesting stories on a variety of topics increases your “interesting quotient.” And it doesn’t hurt to be funny or witty, but that really takes
some practice.
References
http://www.biography.com/people/michael-dell-9542199.
1
Dell Computer Corporation FY 1985 Annual Report, http://www
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CD4QFjAD&url=http%3A%2F%2Fi.dell.com%2Fsites%2Fcontent%2
Fcorporate%2Ffinancials%2Fen%2FDocuments%2Far1995_annual
.pdf&ei=YpM4Uq-ZGsen4AOmp4GwCw&usg=AFQjCNHeqLah27XW
gDuEdK-ncLxZidn0Mw&bvm=bv.52164340,d.dmg&cad=rja; http://www
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/1995; and http://www.wikinvest.com/stock/Dell_%28DELL%29/Data
/Market_Capitalization/2005.
2
C. Christensen, J. Allworth, and K. Dillon, How Will You Measure Your
Life? (New York: HarperCollins, 2012), p. 121.
3
Ibid., pp. 122–123.
4
W. Shih, C. Shih, H. Chiu, Y. Hsieh, and H. H. Yu, ASUSTeK Computer Inc.
Eee PC (A), Harvard Business School Case (2009): 2.
5
6
Ibid., p. 9.
By 2016, ASUS had grown its worldwide market share of PCs to
7.2 percent, almost one-half of Dell’s worldwide market share.
7
8
Christensen, Allworth, and Dillon, pp. 122–123.
M. E. Porter, Competitive Advantage: Creating and Sustaining Superior
Performance (New York: The Free Press, 1998).
9
K. R. Harrigan, “Vertical Integration and Corporate Strategy,” The
Academy of Management Journal 28 (2) (1985): 397–425.
10
D. Hummels, J. Ishii, and K. Yi, “The Nature and Growth of Vertical
Specialization in World Trade,” Journal of International Economics 54
(1) (2001): 75–96.
11
J. T. Mentzer, et. al., “Defining Supply Chain Management,” Journal of
Business Logistics 22 (2) (2001): 1–25.
12
S. D. Hill, ed., “Integration Strategies,” Encyclopedia of Management,
7th ed. (Detroit: Gale, 2012), pp. 476–480.
13
Ibid.
14
Disney ABC Television Group, Disney Media Distribution, http://
www.disneyabctv.com/division/index_media.shtml, accessed February 25, 2013.
15
J. Dyer, “Nike: Sourcing and Strategy in Athletic Footwear,” Strategic
Management (Hoboken: Wiley, 2015).
16
H. W. Chesbrough and D. J. Teece, “Organizing for Innovation: When Is
Virtual Virtuous?” Harvard Business Review 80 (8) (2002): 127–125.
17
J. B. Barney, “Firm Resources and Sustained Competitive Advantage,”
Journal of Management 17 (1991): 99–120. See also J. B. Barney, “How
18
a Firm’s Capabilities Affect Boundary Decisions,” Sloan Management
Review 40 (3) (1999).
Ibid.
19
Y. I. Kane and D. Clark, “In Major Shift, Apple Builds Its Own Team to
Design Chips,” The Wall Street Journal (April 30, 2009), http://online
.wsj.com/news/articles/SB124104666426570729.
20
A. Satariano, P. Burrows, and I. King, “Apple Said to Be Exploring
Switch from Intel for Mac,” Bloomberg (November 5, 2012), http://
www.bloomberg.com/news/2012-11-05/apple-said-to-be-exploring
-switch-from-intel-chips-for-the-mac.html.
21
22
D. Clark, “Chip Design Luminary Leaves Samsung for Apple,” WSJ Blog
(2012), http://blogs.wsj.com/digits/2012/10/11/chip-design-luminary
-leaves-samsung-for-apple/.
W. G. Astley and E. J. Zajac, “Intraorganizational Power and Organizational Design: Reconciling Rational and Coalitional Models of Organization,” Organization Science 2 (1991): 399–411.
23
S. G. Lazzarini, F. Chaddad, and M. L. Cook, “Integrating Supply Chain
and Network Analyses: The Study of Netchains,” Journal on Chain and
Network Science 1 (1) (2001): 7–22.
24
R. Gulati and H. Singh, “The Architecture of Cooperation: Managing
Coordination Costs and Appropriation Concerns in Strategic Alliances,”
Administrative Science Quarterly 43 (1998): 781–814.
25
“United States Men’s National Basketball team,” Wikipedia, accessed
March 13, 2013.
26
Barney, pp. 99–120.
27
O. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: Free Press, 1975).
28
B. Klein, R. Crawford, and A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law
and Economics 21 (1978): 297–326. See also A. Vining and S. Globerman,
“A Conceptual Framework for Understanding the Outsourcing Decision,”
European Management Journal 17 (6) (1999): 645–654.
29
Klein, Crawford, and Alchian.
30
L. Willcocks and C. Sauer, “High Risks and Hidden Costs in IT Outsourcing,” Financial Times, Mastering Risk (May 23, 2000): 3.
31
A. Affuah, “Dynamic Boundaries of the Firm: Are Firms Better Off
Being Vertically Integrated in the Face of a Technological Change?” The
Academy of Management Journal 44 (6) (December 2001): 1211–1228;
S. Balakrishnan and B. Wernerfelt, “Technical Change, Competition and
Vertical Integration,” Strategic Management Journal 7 (1986): 347–359.
32
Chesbrough and Teece, pp. 127–125.
33
132
C H A PT E R 7
Vertical Integration and Outsourcing
K. Boudreau and K. Lakhani, “Using the Crowd as an Innovation
Partner,” Harvard Business Review (April 2013).
34
39
http://www.threadless.com/?ef_id=UYUXXQAAAJHZeYwc:2013050414
1245:s.
M. Chafkin, “The Customer Is the Company,” Inc. (June 1, 2008).
http://en.wikipedia.org/wiki/Wikipedia.
40
http://cardmunch.com/press.html.
41
35
36
37
http://www.inc.com/magazine/20080601/the-customer-is-the
-company.html.
R. MacLary, “Threadless Uses Crowdsourced Design Ideas for Tee
Shirt Success,” http://dailycrowdsource.com/crowdsourcing/company
-reviews/81-threadless-uses-crowdsourced-design-ideas-for-t-shirt
-success.
38
S. Lohr, “A $1 million Research Bargain for Netflix, and Maybe a Model
for Others,” New York Times (September 1, 2009).
“Netflix Prize,” http://en.wikipedia.org/wiki/Netflix_prize.
42
Chesbrough and Teece, pp. 127–125.
43
Interview by Jeff Dyer with IBM executive in November of 1992.
44
Quoted in J. Dyer, H. Gregerson, and C. Christensen, The Innovator’s
DNA (Boston, MA: Harvard Business School, 2011), p. 113.
45
CHAPTER 8
Strategic Alliances
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Differentiate among strategic alliances, vertical
integration, and arm’s-length supplier relationships.
2. Explain the different types of strategic alliances, how
they are governed, and the conditions under which each
type is preferred.
4. Discuss the two potential dangers of strategic alliances
and three ways that firms can protect themselves
against these dangers.
5. Describe the importance of building an alliance
management capability.
3. Describe the different ways value is created in alliances.
Ma Ping/Xinhua News Agency/Tokyo/Newscom
Tokyo Disneyland
Excited tourists who enter Tokyo Disneyland are immediately
transported into a uniquely American dream world. Nearly everything at Tokyo Disneyland is a replica of the original Disneyland in
Anaheim, California, from Sleeping Beauty’s castle to Disneyland’s
famous “Main Street” attraction. Signs are printed in English, with
only small Japanese subtitles. When the park opened in 1984, only
2 of its 27 restaurants even sold Japanese foods.1 Instead, visitors
snacked on hot dogs, popcorn, and “spaceburgers” between rides.
The only observable Japanese touch is an enormous roof-covering
over Main Street, a symbol reminding visitors that they truly are in
Japan, rainy season included.
Despite all appearances, the interesting thing about Tokyo
Disneyland is that the Walt Disney Company is not involved in the
day-to-day operations of the park. It simply collects a licensing fee
from Oriental Land Company (OL), a Japanese real estate firm that
financed, built, and runs both Tokyo Disneyland and its neighboring
park, Tokyo DisneySea. Walt Disney and Oriental Land came together
in 1979 to form a strategic alliance and make the Tokyo Disney dream
a reality. OL had what Disney did not: 115 acres of open real estate
on the outskirts of Tokyo, financial resources, and knowledge of
Japanese and Asian culture that could make the venture a success.
Disney had its brand, park design, and management capabilities, and
a host of movie characters that people would pay just to stand next to
and snap a photo with, as outlined in Table 8.1.
A Disney resort in Japan seemed to make sense, given that
Japanese tourists flocked to Disneyland in the United States. Furthermore, since there are almost no imports or exports between foreign
markets in the leisure industry, there would be none of the negative
side effects typically associated with Japanese–American licensing
agreements. But there were still risks involved. Would Japanese and
other Asians want to go to a Disneyland that wasn’t in America? Would
a theme park work in Tokyo’s cold, humid, rainy climate? Disney’s
two US parks in Florida and southern California are both “vacation
destination” parks with warm weather.
Moreover, back in the late 1970s, Disney was hurting financially. It didn’t have the capital to make the investment needed
to build a park in Japan. Disney received more than 20 offers from
133
134
C H A PT E R 8
Strategic Alliances
TA B L E 8 . 1
Disney–Oriental Land Co. Alliance
Disney Resources and Capabilities
OLC Resources and Capabilities
Disney brand
Land for the park near Tokyo
Disney theme park rides and designs
Financial resources to build the park
Park management processes
Relationships with construction firms to build
the park
Ongoing stream of Disney characters from
movies
Knowledge of Japanese culture and how to
manage Japanese workers
Disney consumer products to sell at the park
Japanese firms vying for the chance to become its partner in building and running the park. So Disney did its due diligence of potential partners in Japan and eventually decided that OL would be the
best partner.
Forming the partnership was not necessarily a walk in the park.
Negotiating a satisfactory partnership agreement required that both
sides overcome cultural barriers and major disagreements. OL wanted Disney to contribute funds to build the park, but Disney refused
to contribute in any way toward the initial investment. Disney also
required a 50-year contract, a time commitment that frightened OL
when so many unknowns remained. Moreover, Disney demanded
a high licensing fee of 10 percent of all gross revenues; OL wanted
to pay 5 percent. OL initially called Disney’s terms a “servile agreement,”2 and it took more than four years of negotiating for the two to
reach common ground in 1979. In the end, Disney paid a sum of less
than 1 percent of the initial investment and received a license fee of
10 percent of gate receipts, but did lower its license fee to 5 percent
on nongate receipt sales.3
Despite the difficult negotiations, Tokyo Disneyland has been a
smashing success. Even though it had to pay high interest costs from
the $1.53 billion upfront investment required to build the park, as
well as the average 7.5 percent license fee to Disney, OL was able to
make the project profitable in just four years after the park opened
in 1983. The firms continued their partnership, working together to
build Tokyo DisneySea in 2001. Together with Tokyo Disneyland and a
number of Disney-branded hotels, the two parks make up the Tokyo
Disney Resort. Disney’s Imagineering unit continues to design and
develop new theme concepts and attractions for the parks. In fact,
in 2016 the two companies announced a large-scale expansion that
will include a castle and village from “Beauty and the Beast,” a new
“Big Hero 6” themed attraction, and a full-scale indoor theater for live
performances.
All in all, Disney’s support through providing its image, know-how, and design skills has been
invaluable, and Oriental Land’s management and execution is unmatched by Disney’s other
international partners. The Tokyo Disney Resort has received more than a half billion total
visitors since Tokyo Disneyland opened in 1983, with more visitors each year than either of
Disney’s US parks. The annual number of visitors has never dropped below 10 million, and it
reached a high of 17 million visitors in 1997. OL, which runs few destinations other than the
Tokyo Disney parks, is now ranked as the second-largest tourism-leisure firm in the world, just
behind Disney itself.4 In one recent year, Tokyo Disney Resort generated revenues of approximately US$4.15 billion. That translated to about US$690 million in operating profits for OL.
Disney received about $300 million from its licensing fees, a sum that is basically pure profits
for Disney, since it has negligible costs associated with Tokyo Disneyland and no investment
in assets.
There are currently no plans for a third park in Japan, but Disney has confirmed that
if another park was planned, Disney would be happy to work with Oriental Land to make it
a success.5
strategic alliance A cooperative
arrangement in which two or more
firms combine their resources
and capabilities to create new
value; sometimes referred to as a
partnership.
What Is a Strategic Alliance?
The Walt Disney–Oriental Land Company alliance illustrates how strategic alliances can be a
vehicle for achieving important strategic objectives—such as lowering costs, creating new
sources of differentiation, or entering new markets. A strategic alliance—sometimes referred
What Is a Strategic Alliance?
to as a partnership between firms—is a cooperative arrangement in which two or more firms
combine their resources and capabilities to create new value.6 Strategy scholars sometimes
refer to these types of arrangements, in which firms cooperate to create competitive advantage
through their collaboration, as cooperative strategy or a relational advantage.7
Strategic alliances have grown dramatically in importance during the past 25 years. Strategic alliances accounted for only about 5 percent of the revenues of Fortune 1000 companies
in 1980, but by 2010 it is estimated that they accounted for almost one-third of the revenues of
Fortune 1000 companies. In Walt Disney’s case, Tokyo Disneyland contributed almost 20 percent of Disney’s total theme park profits in 2011.8
Today, many companies are increasingly using alliances to achieve strategic objectives.
The basic logic for alliances can be summed up in the adage, “Two heads are better than one.”
Sometimes it just makes sense to combine the resources and capabilities of two companies to
solve certain problems or achieve particular objectives.
Companies can choose to cooperate at any stage along the value chain, from research
and development to manufacturing to the marketing, sales, or service of products or services.
For example, BMW and Toyota are doing R&D together to develop new fuel-cell technology
to increase fuel efficiency.9 Intel and Micron have teamed up to manufacture flash memory
together.10 Target and Neiman Marcus have partnered to sell affordable luxury brands.11
In these instances, firms collaborate to improve their performance at common stages of the
value chain. In other instances, a firm might team up with a firm at a different stage of the value
chain. For example, Apple and AT&T teamed up to sell the iPhone—Apple provided the phones
and AT&T provided the cellular network.12 Although there are different ways to categorize
alliances, perhaps the most common way to distinguish one type of alliance from another is
by the mechanism used to govern the alliance. We explain these different types of alliances in
the next section.
Choosing an Alliance
Companies have three choices—summarized as make, buy, or ally—when it comes to
conducting any particular activity that needs to be done to offer a product or service
to a customer.
• First, they can make, or conduct the activity themselves within the firm.
• Second, they can buy, or purchase, the activity or input from another firm, using an
“arm’s-length relationship,” in which the buyer purchases an input with no obligation
to have a long-term relationship with the supplier. Companies that send out a “bid” to
numerous suppliers and then buy from the supplier that offers the lowest price have an
arm’s-length relationship with those suppliers. The winner of the bid this month might
lose next month.
• Finally, they can ally, or access, the activity or input from another firm, using an exclusive
partnership with that firm.
As discussed in Chapter 7, companies want to conduct those activities internally that are
most important to delivering the unique value they hope to offer. Disney prefers to create its
own stories and characters for its movies, make its own movies, and run its own stores. These
activities are most important to its success with customers, and therefore it wants to have control over those activities.
However, companies can’t do everything, so they buy many inputs from other companies
using an arm’s-length relationship. Arm’s-length relationships work just fine for purchasing
commodities, inputs that aren’t differentiated on anything but price. For example, Disney
doesn’t have a partnership with suppliers that provide fabric for its character’s costumes or hot
dogs and buns for its theme park restaurants. It can purchase those inputs from whatever supplier offers the lower price. Similarly, automakers need to purchase basic inputs such as nuts
and bolts from suppliers to put their cars together, but they usually don’t have a partnership
with those suppliers.
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Other inputs or activities, however, do require a partnership, a long-term relationship in
which both parties work closely to create new value together. Four kinds of inputs and activities
might qualify as “strategic” inputs that merit forming an alliance relationship.
1. Inputs that can differentiate your product in the minds of customers. Automakers are much
more likely to want to partner with a supplier that provides important engine or drivetrain
components that influence engine performance or reliability than one that provides fasteners. For example, truck manufacturers often partner with Cummins, a respected maker
of truck engines and components, in the manufacture of their trucks.
2. Inputs that influence your brand or reputation. Volvo, a Swedish manufacturer of cars and
trucks, has tried to develop a reputation on the safety of its cars. Consequently, it has
worked closely with key suppliers, including Autoliv, a Swedish supplier of seat belts and
airbags, to put pioneering safety technology into its vehicles.
Strategy in Practice
Walt Disney and Oriental Land: Why Ally?
One might reasonably ask why Disney didn’t just build Tokyo
Disneyland on its own. Disney obviously knew how to run a theme park.
It owned and operated two theme parks in the United States without
the involvement of a partner. Disney could have captured the $690
million that went to the Oriental Land Company in a recent year, as
well as the $300 million it did get. Why share the profits with a partner?
The first question that Disney certainly must have asked with
regard to Tokyo Disneyland was whether it could “make” another
park: Do we have the resources and capabilities to build Tokyo
Disneyland on our own? The answer to that question was not entirely
straightforward. Building a theme park in a new, foreign environment
came with a host of risks. Tokyo is not a warm-weather “vacation
destination,” as are California or Florida. Disney had absolutely no
experience in hiring, training, and managing a Japanese workforce.
Would Oriental Land Company have sold Disney the 115 acres of land
required for the park? If so, at what price? Did Disney have the $2.0
billion investment required to buy the land and build the park? If it
chose to make the investment in Japan, what other opportunities
would it have to forgo? Finally, and maybe most importantly, how
confident was Disney that Tokyo Disneyland would succeed?
When companies face an opportunity that comes with risks, they
might look to a partner to share or mitigate the risks. In this particular
case, Disney solved most of its problems by partnering with OL. That
company provided high-value resources; it owned the land and took
virtually all of the investment risk. Disney didn’t have to risk much
capital investment and was able to deploy its capital elsewhere. OL
runs the park, so Disney didn’t have to learn how to manage a Japanese workforce. Disney gets 10 percent return on gate receipts regardless of the profitability of the park. The two companies are able
to share ideas on how to best localize the Disneyland park within the
Japanese environment.
In the end, the park proved successful, and both OL and Disney
received value from the partnership. It is possible that Disney might
have been just as successful if it had built and run the park on its
own. But it’s also possible that, without OL as a partner, Disney
might have made different decisions about how to build or run the
park that would have hurt performance. Indeed, when Disney built
EuroDisney (now Disneyland Paris) in France, it experienced a host
of problems, and the park struggled for years.13 In particular, Disney
didn’t take into account important local preferences such as serving
wine with meals in the park, and the marketing was described as
“too Americanized” and not tailored to the needs of customers in
individual European countries.14 The alliance with OL clearly mitigated many of the risks associated with the venture, and OL’s resources
and capabilities likely increased the probability of success.
3. High-value inputs or activities that make up a high percentage of your total costs. Companies
that make refrigerators are more likely to partner with the supplier who provides the
compressor—the component that costs the most and cools the refrigerator—than with the
suppliers of plastic trays or fixtures.
4. Inputs or activities that require significant coordination in order to achieve the desired fit,
quality, or performance. Whenever you need to coordinate closely with another firm to get
the desired performance from their input or activity, you probably want a partnership relationship. For example, automakers must typically work closely with the supplier that provides the HVAC system (heating, ventilation, and air conditioning) for a vehicle, because
the supplier must know the geometric constraints in the dashboard, as well as where to run
the lines to the vents throughout the car, and because the HVAC system influences, and is
influenced by, the catalytic converter and other engine components.
The Strategy in Practice feature explores the factors that helped Disney make the “make,
buy, or ally” decision about Tokyo Disneyland.
Types of Alliances
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Types of Alliances
As Figure 8.1 shows, there are three basic types of alliances. Each is governed in a different way,
in order to split the gains from the alliance and protect each partner’s interests.
Nonequity or Contractual Alliance
The first type is a contractual or nonequity alliance, in which two or more firms write a contract to govern their relationship.15 The contract specifies what each party is to do in the
alliance—and what each party should receive if it fulfills its duty in the alliance. For example,
when Disney wants to promote the characters from a new movie, it will often create promotional materials such as figurines or games and partner with McDonald’s to put them into
Happy Meals for kids. Then Disney and McDonald’s jointly pay for TV commercials to advertise
the movie and the Happy Meal promotional materials. Combining meals and toys creates value
for both Disney and McDonald’s, who create a contract to govern the relationship.
Different types of nonequity alliances include:
• Licensing agreements, in which one firm receives a license, or permission to use a resource,
such as a brand or a patent, from another firm in return for a percentage of the revenues
or profits.16
• Supply agreements, in which a supplier might agree to develop certain customized inputs
for a customer.
• Distribution agreements, in which a distributor or retailer might agree to provide certain
customized services in order to help sell a product.17
As the name nonequity alliance suggests, companies do not take equity positions in each
other. They also do not form a joint venture. Companies tend to choose nonequity alliances
when it is easy to specify what each party is supposed to do in the relationship, as well as the
rewards that should come from meeting those obligations. Nonequity alliances tend to be less
complex and to require less interdependence and coordination between the companies than
alliances that involve equity. When an alliance requires the joint creation of new resources and
capabilities by the partners, companies often tend to opt for equity alliances or joint ventures.
Types of Strategic Alliances
Contractual Alliance
Cooperation between firms
is managed directly through
contracts, without crossequity holdings or an
independent firm being
created.
Preferred When:
• Interdependence
between partners is
low (e.g., pooled).
• It is easy to measure
the contributions of
each partner and write
it in a contract.
FIGURE 8.1
Equity Alliance
Cooperative contracts are
supplemented by equity
investments by one partner
in the other partner.
Sometimes these equity
investments are
reciprocated.
Joint Venture
Cooperating firms combine
resources to form an
independent firm in which
they invest. Profits from this
independent firm
compensate partners for
this investment.
• Interdependence between • Interdependence
between firms is very high
firms is moderate (e.g.,
(e.g., reciprocal).
sequential).
• Firms bring knowledge or • Firms bring knowledge or
difficult-to-measure
difficult-to-measure
contributions that must
contributions, but they can
be combined into a single
perform their roles
organization to coordinate
separately.
effectively.
Types of Strategic Alliances
contractual or nonequity
alliance Two or more firms
write a contract to govern their
relationship. Ownership is shared
between the companies.
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Equity Alliance
equity alliance The collaborating
firms in an alliance supplement
contract with equity holdings in
their alliance partners.
In an equity alliance, the collaborating firms often supplement contracts with equity holdings
in their alliance partners.18 For example, Toyota owns between 5 and 49 percent of the equity of
its 10 largest Japanese suppliers, who all work very closely with Toyota in the development and
production of its automobiles.19 The fact that Toyota owns some equity in these suppliers aligns
their incentives with Toyota’s needs and encourages the suppliers to make investments that
benefit Toyota. For example, Toyota’s equity investments encourage its suppliers to locate their
manufacturing plants next to Toyota’s assembly plants to reduce the costs of shipping and
inventory.
In situations where the parties to an alliance need incentives to bring their best resources
to the alliance, equity is often preferred to contracts as a way to align the incentives of partners.
For example, many large pharmaceutical companies, such as Eli Lilly, Merck, and Pfizer, own
equity positions in start-up biotechnology companies. The large pharmaceutical firms’ equity
positions give them the option to be part owners of new biotechnology drugs the start-ups
develop. This option of owning a stake of a potentially profitable new drug creates incentives
for companies such as Eli Lilly to provide financial resources to help develop a drug, as well any
other support that might increase its probability of success. For instance, if a new drug looks
promising, Lilly will use its sales force and distribution channels to sell it around the world.20
Joint Venture
joint venture An alliance
in which collaborating firms
create and jointly own a legally
independent company.
The final form of alliance, a joint venture, is one in which collaborating firms create and jointly
own a legally independent company. The new company is created from resources and assets
contributed by the parent firms.21 The parent firms jointly exercise control over the new venture
and consequently share revenues, expenses, and profits.
Joint ventures are preferred when firms need to combine their resources and capabilities
in order to create a competitive advantage that is substantially different from any they possess
individually. For example, Intel makes microprocessors and Micron makes advanced semiconductors, but both companies saw an opportunity in flash memory, the type of memory used
in flash drives and increasingly used in mobile devices such as MP3 players and smartphones.
Both companies had some relevant skills and assets, so they decided to each put in $1.2 billion
in cash and assets and create IM Flash, a new company jointly owned by Intel and Micron.22 The
new company focused on the flash memory market and didn’t deflect the attention of Intel and
Micron from their core businesses.
In similar fashion, when GM wanted to enter the Chinese market, it teamed up with SAIC,
a Shanghai-based automobile company, to create Shanghai-GM, a joint venture that brings
together GM’s expertise and technology for making cars with Shanghai’s knowledge about the
Chinese market and experience managing a Chinese workforce.23
Typically, partners in a joint venture own equal percentages and contribute equally to the
venture’s operations, as was the case with IM Flash. However, in some cases one party might
bring more resources to the venture, which will lead to a higher equity stake. Moreover, over
time, a firm’s priorities might change, which can lead to one partner purchasing the equity
stake of the partner. For example, in 2012 Intel decided that IM Flash was less of a priority so
it sold $600 million of its stake in the company to Micron.24 Many joint ventures end with one
partner selling some or its entire ownership stake in the joint venture to the other partner.
Vertical and Horizontal Alliances
vertical alliance An alliance
between firms that are positioned
at different stages along the
value chain, such as a supplier
and a buyer.
In addition to distinguishing alliances by the type of governance arrangement (e.g., nonequity,
equity, joint venture), alliances are sometimes categorized as either vertical alliances or horizontal alliances.
A vertical alliance is an alliance between firms that are positioned at different stages
along the value chain, such as a supplier and a buyer.25 Toyota’s relationships with its top
Types of Alliances
139
Strategy in Practice
Bose: Working with Suppliers in Vertical Alliances
and essentially works for Bose procurement and logistics.
Duties involve placing purchase orders, monitoring materials
requirements, and assisting with manufacturing planning.
Bose interviews and approves the “in-plant rep” and essentially treats the rep as a Bose employee—the “in-plant” has
access to Bose facilities, personnel, and computer systems,
and even gets a performance review.
Bose Corporation, known for its sound systems and pioneering
innovations in acoustic technology, has also been a pioneer in
establishing what it calls “JIT II Partnerships” with some of its
suppliers. A JIT II partnership (named after Toyota’s Just-In-Time
delivery practice with suppliers) is a relationship with a supplier
that involves the following characteristics:26
• Bose selects a supplier that it believes has the best capabilities to meet its needs and agrees to give that supplier all of
its business.
• The supplier must give Bose its best pricing on products. Bose
can bid a product on the market if it doesn’t think it is getting
the best prices.
• Bose gives the supplier an “evergreen” contract, meaning that
as long as the supplier performs according to expectations, the
contract rolls over for another year.
• The supplier agrees to provide at least one “in-plant representative” who will work at Bose for 30 to 40 hours per week.
This person replaces the Bose buyer and production planner
Lance Dixon, Bose director of procurement and logistics, initiated JIT II partnerships when he realized that by working more
closely with key suppliers, both Bose and the suppliers could reduce
costs. Dixon said, “Suppliers are normally outside of your company
trying to see through the window into what you are doing. We open
the door and let them in to do the work together.”27
G&F Industries, a Bose supplier of plastic components for Bose
speakers, has been a JIT II supplier for 20 years. G&F’s “in-plant rep”
Chris LaBonte said that working inside Bose every day gives him the
information he needs to help G&F better meet Bose’s needs. “Being
here onsite at Bose allows me to get the right jobs running at the
right times with the right quantities,” said LaBonte, “It’s a real positive, open, trusting, and nonadversarial, yet direct, relationship.”28
How JIT II Partnerships Create Value at Bose Corp.
BOSE ORGANIZATION
Traditional
Process
Bose
Design
Engineer
Bose
Production
Planner
Bose
JIT II
Partnership Design
Engineer
Process
Bose
Production
Planner
SUPPLIER ORGANIZATION
Bose
Materials
Planner
Bose
Buyer
Supplier
“In-plant”
Representative
Supplier
Salesperson
Supplier
Production
and
Engineering
Personnel
Supplier
Production and
Engineering
Personnel
“The major advantage isn’t having a customer rep at our location—rather it’s that the
customer rep is ‘empowered’ to use our system, thereby replacing the planner, buyer, and
salesman.”
Sherwin Greenblatt, President, Bose Corp.
JIT partnerships have lowered Bose’s administrative costs
by more than 20 percent. Bose simply doesn’t have to hire as
many people, because its supplier partners do the work that
employees previously did. Bose claims it also reduced inventory
and logistics costs by more than 25 percent as a result of its JIT II
partnerships, because of better planning and increased supplier
efficiency, with suppliers delivering components exactly when
Bose needs them. Suppliers enjoy having a partnership with
Bose because they have guaranteed sales and they can plan
more effectively for their own production runs. Both Bose and its
partner suppliers are better off, which is the primary goal of an
effective partnership.
10 suppliers are considered vertical alliances—the output of one of the firms in the relationship
is the input of the other. Vertical alliances are usually formed to combine unique resources, create new alliance-specific resources, or lower transaction costs between two companies that are
already transacting. The Strategy in Practice feature describes the details of how Bose handles
vertical alliances with its suppliers.
In contrast, a horizontal alliance is between two firms that do not have a supplier–buyer
relationship and are typically positioned at a common stage of the value chain (e.g., competitors).
horizontal alliance An alliance
between two firms that do not
have a supplier–buyer relationship
and are typically positioned at a
common stage of the value chain.
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The Shanghai-GM partnership is a horizontal alliance. The partners conduct activities at a
common stage along the value chain, which means they conduct similar activities internally. In
this case, both of them manufacture automobiles. Horizontal alliances can also occur between
companies that don’t do the same activities but do complementary ones, such as Electronic Arts
developing games for the Sony PlayStation. Horizontal alliances are often created to pool similar
resources, or to combine complementary knowledge. We discuss these different ways to create
value in alliances in the next section.
Ways to Create Value in Alliances
Alliances are a vehicle that allows a company to access the resources and capabilities of
another firm in order to create value by either lowering its costs or differentiating its offerings. How can managers determine if accessing the resources and capabilities of a partner
really will help their company create value? Alliances can create value if they do any these
four things:29
1. Combine unique resources
2. Pool similar resources
3. Create new alliance-specific resources
4. Lower transaction costs
We will examine each of these different ways to create value in partnerships, but it is worth
noting that these are not mutually exclusive ways for creating value in an alliance. Alliance
partners might use several of these ways of creating value in a single alliance.
Combine Unique Resources
The first way that firms create value through an alliance is by combining unique resources
to create an even more powerful offering. This is what Pixar and Disney did to dominate
computer-animated films.30 As described in Chapter 3, Pixar contributed computer-generated
animation (CGA) and story-writing skills that brought to life unique stories in films such
as Toy Story, Finding Nemo, Cars, and The Incredibles. Disney contributed worldwide film
distribution to the partnership and sold products involving Pixar’s movie characters—such
as Woody and Buzz Lightyear—at its Disney stores and theme parks. No other film distributor could bring Pixar characters to stores or theme parks like Disney. By combining
their unique resources, Pixar and Disney created synergy that increased profits for both
firms. In fact, Disney eventually acquired Pixar in order to gain full control over Pixar’s
unique resources.31
In similar fashion, Target decided to team up first with high-end designer Missoni, and
later with Neiman Marcus, in contractual alliances to bring high-end fashion to the masses.
Target had long been playing a unique tune among box-store discounters, differentiating
itself from Walmart as a place for the younger generation to get affordable fashion. It hoped
that partnerships with designers could boost the image of “Tar-zhay,” as more upscale consumers like to call Target. When Target first teamed with Missoni in 2011 to offer a line of
Missoni-designed products through its 1,700-plus stores,32 the demand for Missoni products at Target quickly swept up every available item, leaving many customers disappointed
that they had missed out. The sheer volume of traffic online caused the Target website
to crash for nearly a whole day.33 This led to a similar partnership with high-end retailer
Neiman Marcus in July 2012—with the idea to bring a larger number of designers to the
masses. Target brought size, scale, and distribution to these partnership relationships, and
Missoni and Neiman Marcus brought a chic factor that Target simply could not replicate on
its own.34
Ways to Create Value in Alliances
141
Strategy in Practice
Google and Luxottica’s Learning Alliance
“Google’s futuristic eyewear is on its way back, and with an Italian flavor this time,” read the introductory line of a Fortune article on “tech
wearables.”35 Google Glass, the “smart eyewear” technology developed by Google, had not taken off as planned. The eyewear design
was viewed as clunky and expensive, and it wasn’t clear exactly what
problem the glasses were solving for consumers. Moreover, Google
wasn’t particularly skilled at selling consumer products. So Google
and Luxottica Group, a leader in the design, manufacture, distribution, and sales of premium, luxury, and sports eyewear (e.g., Ray-Ban,
Oakley) announced that they had agreed to join forces to design,
develop, and distribute a new breed of eyewear for Glass.
Google’s objective with the alliance appears to be to tap into
the design capabilities at Luxottica as well as to better understand
the process for manufacturing and distributing eyewear. For its part,
Luxottica is interested in understanding technology and how it can
be embedded in eyewear. Luxottica added that the two major proprietary brands of the Group, Ray-Ban and Oakley, which have a 10-year
heritage in wearable technology that has evolved from MP3 to HUD
devices, will be a part of the collaboration with Google Glass.
“We are thrilled to announce our partnership with Google,”
said Andrea Guerra, chief executive officer of Luxottica Group. “We
live in a world where technological innovation has dramatically
changed the way in which we communicate and interact in everything that we do. More importantly, we have come to a point where
we now have both a technology push and a consumer pull for wearable technology products and applications. . . . We believe it is high
time to combine the unique expertise, deep knowledge and quality
of our Group with the cutting edge technology expertise of Google
and give birth to a new generation of revolutionary devices.”36
The two corporations will establish a team of experts devoted to
working on the design, development, tooling, and engineering of Glass
products that straddle the line between high fashion, lifestyle, and innovative technology. “Luxottica has built an impressive history over the last
50 years designing, manufacturing and distributing some of the most successful and well-known brands in eyewear today,” said Google vice president and head of Google X, Astro Teller. “We are thrilled to be partnering
with them as we look to push Glass and the broader industry forward into
the emerging smart eyewear market.”37 Time will tell whether the partnership will bear fruit, but a partnership like this was viewed by many as
one of the few ways that Google could make Glass a success.
Companies typically combine unique resources to create new products, enter new
markets, or avoid the costs of entering different stages of the value chain. For example, Pixar
decided not to invest in movie distribution, instead relying on the distribution resources and
capabilities that Disney had already built.
Sometimes, the unique resources that the partners combine are intangible resources in
the form of knowledge. Such “learning alliances” are increasingly popular. The goal is for each
alliance partner to learn something that it believes will be a valuable addition to its capabilities
in the future. The Strategy in Practice feature describes an example of a learning alliance between Google and Luxottica Group.
In a similar fashion, when Visa wanted to learn about how to bring financial literacy, and
credit cards, to a younger crowd, it turned to an unlikely partner—Marvel Comics. Visa and
Marvel jointly developed a unique comic book addressing money-management issues, starring Marvel characters The Avengers and Spiderman. Imagine Spiderman and Hulk discussing
different options for financing Spiderman’s new big-screen TV! That will grab the attention of
teenagers. Through the partnership, Marvel learned to use its comic books for educational purposes, and Visa learned about a unique way to educate potential customers. This was a case
where both partners also brought unique resources to the relationship.
Pool Similar Resources
A second way that alliances create value is by pooling similar resources to achieve economies
of scale that neither firm could achieve on its own. For example, as described earlier, Intel and
Micron wanted to get into manufacturing flash memory—a business that required billions of
dollars of investment in a plant and equipment. So they decided to create IM Flash, a joint venture designed to produce flash memory products. By splitting the cost of the plant and equipment, the two companies were able to build a much larger plant and, through economies of
scale, produce flash memory at a lower cost per unit.38 This value didn’t necessarily require
combining unique resources, just the pooling of total resources to achieve economies of scale
in the R&D and production of flash memory.
In addition to achieving economies of scale, another reason firms pool similar resources is
to share the risks associated with conducting a particular activity. BP and Statoil formed a joint
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venture, pooling their financial resources and knowledge to share the expense and lower the
risks associated with costly international oil exploration and production activities.39 By sharing
the costs of the drilling equipment and the other fixed assets, the two firms were each able to
lower their fixed costs per barrel of oil.
Create New, Alliance-Specific Resources
A third way alliances create value is through new, alliance-specific resources. Alliance-specific
resources are those that are created specifically to help the partners achieve the alliance objectives. Alliance-specific resources can be owned by one partner or jointly held. Firms typically
create alliance-specific resources to increase the efficiency of doing business together or to
expand the available resources of all the partners.
The alliance between Toyota Boshoku and Toyota is an example of building new resources
in order to improve efficiency, and the ability of the partners to coordinate their joint work.
Toyota Boshoku, which supplies automobile seats to Toyota, built its factory next door to
Toyota’s assembly factory.40 Because seats are bulky and costly to ship, building the plant
nearby lowered Toyota Boshoku’s costs of inventory and shipping to Toyota. Then, to further
reduce shipping costs, Boshoku decided to build a conveyer belt to take seats directly from its
factory into Toyota’s. The factory plant and the conveyor belt were both new resources that
were created to support Boshoku’s transactions with Toyota. These investments substantially
lowered transportation costs, inventory costs, and the costs associated with having face-to-face
meetings. In comparison, General Motors does not have alliance relationships with its seat suppliers. As a result, the suppliers have not built their factories nearby. Not surprisingly, GM and its
seat suppliers have higher inventory and transportation costs, which give Toyota and Boshoku
a cost advantage over GM and its suppliers.41
Visa represents an example of alliance partners creating a jointly held alliance-specific
resource. In the 1970s, Bank of America and a group of other financial institutions decided to
form a joint venture company with the purpose of building a credit card business. Credit cards
were new at the time, and the banks hoped to get customers to widely use them. The new joint
venture company was named “Visa,” and the company then built the Visa brand with customers
through marketing and advertising. The Visa brand was perhaps the most valuable resource
created through the alliance, because it allowed member banks to issue credit cards that were
immediately recognizable to customers. Over time, many other banks and financial institutions wanted the benefits of issuing a Visa credit card, so they joined the private membership
association that owned Visa. Visa finally became a public company in 2007, but its primary
owners are still the banks that were part of the original private membership association that
established Visa.42
Lower Transaction Costs
A fourth way that alliances create value is by lowering transaction costs. Alliances that create
value through lower transaction costs are primarily trying to increase efficiency and lower the
costs between transactors in the value chain: buyers and suppliers.
By transaction costs, we mean all of the costs associated with making a transaction
happen.43 In most companies, purchasing personnel, sales personnel, and attorneys are
primarily responsible for finding and negotiating agreements with suppliers of inputs and
buyers of outputs. If alliance partners can create relationships with suppliers or buyers
based on mutual trust, then they don’t have to employ as many purchasing or sales personnel. They also don’t have to employ as many lawyers to write costly contracts to protect
their interests.44
One study of Toyota and General Motors found that Toyota’s procurement and legal costs
were half those of General Motors.45 The study concluded that General Motors and its suppliers had higher transaction costs because they didn’t trust each other; so they spent a lot of
time negotiating agreements and writing legal contracts. In contrast, Toyota had developed
The Risks of Alliances
143
relationships with its supplier partners that were based on mutual trust. One thing that Toyota
did to build trusting relationships with some suppliers was to purchase a minority stock ownership stake in the supplier. Because Toyota owned part of the suppliers’ stock, suppliers felt that
Toyota would behave in a trustworthy manner.
The Risks of Alliances
The issue of protecting one’s interest in an alliance is real—alliances are not without risks.46
When a company agrees to an alliance, it loses some of its independence. It must rely on its
partner to produce and perform as expected. Just as there are incentives to cooperate in
alliances, there are also incentives for companies to act opportunistically, to take advantage of
a partner if the situation presents itself. So managers need to be aware of the two major ways
that partners can take advantage of one another in an alliance: hold-up and misrepresentation.
(You can remember these two forms of opportunism as H&M.)
Hold-Up
Hold-up occurs when one partner tries to exploit the alliance-specific investments made by
another partner.47 In the case where Toyota Boshoku built its factory next to Toyota’s, this created
an opportunity for Toyota to “hold up” Boshoku by opportunistically renegotiating lower prices
after Boshuku made the investment. After Toyota Boshoku built its factory next door to Toyota,
it was highly committed to Toyota; its investments could not be easily redeployed to serve other
customers. It was important for Boshuku to make sure that Toyota would be trustworthy and not
try to negotiate lower prices after Boshoku built its factory next door. So it created an equity alliance with Toyota, in which Toyota owned 49 percent of Toyota Boshoku’s stock.48
Managers must be aware that whenever they make investments in equipment, facilities,
or processes that are customized to a partner—and therefore not easily redeployable to other
uses—there is the potential for the partner to hold up their company.
hold-up When one partner
tries to exploit the alliancespecific investments made by
another partner.
Misrepresentation
Misrepresentation occurs when one partner in an alliance creates false expectations
about the resources it brings to the relationship or fails to deliver what it originally promised.49 For example, suppose a start-up biotechnology company is developing a new drug
to fight Alzheimer’s disease. It needs additional resources to conduct clinical trials in order
to get approval for this new drug. To convince a pharmaceutical company to provide the
necessary resources, the biotech start-up could misrepresent how far along the drug is in
the development pipeline. Or it could overstate the effectiveness of the drug in initial clinical trials.
A company that considers entering into an alliance with a firm that brings intangible
resources to an alliance—such as local market knowledge or relationships with key political
figures—needs to research its partner thoroughly to guard against this form of opportunism.
Ultimately, however, misrepresentation is a hazard that firms face when doing business with
others of questionable moral character. The only true way to protect against misrepresentation
is to partner with trustworthy individuals and firms.
Building Trust to Lower the Risks of Alliances
The bottom line is that, while alliances have the potential to create value, they are
also fraught with challenges and risks. Alliances cause independent firms to become interdependent, which means they must work effectively together to succeed.
misrepresentation When one
partner in an alliance creates false
expectations about the resources
it brings to the relationship
or fails to deliver what it
originally promised.
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Ethics and Strategy
The Blame Game in Strategic Alliances
On April 20, 2010, disaster struck on a BP oil rig in the Gulf of Mexico.
An explosion claimed 11 lives and resulted in a sea-floor gusher that
flowed for 87 days—spilling 210 million gallons of oil into the Gulf.
BP took a thrashing in the press and agreed to a record-setting fine
of $4.5 billion. But not long after agreeing to the fine, BP decided
to go on the offensive with multibillion-dollar lawsuits seeking to
shift the blame to its partners—Transocean, owner of the ill-fated
rig, and Halliburton, the company that supplied the cement that
didn’t hold. BP sued rig-owner Transocean for more than $40 billion
because of failures in the rig’s safety system. That’s a remarkable
figure because it comes close to what BP estimates will be its entire
liability for paying claims and cleaning up in the wake of the spill.
BP sued Halliburton for an estimated $10 billion, contending that
Halliburton’s “unstable” cement job failed to block the spill. BP also
accused Halliburton of destroying post-spill test results to cover up
the cement contractor’s culpability. In response, Transocean and
Halliburton each filed lawsuits of their own. Transocean claimed
that BP jeopardized the rig through risky cost-saving moves, and
Halliburton said its work on the rig was done “under BP’s direction
and according to their plan.” However, Halliburton eventually
admitted that it did destroy critical post-spill test results in the
aftermath of the 2010 Gulf of Mexico oil spill. BP and Halliburton
are now spending millions pointing the finger at each other.
The now-defunct partnerships among BP, Transocean, and
Halliburton highlight a key ethical dilemma in strategic alliances.
The dilemma has to do with the fact that alliance partners are
interdependent—which means they must trust and rely on each
other to accomplish key objectives. When things go wrong, partners
have strong incentives to blame the other party—even if it might be
their fault—because the interdependencies between the two parties
make it difficult to assign blame. The blame game is clearly going
on with BP and its former partners. When this happens, parties
often have strong incentives to misrepresent or hide information
to avoid blame. This is a key ethical dilemma faced by BP and its
former partners as they look to the courts to divvy up their financial
responsibility for the spill.
This might explain why some studies of alliances have found that trust between partners
is the most important ingredient for alliance success. Next we examine four ways that
companies attempt to protect themselves from opportunism and build trust with their
alliance partners.
Personal Trust The first way to prevent against opportunism by a partner is to initiate
partnerships only with people who you know to be trustworthy. These would likely be individuals you have known for a long time, such as family, friends, classmates, or others within
your social network. Of course, you need to know them well enough to be able to judge their
character—and you need to be accurate at evaluating their character. This type of trust is sometimes called goodwill trust, because you are relying on the goodwill of the other party to protect
your interests.
Some research has shown that compared to US firms, Japanese firms are much more likely
to rely on personal trust to govern their alliances.50 As a result, managers often partake in a long
“honeymoon” period of meetings, dinners, and even activities such as singing karaoke, to get
to know individuals in the other firm before deciding whether they think they can trust the firm
enough to enter into a partnership. This is often frustrating for US firms who are more willing to
write contracts to govern their alliances than to rely on personal trust.
Legal Contracts
In most cases, when firms initiate a partnership, they write a legal
contract to protect their interests. Legal contracts are usually used to help protect the
interests of alliance partners and to spell out the obligations and expectations of
the partners.
A contract is a substitute for personal trust. If someone violates personal trust, there is
no real economic recourse other than ending your friendship or relationship. But if someone
violates a contract, you can sue the other party in court to get some economic recourse. This
threat of a lawsuit can be an important incentive for partners to perform according to legally
established obligations and expectations. As detailed in Table 8.2, most contracts have clauses
that clarify three categories of issues:
1. Governance issues, such as how decisions will be made, how profits will be split and how
disputes will be resolved
The Risks of Alliances
TA BL E 8 . 2
145
Common Clauses in Alliance Contracts
Governance Clauses
Residual rights clauses
In contractual alliances, parties often specify how the profits or assets created from the alliance
are to be split among the partners.
Equity/ownership clauses
Equity alliances or joint ventures must specify what percentage of equity is owned by each of
the partners.
Voting rights clauses
Specify the number of votes for decision making assigned to each partner in an alliance. In
equity alliances, voting rights usually correspond to equity ownership.
Minority protection clauses
Specify the kinds of decisions that can be vetoed, if any, by firms with a minority interest in the
alliance.
Dispute resolution clauses
Specify the process by which disputes among partners will be resolved.
Operating Clauses
Performance clauses
Specify the specific duties and obligations of each of the partners, including warranties and
minimum performance levels required to satisfy the contract.
Noncompete clauses
Specify product markets or businesses that partners are restricted from entering.
Intellectual property right
protection clauses
Specify intellectual property or confidential information brought to the alliance by the partners
that is not to be used by other partners or shared outside of the alliance without the partner’s
written consent.
Intellectual property rights
creation clauses
Specify ownership rights to intellectual property (such as patents) created as a result of the
alliance.
Exit/Termination Clauses
Preemption rights clauses
Specify that if one partner wishes to sell its equity, it must first offer to sell the equity to the
other partner.
Initial public offering (IPO)
clauses
Specify conditions under which partners in equity alliances or a joint venture will pursue an
initial public stock offering.
Call/put option clauses
Specify the conditions under which one partner can force another partner to sell (or buy) its
shares and at what price.
Termination clauses
Specify under what conditions the contract can be terminated and the consequences of
termination for each partner.
2. Operating issues, such as what performance is expected, and how intellectual property will
be shared and protected
3. Exit/termination issues, including the conditions under which partners can exit the alliance
or the contract can be terminated
Shared Ownership/Financial Collateral Bonds When one partner owns a
financial stake in another partner, as Toyota does with some of its supplier partners, it has an
incentive to cooperatively help the partner be as financially successful as possible because it
shares in the partner’s profits. By having your partner purchase a stake in your organization,
you align the incentives of both partners to work together.
Another way to align incentives and build trust is by having a partner post a financial
collateral bond that it will lose if it doesn’t perform according to a specified contract. For
example, fast-food chains such as McDonald’s will often partner with franchisees, individuals
who purchase a franchise from McDonald’s that gives them the right to operate a McDonald’s
outlet at a particular location. The franchise fee is essentially put into something like an
escrow account, while McDonald’s monitors the franchisee to ensure that it operates the outlet
according to McDonald’s guidelines. If the outlet fails to provide McDonald’s quality food or
service (which McDonald’s checks by sending in inspectors), McDonald’s can keep the franchise
fee and take away the franchise.
146
C H A PT E R 8
Strategic Alliances
Building an Alliance Management Capability
Strategic alliances have become a fast and flexible way to access complementary resources and
capabilities that reside in other firms. They are also profitable. One study found that a company’s stock price jumped roughly 1 percent, on average, with each announcement of a new
alliance, which translated into an average increase in market value of $54 million per alliance.51
Yet, as we’ve seen, alliances are fraught with risks. Indeed, almost half of them fail.52 In such an
environment, the ability to form and manage alliances more effectively than competitors can
itself become an important source of competitive advantage. In Chapter 3, we discussed the importance of a firm building internal resources and capabilities, which can be used to accomplish
key strategic objectives. One of those capabilities is an alliance capability—the focus of the final
section of this chapter.
How do some firms develop a capability for successfully forming and managing alliances?
Professors Jeff Dyer, Prashant Kale, and Harbir Singh conducted an in-depth study of 200 corporations and their 1,572 alliances to learn how firms can systematically manage alliances to
maximize success.53 Although all companies seem to generate some value from alliances, some
companies—such as Eli Lilly, Oracle, and Hewlett-Packard—systematically generate much more
than other firms.
How do they do it? By building a dedicated strategic alliance function within the company.
Companies such as these appoint a vice president or director of strategic alliances with his or
her own staff and resources. The dedicated function coordinates all alliance-related activity
within the firm and is charged with creating processes to share and leverage prior alliance
management experience. Companies with such an alliance function achieved a 25 percent
higher long-term success rate with alliances than companies that did not have a dedicated
function. They also generated almost four times as much stock market wealth whenever they
announced the formation of a new alliance.
The research showed that an effective dedicated alliance function develops a firm’s capability to perform four key functions: It improves knowledge management efforts, increases
external visibility, provides internal coordination, and eliminates accountability and intervention problems.54
Improves Knowledge Management
A dedicated function acts as a focal point for learning, helping the company leverage lessons
and feedback from prior and ongoing alliances. It systematically establishes a series of routine
processes to articulate, document, codify, and share know-how about the key phases of the alliance lifecycle. Many companies with dedicated alliance functions have codified explicit alliancemanagement knowledge by creating guidelines and manuals to help them manage specific
aspects of the alliance lifecycle, such as partner selection and alliance negotiation and contracting. For example, Hewlett-Packard has developed 60 different tools and templates, included in
a 300-page manual that can be used to guide decision making in specific alliance situations.
The manual includes such tools as a template for making the business case for an alliance, a
partner evaluation form, a negotiations template outlining the roles and responsibilities of different departments, a list of ways to measure alliance performance, and an alliance termination
checklist. Figure 8.2 lists more of the guidelines and tools companies have developed.
Increases External Visibility
A dedicated alliance function can keep the market apprised of new alliances and about
successful events in ongoing alliances. Such external visibility can enhance the reputation of
the company in the marketplace and create the perception that alliances are adding value. The
creation of a dedicated alliance function sends a signal to the marketplace that the company is
committed to its alliances and to managing them effectively.
Building an Alliance Management Capability
* Needs analysis
checklist
* Partner
screening form
* Negotiations
guidelines
* Make vs. buy vs.
ally analysis
* Technology and
patent domain
maps
* Needs vs.
wants checklist
* List of possible
alliance partners
with resources to
meet needs.
* Cultural fit
evaluation
form
* Due diligence
team
Alliance
Business
Case
Partner
Assessment &
Selection
* Alliance
contract
template
* Alliance structure
guidelines
* Alliance metrics
framework
Alliance
Negotiation &
Governance
* Decisionmaking
template
* Relationship
evaluation
form
* Trust-building
worksheet
* Yearly status
report
* Work-planning
worksheet
* Termination
checklist
* Alliance
communication
infrastructure
* Termination
planning
worksheet
Alliance
Management
Assessment
&
Termination
ALLIANCE LIFECYCLE
FIGURE 8.2
Example of Tools to Use Across the Alliance Lifecycle
In addition, when a potential partner wants to contact a company about a potential
alliance, a dedicated alliance function makes an easy, highly visible point of contact. The
alliance function typically screens potential partners, and brings in the appropriate internal
parties if a partnership looks attractive. For instance, Oracle has an “Alliance Online” website
that actually puts the partnering process online. Oracle describes the terms and conditions of
different “tiers” of partnership on its website, allowing potential partners to choose which level
fits them best. Alliance Online has emerged as Oracle’s primary vehicle for recruiting and developing partnerships, with more than 7,000 tier I partners. It has also conserved human resources,
allowing Oracle’s strategic alliance function to focus the majority of its human resources on its
12 higher-profile and more strategically important tier III partners.
Provides Internal Coordination
One reason alliances fail is because of the inability of one partner or another to mobilize internal resources to support the alliance initiative. Visionary alliance leaders might lack the power
or organizational authority to access key resources that might be necessary to ensure alliance
success. One alliance executive at a firm without a dedicated alliance function explained, “We
have a difficult time in supporting our alliance initiatives because many times the various
resources and skills needed to support a particular alliance are located in different functions
around the company. You have to go begging to each unit and hope that they will support you.
But that’s time consuming, and we don’t always get the support we should.”
A dedicated alliance function helps solve this problem in two ways. First, it has the organizational legitimacy to reach across business units and request the resources necessary to
support the alliance. If a particular business unit is not responsive, it can quickly elevate the
issue to a senior executive. Second, over time, individuals within the alliance function develop
networks of contacts throughout the organization. These networks engender a degree of trust
between alliance managers and employees throughout the organization, thereby allowing
them to engage in reciprocal exchanges in support of alliance initiatives.
Facilitates Intervention and Accountability
Alliance failure is the culmination of a chain of escalating events. Signs of distress are often
visible early on. If alliances are adequately monitored, the alliance function can step in and
147
148
C H A PT E R 8
Strategic Alliances
intervene appropriately—much like a marriage counselor. However, only 50 percent of all
companies that form alliances have any kind of formal metrics in place to assess how well the
alliance performs. In contrast, 76 percent of companies with a dedicated alliance function have
formal alliance metrics to keep tabs on how the alliance is performing.55
To illustrate, Eli Lilly’s alliance function does an annual “health check” of its key alliances,
surveying both Lilly employees and the partner’s alliance managers. After the survey, an alliance manager sits down with the leader of a particular alliance to discuss the results and offer
suggestions for improvement. When serious conflicts arise, the alliance function can help
resolve the dispute. In some cases, Lilly found that it needed to replace its alliance leader. One
executive at Lilly commented, “Sometimes an alliance has lived beyond its useful life. You need
someone to step in and either pull the plug or push it in new directions.”56
The bottom line is that developing processes to effectively form and manage alliances
builds a capability for generating value through strategic alliances.
Summary
• A strategic alliance is a cooperative arrangement in which two or
more firms combine their resources and capabilities to create new
value.
• There are three basic types of alliances, each structured differently
to split the gains from the alliance and protect each partner’s interests. In a nonequity or contractual alliance, the firms write a contract
to govern the relationship. In an equity alliance, collaborating firms
often supplement contracts with equity holdings in their alliance
partners. In situations where alliance parties need incentives to
bring their best resources to an alliance, equity is often preferred
to contracts as a way to align the incentives of partners. In a joint
venture, the collaborating or “parent” firms combine their resources
to create a jointly owned but legally independent company.
• The primary strategic objective of firms is to offer unique value to
customers, either through low cost or differentiation. Alliances are a
vehicle for accessing the resources and capabilities of another firm
that will help you lower costs or differentiate your offering.
• There are four primary ways to create value with an alliance partner:
1. Combine unique resources
2. Pool similar resources
3. Create new alliance-specific resources
4. Lower transaction costs.
• As partners work together to create new value, they have to build trust
to ensure that they cooperate effectively. There are four primary ways
that partners build trust in alliance relationships: (1) personal trust,
(2) legal contracts, (3) shared equity/financial collateral bonds, or (4)
reputation. The ability to build trust with a partner has often been
viewed as the single most important contributor to alliance success.
Key Terms
contractual or nonequity alliance 137
equity alliance 138
hold-up 143
horizontal alliance 139
joint venture 138
misrepresentation 143
strategic alliance 134
vertical alliance 138
Review Questions
1. What is a strategic alliance?
2. Describe and give examples of the three different types of strategic
alliances. Identify the conditions under which each type is preferred.
3. What is the difference between a vertical alliance and a horizontal
alliance?
4. What are four primary ways in which firms create value through strategic alliances?
5. Describe the two potential dangers of strategic alliances summarized by the initials H&M, and four ways that firms in alliance can build
trust to minimize the risk of these dangers.
6. What is a strategic alliance function? Identify at least two ways that
a strategic alliance function helps a firm be more successful with its
alliances.
Strategy Tool
149
Application Exercises
Exercise 1: Look for a story in a news source such The
Wall Street Journal, Forbes, Fortune, or Bloomberg
Businessweek about two companies that have announced
an alliance or partnership. As you read the announcement
of the alliance, answer the following questions
1. What are the strategic objectives of each alliance partner?
2. Is this a vertical alliance or a horizontal alliance?
3. What resources and capabilities are brought to the alliance by
each partner? In your opinion, which partner seems to bring the more
valuable resources?
4. Which type of alliance is this: contractual, equity, or joint venture?
Does the article describe how the partners will split the gains from the
alliance? If so, does the split seem reasonable?
5. How do you think the firms will create value in the alliance? Is value
mostly created by combining complementary resources, pooling similar resources, creating entirely new resources, or reducing transaction
costs/increasing efficiency between the two organizations?
Exercise 2: Brainstorm opportunities to create
partnerships—and value—with other companies
1. Identify a target company that you understand well—either because
you have worked for the company or have read a lot about it. To
illustrate, let’s assume you select Marriott Corporation, the hotel and
time-share resort company.
2. Identify three to four other companies in other industries that might
be related in some way to the target company’s industry. Gather data
about the strategy of each company, using public sources such as the
company website or its annual reports, public articles, and your own
experience. In our example, you might choose, and gather data about
Disney (entertainment), Apple (computers, tablets, music, phones)
and Nike (shoes).
3. Work with three to four classmates to brainstorm ways in which
each of the other companies you chose could create new value with
the target company. To continue the Marriott example, perhaps
Marriott could create Disney-themed rooms at its timeshare resorts,
such as a Disney Princess or Pirates of the Caribbean room. Or maybe
Marriott could turn an elevator shaft into a “Tower of Terror” ride. Perhaps Apple could provide each Marriott room with Apple technology
and products. When guests check in to the hotel, perhaps they could
do it on their iPhone (and even have an electronic key sent to their
phone to open the door). Or maybe the room would be equipped with
an iPad filled with music and movies to try out. Perhaps Nike could
help design Marriott’s workout room and provide a variety of Nike
athletic footwear or apparel products for guests to purchase. Have fun
and be creative as you brainstorm ways that companies can combine
their resources and capabilities to create new value.
Strategy Tool
When to Choose an Alliance Versus an Acquisition
Alliances and acquisitions are alternative vehicles for accessing
important resources or capabilities that reside in another firm. Each
approach might be preferable in different situations, and managers
must carefully analyze several key factors before deciding whether to
ally with a company or acquire it. These factors include the following:
1. Type of synergies or interdependence between the firms. Managers should assess the nature of the coordination and interdependencies that will be required to generate synergies through
the collaboration. When interdependencies are low (pooled/
modular), nonequity alliances are preferred. As interdependencies increase and become sequential and reciprocal in nature,
managers should consider first equity alliances/joint ventures
and then acquisitions (see Chapter 7 discussion of pooled,
sequential, and reciprocal interdependencies).
2. Nature of resources being combined. Managers should assess
whether they must create the synergies they desire by combining
hard resources, like a product, equipment, manufacturing plants,
or patents or soft resources, such as people, relationships, or
unpatented intellectual property. When the synergy-generating
resources are hard, acquisitions are typically a better option
because it’s easier to value the assets you are purchasing. When
companies have to generate synergies by combining human
resources, it’s a good idea to avoid acquisitions because people
often walk out the door after acquisitions.
3. Extent of redundant resources. When two companies can team up
to create value by essentially eliminating redundant resources
that each has then acquisitions are the preferred option. For
example, companies might have redundant R&D activities, manufacturing plants, or sales/services forces and want to leverage
the best of each firm while eliminating redundancies. When companies want to create value by eliminating redundant resources,
acquisitions are preferable to alliances.
4. Degree of market uncertainty. When a company estimates
that there is high uncertainty or high risk about whether a
particular collaboration will yield positive results, it should
enter into a nonequity or equity alliance rather than acquire
the would-be partner. An alliance will limit the firm’s exposure
since it has to invest less time and money than it would in
an acquisition. If the collaboration doesn’t yield results, the
company can withdraw from the alliance. It might lose money
and prestige, but that will be nowhere near the costs of a
failed acquisition.
5. Degree of competition for partner’s resources. There’s a welldeveloped market for mergers and acquisitions, so it is wise to
check if you have rivals for potential partners before pursuing a
deal. If a company has several suitors, you might have no choice
but to buy it in order to preempt the competition. When there
are many suitors for a partner’s resources, we recommend you
acquire those resources to gain full control.
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C H A PT E R 8
Strategic Alliances
Given the factors described, the following evaluation tool can be
used as a guide to assess whether an alliance or acquisition is likely to
be more appropriate in a particular situation. Evaluate your collaboration partner on each of the five factors below and then add up the
point total to assess whether acquisition or alliance would be preferred.
If your point total is 11–15, then acquisition is likely the preferred option.
If your point total is 8–11, then an equity alliance might be your best
option. If your point total is below 8, then a nonequity alliance is likely to
be your best option. You can change the weighting of the factors if you
think a particular factor is more important in your particular situation.
Factor
1.
2.
Vehicle
Point Value
Type of Interdependence That Will Generate Synergies
Modular
Nonequity alliance
1
Sequential
Equity alliance
2
Reciprocal
Acquisition
3
Low
Nonequity alliance
1
Medium
Equity alliances
2
High
Acquisition
3
Low
Nonequity alliance
1
Medium
Equity alliance
2
High
Acquisition
3
Low
Acquisition
3
Low/Medium
Equity alliance
2
High
Nonequity alliance
1
Low
Nonequity alliance
1
Medium
Equity alliance
2
High
Acquisition
3
Nature of Resources That Will Generate the Synergies
Relative value of hard to soft resources
3.
4.
5.
Extent of Redundant Resources Between Two Firms
Degree of Market Uncertainty
Level of Competition for Partner’s Resources and Capabilities
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36
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37
If Intel and Micron had each built separate plants, they would have
produced at lower volumes than their joint plant, which would have
resulted in higher costs per unit, because they would have been higher
on the experience curve described in Chapter 4. If they had both built
the same size plants, it would have increased supply and competition
in the market, which would have led to lower prices. Alliances can also
be useful as a way to minimize competition.
38
“BP–Statoil Partnership Takes Shape,” Oil and Gas Journal 89 (5)
(1991), http://www.ogj.com/articles/print/volume-89/issue-5/in-this
-issue/general-interest/bp-statoil-partnership-takes-shape.html, accessed
July 31, 2017.
39
R. Schreffler, “Quake Changes Little in Toyota’s Supply-Chain Strategy,”
WardsAuto (2012), http://wardsauto.com/supply-chain/quake-changes
-little-toyota-s-supply-chain-strategy-0, accessed July 31, 2017.
40
Dyer, “Specialized Supplier Networks as a Source of Competitive
Advantage,” pp. 271–292.
41
http://en.wikipedia.org/wiki/Visa_Inc.#IPO_and_restructuring,
accessed July 31, 2017.
42
O. E. Williamson, The Economic Institutions of Capitalism (New York:
Free Press, 1985).
43
44
A. Zaheer and N. Venkatraman, “Relational Governance as an Interorganizational Strategy: An Empirical Test of the Role of Trust in Economic
Exchange,” Strategic Management Journal 16 (1995): 373–392.
J. H. Dyer and W. Chu. “The Role of Trustworthiness in Reducing
Transaction Costs and Improving Performance: Empirical Evidence
from the United States, Japan, and Korea,” Organization Science 14 (1)
(2003): 57–68.
45
T. K. Das, “Trust, Control, and Risk in Strategic Alliances: An Integrated
Framework,” Organization Studies 22 (2) (2001): 251–283.
46
B. Klein, R. G. Crawford, and A. A. Alchian. “Vertical Integration,
Appropriable Rents, and the Competitive Contracting Process,” Journal
of Law and Economics, 21 (1979): 297–326; “Hold-up Problem,”
Wikipedia Online Encyclopedia, http://en.wikipedia.org/wiki/Hold-up
_problem#cite_note-1, accessed February 19, 2013.
47
48
http://www.wikinvest.com/stock/Toyota_Motor_(TM)/Automotive
_Market_Environment, accessed July 31, 2017.
T. K. Das and N. Rahman, “Partner Misbehaviour in Strategic Alliances:
Guidelines for Effective Deterrence,” Journal of General Management
27 (1) (2001).
49
C. W. L. Hill, “National Institutional Structures, Transaction Cost
Economizing, and Competitive Advantage: The Case of Japan,” Organization Science 6 (1995): 119–131. J. H. Dyer, “Does Governance Matter?
Keiretsu Alliances and Asset Specificity as Sources of Japanese Competitive Advantage,” Organization Science 7 (6) (1996): 649–666.
50
Dyer, Kale, and Singh, 2001.
51
S. H. Park and G. R. Ungson, “Interfirm Rivalry and Managerial Complexity: A Conceptual Framework of Alliance Failure,” Organization
Science 12 (1) (2001): 37–53; P. Kale, J. H. Dyer, and H. Singh, “Alliance
Capability, Stock Market Response, and Long-Term Alliance Success:
The Role of the Alliance Function,” Strategic Management Journal
23 (8) (2002): 747–767.
52
Dyer, Kale, and Singh, 2001.
53
Ibid.
54
Kale, Dyer, and Singh, 2002, pp. 747–767.
55
N. Sims, R. Harrison, and A. Gueth. “Managing Alliances at Lilly,”
Windhovers Invivo Business and Medicine Report (19) (6) (2001).
56
CHAPTER 9
International Strategy
L EARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Discuss the globalization of business.
2. Explain why firms choose to expand internationally.
3. Describe different kinds of distance, how they
affect successful international expansion, and how
this affects the choice of where firms should go when
they expand.
4. Explain the three primary types of international strategy
and be able to use the international strategy triangle
to determine which international strategy is right for a
specific firm.
5. Explain when a firm should use each of four major ways
to enter a foreign market.
Sipa Asia/Shutterstock.com
Huawei: An Emerging Global Consumer Electronics Giant
“A Chinese-telecommunications giant founded by a former engineer
of the People’s Liberation Army is about to take a shot at challenging Apple Inc. and Samsung Electronics Co. in the global smartphone
market.” —Wall Street Journal, April 5, 20161
The headline above from a Wall Street Journal article signaled the emergence of the world’s third largest maker of smartphones. By the end of 2018, most US users of smartphones were
well aware of the two largest, and most popular, smartphone
152
makers in the United States: Apple and Samsung. Indeed, the
two firms accounted for roughly 36.9 percent of the shipments of
US smartphones in Q4 2018.2 But most smartphone users hadn’t
even heard of Huawei, the company referenced in the Wall Street
Journal article (or if they had, it was probably because the company was being investigated for allegedly making 4G telecommunication equipment that allowed the Chinese government to spy
on foreign firms).
Headquartered in Shenzhen, China, Huawei had become a
technology giant by providing telecom carriers, enterprises, and
consumers with products and services including ICT (information
and communication technology) solutions, fixed and mobile networks, routers, smartphones, and other mobile devices. Huawei
served customers in more than 170 countries and had emerged
as the world’s largest player in the global telecom equipment
market (replacing Ericsson in 2013) and number three behind
Samsung and Apple in the global smartphone market.3 Huawei
began selling private branch exchange (PBX) switches and
developed relationships with the largest telecommunications
companies around the globe, eventually selling equipment that
allowed them to run their 3G and 4G (LTE) networks. By 2018,
Huawei derived 57.5 percent of its total revenues of US$109 billion from overseas.4
Smartphones with Google’s Android OS launched in 2008 with
HTC, Samsung, and Motorola being the first to launch phones based
The Globalization of Business
on Android OS. Huawei decided to leverage its expertise making telecommunications equipment and its relationships with telecommunication carriers around the globe to launch its own smartphone in
2010. Huawei initially offered low-end phones (below US$150); the
high-end market was seen as being the exclusive domain of Apple
and Samsung. Indeed, initially over 80 percent of Huawei phones
were made for telecom carriers (with their brand on it) and targeted
to the low-end mass market in emerging economies and the pricesensitive segment in developed economies. As a result, these smartphones did not help Huawei build any brand awareness.
Once Huawei had gained experience and volume making lowend smartphones, it decided it was time to move up-market and
compete in the premium segment of the market. In April 2016,
Huawei released three variants of its latest P9 series smartphone
in London, with a price tag from US$699 to $849, matching that of
Apple’s iPhone 6 in the United Kingdom. With Leica’s dual-lens camera and Huawei’s own Kirin 955 chip, the P9 was a powerful smartphone with a top-quality camera. The release of the P9 sent a strong
signal of the company’s ambitions in the global smartphone market.
In the fourth quarter of 2018, Huawei’s global shipments of smartphones topped 59.7 million units, boosting its market share to 16.1
percent from 10.7 percent in 2017. Huawei even sold more units than
Apple in quarters two and three in 2018. In fact, by 2018 Chinese
brands, led by Huawei and Xiaomi, accounted for 42 percent (656 million of 1,561 million) of global shipments in 2018. Indeed, 7 of the top
10 smartphone brands that year were made by Chinese companies.5
153
The global smartphone market saw significant growth from
2009 to 2015, with units increasing from 174 million units in 2009
to 1,433 million units in 2016, an average annual growth rate of
43.8 percent. The growth rate from 2015 to 2018 had slowed to
roughly 10 percent per year. But growth in emerging markets in
Asia (e.g., China, Vietnam), Asia-Pacific (Philippines, Indonesia), the
Middle East, and Africa had continued strong at greater than 35
percent. The shift in demand from developed markets to emerging markets triggered growth in demand for low-end smartphones, driving down the average sale price from US$440 in 2010
to US$305 in 2015.6 Huawei was well positioned to compete in the
low end of the market but hoped that it would be able to compete in the high end of the market by leveraging its technological
capabilities as a telecom equipment provider. For example, battery life was a problem for smartphone users, so Huawei developed the Kirin 950 SoC to address this problem by leveraging its
deep understanding of 3G and 4G wireless modem technologies
to provide two days of continual battery life. But despite synergies with other businesses and deep technical expertise, many
questioned whether Huawei could truly challenge Apple and
Samsung at the high end of the market. Nonetheless, in February 2016, CEO Chengdong Yu announced that Huawei’s strategic goal for its smartphone business was to overtake Apple in
three years and Samsung in five years. Can Huawei realistically
challenge Apple and Samsung for world dominance in high-end
smartphones?
This chapter will help you to answer three critical questions about strategy, specifically
concerning international expansion: Why, Where, and How. Carefully researched and thoughtful responses to those three questions can make the difference between a successful expansion
effort and failure. Huawei is hoping to successfully challenge Apple and Samsung in smartphones in the United States, but this will only be possible if it can leverage its global scale and
synergies across multiple businesses in multiple countries.
The Globalization of Business
During the last 50 years, the scope of business has changed for most organizations. Companies used to compete primarily within their own country. Technological advancements in
communications and transportation, along with falling trade barriers, have changed that for
most firms. The average tariff, the tax on goods imported into a country, has dropped from
more than 40 percent to an average of 4 percent in developed nations. At the same time,
countries across the globe repealed regulations that kept foreign firms from buying local
companies and building plants and stores in their markets. As a consequence, the volume of
international trade and companies selling across national borders, has increased more than
28-fold since 1970.
International trade in merchandise alone topped $12 trillion in 2016.7 During the same
period foreign direct investment (FDI), companies building factories and stores in foreign
countries, increased more than 500 percent (see Figure 9.1).8 Although there is no consensus on
why FDI flows to some countries and not others, common factors include low labor and tax
costs, low trade barriers, and favorable exchange rates.9
foreign direct investment Direct
investment in production or
business in one country by a
business from another country.
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2500000
2000000
1500000
1000000
500000
19
7
19 0
71
19
7
19 2
7
19 3
74
19
7
19 5
7
19 6
7
19 7
7
19 8
7
19 9
8
19 0
8
19 1
82
19
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
88
19
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
96
19
9
19 7
98
19
9
20 9
00
20
0
20 1
0
20 2
0
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0
20 9
1
20 0
11
20
1
20 2
1
20 3
14
20 2015
16
es
t
0
FIGURE 9.1
Global Foreign Direct Investments, 1970–2016 (in 2016 US. dollars)
Source: UNCTAD, Inward and outward foreign direct investment flows, annual, 1970–2016,
and OECD FDI in Figures, February 2017.
multinational firms Firms
that sell or produce in multiple
countries.
This trend toward increased international trade has allowed organizations to place parts of
their value chains in different countries, depending on where each part can generate the most
value. Manufacturing, as well as service industries, has become global. Trade in commercial
services, such as licensing and franchise fees, as well as other types of services such as financial, information, computing, insurance, and consulting services has increased 272 percent just
in the last decade, totaling more than $4.8 trillion in 2015.10
What this means for strategy is that both production and the market for many products
and services aren’t national anymore—they’re regional (multiple countries) or global.11 For
most industries, the competition isn’t just local or national anymore, either—it’s also global,
and key competitors may be located in another country. Indeed, the World Trade Organization
says that half of all the productive wealth in the world is generated by multinational firms that
compete with an international strategy.
Even for small companies, international strategy is often key to success. Of the more than
408,000 US firms that competed across borders in 2014, 98 percent were small to medium-sized
firms.12 Companies with effective international strategies tend to dominate both at home and
throughout the world. Most organizations that hope to be leaders in their industry realize that
they have to compete on a global scale.13 Indeed, for many companies, even basic survival is
predicated on a clear understanding of international strategy.
Of course, competing on a global stage isn’t just about protecting oneself from foreign competition. It also opens up tremendous new opportunities,14 but these new opportunities come
with an exponential increase in complexity. Just ask the top management team at Huawei as it
looks to successfully compete in the United States. Some of the differences between countries
that increase complexity and affect the success of international strategies include variations in:
• Customer tastes, needs, and income levels
• Government regulations
• Legal systems
• Public tolerance for foreign firms
• Reliability, and even existence, of basic infrastructure, such as roads and electricity
• Strength of supporting industries, including distribution channels to customers
This chapter addresses the complexity of international strategy by answering three questions strategists ask when thinking about going international:
1. Why should we go international? What specific cost or revenue advantages might we gain?
2. Where should we expand? Of all the countries we could enter, which are the right ones?
3. How should we expand? What international strategy should we employ? How can we tell if we
have the right one? And, what strategic options do we have for entering a foreign country?
One thing to keep in mind as you read this chapter is that many of the concepts actually
apply to geographic expansion within a country as well as international expansion. We focus
the chapter on international expansion because the complex issues behind a successful expansion strategy are magnified exponentially when you cross international borders.
Why Firms Expand Internationally
Why Firms Expand Internationally
There are a number of reasons why firms choose to compete in international markets. These
include increasing sales to grow the company beyond what the home market can offer, becoming more efficient (raising profits by lowering costs), managing risks better, learning from consumers in other markets, and responding to the globalization moves of other firms.
Growth
The need to grow sales is one of the biggest reasons that firms expand internationally.15 Some
firms have saturated their home markets, and entering foreign markets is the only way for them
to sustain growth. This is one of the primary reasons that Harley-Davidson started selling in
foreign markets. It now sells in Europe as well as Asia and the Middle East. Figure 9.2 shows
Harley-Davidson Unit Sales: 2008—2016 US vs. Foreign Sales
250000
Unit Sales
200000
150000
100000
50000
0
2008
2009
2010
2011
2012
2013
US Sales Foreign Sales
2014
2015
2016 est.
Harley-Davidson % Change in Unit Sales: 2008—2016 US vs. Foreign Sales
20
15
% Change in Unit Sales
10
5
0
–5
2009
2010
2011
2012
2013
2014
2015
2016 est.
–10
–15
–20
–25
–30
–35
US Change
FIGURE 9.2
Foreign Change
Harley-Davidson US and Foreign Sales, 2008–2016
Source: (1) Anonymous, “Harley-Davidson Is Taking Steps to Reverse Its Declining Sales Trends,” Forbes
(December 9, 2015).
(2) Anonymous, “Harley-Davidson Reports Fourth Quarter and Full-Year 2015 Results,” PRNewswire (January 28, 2016).
(3) Anonymous, “Tough Times Ahead in the Domestic Market,” Forbes (September 13, 2016).
globalization The spread
of businesses across
national borders.
155
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just how important that foreign expansion has been. When unit sales in the US market have
softened, sales overseas have continued to grow, mitigating Harley-Davidson’s flat to declining
sales in the US market.
Efficiency
Many firms enter additional markets in order to become more efficient. Efficiency takes a number of forms, including obtaining lower-cost resources, extending the lifespan of products, and
achieving economies of scale and scope.
Lower-Cost Resources
In many cases, key resources may be cheaper in foreign
countries. One of the most common resources firms seek abroad is low-cost labor, which
is often referred to by the buzzwords offshoring or outsourcing. Firms may also expand
abroad in search of lower-cost sources of raw materials.16 For example, the United States
is seeing an increase in foreign companies opening new plants in the United States to take
advantage of cheap natural gas made available through hydraulic fracturing technology,
known as fracking.
Beyond looking at the price of a particular resource, though, companies also have to
take into account factors that might increase the cost to use the resource, including labor
productivity, and the transportation and communication costs needed to acquire the
resource. Moreover, companies must also consider a variety of other costs of doing business
in a particular country, such as regulations and the challenges of managing in a different
culture. Companies tend to seek an optimal location for expansion, not just the one with
the lowest cost resources. For instance, although sub-Saharan Africa has the cheapest labor
in the world, China’s abundance of relatively skilled and productive cheap labor, coupled
with excellent communications and transportation infrastructure and a relatively stable
political climate, made it the country of choice for many firms for decades. Then China’s
labor costs began to rise, and countries in Southeast Asia began to develop sufficient infrastructure with labor cheaper than China’s, making that region more attractive as a place to
do business.
product life cycle The stages a
product or service goes through
during its lifespan.
Longer Product Life Sometimes firms enter foreign countries to extend a product’s
life cycle, leveraging their investment in assets and equipment.17 For example, in Chapter 2
we introduced the plight of Nokia, a one-time world leader in the cell phone industry.
Although Nokia’s cell phone business, now a subsidiary of Microsoft, is no longer the world’s
leading manufacturer of cell phones and smartphones, the company continues to generate
substantial revenue by selling its older-model phones in Africa, the Middle East, and
Southeast Asia.
In addition to leveraging prior investments in their products, firms can also leverage their
capabilities. As discussed in Chapter 3, capabilities that generate competitive advantage for
firms typically are difficult and costly to build. Some firms try to leverage their investments
in building capabilities by using those capabilities in multiple countries.18 Fast-food restaurants such as McDonald’s are masters of this technique.19 Manufacturing firms can also gain
efficiencies from leveraging their capabilities. Toyota, for instance, has been quite successful
in implementing the Toyota Production System in its US auto plants, helping to keep its costs
lower than those of rivals GM and Ford.
Economies of Scale and Scope
Another critical source of efficiency that firms seek
to gain by going international is economies of scale, whether they come in manufacturing,
R&D, or sourcing.20 Recall from Chapter 4 that economies of scale occur when firms are able to
Why Firms Expand Internationally
spread the costs of investments in plant, equipment, or knowledge across many sales. As firms
compete in foreign markets, they increase the number of units sold, sometimes radically, possibly reaping greater economies of scale.
Related to efficiencies gained through economies of scale are economies of scope. Competing in multiple markets allows firms to spread their costs across more units in multiple product categories. For example, Unilever, a Dutch company, takes advantage of economies of scope
by globally selling and distributing, products as diverse as food products, such as ketchup, noodles, salt, flour, and tea, and personal products, such as soap and shampoo—all things one can
buy at a supermarket. Economies of scale and economies of scope, indeed. Unilever lowers its
costs of distributing these products because they can be stored and shipped from the same
warehouses using the same logistics systems.
Managing Risk
Operating in more than one country can also provide firms with a measure of protection against
disaster, both economic and natural.21 Even when there are worldwide economic downturns,
such as during the period from 2007 to 2012, problems are not usually spread evenly across
all countries. During that period, the United States and the European Union fell into recession,
while China continued to grow at a fairly rapid pace. When firms have sales in multiple countries, a slowdown in one country may be offset by continued sales in another. For instance,
many observers thought that General Motors would lose a good portion of its market share in
2007, when the US market for automobiles collapsed. However, within a short time, GM had
actually increased its worldwide market share, regaining the title of the largest auto company
based mostly on sales growth in China.
The same principle works for other types of disasters, such as natural disasters or social
upheaval. If firms have operations in multiple locations they may be able to relocate production or increase sales in another country to make up for the shortfall in the area where the
disaster occurred.
Knowledge
Another reason for expanding into other countries is to acquire valuable knowledge,
the basis for innovation. When a firm sells in different countries, to people with different tastes and needs, it often gains new insights about its products and services. Serving
multiple types of customers can help a firm to identify unmet needs in multiple markets.
Those insights can be valuable for increasing sales in many locations. Gathering information from customers in multiple countries can also help organizations more easily identify
changes in customer needs, making it more likely that they will be at the forefront of the
next big innovation in their industry. Research suggests that generating more knowledge
may be the greatest advantage a multinational organization has over purely domestic
companies.22
As an example, GE’s Healthcare division developed an inexpensive, portable ultrasound
machine to serve the rural Chinese market, where health-care providers couldn’t afford GE’s
large, expensive ones. GE realized that there were also markets for an inexpensive, portable
ultrasound machine in Europe and the United States, specifically with first responders who
don’t have space in ambulances and fire trucks for large ultrasound machines. GE now sells the
product in all of its markets.
Companies can generate knowledge not only from diverse customers but also from their
own units in different locations. For instance, Europe has higher energy costs than the United
States does. US firms that operate in Europe have been learning how to save energy costs more
rapidly than those that aren’t in Europe.
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Responding to Customers or Competitors
Last, but not least, firms may expand internationally in response to either customers or competitors. This is particularly true of business-to-business (B2B) firms that perform intermediate
steps of the value chain for large customers.23 For example, the “Big 4” accounting firms—
Deloitte Touche Tohmatsu, Ernst & Young, KPMG, and PricewaterhouseCoopers—have all
expanded globally to better serve their largest clients, who are multinationals with operations
around the globe. Indeed, sometimes customers demand that their suppliers go international
when they do.
Sometimes firms feel compelled to go global because their rivals do. If the rivals gain
any of the advantages previously discussed, they may use those advantages to subsidize
aggressive sales and marketing campaigns in the home markets of their competitors.24 If a
firm doesn’t expand to replicate those advantages, it may be at a distinct disadvantage. This
is one of the primary reasons that Lincoln Electric, a manufacturer of arc-welding products,
expanded abroad—to respond to ESAB, a Swedish welding company, that had just entered
the United States. That is also true of Harley-Davidson. It had to aggressively pursue international expansion because part of its decline in domestic sales came at the hands of foreign
competitors like Honda. Better to force your competition to compete in its home market as
well than to let it gain international economies of scale and beat you without having to fight
on multiple fronts.
Where Firms Should Expand
After a firm has decided to go international, the next question it must answer is where to expand.
The easiest answer is to enter the country with the largest number of potential customers—
often, a country with a huge population, such as China or India. However, wise managers also
think about how likely they are to succeed in a particular foreign market. After all, the word
foreign means different, and different can be difficult to get right. Research on the risks of international expansion refers to this as the liability of foreignness.
Successful international expansion requires a clear understanding of the possible risks.
Some risks are market driven—will foreign customers buy your products at the same rate as
your home country customers? Will distribution work the same way, or will it cost more to get
products to the end customer?
Other risks are political. Sometimes foreign governments enact policies that place additional burdens on foreign firms, such as tariffs that increase the cost of foreign products, laws
requiring a certain percentage of each product be made in the foreign country or a certain
percentage of managers be locals, or laws prohibiting foreign ownership of local firms. Other
burdens come from the uneven application of local laws. For instance, in some countries it
is difficult for foreign firms to protect their intellectual property as local courts may side primarily with local firms. And sometimes nationalistic sentiment leads governments to threaten
foreign firms with additional tariffs, lawsuits in both local and world courts (such as the World
Trade Organization), inspections and fines not levied against local firms, and even seizure of
plants and equipment. Companies entering foreign markets need to be well aware of the possibility of government action.
Finally, other risks are economic in nature. Not all markets are equally stable. Some countries are more susceptible to economic recessions, directly affecting the bottom line of the firms
selling in those markets. Foreign countries may also be susceptible to monetary crises, where
the value of the local currency fluctuates wildly as shown in Figure 9.3. The currencies of some
countries, even when not in crisis, may fluctuate significantly compared to the US dollar. This
can create an adverse exchange rate. This matters because a firm selling in a foreign market
earns profit in that market’s currency, and those producing in a foreign country buy goods and
Where Firms Should Expand
159
Exchange Rate of US Dollar vs. European Euro 2012-March 2017
1.00
0.90
0.80
0.70
0.60
2013
FIGURE 9.3
2014
2015
2016
2017
Exchange Rate of US Dollar vs. European Euro, 2012–2017
Source: XE Corporation, https://www.xe.com/currencycharts/?from=USD&to=EUR&view=5Y, accessed March 20, 2017.
pay labor in the local currency. If that currency fluctuates, the costs and profits, when transferred back into the home currency, fluctuate as well. This can make a significant difference in
how competitive a firm is. If the exchange rate is favorable, they can lower their prices and steal
market share from other firms. If the exchange rate is not favorable, the opposite can happen.
In fact, this is one of the reasons that Harley-Davidson’s domestic sales started to slump in late
2014 through 2017. As Figure 9.3 shows, the dollar strengthened considerably against the euro
during that time. That means that European companies wanting to sell in the United States
could suddenly do it much more cheaply than they could before, increasing the competition for
Harley-Davidson products in its home market.
Organizations considering international expansion need to carefully consider the market,
political, and economic risks of each country they are thinking about entering. Since companies want to do business in the countries where they are most likely to succeed, that means
choosing locations that have the lowest risks. Another way to think about managing the risk
of expansion is to consider the distance between countries. Even though transportation and
communication have advanced to the point where firms can realistically do business in nearly
every country on the planet, the distance between countries still matters. In addition to geographic distance, there are three other kinds of distance that managers should consider when
undertaking international expansion: cultural, administrative, and economic distances.25 A
useful mnemonic for remembering the four types of distance is CAGE—cultural, administrative,
geographic, and economic.26
Even if there are a lot of potential customers, a country might not be the right one to enter
if the likelihood of success is low because of greater distance. The lower the distance determined by a CAGE analysis, with an emphasis on the distance that most affects your specific
industry, the greater the likelihood of a successful expansion.
Cultural Distance
Cultural distance refers to differences in language and culture, the way people live and think
about the world. People in another country might hold different beliefs about a host of significant issues, including how people should interact and how business should be conducted.
cultural distance The degree of
difference between the cultures of
two nations.
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They might have very different worldviews about human nature and the role of individuals and
companies in society. All of these can add up to a very foreign environment that makes it difficult for firms to understand their customers and local employees.27
Although it’s only one aspect of culture, the issue of language is influential. Firms are
42 percent less likely to do business in a country with a different language.28 Language
differences are relatively easy to fix, but potential problems increase rapidly when companies
move into countries with deeper, more difficult to overcome types of cultural distance. These
may include differences in:
• Religion
• Ethnicity
• Trust for outsiders29
• How genders are expected to behave
• The degree to which the culture is focused on individuality or collective action
• How people accept ambiguity or follow rules and laws
• The degree to which people allow abuses of political or market power30
Many of these types of cultural differences can be subtle but still have a significant impact on
consumer behavior and shape the market demand for foreign products.
Not all industries are affected the same way by cultural distance. Firms that sell commodity products, such as corn, wheat, oil, or cement, don’t tend to have difficulty with cultural
distance. However, firms with products that have high linguistic content, such as TV shows,
movies, music, and even textbooks, have to be careful. Likewise, products that affect how
people see themselves, such as food and clothing, are affected by cultural distance. This is
particularly true if those products clash with religious or national identities. It is difficult to
sell pork products in the Middle East, as pork is forbidden in both Judaism and Islam. Other
products might not directly clash with religion, but they might not match cultural norms. For
instance, in Germany parents have a tendency to prefer well-crafted, wooden toys for their
children. Firms that focus on less-expensive plastic toys do much better in markets such as
the United States.
Sometimes, however, cultural distance can be a selling point for multinationals. For
instance, in Russia, foreign products are often seen as superior to local ones. Likewise, being
associated with a particular country can sometimes increase sales of a product worldwide, as
is the case for German luxury automobiles, Italian fashion, and US fast food.
Administrative Distance
administrative distance The
degree of differences between the
legal and regulatory frameworks
of two nations.
Administrative distance refers to differences in the legal, political, and regulatory institutions
between countries. For example, are laws and government policies similar or different between
two countries? This is important for firms because understanding the political and legal environment is often a key to success in a foreign country.31
You can have the best product or service at the cheapest price, but if you don’t understand
how contracts will be enforced or how local and national policies apply to foreign firms, you
may fail. Administrative distance often causes challenges for US firms in industrialized nations
such as France (which relies on a different legal system than the United States and the United
Kingdom), but it can become bewildering in many emerging and Third World markets, where
regulations and laws may be applied capriciously.
Low administrative distance can increase the rate of entry by foreign firms into a country
by as much as 300 percent.32 Administrative distance is low among countries that (1) use the
same legal system, such as the common law system used in the Anglo sphere (the United
Kingdom and its former colonies, including the United States, Canada, Australia, and India);
(2) used to be part of a colonizer/colony network, such as some European countries and their
former African colonies; (3) use the same currency; or (4) are part of the same trading bloc, such
as NAFTA in North America or the European Union.
Where Firms Should Expand
161
Industries most directly affected by administrative distance are those in which governments are most likely to have a stake. This includes industries that provide equipment
or services critical to national security, such as providers of steel or telecommunications;
those that employ large numbers of people; those that serve government directly, such as
mass-transportation equipment manufacturers; those that extract natural resources; and
those that produce staple goods that most people buy, such as rice in Thailand or corn in
Mexico. A specific firm might also confront increased administrative distance if it competes
head-to-head with a local champion, a local firm that government sees as important to its
future, such as Airbus, the EU airplane manufacturer, or Gazprom, the Russian state-owned
natural gas firm.
Geographic Distance
At its most basic, geographic distance refers to how many miles separate two countries.
Companies are more likely to succeed in nearby countries, because physical proximity lowers
both transportation and communication costs. That’s one reason most US companies expand
first to Canada and Mexico. Even with fast air travel and consistent, reliable container shipping, research suggests that for each 1 percent increase in the distance between countries
there is a 1 percent decrease in the number of foreign firms selling in those countries.33
Clearly, miles still matter.
In addition to the actual physical distance between countries, however, geographic distance is also influenced by how easy it is to travel between countries. For instance, firms enter
countries with seaports much more frequently than they expand to landlocked nations. Companies are also more likely to enter countries with good transportation infrastructure. For most
firms, geographic distance increases the cost of managing daily operations and coordinating
activities. Despite the availability of instant communications and video conferencing, many
overseas operations require hands-on help from headquarters. When those operations are
many hours away from headquarters by plane, the communication and transportation costs
start to add up.
Not all industries are affected the same way by geographic distance. Firms, such as Google,
that sell electronic products that can be transmitted to the other side of the world in fractions
of a second at almost no cost don’t have to worry as much about geographic distance as firms
that sell heavy, bulky products such as finished computers. That is one reason that companies
such as Dell buy their parts from all over the world but then put them together near their target
markets. Other industries that are heavily affected by geographic distance are those that sell
fragile products that might be damaged in transport, or perishable products, such as fresh-cut
flowers, that must be transported rapidly. Even for Google, however, the need to oversee operations means that the company must set up local offices in some countries, such as Russia,
because the product still needs to be localized (if only for language and currency reasons) and
constant travel from California is too unwieldy.
geographic distance The
distance in miles, or kilometers,
between two countries.
Economic Distance
Economic distance refers primarily to differences in the average income of customers in two
countries, usually measured as per capita GDP (gross domestic product). Firms from wealthy
nations tend to expand to other wealthy nations because the customers there earn enough
income to buy similar products. This is clearly true for expensive products such as cars or home
appliances but is also true of a wide variety of products that wealthier customers tend to think
of as inexpensive, such as laundry detergent or snack food (see the Strategy in Practice for
an example).
The industries most affected by economic distance are those for which the demand for
products is very elastic—meaning demand changes dramatically as prices go up or down. In
these types of industries, demand is significantly affected by customers’ purchasing power and
the ability of producers to lower prices.
economic distance The degree
of difference between the average
income of people in two different
countries.
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International Strategy
Strategy in Practice
How Unilever Manages Economic Distance
in Rural India
Laundry soap isn’t something that most of us give much thought to.
We can buy it in small boxes or giant packages, but no matter how
we buy it, the cost per use is small enough that few in Organization
for Economic Co-operation and Development (OECD) countries give
it much thought. The same is not true in other places around the
world. While India has been making great strides, it still has millions of people who live on less than $2 a day. At that wage no one
can afford to buy a box of laundry detergent, not even the generic
brand. So if you are a manufacturer of laundry soap, how do you
reach these customers? After all, they represent nearly 750 million
people worldwide.34 That is not a customer segment you want
to ignore.
Unilever, in a joint venture with an Indian firm called Hindustan
Unilever Limited, has figured out how to bridge that economic
distance and sell to the poorest of the poor in India. They call the
approach Project Shakti, which means Project Strength. They first
had to learn how to break their product down into the smallest
possible packages and figure out how to reduce manufacturing
costs. The big problem, however, was how to deal with distribution.
While many poor live in the big cities and can be serviced by the
more than 1.5 million small retail outlets that Hindustan Unilever
operates, the vast majority live in rural villages, with little to no
infrastructure connecting them.35
Hindustan Unilever’s response to the distribution problem
was to create Shakti Ammas in the rural villages. Many of these
villages had developed women’s self-help groups where women
counseled each other and pooled their money to help each other
financially. Combined with micro-loans, Hindustan Unilever
created a direct sales force of women in thousands of rural
villages. Each woman sold to her own village, as well as smaller
ones nearby. Most of these women have been successful enough
that they have been able to double their family’s income. To date
Hindustan Unilever has nearly 70,000 Shakti Ammas reaching
more than 162,000 rural villages and 4 million rural households
with a variety of household products beyond laundry soap that
have been manufactured to meet the budget of the poorest of
the poor. It has been successful enough that Hindustan Unilever
has expanded the project to include husbands of Shakti Ammas,
called Shaktimaans, who can reach villages farther away than
their wives. There are now 48,000 Shaktimaans.36 The impact of
this program on the poorest in India is striking. The head of the
Project Shakti, Sharat Dhall, called it “the biggest rural operation
in the history of India.”37
How Firms Compete Internationally
local responsiveness A firm’s
adjustments to products, services,
and processes in order to account
for local culture and needs.
standardization Making products
and/or processes consistent
across different units within a firm
and/or across different countries
the firm operates in.
global integration The
standardization of processes
within a single business in
different locations around
the world.
As companies expand internationally, they often find themselves torn by two competing
pressures.38 The first pressure is toward local responsiveness, the need to tailor their products, marketing, and distribution strategies to the local customers in a foreign country. For
instance, Coca-Cola isn’t the same in every country. In fact, Coca-Cola demonstrates its
responsiveness by manufacturing more than 48 different flavors of Coke alone (not to mention the more than 100 non-cola beverages sold worldwide by Coca-Cola) to suit local tastes.
Coca-Cola also changes its distribution method to fit local markets.
However, adapting products and operations to fit local circumstances isn’t cheap. In general, the more a company tailors a product or service to a local market, the higher the cost.
Higher costs are risky, because companies with lower costs can beat their competition through
lower prices. When firms begin to compete on a global stage, the number of rivals can increase
dramatically, putting intense pressure on firms to cut costs. Furthermore, many firms expand
internationally in order to increase efficiency and to lower costs. Firms achieve economies of
scale by standardizing their products, producing them without variations, or integrating their
processes on a global scale, called global integration. Thus, firms have two competing
pressures they must address: local responsiveness and cost reduction.
There are three primary strategies firms can use to manage this strategic tension:
1. Multidomestic strategy—emphasizes local responsiveness over standardization
2. Global strategy—emphasizes global standardization and economies of scale over local
responsiveness
3. Arbitrage strategy—takes advantage of country-comparative advantages—sources of low
cost (e.g., cheap labor) or unique resources (e.g., skilled workers)
How Firms Compete Internationally
Global
strategy
Pressures for
standardization
High
Multidomestic
strategy
Low
Low
FIGURE 9.4
Pressures for local
responsiveness
High
International Strategies and Local Responsiveness Versus Standardization
The first two strategies deal directly with the tug-of-war between local responsiveness
and cost-reducing standardization differently as illustrated in Figure 9.4. The third strategy,
arbitrage, can focus on either local responsiveness or standardization, but does so from a position of taking advantage of country differences rather than trying to overcome them.
Each strategy is appropriate for a different set of industry dynamics and firm capabilities.
We’ll discuss each in turn as well as discussing combining strategies. The three primary strategies are not mutually exclusive. Some firms are successful at pursuing two at the same time,
although it becomes increasingly complicated to manage operations and maintain strategic
focus when doing so. At the end of the chapter we’ll introduce a tool for determining which
strategy is best for any given firm.
Multidomestic Strategy—Adapt to Fit the Local Market
The multidomestic strategy centers on tailoring products and operations to individual markets.39 Firms in industries where customer needs and preferences vary widely from country to
country, such as food or media, often use this strategy. By tailoring their products and services
to better meet the needs of local customers, firms can maximize their responsiveness, increasing their sales and market share in each country. They usually succeed through a differentiation
strategy rather than a cost leadership strategy. Unilever uses this strategy. It sells more than
1000 brands worldwide. In most of the countries it enters it uses different brand names (i.e., in
the case of bar soap—Dove in the United States, Block & White in the Philippines, and Gessy
in Brazil).
As firms enter more countries and the differences between the home country and each
foreign country increase, firms must expand the degree of tailoring, or adaptation. Consequently, many firms that pursue a multidomestic strategy put autonomous decision-making
authority into the hands of managers in charge of individual regions or countries.40
To enable such autonomous decisions, significant parts of the value chain have to be replicated in each country. For instance, each country may have a product development and design
lab, manufacturing plants, and sales and distribution personnel. Replicating these different
functions in each country comes at a significant cost. Not surprisingly, firms find it hard to tap
into economies of scale if they are designing and producing something different in each country.
As companies decentralize their operations to be locally responsive, it also makes it difficult to share valuable knowledge across the firm globally. As a consequence, firms that pursue
a multidomestic strategy often find it difficult to develop a worldwide competitive advantage.
At best, they produce a series of local competitive advantages.
multidomestic strategy A
strategy involving tailoring
products or services to
local markets.
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International Strategy
Strategy in Practice
National Competitive Advantage
Have you ever wondered how firms from the same country dominate their industries worldwide? For example US companies Apple,
Google, and Microsoft control the worldwide industry for computer
operating systems; German organizations dominate in machine
tools; and Italian firms lead in the sale of leather goods. Michael
Porter developed a tool, the Porter’s Diamond of National Competitive Advantage, that explains how this happens.
Four factors help push organizations toward greater innovation, with those companies that innovate the most having an
advantage in international competition:
1. Factor conditions. An abundance of critical resources including skilled labor, a technologically advanced knowledge base,
easy access to capital, and solid infrastructure provide firms
with the tools they need to innovate. Germany is known for
an educated, manufacturing-oriented workforce, giving it an
advantage in the machine tool industry.
2. Demand conditions. The more a country’s customers demand
innovation, the more likely domestic firms are going to be at
the forefront of innovation. Japanese consumers tend to be
ahead of the curve in demanding the latest consumer electronics products, giving Japanese consumer electronics firms
direction in developing new products.
3. Related and supporting industries. If a country has multiple parts of the value chain located near each other, it
is easier to coordinate innovation, speeding up the pace.
Italy is known not just for leatherworking but leatherworking machinery, fashion, and shoes. The four industries
being co-located allows for closer coordination and faster
innovation.
4. Firm strategy, structure, and rivalry. Different types of
firm structure are suited to particular types of industries.
Laws governing how firms are started and how they interact
with labor have a large impact on the international strategies that firms pursue. Rivalry also plays a large role.
While rivalry, according to the five forces model discussed
in Chapter 2 and illustrated in Figure 9.5, tends to decrease
profit, it also spurs innovation. Firms that survive high
levels of rivalry are usually more prepared to take on international competition.
Firm Strategy, Structure,
and Rivalry
Factor Conditions
Demand Conditions
Related and Supporting
Industries
FIGURE 9.5
Porter’s Diamond of National Competitive Advantage
Source: Adapted from M. E. Porter, The Competitive Advantage of Nations
(New York: Free Press, 1990).
factor conditions Land, natural
resources, and labor that allow for
production of goods and services.
demand conditions The
conditions in a market that
determine the degree of demand
for a product or service.
related and supporting
industries Industries that
produce products or services that
are inputs or complements to the
industry you are studying.
In most industries, firms find a pure multidomestic strategy unworkable. Cost pressures
are simply too intense. The key to successfully pursuing this strategy is to manage the variation
that occurs across countries. Firms can manage variation in three major ways:
1. Focus adaptations. Some firms manage the variation by tightly focusing on a particular
product, customer segment, or geographic area. Such highly focused firms still tailor
their products, but the amount of variety they face is more manageable by maintaining a
tight focus.
2. Externalize adaptations. Some firms externalize the work of adapting the product for local
needs, generally by arranging for local customers to do it. Methods of externalization
include franchising and alliances, which are discussed later in this chapter.
3. Design adaptability. A third method for managing the costs of localization involves
designing a product so that it can be adapted while still maintaining some economies of
scale. Some companies design for cheap adaptation by investing in flexible manufacturing
How Firms Compete Internationally
that reduces the costs of short manufacturing runs. Others modularize their product,
creating a set of standard interfaces that allow many different types of alternatives to plug
into one another. For example, appliance manufacturers such as GE and LG offer a variety
of refrigerators, with different sizes, different number of doors, and other features, but all
their different refrigerators are designed to share a common set of core components. This
allows some economies of scale while still adapting refrigerators to local tastes.
Global Strategy—Aggregate and Standardize to Gain
Economies of Scale
A global strategy centers on capturing the efficiencies that can come with expanding overseas, particularly economies of scale, learning, and leveraging firm capabilities. Most firms
that pursue a global strategy standardize their products, marketing, and operational practices, and aggregate, or centralize, them in only a few locations, to achieve economies of
scale.41 Individual country-level units are tasked mostly with implementing decisions made at
a central headquarters,42 and the firm uses the same tactics in most, if not every, country
where it competes.
The most extreme versions of a global strategy might have all functions located in
the same place, with country units overseeing only local sales. For example, Red Bull, the
energy drink, is manufactured in a single location next to its headquarters in Fuschl am See,
Austria (did you know Red Bull was an Austrian firm?). In 2016, it produced approximately
2.5 billion cans of Red Bull, all in the same factory. And while their marketing might seem
like it is tailored to different locations, it actually follows the same format everywhere Red
Bull is sold—sponsoring extreme sporting events. In practice, many global firms have factories on multiple continents, producing the same product, in order to reduce transportation costs and manage risk. Moreover, when factories in different locations are producing
the same products, they are more likely to share best practices, helping firms reduce the
learning curve.
A global strategy is typically a low-cost strategy, with low costs achieved through economies of scale. However, it can also be used effectively as a differentiation strategy that
the company applies in the same way, to the same customer segment, worldwide. Apple
is a great example of a firm that standardizes its products to achieve economies of scale
but differentiates them from other smartphones, computers, or tablets in order to increase
the price customers are willing to pay for them. Firms that pursue a global strategy tend to
enter countries that have a large, ready-made market for their products. They also tend to
be in industries where cost pressures are high and standardized products can meet relatively
universal needs. For instance, elevators are used the same way in Hong Kong as they are in
Chicago, making elevator manufacturing firms, such as Otis Elevator, prime candidates for a
global strategy.
The downside of a global strategy, however, is that standardized products may not meet
the needs of customers in particular countries. As a consequence, global firms may not be able
to compete in as many markets as multidomestic firms, and they may not be able to penetrate those markets as deeply.43 Another disadvantage is that, although global firms share
knowledge between units with greater ease than multidomestic firms do, a global firm generates less knowledge overall, because it isn’t as actively trying to meet a wider variety of customer needs. So, in the short term, global firms may miss sales by not being responsive, and in
the long term they may miss changes in local market conditions.
However, just as there are ways to manage the cost of variation in multidomestic firms,
there are also methods for dealing with excessive centralization and standardization in global
firms. First, a firm need not centralize all parts of the value chain. The greatest cost savings from
economies of scale often occur in R&D and manufacturing. A global firm can centralize some
functions while localizing others in order to penetrate local markets more fully. For instance,
in the 1980s and 1990s, the household appliance manufacturer Whirlpool pursued component manufacturing and R&D primarily on a global scale, but carried out product design, final
assembly, marketing, and sales at regional and local levels.
global strategy A strategy
involving selling standardized
products, using standardized
processes, around the world.
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C H A PT E R 9
International Strategy
Ethics and Strategy
Is Economic Arbitrage Ethical? Won’t It Lead
to Worker Exploitation?
• 320 workers share 24 toilets and 24 showers. No hot water.
Rusted pipes. No shower heads. Workers are forced to use
buckets or pans to bathe.
In recent years, numerous news reports have emerged detailing the exploitation of low-cost labor in foreign countries. China
Labor Watch, a nonprofit working to raise awareness of worker
exploitation issues in China, found that suppliers of Disney toys
have been accused of exploiting lax enforcement of labor laws in
order to keep costs low. China Labor Watch calls it the Dark World
of Disney.44
Mistreatment of workers includes:
• Cafeteria facilities are inadequate. Workers are fed inadequately.
Food often has foreign matter in it.
• Workers work with toxic chemicals all day long yet are given little
to no training and little to no protective gear.
• Workers earn only $1.38 (USD) per hour, so low that it is insufficient to pay for basic living necessities without overtime pay.
Many workers live in the factory, a perk for which they pay (and
need overtime to cover the cost).
• Workers typically work 11 to 12 hours a day, with 90 overtime
hours per month—2.5 times the upper limit set by Chinese
labor law.
• In the dormitories, 16 workers share a 16-square-meter
(172-square-foot) room—just larger than a typical child’s
bedroom in the United States.
• In practice, during peak months, no leave or sick leave
is approved.
Such abuses are common across a wide range of industries,
and not just in China but also in many low-wage countries. Indeed,
in one case in Bangladesh, more than 1,100 workers were killed
when an eight-story building housing multiple garment factories
collapsed in 2013. The factories had not installed appropriate safety
measures. Many companies, including Nike, Apple, and Walmart,
have been accused of exploiting workers in foreign countries.45
Economic arbitrage, in and of itself, is not necessarily unethical. In many cases, foreign firms pay better than average wages and
bring improved safety and labor practices to their factories and their
supplier’s factories.46 However, when many firms in the same industry
are seeking a cost advantage by utilizing an arbitrage strategy, the
pressure to decrease costs can be immense, and firms have to be vigilant that workers aren’t exploited. To that end, companies such as Nike
and Apple have developed a supplier code of conduct, which they use
to audit their overseas suppliers.47 Although this doesn’t always work,
because suppliers sometimes find ways around the audits,48 it does
decrease the incidence of unethical exploitation of workers.49
Arbitrage Strategy
arbitrage strategy A strategy
involving buying where costs
are low and selling where
prices are high.
economic arbitrage Capitalizing
on differences in costs by buying
where costs are low and selling
where prices are high. This is the
traditional, age-old definition of
arbitrage.
capital arbitrage Capitalizing on
differences in the cost of capital by
acquiring capital where it is less
expensive.
cultural arbitrage Capitalizing
on differences in culture between
countries by actively using the
culture of one country as a selling
point for products being marketed
in another country.
administrative arbitrage
Capitalizing on differences in taxes,
regulations, and laws between
countries by operating where they
are lower or more lax.
An arbitrage strategy is the third of the three primary international strategies. While the other
two strategies view foreign markets as sales opportunities with the need to manage differences between countries, the essence of arbitrage is taking advantage of those differences.
Arbitrage, at its simplest, is defined as using differences between markets to buy low in one
location and sell high in another.
It can involve economic, cultural, administrative, or capital arbitrage. One of the most
common modern forms of arbitrage is also one of the basic reasons firms expand internationally, to find the lowest-cost source of labor or raw materials. This is called economic arbitrage,
and it often involves offshoring manufacturing or R&D to countries with low labor costs. However, some firms also practice capital arbitrage. For example, CEMEX, a Mexican cement manufacturer, operates plants in Spain so that it can raise capital in the European Union, where
interest rates are often lower than they are in Mexico.
Not all arbitrage involves sourcing low-cost resources, however. Some forms of arbitrage take advantage of differences between countries to sell products. Cultural arbitrage
trades on the culture of one nation to sell in another. US-based fast-food restaurant chains
are popular worldwide partly because they embody US culture. Likewise, for centuries the
French were able to sell wine at a premium price because it came from France. Some firms
also utilize what is known as administrative arbitrage, taking advantage of differences
between countries that are created by laws and government regulations. Many companies
incorporate in the Cayman Islands because of low corporate tax rates. Likewise, nearly
one-third of all foreign capital flowing into China actually originates in China, but the investors process their financial transactions through Hong Kong in order to avoid government
regulation.
How Firms Compete Internationally
167
Combining International Strategies
As many industries have become increasingly global, the pressures for both local responsiveness and the efficiency that comes from standardization have become more intense. Some
companies try to use a hybrid of the multidomestic and global strategy in order to be glocal.
These firms typically begin with a strong emphasis in a single strategy and then work to minimize the downsides associated with that strategy as much as possible as they begin to implement the second strategy. As shown in Figure 9.6, competing with both a multidomestic and a
global strategy, in order to achieve both local responsiveness and standardization, is often
called a transnational strategy.50 Strategy combinations, of course, can also include multidomestic and arbitrage strategies or global and arbitrage strategies as well.
Procter & Gamble is an example of a firm that started with a strong position in a multidomestic strategy and then added a global one. When P&G first expanded internationally, it replicated its operations in each country where it competed. However, beginning in the 1980s, P&G
began to balance adaptation with a greater focus on centralized decision making to allow for
greater economies of scale across countries. It established global business units (GBUs), one for
each major product category, which operated concurrently with the traditional country units
using the IT systems to tie the two types of organizations together. They also required executive
career paths to include both organizations. Although it took more than a decade, P&G succeeded
in gaining some of the benefits of a global strategy without losing its multidomestic focus.
At the end of this chapter we present a tool, the international strategy triangle, that can
help you assess the international strategies that firms currently pursue or help you determine
which international strategy a firm should pursue if it is considering doing business overseas.
Global
strategy
Transnational
Strategy
Pressures for
standardization
High
transnational strategy A
strategy involving a combination
of both local responsiveness and
standardization.
Multidomestic
strategy
Low
Low
FIGURE 9.6
Pressures for local
responsiveness
High
International Strategies and Local Responsiveness Versus Standardization
Strategy in Your Career
Why should you develop a deep understanding of international
strategy? What good might it do you in your career? Some points
to consider:
generate a lot of goodwill from those above you if those
goals have to include transferring some company operations overseas.
1. Companies are looking to hire and promote those with a
global outlook.
4. Companies are increasingly likely to have a diverse, international company culture. And if they don’t, they likely deal with
suppliers and/or buyers who do. Companies these days are
less hierarchical and accomplish a lot more with teams. If you
have a global outlook and can work with people from different
cultures, you will be more successful.
2. It used to be that few employees spent time overseas. Now
being transferred abroad for a period of time is much more
likely to happen.
3. Understanding and supporting your company’s international
goals will help you further develop your skills and may also
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C H A PT E R 9
International Strategy
How a Firm Gets into a Country:
Modes of Entry
modes of international market
entry Methods for entering a
foreign market for the purposes
of either selling or producing
products or services.
In this final section, we discuss four different modes of international market entry: (1) exporting, (2) licensing and franchising, (3) joint ventures and alliances, and (4) wholly owned subsidiaries. Entering foreign markets can be very risky. There are pros and cons to each entry
mode. The best method for a firm is often based on which international strategy the firm has
chosen: global, multidomestic, or arbitrage. We will look at each mode in turn, starting with
those that involve the least risk and least control and moving to those with the most risk and
most control.
Exporting
exporting Sending goods
or services to another
country for sale.
Exporting involves producing goods in a single location and selling them in foreign markets.51
Although most exporting happens from a home country, firms can also use it with an arbitrage
strategy by producing in a low-cost location and exporting to other countries from there.
Exporting is the first entry mode most companies choose when they decide to go international.52 Exporting allows a firm to ramp up production in a single location, thereby increasing
economies of scale. As we saw earlier, exporting is how Red Bull has captured the majority
market share in the energy drink business. It also is how Samsung is keeping pace with Apple in
the smartphone and tablet computer industries.
Exporting works well when little adaptation of a product is required and good distribution networks are in place in the foreign market. It is also the least risky of the entry modes, as
it involves the least investment in the foreign country. If cultural or administrative distance is
large, exporting might be the right decision, because you avoid the challenges of managing a
culturally different workforce in a foreign country. It is also a good choice if speed to market is
important, as products can be shipped and sold in foreign markets quickly.
Of course, exporting also has its limitations. Transportation costs and government trade
tariffs can both increase the cost of selling in a foreign market. Your company and its products
will likely be viewed as “foreign,” which can be a problem in some countries. Exports also may
suffer if the value of the home nation’s currency rises compared to the currency of target foreign
markets.53 As the exchange rate fluctuates, so does the price of a firm’s product in the foreign
market. For instance, in 2007, one US dollar cost 121 Japanese yen. By 2012, the dollar was
trading for only 77 yen.54 The yen had strengthened compared to the dollar. The consequences
were that a product manufactured in Japan and sold in the United States for $100 brought the
Japanese company 12,100 yen in 2007, but only 7,700 yen in 2012, a 36 percent drop in profit
for no other reason than changes in the currency exchange rate. Although firms can try to cut
costs to compensate for such involuntary price changes, exporters are often at the mercy of
exchange rates.
Licensing and Franchising
licensing Granting another
business the permission to use or
sell a firm’s product, technology,
or process.
franchising A license that allows
a person or firm access to a
business’s proprietary knowledge,
processes, or trademarks in order
to allow them to sell a product or
service under the business’s name.
Licensing and franchising both involve selling the rights to produce a firm’s products or services.54 The licensee or franchisee typically pays a negotiated fee (usually 5 percent to 10 percent) as a royalty, based on the number of units sold. As described in Chapter 8, Disney receives
royalties from the Oriental Land Company on revenues derived from Tokyo Disneyland. This is
an example of licensing. Franchising is a special form of licensing with a longer-term commitment, the use of the brand name, and more often involves a transfer of firm knowledge and
business processes. In addition to negotiating a contract concerning royalty payments, firms
that franchise usually impose strict rules on franchisees concerning how the business is operated and marketed, and provide them with ongoing support and oversight.
How a Firm Gets into a Country: Modes of Entry
169
Licensing and franchising are good entry modes for firms that have unique know-how or
a solid brand that can be easily valued (so the price of the license or franchise can be negotiated), but do not have the capital or resources and capabilities to expand abroad themselves.
Because they involve only the transfer of knowledge, rather than building operations in a
foreign country, these two modes of entry require less investment and are often among the
faster ways to earn a profit in foreign markets. The lower risk and speed of entry make these
attractive entry choices when the risk is otherwise high because of large distances (any of the
four distances) between countries.
As with each mode of entry, there are downsides to licensing and franchising. First, they
offer the least amount of control of all the various modes of entry.55 Firms may try to include
contractual safeguards, but the firm that buys the license or franchise is ultimately in charge of
manufacturing and marketing. Sometimes the licensee or franchisee does not invest enough in
the business to maintain quality and build a strong brand. Lack of control also can make it hard
to tap into local knowledge and innovation. Moreover, any knowledge being generated from
the foreign operations belongs to the licensee or franchisee. Extracting that knowledge for use
in other locations can be problematic.
Finally, there is a risk that the firm licensing the product or service can become a competitor. If you let others manufacture your product or operate your business model, they are
going to gain critical capabilities in your business. RCA, a US-based manufacturer of color televisions, met its death this way. It licensed its technology to Japanese firms in the 1970s, only to
have them enter the US market soon after their licenses expired and put RCA out of the television business.
Alliances and Joint Ventures
Alliances (discussed in detail in Chapter 8) involve sharing resources, risks, and rewards.56 They
are an increasingly favored way to enter markets that are distant (i.e., more risky) from the
home market.57
Many companies use alliances to access complementary assets.58 For instance, a common
way to enter a distant, foreign market is to create an alliance with a local company that knows
what consumers want and knows how to navigate local government regulations and distribution channels. An alliance with a local firm also mitigates some of the foreignness of the
entering firm, allowing the alliance to be perceived by both government and consumers as
local. Sometimes this is the only way to enter a market. For example until recently, in many
industries India did not allow foreign retailers to enter the country unless they partnered with
a local firm.
A joint venture is a special form of alliance involving the joint creation of a new firm.
Most joint ventures involve a 50/50 share of ownership; each company puts in 50 percent
of the value and gets 50 percent of the rewards. If the venture doesn’t work, the homecountry firm loses only half the overall investment in the joint venture. When General Mills
wanted to enter the European Union in the early 1990s, it created a joint venture with
Nestlé. The complementary asset was Nestlé’s distribution system that put Nestlé products
in every big and little store in the many different countries in Europe. Indeed, between the
two companies the distribution system was considered important enough that the products are under the Nestlé brand. So, if you buy Cheerios in Hungary, you will be buying
Nestlé Cheerios.
Although alliances allow faster and less risky access to new markets than wholly owned
subsidiaries (discussed next), they also present significant management challenges. Overcoming cultural and linguistic barriers to bring together teams of managers from both
companies increases the difficulty of operations. Each party in the alliance may also hold
different strategic goals. These challenges cause many alliances to fail. Moreover, as with
licensing, the lack of tight control can create serious problems by allowing the partner
firm to develop resources and capabilities that enable it to become a competitor. Indeed,
the Chinese government forces foreign firms in strategic industries to form joint ventures
alliances An agreement between
two businesses to cooperate on
a mutually beneficial project. It
usually involves the sharing of
resources and/or knowledge.
complementary assets Assets
owned by another company that
are needed in order to successfully
commercialize and market a
product or service.
joint venture An alliance
between firms involving the
creation of a new entity where
both firms provide assets and/
or knowledge, processes, or
technology.
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C H A PT E R 9
International Strategy
with Chinese firms for the explicit purpose of learning their technology in order to compete
against them.
Wholly Owned Subsidiaries
wholly owned subsidiary A unit
in a foreign country that is wholly
owned by the parent company.
greenfield investment A wholly
owned subsidiary in which the
firm involved builds the facility
from the ground up.
TABLE 9 .1
Wholly owned subsidiaries are local units owned outright by the entering firm. This type of
entry requires the most investment and creates the most risk, as the firm has to put up all of the
capital itself. Wholly owned subsidiaries can, however, overcome trade and transportation barriers by producing locally. They may also allow a foreign firm to appear more local to hostcountry governments and consumers.
In addition, this mode offers the firm the most control over what its local subsidiary does.
Many high-tech firms form wholly owned subsidiaries as a way to control access to their technology and avoid leaking it to a licensee or alliance partner. A wholly owned approach gives
firms that use a combination of international strategies sufficient control to realize economies
of scale. For example, wholly owned entry can allow a firm enough control to coordinate a
worldwide value chain with key elements of the value chain located in the lowest-cost location
to gain an arbitrage advantage. Such a firm might manufacture all of a certain type of component in one location in order to gain economies of scale and then ship the components from
one location to another for assembly.
There are two ways of entering with wholly owned subsidiaries: (1) a greenfield investment,
in which the firm builds operations from scratch; or (2) acquiring a local firm. Greenfield investments give the firm the greatest amount of control, because they build the operations,
marketing, and distribution from the ground up. However, they are also the slowest entry
mode, as it takes time to build capabilities. Moreover, although the firm maintains tight control
over its own technology and processes, it also has to learn about the local market and
government regulations on its own.
Acquisitions involve buying local firms. Such a purchase allows the entering firm to acquire
local resources, knowledge, and expertise while still maintaining control through 100 percent
ownership. However, acquisitions typically involve paying a price premium, and they can also
be notoriously difficult to integrate into the rest of the firm’s worldwide operations. Merging
two firms is difficult enough within the same country. Cultural differences complicate the process considerably, often resulting in a slower integration process and a higher risk of failure.59
Table 9.1 summarizes some of the key differences among the modes of entry.
Entry Modes
Exporting
Licensing/
Franchising
Alliance/Joint
Venture
Wholly Owned
Subsidiary
Investment required
Low
Low
Medium
High
Level of risk
Low
Low
Medium
High
Overcome trade barriers?
No
Yes
Yes
Yes
Speed of entry
Fast
Fast
Medium
Slow (faster for acquisition
than greenfield)
Acquire local resources,
including knowledge?
No
No
Yes
Yes
Viewed as insider or outsider?
Outsider
Insider
Possibly insider
Possibly insider
Degree of control
Low
Low
Medium
High
Summary
171
Choosing a Mode of Entry
The choice of which mode to use is based on the firm’s situation, including its access to capital and need for local resources or capabilities, as well as the firm’s primary international
strategy. Global strategies require more control, moving firms toward exporting and wholly
owned subsidiaries, whereas multidomestic strategies encourage local innovation, which
could involve joint ventures, franchising, or autonomous wholly owned subsidiaries. Arbitrage
strategies require ownership, suggesting that exporting and licensing/franchising will not be
good choices.
The choice of which mode to use is also based on a firm’s international experience. Most
firms start their international expansion by first exporting, or selling to target country wholesalers. Firms may then move to joint ventures, and finally to wholly owned subsidiaries as
they become more comfortable managing operations in the foreign market. Figure 9.7 highlights this effect of learning over time in a more nuanced fashion. It shows the typical paths
followed by firms who first enter a foreign market through exporting, licensing, or franchising.
The beginning points for most firms are on the left with most firms moving toward the right as
they gain experience.
Length of Time to Enter
Franchising
Wholly Owned
(Greenfield,
Acquisition)
Control
Licensing
Joint Venture
Exporting
FIGURE 9.7
Risk
Experience and Entry Modes
Source: Adapted from F. R. Root, Entry Strategies for International Markets (San Francisco: Jossey-Bass, 1994), p. 18.
Summary
• There is a clear trend toward increased international trade.
Indeed, the trend has become so prevalent that a large proportion of US firms, including small- and medium-sized firms,
participate in international trade, and thus need an international
strategy.
• Firms expand internationally for many reasons, the most important of which are growth, efficiency, managing risk, gaining
access to more knowledge, and responding to customers and/or
competitors.
• There are four types of distance—cultural, administrative, geographic, and economic (CAGE)—that firms should keep in mind
when entering a particular country. The shorter the overall distance,
the greater the likelihood of success.
• There are three types of international strategy—multidomestic,
global, and arbitrage.
• Exporting, licensing/franchising, alliances/joint ventures, and wholly
owned subsidiaries are four different ways of entering a country.
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C H A PT E R 9
International Strategy
Key Terms
administrative arbitrage 166
administrative distance 160
alliances 169
arbitrage strategy 166
capital arbitrage 166
complementary assets 169
cultural arbitrage 166
cultural distance 159
demand conditions 164
economic arbitrage 166
economic distance 161
exporting 168
factor conditions 164
foreign direct investment 153
franchising 168
geographic distance 161
global integration 162
globalization 155
global strategy 165
greenfield investment 170
joint venture 169
licensing 168
local responsiveness 162
modes of international market entry 168
multidomestic strategy 163
multinational firms 154
product life cycle 156
related and supporting industries 164
standardization 162
transnational strategy 167
wholly owned subsidiary 170
Review Questions
1. What are the five main reasons that firms expand into international markets?
2. Describe the four types of distance that firms should consider when
choosing which foreign markets to enter. What factors help managers
determine which type of distance is most likely to affect the success of
an international expansion?
3. Describe the concepts of local responsiveness and standardization.
Determine which international strategy is best suited to each pressure
and explain why.
4. Describe the three primary international strategies.
5. What does a multidomestic strategy look like? What are the key elements? Comparatively, what are the key elements of a global strategy?
Can you name a firm that pursues each strategy?
6. What makes an arbitrage strategy different from a multidomestic or
global one? Name the four types of arbitrage and explain how each
one works.
7. Describe the ways that managers can help keep multidomestic
strategies from becoming too costly and global strategies from failing
to meet local needs.
8. Explain the international strategy triangle that follows in Figure 9.8
and list the steps to construct one.
9. Explain how you would you use the international strategy triangle
to identify which international strategy a firm should use. Explain how
you would use it to evaluate the strategies of firms that have already
gone international.
10. What is a mode of entry? Describe the four main types of
entry modes.
11. Which type of entry mode is most appropriate for each of the primary international strategies? List the factors that firms using each primary strategy should consider when choosing an entry mode.
Application Exercises
Exercise 1: Pick a firm of your choice or one that your
professor has assigned you.
1. If the firm has already expanded internationally, using the reasons
why firms go global (the first major section of this chapter), determine
the primary reason that your firm went global.
2. If your firm has not yet expanded internationally, determine what
forces are likely to drive it to go global.
Exercise 2: Use the four types of distance to evaluate
the likelihood of a successful foreign expansion effort
(choose one of the following or the one that your professor
has assigned):
1. Choose a firm that has not yet expanded internationally. Choose a
market for the firm to enter. Use the four types of distance to evaluate
the firm’s likelihood of successfully entering that market.
2. Choose a firm that has already expanded internationally. For one or
more of the firm’s markets, measure all four types of distance between
the firm’s home country and the country entered. Evaluate the degree
to which distance played a role in the success or failure of the expansion. Which type of distance mattered the most? Why?
3. Read the Samsung case. Use the case, along with data you gather
from outside sources, to measure the distance, using all four types of
distance, between each company’s home (South Korea for Samsung,
the Netherlands for Philips, and Japan for Panasonic) and a target
Strategy Tool
173
expansion country of your choice. Based on your measurements,
which firm is most likely to succeed in entering the country? Why?
do they say about the firms’ efforts to adapt to changing conditions?
Which firm is succeeding?
Exercise 3: Develop and interpret an international strategy
triangle (choose one of the following or the one that your
professor has assigned):
Exercise 4: Determine the appropriate mode of entry
(choose one of the following or the one that your professor
has assigned):
1. For the industry of your choice, determine the correct measures
for each axis, and find the median and 90th percentile points for the
industry. Pick the top three competitors and draw their triangles. What
do your results say about the strategy of each firm and its competitive
advantage?
1. Choose a firm that has not yet expanded internationally. Choose a
market for the firm to enter. Determine which mode of entry is the right
one for the firm to use. Justify your choice.
2. Use data from the Samsung case. Draw the triangles for two or more
of the four companies on Figure 9.9 (a generic international strategy
triangle). Create triangles for 1960 (estimating the points on the axes
from the descriptions of the firms in the case) and 2016 (use older
data if the case doesn’t have up-to-date data). What do your results
say about the international strategy that each firm has pursued? What
2. Choose a firm that has already expanded internationally. Choose
one foreign market that the firm entered. Determine which mode of
entry it used. Given the firm’s international strategy, evaluate whether
it used the right mode of entry.
3. Use the Samsung case. Assume that none of the four firms has
entered any African markets. Given their respective strategies, determine which mode of entry each firm should use to enter the African
market of your choice. Justify your decision.
Strategy Tool
The International Strategy Triangle—Determining Which
Strategy to Use
Professor Pankaj Ghemawat has developed a tool for assessing the
international strategy of firms, the international strategy triangle—or
the AAA triangle, as Ghemawat labels it—AAA for adaptation (multidomestic strategy), aggregation (global strategy), and arbitrage. The
triangle can be a helpful tool for determining which international
strategy a company should pursue or for helping outsiders analyze
the international strategies of firms, and can also help a firm assess
the current strategic positions of competitors.
The international strategy triangle plots the strengths of a firm
and its primary competitors along three axes, each axis corresponding to one of the primary strategies: multidomestic, global, or arbitrage. Figure 9.8 shows an international strategy triangle for the major
Multidomestic
Global
competitors in the medical diagnostic imaging industry: Philips, GE,
and Siemens. The farther along an axis a company ranks, the more the
company should follow that strategy. One point of Philips’s triangle, for
example, is quite far toward the end of the multidomestic axis, while
the other two points are closer toward the center of the global and
arbitrage axes. This indicates that Philips should pursue, if it doesn’t
already, a multidomestic strategy. The two corners of GE’s triangle that
are farthest from the center are along the global and arbitrage axes,
suggesting that GE might be pursuing a two-pronged approach combining a global strategy with an arbitrage strategy. Siemens’s triangle
suggests that its most promising strategy might be a global strategy.
How are the firm’s places along each axis calculated? The measures you use for the three axes depend on the type of industry you are
analyzing. For many industries, the following ratios of costs as percentages of sales are good measures:
• Multidomestic axis—Ratio of advertising costs to sales
• Global axis—Ratio of R&D costs to sales
• Arbitrage axis—Ratio of labor costs to sales
Other measures are possible, depending on a company’s goals or
the industry it is in. These could include the following:
Philips
Siemens
GE
Arbitrage
International Strategy Triangle—Medical
Diagnostic Imaging Industry
FIGURE 9.8
Source: Adapted from P. Ghemawat, Redefining Global Strategy
(Cambridge: Harvard Business School Press, 2007).
• Multidomestic axis—Percentage of local employees in country-level
management positions or rate of new product development at the
country level
• Global axis—System integration across countries, standardization
of business practices, or the percentage of revenue from customers
that are global in nature
• Arbitrage axis—Percentage of back-office activities (labor other than
manufacturing labor) that are offshored to low-cost countries
Remember that the appendix can help you find sources for the
data you will need to compute these ratios.
After you have determined the appropriate measures for the axes,
you’ll need to obtain information to help you plot two points along
each axis:
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C H A PT E R 9
International Strategy
1. The median of the industry you are analyzing
2. The 90th percentile of the industry you are analyzing—the point
below which 90 percent of the firms in the industry rank on that
particular measure
To find the median and 90th percentile points, you will need
to get information about a variety of firms in your industry, particularly the most important firms, such as those with the most market
share or the most recognized brand names. The appendix at the end
of the book contains extensive information about how to obtain such
information.
Figure 9.9 shows an international strategy triangle for a generic
industry. The median and 90th percentile points are connected,
highlighting two triangles, to help you visualize how you might construct your international strategy triangle. As an illustration, in this
generic triangle, the median ratio of labor costs to sales, the bottom
axis, is 20 percent, and the 90th percentile is 50 percent—meaning
that 90 percent of firms in the generic industry have a labor-tosales percentage of less than 50 percent. When you use the triangle, the median and 90th percentile points—as well as the measures
you use on each axis—should be customized to the industry that
you analyze.
Multidomestic
Advertising to Sales
Global
R&D-to-Sales
10%
This tool can be very helpful in determining what international
strategy a firm should use. If a firm ranks at any point beyond the
median along any axis, managers should consider pursuing that strategy. If a firm ranks beyond the 90th percentile it is critical that a firm
consider that strategy.
It is also useful to plot a firm’s biggest rivals. This can tell you a
lot about the dynamics of competition in the industry, including who
is likely to win and who is likely to lose. For example, refer to the international strategy triangle for the medical diagnostic imaging industry
in Figure 9.8. Although Siemens’s triangle suggests that it pursues
a global strategy, notice that Siemens does not rank as strongly on
the global axis as GE does. This suggests that, unless things change,
Siemens might be at a cost disadvantage to GE, losing sales on price.
The triangle also suggests that Siemens would also likely lose
sales to Philips, which is better at meeting local needs, as indicated
by the firms’ positions on the multidomestic axis. Furthermore, this
triangle also shows that Philips, although the most adapted, is likely
to have the highest cost structure. Although GE does not have Philips’
strengths for adapting to local needs, GE might nonetheless be able to
meet a good portion of local demand at a much lower price, enough so
that Philips can’t count on maintaining market share, even though it
may meet local needs better.
The steps in using the international strategy triangle are summarized as follows:
1. Determine the appropriate measures to use for the three axes. For
many manufacturing industries, these measures will be:
10%
8%
8%
6%
• Multidomestic axis—Advertising to sales
6%
4%
2%
2%
4%
• Global axis—R&D to sales
90th percentile
Median
• Arbitrage axis—Labor to sales
2. Plot the median and 90th percentiles for the industry as a whole on
each axis. You will do this by gathering data on the measure for each
axis from the most important firms in the industry you are examining. When you have that data, calculate the median and the 90th
percentile point, where 90 percent of the firms are below that point.
This is likely to be close to the firm who is farthest along the axis.
20%
40%
60%
80%
3. Plot the appropriate point on each axis for the firm you are analyzing. Draw a triangle connecting these three dots. You might
also want to carry out this process for two or more of the firm’s
major competitors.
100%
Arbitrage
Labor-to-Sales
FIGURE 9.9
Generic International Strategy Triangle
4. Use the shape of the triangle to help determine the appropriate
international strategy for the firm being analyzed and to understand competitive dynamics in the firm’s industry.
Source: Adapted from P. Ghemawat, Redefining Global Strategy
(Cambridge: Harvard Business School Press, 2007).
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a Transitioning Economy,” Journal of International Business Studies 39
(3) (2008): 491–507.
57
A. C. Inkpen and A. Dinur, “Knowledge Management Processes
and International Joint Ventures,” Organization Science 9 (4) (1998):
454–468.
58
59
F. S. Chen, “The Motives for International Acquisitions: Capability
Procurements, Strategic Considerations, and the Role of Ownership
Structures,” Journal of International Business Studies 39 (3) (2008):
454–471; K. E. Meyer, M. Wright, and S. Pruthi “Institutions, Resources,
and Entry Strategies in Emerging Economies,” Strategic Management
Journal 30 (5) (2009): 61–80.
CHAPTER 10
Innovative Strategies That
Change the Nature
of Competition
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Discuss innovative strategy and the differences among
the types of innovation.
3. Describe the accelerating pace of innovation and the
product, business, and industry life cycle.
2. Identify the different categories of innovative strategies.
Jeff Bukowski/Shutterstock.com
Hey Google … Here Comes Alexa, Siri, and Cortana
In 1998 Larry Page and Sergei Brin launched Google, a search engine that allowed users to search the world wide web for information. Google used a page-ranking algorithm that worked like
academic citations—the more people selected a website page to
be viewed, the higher it ranked in the search algorithm. Google
quickly became dominant in web searching and began generating
revenues using a “free” third-party-pay revenue model. Compa-
nies paid Google to advertise to their users while they were engaged in a web search. If the user typed in “ski,” then companies
selling skis, ski boots, ski gloves, ski vacations, and so forth would
pay to advertise to that particular user. Advertisers were willing
to pay more for this type of targeted advertising to customers. Indeed, one study in 2009 revealed that Google made $15.96 per
unique user per year compared to Yahoo’s $11.06, Facebook’s
$3.50, and Skype’s $1.60.1 By the end of 2018 Google’s parent
company, Alphabet, realized revenues totaling $136.8 billion2 and
had achieved a market value of $740 billion,3 one of the highest
market values of any public company. Google’s only real challenge in web search had come from Microsoft when it launched
Bing in 2009. But even with Microsoft’s vast resources, Bing had
only managed to capture 3.4 percent4 of the market. Google’s position in search seemed secure.
But in 2011 Apple launched Siri on its iPhone, an intelligent voice assistant that allowed users to simply ask for information, and Siri would provide it via voice or a digital document. This initiated an innovative approach to web search,
allowing anyone to search the web using voice commands. Then
in 2014 Amazon launched Alexa, its intelligent voice assistant
that came with an echo speaker. The inspiration for Alexa was
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the Star Trek voice computer that would respond to Captain
Kirk’s various requests. “Our vision is that it would become like
the Star Trek Computer,” says Amazon CEO Jeff Bezos, a big Star
Trek fan. “You could ask it anything, and ask it to do things for
you—ask it to find things for you—and it would be easy to converse with, in a very natural way.”5 But Alexa wasn’t just designed
to search for information; it was designed to be the hub of the
“connected home.” Alexa could be used to control lights, thermostats, appliances, security systems, and more. And, of
course, it could be used to order products directly from Amazon.
Following closely behind Amazon, Microsoft launched its intelligent voice assistant, Cortana, in 2015. The emergence of Siri,
Alexa, and Cortana ushered in a new era of competition for Google
in search.
Google quickly responded to Amazon Alexa with its own
digital assistant speaker called Google Home. Google’s digital assistant could be used not only on Google Home smart speakers
but also on Android phones and laptops offered by Google (e.g.,
Pixel) and other consumer electronic companies like Samsung
and LG. “On voice search, we are really excited about it,” Google
CEO Sundar Pichai said. “It’s a very natural way for users to interact. And for voice, we expect voice to work across many different
contexts. So we are thinking about it across phones, homes, TVs,
cars, and you know, trying to drive that ecosystem that way. And
we want Google to be there for users when they need it.”6 Pichai
understood that Google needed to succeed in voice search because by 2020 estimates projected that 50 percent of all searches
would be voice searches. But it wasn’t going to be easy. Alexa had
captured 66.7 percent of the smart speaker market, compared to
29.5 percent for Google Home.7 Moreover, both Apple, with Siri,
and Microsoft, with Cortana, were poised to continue to make significant investments to be relevant in voice search. Voice-activated
artificial intelligence had ushered in a new era of competition
that raised a number of questions for Google and CEO Pichai. How
would voice search affect the revenues and profits of Google web
search? What actions would Google need to take to catch Alexa in
the race to control the connected home? Would the availability
of Google’s voice assistant on phones, laptops, and other devices
provide an advantage relative to Alexa that was not as accessible
on phones and laptops?
The opening case illustrates how Amazon (Alexa), Apple (Siri) and Microsoft (Cortana) used an
innovative voice-activated search technology to challenge Google in the web search business.
Innovation is a powerful driver of competition and competitive advantage. New entrants, in
particular, have strong incentives to offer different value propositions than incumbents—and
preferably in a way that is hard to imitate. Strategies that offer a different value proposition
to customers using different resources and capabilities are often referred to as “innovative
strategies,” “revolutionary strategies,”8 or “disruptive innovations.”9 Famed economist Joseph
Schumpeter argued that competition is a process that is driven by the “perennial gale of creative
destruction.”10 Innovative products and strategies—such as the ones launched by Amazon and
Apple—simultaneously create and destroy value. This is what makes strategy a dynamic process. The strategy that worked yesterday might not work today—and what works today might
not work tomorrow. Consequently, companies must be able to innovate and change in order
to weather the storms of creative destruction that will certainly come their way. The primary
focus of this chapter is to examine innovation-based strategies—that prove to be revolutionary
or disruptive in their industries.
What Is an Innovative Strategy?
invention The creation of an idea
or method; a novel concept.
innovation The conversion of a
novel concept (an invention) into
a product, process, or business
model that generates revenues
and profits.
To understand innovation, it is first important to understand the difference between an invention and innovation. Invention describes the creation of a unique or novel concept, method, or
process that is often turned into a tangible outcome—such as new product. An innovation is
the conversion of a novel concept (an invention) into a product, process, or business model
that generates revenues and profits.11 Innovation differs from invention in that innovation
refers to the use of a novel idea or method, whereas invention refers more directly to the
creation of the idea or method itself.12
For example, the scientists at Xerox PARC (Palo Alto Research Center) invented the computer mouse as a new way to navigate a computer. This invention would allow users to select
from images and menus on a computer monitor through a graphical user interface (GUI). But it
was Steve Jobs and Apple computer who launched the Macintosh computer—the first commercialized microcomputer that came with a mouse and graphical user interface. Apple’s Macintosh
What Is an Innovative Strategy?
Novel
179
Useful
Implemented
FIGURE 10.1
Definition of Innovation
turned Xerox’s invention into an innovation that could generate revenues and profits. In similar
fashion, the Wright brothers invented the airplane at Kitty Hawk, but Boeing and others commercialized the idea by designing and building commercial aircraft that could be sold as products. As shown in Figure 10.1, an innovation needs to be (1) novel, (2) useful, and (3) successfully
implemented in order to help companies succeed in the marketplace.
Incremental Versus Radical Innovation
Innovation enables firms to deliver value in new ways. Innovations fall into two general categories: incremental innovations and radical innovations. An incremental innovation builds on a
firm’s established knowledge base and steadily improves the product or service it offers.
For example, when Gillette offers a razor with five blades instead of four, or when Samsung
offers a TV with an LED screen instead of a plasma screen, those are incremental innovations.
In similar fashion, when any company makes incremental improvements to their operations
to accomplish a task faster, better, or with fewer resources, these are also incremental innovations. Incremental innovations are also sometimes called “sustaining” innovations because
they sustain a company’s current product offering and revenues.
In contrast, a radical innovation draws on a different knowledge base, technologies, or
methods to deliver value in a truly unique way. Examples of products based on radical innovations include the computer (versus the typewriter), CT scanner (versus the X-ray), cell phone
(versus the landline phone), and MP3 player (versus the CD player).
Processes can also be based on more radical innovations. For example, Toyota engineer
Taiichi Ohno developed a set of flexible production techniques, often referred to as lean manufacturing, that minimizes inventories and waste despite being designed for rapid product
changeovers.13 This system of production was significantly different from the mass production system developed by Henry Ford that was based on standardization, significant automation, and few product changeovers. Toyota’s deployment of its “flexible” or “lean” production
system has helped it produce high-quality cars at low cost and propelled it to worldwide leadership in the automobile industry.
Strategies that draw on more radical innovations often use new technologies or employ
a fundamentally different business model than rivals, meaning they create, deliver, and
capture value through very different resources and capabilities. As illustrated in the opening case, Alexa and Siri use voice-activated search, enabled through artificial intelligence, to
deliver information in a radically different way than Google does when someone types in a web
search. Amazon Alexa is embedded in echo devices which are distributed largely by Amazon or
incremental innovation Building
on a firm’s established
knowledge base to create minor
improvements to the product or
service a firm offers.
radical innovation Innovation
that draws on a different
knowledge base, technologies, or
methods to deliver value in a truly
unique way.
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innovative strategy A strategy
that introduces a fundamentally
different business model
than rivals.
Best Buy—a very different distribution channel than Google Search. This chapter focuses on
innovative strategies that are based on more radical innovations.
We define an innovative strategy as a strategy that introduces a fundamentally different
business model than rivals. The term business model refers to the rationale of how an organization delivers and captures value. More specifically, business models typically differ on one of
three dimensions:
1. The choice of customer segments to serve and the unique value (value proposition) offered
by the company
2. The choice of activities the company performs and the resources used to deliver value
to customers
revenue model The approach, or
pricing strategy, a company uses
to get paid for the value it delivers
through its business model.
3. The way a company generates revenue streams to get paid for the value it delivers. The
term revenue model is sometimes used to refer to the approach, or pricing strategy, a
company uses to get paid for the value it delivers through its business model (see Strategy
in Practice: Understanding Business Models)
Strategy in Practice
Understanding Business Models
Over the past few years, the term business model has often been
used to describe a company’s strategy. Perhaps the most comprehensive approach to defining a company’s business model has
been developed by Alex Osterwalder and Yves Pigneur in their tool,
the business model canvas.14 They argue that there are nine components to a business model, and firms can innovate by changing one
or more of those components as they seek to deliver and capture
value. The nine components are:
1. Value propositions. A firm seeks to solve customer problems
and satisfy needs with a particular unique value or value
proposition.
2. Customer segments. The value propositions are designed to
meet the needs of one or several customer segments.
3. Channels. Value propositions are delivered to customer segments through communication, distribution, or sales channels.
4. Customer relationships. Customer relationships are established
and maintained with each customer segment.
5. Revenue streams. Revenue streams result from value propositions that are successfully offered to customers through pricing strategies.
6. Key resources. Key resources are the assets required to offer
and deliver the company’s value proposition.
7. Key activities/capabilities. Value propositions are developed
and delivered through key activities or capabilities.
8. Key partnerships. Some resources and activities that are critical to delivering the value proposition are outsourced to partners outside the company.
9. Cost structure. The business model elements above result
in the cost structure for delivering the value proposition to
the customer. These costs must be covered by the revenue
streams in order for a firm to be profitable.
To illustrate, Amazon has a different business model than
Barnes & Noble (B&N), with the most obvious difference being
channels—Amazon sells books over the Internet rather than through
bookstores. But this means that Amazon’s value proposition is different, as are its primary customer segments. Amazon’s primary
customer segment prefers the lower prices that Amazon offers, but
it also likes the convenience of shopping from computers or cell
phones. In contrast, B&N’s customers like the ability to get their books
immediately and may enjoy the shopping experience at a B&N store.
To deliver their value propositions through the distribution channels
they’ve chosen, each firm must be good at different activities and have
different resources. For example, Amazon needs to be good at writing
software and fulfilling orders from warehouses, whereas Barnes &
Noble has to be good at finding the best locations for its stores,
designing stores to create a great shopping experience, and efficiently
operating each store. Amazon and Barnes & Noble are described as
having different business models because they differ on most, if not
all, of the nine components of the business model canvas.
In some cases, firms deliver similar value to similar customer
segments—and might even use similar resources and capabilities
to deliver value—but they may differ in their pricing strategy or their
approach to generating revenues streams and capturing value. For
example, Apple, Spotify, and Pandora use different revenue models or
pricing strategies to generate revenue streams. Apple makes money
primarily by selling songs and albums over the Internet for a specific
price. In contrast, Spotify provides consumers with unlimited access
to all songs in its library for a monthly subscription fee. Pandora uses
a “free” revenue model like a radio station, and provides songs via the
Internet that are tailored to a listener’s preferences. Pandora makes
money by selling advertising.
Companies sometimes attempt to change their business model
in response to competition. For example, Barnes & Noble added the
online book retailing business model to its bricks-and-mortar bookstore business model in response to Amazon’s entry into book retailing.15 In similar fashion, Apple launched iTunes Radio in 2013 to directly
compete with Pandora.16 In this way, it has imitated Pandora’s business
model including the revenue model for capturing value. In most cases,
the company that is first to launch a business model has a first-mover
advantage because it becomes known as the pioneer. In order to successfully compete with pioneers, second movers must offer unique value relative to the first mover—for example, lower prices, more features,
or greater convenience—to lure customers in their direction.
Categories of Innovative Strategies
181
• Value Chain Reconfiguration to Eliminate Activities
• Low-End Disruptive Innovations
• High-End Disruptive Innovations
• Value Chain Reconfiguration to Allow for Mass Customization
• Blue Ocean Strategy—Create New Markets by Targeting Non-Consumers
• Create a Platform to Share Assets
• Free Business Models
FIGURE 10.2
Categories of Innovative Strategies
Innovative strategies based on radical innovations are sometimes referred to as
disruptive innovation because companies in the same industry find the innovation so disruptive that they can no longer do business as usual.
For example, when Netflix introduced an innovative way for customers to access home
entertainment, it “disrupted” Blockbuster’s strategy, and Blockbuster could no longer succeed
by doing business as usual. Innovative strategies are disruptive when they offer value that is
attractive to incumbent’s customers, and are delivered through a business model that is difficult for incumbents to imitate. Not surprisingly, new entrants with innovative strategies want to
disrupt established companies and offer value in a way that is difficult to imitate. We now turn
to discussing different types or categories of innovative strategies that have been successfully
deployed by various companies.
Categories of Innovative Strategies
Because innovative strategies are about delivering unique value through a business model
that differs from the competition, there are many different ways to offer them. It would be
impossible to put each new strategy into a predefined category, because new innovative strategies are often unique relative to strategies being used by established firms. That’s the power
of innovation. However, over the years strategists have noticed that some types of innovative
strategies enable disruptive innovation through similar tactics and patterns—or what some
strategy scholars have referred to as a similar dominant logic.17 By dominant logic, strategists mean the primary logic behind how the company is trying to deliver unique value to
customers.
For example, the dominant logic behind the strategies of Netflix (versus Blockbuster) and
Amazon (versus Barnes & Noble) was to lower costs by eliminating retail stores and shipping
directly to the customer. The categories of innovative strategies we identify in Figure 10.2 can
be useful as a guide to launching a disruptive innovation. In this section we examine a few of the
most well-known patterns of innovative strategies as identified by various strategy scholars.
Reconfiguring the Value Chain to Eliminate Activities
(Disintermediation)
One type of innovative strategy is based on reconfiguring the value chain to eliminate activities
or steps. The most typical pattern is to eliminate a step in the path from production to customer,
such as eliminating a store, which also eliminates the need for salespeople and inventory. This
allows the disruptor—the firm launching the game-changing strategy—to offer lower prices for
similar products and services. This is the approach that Netflix used to gain a cost advantage
against Blockbuster and Redbox. Amazon used this same approach—selling books over the Internet—to offer books at lower cost than Barnes & Noble (see Figure 10.3).
disruptive innovation Radical
innovative strategies in which
companies in the same industry
find the innovation so disruptive
that they can no longer do
business as usual.
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Barnes & Noble
Authors
Warehouse
Publishers
Store
Customer
Distributor
Amazon.com
Authors
FIGURE 10.3
Publishers
Warehouse
Customer
Value Chains of Barnes & Noble Versus Amazon.com
The approach of eliminating stores and selling products over the Internet has worked
well for products such as books and movies—items that are standardized and predictable.
But can this work for a product that people like to try out before buying? What about a
mattress? The company 1-800-Mattress has been quite successful selling mattresses online
as well as over the phone. Since the company sells mattresses that are similar to models
sold in stores, customers can go try one out to see what they like. Their strategy is to sell
mattresses for 20 to 30 percent lower than the competition and deliver it to your home. Not
only that, but if the customers are not satisfied, they can exchange it for another mattress,
satisfaction guaranteed.
Southwest Airlines has used a similar strategy of eliminating steps in the value chain to
offer low airfares relative to other airlines. By eliminating meals, seat reservations, and luggage
transfers, Southwest is able to lower total costs and offer less expensive airline tickets to its
customers.
Low-End Disruptive Innovations
low-end disruption Producing a
low-cost product or service for the
low-end or most price-sensitive
segment of the market, and then
gradually moving upmarket as the
product or service improves its
technology and processes.
A second type of innovative strategy is called a low-end disruption.21 Rather than eliminating
steps in the value chain, some firms use a different set of activities or technologies from their
rivals to produce a low-cost product or service. Harvard professor Clayton Christensen observed
a pattern in a number of industries in which a firm leverages new technologies to launch a
product at the low end—the most price-sensitive segment of the market—and then gradually
moves upmarket as it improves its technology and processes.
For example, Nucor used this approach to disrupt integrated steel producers such as US
Steel. Nucor pioneered a new way to create steel products using small electric arc furnaces
to melt scrap metal in mini-mills. This process was much simpler and less expensive than
the traditional method of melting iron ore and other ingredients in enormous blast furnaces.
When mini-mills first emerged, the quality of their output was poor, which meant they could
only make rebar (steel rods) used to reinforce concrete. This was a low-margin market that
the big steel makers were happy to abandon because of the low profitability. But as Nucor’s
mini-mills improved their processes and product quality, their cost advantage enabled them
to offer lower prices than the integrated producers in higher-margin products such as angle
iron, structural beams, and sheet steel. Eventually, many of the integrated steel companies
such as Bethlehem Steel were unable to compete because of their cost disadvantage, and they
went bankrupt.
In a similar fashion, Honda started at the low end in the automobile industry by offering
50cc and 150cc motorcycles. When Honda first launched, Harley-Davidson wasn’t concerned
Categories of Innovative Strategies
183
Strategy in Practice
The Internet has frequently been described as a “disruptive”
technology—one that has enabled innovative strategies that are
disruptive—by allowing digitized information and products to be
easily accessed by anyone throughout the world. By now, we are
all familiar with the impact that the digitization of music, books,
and movies has had on bricks-and-mortar retailers such as Virgin
Records, Borders, and Blockbuster. Web applications such as
TurboTax and LegalZoom are replacing professional tax accountants and attorneys, and online gaming is the fastest-growing
segment in the $97 billion video-game industry.18 The Internet,
and the online digitization it enables, can be either a threat or an
opportunity.
The primary impact of the Internet on companies is that it
has become a low-cost distribution channel for anyone wanting to
sell a product or service. As a result it has dramatically lowered the
barriers to entry into new markets. Just when Barnes & Noble and
Borders thought they had created barriers to entry by building large
book superstores, Amazon entered selling books over the Internet.
The business models of Amazon, Netflix, and eTrade would not
have been possible without the Internet. The Internet has enabled
new entrants to create new business models and deliver value in
innovative ways while lowering costs.
As a result of the Internet lowering the cost of distribution, it
has enabled business models that rely on the long-tail phenomenon, where broader inventory can be offered to meet a wider variety
of consumer needs. Before the Internet, products and services were
usually sold through bricks-and-mortar stores that could handle
only limited inventory. As a result, only those products fortunate
enough to get widespread distribution were big sellers. The “longtail” phenomenon explains that 80 percent of offerings in a product
category (books, songs, movies, clothing, etc.) are not big hits and
only account for about 20 percent of units sold, whereas 20 percent
of offerings account for 80 percent of sales.19
This phenomenon is captured by the Pareto principle, also
known as the 80-20 rule, which says that roughly 80 percent of effects
come from 20 percent of the causes. The Pareto principle is named
after Italian economist Vilfredo Pareto, who observed in 1906 that 80
percent of the land in Italy was owned by 20 percent of the population.20 The Pareto principle is applied to many situations in business
but perhaps most notably to sales, where in most cases 80 percent of
a company’s sales come from 20 percent of its customers. The Internet provides an opportunity for online retailers to benefit from marketing the “long tail,” which is the remaining 80 percent of offerings
as outlined in Figure 10.4.
Online retailers can “sell less of more” by taking advantage of
unlimited virtual shelf space. This is what allowed Netflix to offer
90,000 different movies versus 1,000 at a Blockbuster store, and
Amazon to offer 5 million book titles versus 100,000 at a Barnes &
Noble store.
The Internet has also allowed more companies to employ a
free revenue model because the marginal cost (the incremental
cost of producing one additional unit) of producing and distributing most digital products is zero. After a software program has been
written, it can be copied and shared at virtually zero cost. Skype
would not be able to provide free phone calls, nor could Zynga provide free games, without the Internet.
Number of Units Sold
The Internet as a “Disruptive” Technology
20%
Number of Different Products Offered
FIGURE 10.4
The Long-Tail Phenomenon
about the competition because its market was superheavyweight motorcycles. HarleyDavidson’s CEO even proclaimed that Honda’s entry was good for Harley-Davidson because
Honda would get more people riding a motorcycle and eventually they would graduate to
a Harley.22 But over time, Honda used profits from its large volume of small motorcycles to
invest in the development of larger motorcycles and eventually entered the superheavyweight
motorcycle categories with bikes that were less expensive but more technologically advanced
than Harley-Davidsons (See Strategy in Practice: Why Incumbents Don’t Respond Effectively to
Low-End Disruptions).
Another example is Skype’s cheap—and often free—phone service that has been gradually
moving upmarket as the quality of calls improves and the technology allows for video conferencing and other higher-end business services. Skype has already taken over about one-third of
all long-distance international phone calls from AT&T and other long-distance providers.23 It
will be interesting to see if Skype’s free phone service will eventually be disruptive to the cell
phone giants such as Verizon, AT&T, Sprint, and T-Mobile.
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High-End/Top-Down Disruptive Innovations
High-end, or top-down, disruption is as revolutionary as a bottom-up disruptive innovation. But
in stark contrast to the low-end variety, high-end disruptive innovations actually outperform
existing products when they’re introduced, and they sell for a premium price rather than at a
discount.24 History provides a number of examples: Apple’s iPod outplays the Sony Walkman;
Starbucks’s high-end coffee drinks and atmosphere drown out local coffee shops; and flash
drives fly past zip drives and floppy disks. Products created through high-end disruptive
innovations are initially purchased by the most discriminating and least price-sensitive buyers,
and then they move steadily downward, into mainstream markets. New entrants launching
high-end innovations typically rely on “radical” or leapfrog technological innovations that are
expensive initially, but with improvements in technology, and as they are produced in larger
volumes with greater scale, the costs gradually decline.
A high-end disruptive innovation may initially serve the specialized, high-end niche of
a market for years before it finally trickles down to mainstream markets. Such was the case
with cell phones, which originally cost $3,995 and, only appealed to the high-end niche.25
But as the price (and size) of the phones dropped, they became accessible to a much larger
segment of the market. Today, almost 36 percent of homes are “wireless only” households.26
The cell phone example also introduces an important point: high-end disruptive innovations
don’t need to be superior on every product feature relative to incumbent product offerings.
But they do need to be superior on at least some attributes that customers care about. While
cell phones offered the superior advantage of portability, they were disadvantaged relative to
landline phones in terms of sound quality. But over time, sound quality has improved and is
now comparable to landlines. In similar fashion, digital cameras offered advantages of storing
thousands of images that can be immediately viewed and edited, but initially offered inferior
picture quality relative to 35 mm cameras. As the picture quality improved, digital cameras
began to dominate the camera market.
Tesla is another company that is pursuing a high-end disruption strategy. CEO Elon Musk
has long maintained that Tesla’s strategy is to sell highly desirable electric vehicles in the
high-end niche—such as the Model S and Model X—and then gradually move downmarket,
offering more affordable cars such as the Model 3. Indeed, Tesla has already received more
than 400,000 reservations for the Model 3, a vehicle slated for production in 2018. By starting at
the high end, Tesla has developed a loyal customer base and a premium brand, and has started
Strategy in Practice
Why Incumbents Don’t Respond Effectively to
Low-End Disruptions
In many cases, rivals do not attempt to respond to a new low-cost
offering. Why don’t they respond? They see little to gain by selling what they view as an inferior, inexpensive product to a pricesensitive niche market. After all, why would Harley-Davidson want
to offer an inexpensive motorcycle? The margins are small, and
Harley might tarnish its brand by offering an inexpensive, possibly
inferior, motorcycle. Instead, companies like Harley focus on the
needs of their most profitable customers, who tend to ask for more
features and better performance from their products. By the time
they realize that the new low-end product has improved its performance enough to attract their mainstream customers, incumbents
find it is too late to respond.
Some organizations also find it difficult to respond because a
response would require them to develop a new set of resources and
capabilities. Integrated steel makers would have to learn how to make
steel using mini-mill technology. Harley-Davidson would have to learn
to produce smaller motorcycles in large volumes at low cost. In some
cases these new resources and capabilities are viewed as incompatible
with the firm’s existing set of resources and capabilities. For example,
it would be very challenging for Harley-Davidson to simultaneously
manufacture and sell mostly customized heavyweight motorcycles
while producing high volumes of standardized smaller motorcycles as
does Honda. The production processes that Honda uses to produce
millions of motorcycles each year differ significantly from Harley’s
production processes that produce fewer than 250,000.
Finally, some companies are afraid of cannibalization. They are
concerned that if they provide a less-expensive offering, customers
will switch to it, resulting in a loss in revenues and profits. In the long
run, this can be a recipe for disaster as customers eventually move
to the low-end offering and the incumbent loses significant profits.
For example, AT&T did not want to offer free phone service over the
Internet like Skype because it would cannibalize the paid phone
service that AT&T was providing. AT&T didn’t want to do anything
to encourage customers to move from paid phone service to free
phone service.
Categories of Innovative Strategies
185
to generate enough volume and scale to make more affordable cars. Some research shows that
Tesla is reducing its cost per vehicle by more than 20 percent with every doubling of volume.27
If Tesla can continue to bring down the cost of electric cars at a faster rate than combustion
engines improve, then Tesla’s chance of disruptive success goes way up. Whether Tesla can
successfully move down to mainstream markets and generate high volumes is still uncertain.
But as Tesla builds scale, offers new and cheaper models, and makes charging more convenient
with its supercharging stations, the company should be able to follow the path of other successful high-end disruptors.
High-end disruptions are new products or services that offer either superior performance
on some existing product features or offer new features customers are willing to pay for. In most
cases, these new top-down products are possible only because of innovations in technology
that leapfrog the technologies used in earlier products.
Reconfiguring the Value Chain to Allow
for Mass Customization
Some firms, such as Build-A-Bear Workshop, Dell, and Timbuk2, have launched innovative
strategies based on a concept that is known as mass customization. Mass customization is an
oxymoron, like “jumbo shrimp” or “act naturally.” Until recently, most products in business
were either mass-produced OR customized, but not both. However, new technologies and processes have allowed for the mass production of individually customized goods or services.
Take Build-A-Bear Workshop, for example. Customers “build” their own teddy bear or
other stuffed animal by choosing from a large variety of body styles, after which the animal
is stuffed at the store to the customer’s liking. Customers can also add a heart or sound box
during stuffing, enabling the animal to “talk” or play music. After helping to stuff their animals,
customers can dress their furry friends in outfits of their choice from a soccer uniform, or witch
costume, to a sequin shirt and jeans, and they can even add shoes. In short, the components
of the teddy bear are mass-produced but put together in a customized way by each individual
customer. But mass customization isn’t just for children. Online retailer Timbuk2 uses a similar approach, allowing customers to choose from a set of modules to design their own bag or
purse.28 Both Build-A-Bear and Timbuk2 find that many customers enjoy the experience of creating their own unique product.
Dell used a similar strategy when it successfully launched its PC business using the “Dell
Direct” model. Dell sells directly to customers and allows them to choose the components that
matter most to them; they then custom build and ship the PC to the customer within 48 hours.
Dell’s ability to mass-produce customized PCs requires a flexible and responsive assembly
system and supply chain.
Mass customization seems to work best in markets in which customers have a variety of
different needs and many want a product that is personalized to those needs. It also works best
when the product can be broken into modules that offer different features or performance. This
requires that the product be designed as separate modules that can be mass produced but that
can be quickly and easily linked together to create a functioning product.
mass customization When a
company mass-produces the
various modules of the product
and then allows the customer
to select which modules will be
combined together.
Blue Ocean Strategy—Creating New Markets by Targeting
Nonconsumers
INSEAD professors Chan Kim and Renee Mauborgne identify another type of innovative strategy that they call blue ocean strategy. They argue that a company can succeed by creating new
demand in an uncontested market space. Where sharks competing for the same scarce food
create a red ocean of blood because of intense rivalry, blue ocean success relies on swimming
to empty water—in other words, offering value that is very different from anything on the market.
For example, when Cirque de Soleil opened its first show, it was clear that it would be
nothing like a Ringling Brothers circus. A Cirque de Soleil show combines elements of a traditional circus, acrobatic troupe, street performers, and a Broadway show to offer a unique
blue ocean strategy Creating
new demand in an uncontested
market space.
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entertainment experience. Cirque’s shows are so original that there is no direct competition.
The tagline for one of the first Cirque productions was revealing: “We reinvent the circus.” Moreover, it attracted a new group of customers who were willing to pay several times the price of a
conventional circus ticket for a unique entertainment experience.
As companies try to create new demand, they sometimes target nonconsumption—
individuals who do not currently purchase a product or service—with an offering that might
induce consumption. For example, more than 70 percent of households in India do not have
a refrigerator because they are large, expensive, and require continuous electricity to run. So,
appliance maker Godrej decided to try to create an innovative small refrigerator targeted at
nonconsumption—those 125 million households without a refrigerator. Using battery technology and solid-state thermoelectric cooling, it created a $59 cooler-size refrigerator—called
Chotukool, which translates as “little cool”—to bring affordable refrigeration to everyone in
India. One challenge Godrej had to overcome was how to give Indians in the poorer rural areas
of India access to Chotukool. Since these potential customers didn’t have access to an appliance store, Godrej thought of a unique way to distribute Chotukool: through the post office.
Since the postman goes to every home in India and is often viewed as a trusted friend, Godrej
partnered with the India Department of Post as the distribution partner for Godrej in many
parts of India. By selling a unique product through an innovative distribution channel, Godrej
was able to create new demand in a market without any direct competition.
According to Kim and Mauborgne, most companies focus on incremental improvements
to existing offerings rather than seeking to create new markets. In a study of business launches
in 108 companies, they found that 86 percent of those new ventures were line extensions—
incremental improvements to existing industry offerings—and a mere 14 percent were aimed
at creating new markets or industries. Although the line extensions did account for 62 percent
of the total revenues, they delivered only 39 percent of the total profits. By contrast, the 14 percent invested in creating new markets and industries generated 38 percent of total revenues
and 61 percent of total profits.29 Clearly, success in new markets brings much greater rewards.
However, organizations don’t necessarily have to venture into distant waters to create new
markets. Indeed, many new markets are created from within, not beyond, existing industries.
Godrej’s Chotukool represents a good example. Godrej was already in the appliance business
but was able to create a new refrigerator market within the industry (see Strategy in Practice: Where Do Innovative Strategies Come From?). Chrysler did the same thing in the automobile industry when it launched the first minivan targeted to families who wanted more room
than a station wagon but didn’t want a huge van. The minivan—a vehicle that was essentially
a hybrid between a sedan and a van—created an entirely new category of vehicle and was the
staple of Chrysler’s profits for years.
Create a Platform to Coordinate and Share Private Assets
Uber and Airbnb have ushered in the sharing economy by building coordination apps that help
consumers coordinate and share private assets. In the case of Uber, individuals use their personal car as a taxi, receiving requests for rides and getting paid for driving. With Airbnb home
owners rent out spare rooms to guests. And while Uber and Airbnb are among the most wellknown sharing platforms, more than 9,700 such companies with more than $8.5 billion in funding now exist according to Mesh (meshing.it). Companies have built apps for sharing everything
from washing machines and office space to boats, lawn mowers, and cocktail dresses.
To truly transform industries, however, coordination and sharing platforms must target
significant pockets of consumption, as Uber and Airbnb have done with transportation and
lodging. The companies’ efforts have proven disruptive to incumbents. The San Francisco
Cab Drivers Association (SFCDA) reported that one-third of the 8,500 or so taxi drivers in San
Francisco—more than 2,800—ditched driving a registered cab in the last 12 months to drive for
a private transportation startup such as Uber or Lyft, and taxi use has dropped by 70 percent.
And Airbnb, founded in 2008, now offers more rooms (more than 1 million) than any other hotel
chain in the world.
Several keys make the strategy to coordinate and share assets work. First, sharing solutions seem to work best when asset value is high but use of those assets is low, as is the case
Categories of Innovative Strategies
187
with cars and spare rooms. However, the high asset value must also be combined with a way to
effectively manage risk. Existing insurance policies, such as auto insurance and homeowner’s
insurance, naturally cover drivers and homeowners even while sharing. But bigger challenges
exist with assets that are not insured but that can be easily destroyed by a non-owner (e.g., a
designer cocktail dress).
Second, companies that use this approach must build scale in the network itself—through
the set of buyers and sellers (peers) who use the platform. To grow, these companies must overcome the classic two-sided market paradox: They won’t have buyers until they have sellers, and
they won’t have sellers until they have buyers. That’s why Uber focuses so intently on driver
recruitment as it expands to new markets. The company heavily subsidizes drivers while giving
steep discounts to riders. This explains the more than $1 billion loss the company incurred as
it tried to expand to China. To be successful, companies must have a path to building network
scale in local markets.
Third, the sharing economy is fueled by the uniqueness of Millennial culture and attitudes.
Millennials value community, authenticity, frugality, and genuine experiences. Therefore, companies who wish to transform industries using a platform to leverage private assets will need to
create brands and communities that appeal to this Millennial culture.
Free Business/Revenue Models
A final category of innovative new business or revenue models involves offering products or
services for “free.”30 During the past two decades, we have witnessed the emergence of “free”
products and services in a way never seen before. Free newspapers (Metro), software (Google
Docs), stock trades (ZeccoTrading), and telephone calls (Skype and Zoom). Free product strategies, once the exclusive province of the digital realm, have also been popping up in markets
far removed from the Internet. From free prescriptions for expensive pharmaceuticals, to free
airline tickets, and even free automobile leases, the “free” business models popularized by software companies such as Google, Adobe, and Mozilla are spreading across markets everywhere,
in some cases eliminating rivals. One example is Wikipedia, which destroyed Encyclopedia
Britannica and Microsoft Encarta.
Although many companies offered short-term “freebies” in the past—for example a 30-day
free trial of software—these products and services are perpetually free. What are the characteristics of products or services that are most likely to succeed being offered for free? And how is it
that firms such as Google are making lots of money by not charging users? What is their revenue
model? Here are three “free” strategies that companies use:
Strategy 1: Cross-Sell (Freemium) Strategy The cross-sell strategy involves
offering a free basic product to gain widespread initial use, after which users are offered a nonfree premium version (often called freemium) or are sold products not directly tied to the free
product. Virtually every app on the iPhone uses the cross-sell strategy (e.g., Zynga games), as
does Skype, which offers free phone calls but makes money on the add-ons, such as voicemail
and calls to landlines or cell phones. One tactic is to offer a free version of the product to consumers to use at home, but offer a paid version with additional features to the enterprise market.
For example, Adobe charges only corporate customers for its Reader software—it is free to
all others. Craigslist uses a version of this approach by offering free listings in every category
but one—jobs—which is free for job seekers but not for companies.
Large-scale success with this strategy requires either (1) a free product that appeals to a
very large product user base (e.g., roughly 1.5 billion people with computers are interested in
using Skype to make phone calls); or (2) a high conversion rate, meaning a high percentage of
free users are willing to convert to paid customers for premium features. Skype is successful
because of the sheer total numbers of customers that use its free product. Even if Skype has a
low conversion rate (the general rule is 5 percent of free product users tend to become paying
customers), it still can make money because it has more than 400 million product users.
In contrast, Flickr, the photo-sharing site, has a much smaller total market. The number
of camera users who want to use a photo-sharing service is much smaller than the market for
making free phone calls. Moreover, the conversion rate to Flickr Pro is relatively low because
high conversion rate When a
high percentage of free users
are willing to convert to paid
customers for premium features.
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for most users, the free version is good enough. The fact that Skype appeals to more users with
a conversion rate that is better than Flickr’s translates into a superior business model. This
explains why eBay was willing to pay $2.6 billion for Skype, whereas Yahoo! reportedly paid
only $22 to $25 million for Flickr.33
third-party pay strategy
Providing free products to a
community of product users as
a method of generating revenue
from a third party that pays to
access those users.
Strategy 2: Third-Party Pay Strategy
Firms using a third-party pay strategy—
sometimes called a two-sided market—provide free products to a community of product users
as a method of generating revenue from a third party that pays to access those users. In the
digital age, Google is the poster child for this strategy, offering free Internet search services
Strategy in Practice
Where Do Innovative Strategies Come From?
What makes a business innovator such as Thomas Edison, Steve
Jobs, or Jeff Bezos different from a typical manager? How did they
come up with the innovative ideas that helped them found General
Electric, Apple, and Amazon.com, respectively? Is it genetic? Where
they born intuitive and divergent thinkers?
Research by Jeff Dyer, Hal Gregersen, and Clayton Christensen
reported in The Innovator’s DNA confirms others’ work that creativity skills are not simply genetic traits endowed at birth, and that they
can be developed. In fact, the most comprehensive study confirming
this was done by a group of researchers, Merton Reznikoff, George
Domino, Carolyn Bridges, and Merton Honeymon, who studied creative abilities in 117 pairs of identical and fraternal twins. Testing twins
15 to 22 years old, they found that only about one-third of the performance of identical twins on a battery of 10 creativity tests could be
attributed to genetics. In contrast, roughly 80 percent of twins’ performance on general intelligence (IQ) tests could be attributed to genetics. So general intelligence (at least the way scientists measure it) is
basically a genetic endowment, but creativity is not. Nurture trumps
nature as far as creativity goes. That means that about two-thirds of
our innovation skills comes through learning—first, from understanding the skill, then practicing it, and ultimately gaining confidence in
our capacity to create.
If innovators can be made, then how did Edison, Jobs, and
Bezos come up with their great ideas? Five discovery skills distinguish
innovators from typical executives.31 First and foremost, innovators
count on a cognitive skill called associational thinking, or simply
associating. Associating happens as the brain tries to synthesize and
make sense of novel inputs. It helps innovators discover new directions by making connections across seemingly unrelated questions,
problems, or ideas.
Innovative breakthroughs often happen at the intersection of
diverse disciplines and fields. Author Frans Johanssen described this
phenomenon as the Medici effect,32 referring to the creative explosion that occurred when the Medici family brought together creators
from a wide range of disciplines—sculptors, scientist, poets, philosophers, painters, and architects—in fifteenth-century Italy. As these
individuals connected, they created new ideas at the intersection of
their respective fields, spawning the Renaissance, one of the most
innovative eras in history. Put simply, innovative thinkers connect
fields, problems, or ideas that others find unrelated.
The other four discovery skills trigger associational thinking by
helping innovators increase their building-block ideas. Specifically,
innovators engage the following behavioral skills more frequently.
Questioning. Innovators are consummate questioners who
show a passion for inquiry. Their queries frequently challenge the status quo, or push people to think differently. One of Steve Job’s favorite
questions was: “If money were no object, what kind of product would
we create?” He wanted Apple engineers to imagine the perfect
product—and then try to design and build it. Innovators ask questions
to understand how things really work, why they are that way, and
how they might be changed or disrupted. Collectively, their questions
provoke new insights, connections, possibilities, and directions.
Observing. Innovators are also intense observers. They carefully
watch the world around them, and their observations of customers,
products, services, technologies, and companies help them gain
insights into and ideas for new ways of doing things. Steve Jobs’s
observation trip to Xerox’s research lab, the Palo Alto Research
Center (PARC), provided the insight that was the catalyst for both
Macintosh’s innovative operating system and mouse and Apple’s OSX
operating system.
Networking. Innovators spend a lot of time and energy finding and testing ideas through a diverse network of individuals. They
actively search for new ideas by talking to people who may offer a
radically different view of things. For example, Steve Jobs was told
by Apple Fellow Alan Kay to “go visit these crazy guys up in San
Rafael, California.” The crazy guys were Ed Catmull and Alvy Ray, who
had a small computer graphics operation called Industrial Light &
Magic (the group that created special effects for George Lucas’s
movies). Fascinated by their operation, Jobs bought Industrial Light &
Magic’s computer animation group for $10 million, renamed it
Pixar, and eventually took it public for $1 billion. Had he never
chatted with Kay, he would never have purchased Pixar, and the
creative Toy Story, Monsters Inc., and Finding Nemo films might not
have been produced.
Experimenting. Finally, innovators are constantly trying out
new experiences and piloting new ideas. Experimenters explore the
world intellectually and experientially, holding convictions at bay
and testing hypotheses along the way. They visit new places, try new
things, seek new information, and experiment to learn new things.
Jobs, for example, tried new experiences all his life—from meditation
and living in an ashram in India, to dropping in on a calligraphy class
at Reed College. All these varied experiences triggered ideas for innovations at Apple.
Collectively, these discovery skills—the cognitive skill of associating and the behavioral skills of questioning, observing, networking,
and experimenting—constitute “The Innovator’s DNA,” or the code for
generating innovative business ideas.
Categories of Innovative Strategies
while companies pay Google to advertise to its millions of product users. Google’s approach
works well because product users type in key search words and identify themselves as prime
candidates for advertisers. For example, typing in “skis” or “snowboards” allows companies
selling or servicing those products to advertise to those targeted customers.
The secret to third-party pay is to provide a valuable free service that attracts either (1) a
very large community of product users that can then be segmented in a particular way for
advertisers (the way Google does with search), or (2) a targeted community of users that comprises a customer segment, or group of individuals similar on a key dimension (e.g., this similarity could be based on demographics, for example “teenagers” or “retired people;” or more
need based, such as “video-game players” or “new mothers”). Blyk, a Finnish telecommunications company that was acquired by France Telecom, competes by offering free cell phone service to 16- to 24-year-olds. Product users in the desired demographic fill out a detailed survey
about their preferences and are given 217 free minutes each month if they agree to receive
advertisements. Blyk makes money by selling access to that particular demographic and
providing information on their preferences.34 Blyk also benefits by using freemium, since many
customers go over their free minutes and end up paying a premium for those minutes.
In similar fashion, Ryanair offers a small percentage of its airline seats for free by using
a combination of freemium and third-party pay. The company makes money on the add-on
services: $25 per customer for checked or carry-on bags, $5 for seat reservations and credit
card use, and $4 for priority boarding. Flight attendants sell food, scratch-card games, perfume,
digital cameras, and MP3 players. Ryanair also uses the flight as a platform for advertisers.
When your seat tray is up, you may see an ad for a cell phone from Vodaphone, and when it
is down, you may see an ad from Hertz. Flyers are a captive audience for advertisers targeting
travelers. The key to third-party pay is to deliver a captive audience, preferably a specific customer segment, to an advertiser willing to pay for access to that audience.
189
customer segment Groups of
people who share similar needs
and thus are likely to desire the
same features in a product.
Strategy 3: Bundling Strategy A bundling strategy involves offering a free product
with a paid product or service. For example, Hewlett-Packard may give away a free printer with
the purchase of a computer, or Verizon may give away a free cell phone with the purchase of
a service contract. Of course, the “free” effect here is largely psychological, since the customer
must actually pay in order to get the product for free.
Offering a free product as part of a bundle works well when the product requires ongoing
maintenance or complementary goods. For example, even though Hewlett Packard doesn’t
make money when it gives away a free printer with a computer, it makes money by selling
high-margin ink cartridges for its free printers. Cable companies will frequently bundle a free
phone service when a customer purchases Internet services because, with “voice over IP,” the
company uses the Internet to provide the phone service. The phone service can be provided
with virtually zero incremental cost.35
Additionally, bundling works particularly well when a company offers a broad array of
products. Banks are increasingly bundling free services—free accounts or stock trades—when a
customer uses other services (e.g., keeps investment balances above some minimum). But the
bundled product doesn’t have to be related to the free product. Banks sometimes give away
free products, such as iPods or iPads, to customers opening accounts.
Hypercompetition: The Accelerating Pace of Innovation
During the past 25 years, we have witnessed an accelerated pace of innovation that has had a
significant impact on the nature of competitive advantage. In fact, Dartmouth Professor Rich
D’Aveni coined the term hypercompetition to refer to his argument that competitive intensity
has increased, and that periods of competitive advantage have decreased.36
Recent research provides evidence that the increased pace of change has made it harder to
sustain competitive advantage.37 In fact, one study found that in 1950, when a firm reached the
Fortune 500, on average it stayed in the Fortune 500 for 12 years. However, by 2000, the average
firm that reached the Fortune 500 stayed there for only 7 years because of the emergence of
new, faster-growing firms.38 This all suggests that established companies need to be constantly
hypercompetition A term coined
by Professor Rich D’Aveni to refer
to his argument that competitive
intensity has increased and that
periods of competitive advantage
have decreased.
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looking over their shoulder for new entrants who might be launching new products with innovative strategies. It also suggests that established companies cannot rest on their laurels. They
must continue to be inventive and offer new products and services if they hope to continue
to grow. If they don’t, their current products and businesses will eventually proceed through
the famous “S-curve,” which means that after the growth phase they will eventually mature
and decline.
Innovation and the Product/Business/
Industry Life Cycle (S-Curve)
Innovations frequently lead to the creation of new products, businesses, or even industries.
New products, product categories, and even industries tend to follow a predictable life cycle,
evolving over time through four stages: introduction, growth, maturity, and decline. Figure 10.5
depicts a typical product/business/industry life cycle.
Introduction Stage
During the introduction stage, the company tries to get early adopters—those types of buyers
willing to try out the latest new gadget—to test the potential of its new product. The primary
goal is to get some reference customers who will seed future growth to increase market acceptance. Product innovation is much more important than process innovation during this stage;
as a result, R&D, product development, and design are key competencies. Virtual reality headsets, such as Oculus Rift or Sony Playstation VR, are examples of new products in the introduction stage.
Growth Stage
Sales accelerate during the growth stage as the initial innovation gains traction and increased
market acceptance. Tablets and smartphones are examples of product categories that are in
the growth stage. Demand increases as the early majority, a new group of buyers, is convinced
that the product concept works as demonstrated by early adopters in the introduction stage.
The company continues to refine the product during this stage as it also looks for innovative
ways to reach customers through marketing and new distribution channels. As the product
starts to gain widespread acceptance, a standard (or dominant design) emerges that signals the
Introduction
Growth
Maturity
Sales and Profit
190
Time
FIGURE 10.5
Product/Business/Industry Life Cycle
Decline
Innovation and the Product/Business/Industry Life Cycle (S-Curve)
market’s agreement about a common set of engineering and design features. Toward the end
of this stage, product innovation starts to give way to process innovation.
Maturity Stage
As an industry moves into the mature stage, growth starts to slow as total market penetration
increases. What little growth there is comes from buyers called the late majority entering the
market, people who want not only a proven concept but also a low price. The limited market
growth leads to an increase in competitive rivalry, and cost starts to become more important
as a determinant of success. Process innovation and operational efficiency are typically more
important to success than product innovation. Laptop computers are an example of a product
that is moving from the growth to the mature stage.
Decline Stage
The decline stage is often initiated by new products entering the market that cause demand to
fall. For example, demand for Sony’s Walkman didn’t really start to fall until the introduction of
Discman and then the iPod. As iPod was taking off in its growth phase, Walkman and Discman
were both declining. Similarly, Apple and IBM’s personal computers initiated the decline of
the typewriter, and more recently we’ve seen the original desktop PC start to decline with the
growth of laptops and tablets. As the market size shrinks during the decline stage, some firms
try to minimize competition and consolidate the industry by buying rivals.
Understanding the product life cycle can be useful for identifying the strategic priorities for
a product or business. Each stage of the life cycle requires different priorities and competencies
in order for the firm to succeed and satisfy that stage’s unique customer group. The life cycle
also highlights the importance of innovation—or the ability to launch new product life cycles—
because if you don’t, your products and business will eventually be in decline.
Although launching a business with an innovative strategy sounds alluring, it is also
risky. Why? Because, by definition, when a company launches an innovative strategy it is
offering a unique value proposition using an original business model. Since the organization
is trying to do something that has never been done before, there is tremendous uncertainty
as to whether it will work. Although we’ve talked about a lot of successful innovative strategies in this chapter, there are more failures than successes. For example, Apple launched the
Newton, a personal digital assistant (PDA) that hit the market with a thud before the market
was ready for mobile computing. The Newton didn’t attract customers and was deemed a
huge failure, costing Apple millions of dollars. It was an innovative product, but it wasn’t
successful. The same can be said for Better Place, a $1 billion start-up that introduced free
electric car leases in Israel. It leased electric cars for free by bundling the car with an energy/
maintenance contract. Customers paid 10 cents per mile (less than the cost of gas) to get
their electric car battery packs swapped out at a Better Place service station. Instead of stopping for gas, you stop for a battery swap. But the battery swap costs were much more expensive than expected, and the innovative start-up turned out to be a spectacular failure.39
The bottom line is that if you don’t innovate, you may eventually “be overrun by a swarm
of start-ups,” said Scott Cook, founder and chairman of Intuit, a provider of financial services software including Quicken, TurboTax, and SnapTax.40 However, innovations must be
more than novel offerings to the market. They must be deemed useful by customers and
must be successfully implemented. This makes them risky propositions. Launching an innovative venture is not for the faint of heart. But for those who are successful, the rewards can
be extraordinary.
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Summary
• An innovation is the conversion of a new idea (an invention) into a
product, process, or business model that generates revenues and
profits. An incremental innovation builds on a firm’s established
knowledge base and steadily improves the product or service
it offers. In contrast, a radical innovation draws on a different
knowledge base, technologies, or methods to deliver value in a truly
unique way.
• A low-end disruptive innovation is where a firm leverages new
technologies to launch a product at the “low end”—the most pricesensitive segment of the market—and then gradually moves upmarket as it improves its technology and processes. In stark contrast to
the low-end variety, high-end disruptive innovations actually outperform existing products when they’re introduced, and they sell for
a premium price rather than at a discount.
• Strategies that offer a different value proposition than incumbents’
strategies using different resources and capabilities (e.g., a different
business model) are often referred to as “innovative strategies.”
• Mass customization refers to an approach of using new technologies
and processes to mass produce individually customized goods or
services—as we’ve seen Build-A-Bear Workshop do with stuffed animals and Dell do with computers. Blue ocean strategy refers to creating a product or service that targets “nonconsumption,” by creating
new demand in an uncontested market space.
• One type of innovative strategy is based on reconfiguring the value
chain to eliminate activities or steps to offer significantly lower
prices. The most typical pattern—used by Amazon.com and Netflix—
is to eliminate a step in the path from production to customer, such
as eliminating a store, which also eliminates the need for salespeople and inventory.
• Free business/revenue models are growing rapidly in a wide variety of
industries, and they always use cross sell, third-party pay (advertising),
bundling, or some combination of the three “free” revenue models.
Key Terms
blue ocean strategy 185
customer segment 189
disruptive innovation 181
high conversion rate 187
hypercompetition 189
incremental innovation 179
innovation 178
innovative strategy 180
invention 178
low-end disruption 182
mass customization 185
radical innovation 179
revenue model 180
third-party pay strategy 188
Review Questions
1. What is the difference between an invention and innovation? What
are the differences between incremental and radical innovations?
4. What does mass customization mean? How do companies use mass
customization to succeed in the market?
2. How do companies create an innovative strategy by eliminating
steps in the value chain?
5. What does it mean to target nonconsumption? How does a company
create new markets with a blue ocean strategy?
3. What is the difference between low-end and high-end disruptive
innovations?
6. What are four behaviors of business innovators that help them generate ideas for innovative strategies?
Application Exercises
Exercise 1: Understanding the Nature of Competition
1. Find a company that is rapidly stealing market share from incumbents. How is the business model of the growing company different?
What innovative strategy is it employing?
2. Find a company that the media is touting as doing something new
or innovative. Do you agree that the company is innovative? Why
or why not?
3. Find a company that fits one of the six innovative strategies
described in this text. Does the company employ only one innovative
strategy, or mix several? Which ones?
4. Compare renting movies from a box store, versus mail, versus streaming. How does each successive model eliminate value-chain activities?
5. Find a company that uses a free revenue model. How is it able to perpetually offer the product for free? What kind of free strategy is it using?
References 193
References
1
J. H. Dyer, “Skype: Competing with Free,” in J. Dyer, P. Godfrey, R. Jensen,
and D. Bryce, Strategic Management: Concepts and Cases (New Jersey:
John Wiley and Sons, 2016).
20
https://www.statista.com/statistics/540128/quarterly-revenue
-of-alphabet/
21
2
https://ycharts.com/companies/GOOG/market_cap
3
V. Pareto and A. N. Page, Manuale di economia politica (Manual of
Political Economy), trans. A. S. Schwier, ed. A. S. Schwier and A. N. Page
(New York: Augustus M. Kelley, 1971).
Christensen.
S. Kotha and J. Dutton, Transformation at Harley-Davidson (New York:
New York University, 1996).
22
4
https://www.statista.com/statistics/216573/worldwide-market
-share-of-search-engines/
23
5
https://www.ibtimes.co.uk/star-trek-fans-can-wake-command
-their-amazon-echo-simply-by-saying-computer-1602704; M. Cavna,
“Jeff Bezos, Who Played Star Trek as a Kid, Has a Role in ‘Star Trek
Beyond,’” 2016, https://www.washingtonpost.com/news/comic-riffs
/wp/2016/07/16/from-boyhood-to-hollywood-jeff-bezos-who-played
-star-trek-as-a-kid-has-a-role-in-star-trek-beyond/?noredirect=
on&utm_term=.bf4635a57fe6
24
Alphabet, “Q4 2016 Earnings Call,” https://abc.xyz/investor/static
/pdf/2016_Q4_Earnings_Transcript.pdf
6
D. B. Yoffie, L. Wu, J. Sweitzer, D. Eden, and K. Ahuja, “Voice War: Hey
Google vs. Alexa vs. Siri,” Harvard Business School Publishing Case, 2018.
7
G. Hamel, “Strategy as Revolution,” Harvard Business Review (1996).
8
C. Christensen, The Innovator’s Dilemma: When New Technologies
Cause Great Firms to Fail (Boston: Harvard Business School Press, 1997).
9
J. A. Schumpeter, Capitalism, Socialism, and Democracy (New York:
Harper & Row, 1942). Also see R. Foster and S. Kaplan, Creative
Destruction: Why Companies that Are Built to Last Underperform the
Market—and How to Successfully Transform Them (New York: Currency/
Doubleday, 2001).
10
A. G. Lafley and R. Charan, The Game Changer (New York: Crown
Publishing Group, 2008).
11
http://en.wikipedia.org/wiki/Innovation.
12
T. Epply, The Lean Manufacturing Handbook, Part 3, Second Edition,
(Anderson, IN: Continental Design & Engineering, 2012).
13
A. Osterwalder and Y. Pigneur, Business Model Generation (Hoboken:
John Wiley & Sons, 2010).
14
http://www.barnesandnobleinc.com/our_company/history/bn
_history.html.
15
S. Cole, “Apple Plans to Utilize iTunes Radio to Stream, Promote Albums
Before Release,” AppleInsider (October 2, 2013), http://appleinsider
.com/articles/13/10/02/apple-plans-to-utilize-itunes-radio-to-stream
-promote-albums-before-release.
16
C. K. Prahalad and R. A. Bettis, “The Dominant Logic: A New Linkage
Between Diversity and Performance,” Strategic Management Journal 7
(6) (November/December, 1986): 485–501. To illustrate, the dominant
logic behind the strategies of Netflix (vs. Blockbuster) and Amazon
(vs. Barnes & Noble) was to eliminate retail stores and ship directly to
the customer.
17
P. Goldstein, “Report: Skype Makes Up One Third of International
Phone Traffic,” Wireless Carrier News (February 15, 2013).
N. Carr, “Top Down Disruption,” Strategy + Business 39 (May 23, 2005).
C. Ngak, “Cell Phone Turns 40: Martin Cooper’s First Call on the
DynaTAC,” CBSNews.com (April 4, 2013), http://www.cbsnews.com
/8301-205_162-57577736/cell-phone-turns-40-martin-coopers-first
-call-on-the-dynatac/.
25
CTIA Advocacy, Wireless Quick Facts (2012), http://www.ctia.org
/advocacy/research/index.cfm/aid/10323.
26
See J. Dyer and D. Bryce “Tesla’s High End Disruption Gamble,” https://
www.forbes.com/sites/innovatorsdna/2015/08/20/teslas-high-end
-disruption-gamble/#32991a6477ed
27
http://www.timbuk2.com/tb2/.
28
W. C. Kim and R. Mauborgne, “Blue Ocean Strategy,” Harvard Business
Review (October 2004).
29
D. Bryce, J. Dyer, and N. Hatch, “Competing Against Free,” Harvard
Business Review (2011).
30
J. Dyer, H. Gregersen, and C. Christensen, The Innovator’s DNA
(Boston: Harvard Business Review Press, 2011).
31
F. Johansson, The Medici Effect (Boston: Harvard Business School
Press, 2006).
32
V. G. Kopytoff, “At Flickr, Fending Off Rumors and Facebook,”
The New York Times (January 30, 2011); M. Honan, “The Most Fascinating Profile You’ll Ever Read About a Guy and His Boring Startup,”
Wired (August 7, 2014).
33
R. Wray, “Teens to Get Free Mobile Calls—with a Catch,” The Guardian
(March 25, 2007), http://www.theguardian.com/money/2007/mar/26
/internetphonesbroadband.digitalmedia.
34
Bryce, Dyer, and Hatch.
35
R. A. D’Aveni, Hypercompetition. Managing the Dynamics of Strategic
Maneuvering (New York: Free Press, 1994).
36
37
R. R. Wiggins and T. W. Ruefli, “Schumpeter’s Ghost: Is Hypercompetition Making the Best of Times Shorter?” Strategic Management Journal
26 (2005): 1249–1259; H. McNamara, P. M. Vaaler, and C. Devers, “Same
as It Ever Was: The Search for Evidence of Increasing Hypercompetition,” Strategic Management Journal 24 (2003): 261–278. Note: While
there appears to be increasing evidence that competition has increased
and periods of competitive advantage are shorter, there is an ongoing
debate in the literature whether the empirical data indeed confirm it.
N. Furr and J. Dyer, The Innovator’s Playbook (Boston: Harvard
Business Review Press, 2014).
38
“Gartner Says Spending on Gaming to Exceed $74 Billion in 2011,”
Gartner Press Release, Egham, UK, 2011
39
E. Brynjolfsson, Y. J. Hu, and D. Simester, “Goodbye Pareto Principle,
Hello Long Tail: The Effect of Search Costs on the Concentration of
Product Sales,” Management Science (January 1, 2011).
40
18
19
S. Blank and B. Dorf, The Start-Up Owner’s Manual: The Step-by-Step
Guide for Building a Great Company (Pescadero: K&S Ranch Publishing
Division, 2012).
Author interview with Scott Cook, June 7, 2013.
CHAPTER 11
Competitive Strategy and
Sustainability
L EARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Create a strategic group map and a strategy canvas of a
competitive landscape.
2. Analyze a company’s competitors to identify the likely
ways they will respond to a company’s strategic moves
using a competitor response profile.
3. Describe the different types of competitive strategies
that can be deployed contingent on the environment in
which a company operates.
4. Choose or create a competitive strategy suitable to a
company’s competitive situation.
Ethan Miller/Getty Images News/Getty Images
Delta Simplifies Its Fares
One cold January, facing increasing competition from low-fare
carriers, Delta Airlines introduced a new pricing plan called simplifares that dramatically cut ticket prices across most of Delta’s
domestic US routes. Paul Matsen, Delta’s chief marketing officer,
stated, “We could sit back and wait for low-fare competition to force
us to react, but we’re going on the offense.”1 The company cut ticket
prices by as much as 50 percent and eliminated the Saturday-night
stay requirement that had long helped airlines distinguish between
leisure travelers and business travelers. Furthermore, it capped the
price for a last-minute coach fare at $499 and a first-class fare to
anywhere in the country at $599. Although the new pricing scheme
would immediately create a drag on revenue, Delta expected that
194
over the long run the pricing move would be good for the airline by
helping it take back passenger volume from the low-fare carriers.
Business travelers, in particular, had been increasingly moving to
low-fare carriers for their travel. In fact, near Cincinnati, where simplifares was first piloted, many business travelers preferred to drive
to a smaller airport and pay the fares of AirTran or ATA rather than
the higher fares of Delta. The new pricing structure was expected to
bring these customers back to Delta.
Although Delta hoped for a new source of advantage from this
pricing move, Delta’s main competitors—the full-fare carriers such
as American and United—responded to simplifares by immediately
matching Delta’s prices. Within days, business fares in the top 40
routes flown by major airlines were down by an average of one-third,
and American Airlines’ fares were down by 44 percent.2 Perhaps as a
way to slow the free fall, Northwest airlines warned the industry that
“fare simplifications” would immediately and adversely affect industry revenues, but other airlines ignored the warning.3
By July, just six months later, Delta was already making
upward price adjustments, citing a spike in the cost of fuel.4 The
company abandoned the $499 cap and raised the ceiling by $100.
Again, major carriers immediately followed suit. On the day of the
announcement, a spokesman for Continental stated, “All I can tell
you is that we did match Delta’s fare, and the match was effective
today. Whatever Delta did, we did.”5 Meanwhile, the low-fare carriers welcomed the move as evidence that full-fare carriers were
burdened with cost structures that were simply too high to match
their low ticket prices.
Understanding the Competitive Landscape
Despite the effort exerted to implement the new pricing strategy,
within three years, Delta had completely abandoned the simplifares
initiative, discovering that it provided no sustainable advantage.
Delta’s CEO seemed to suggest that efforts to compete on price with
the low-fare carriers had been misguided. Cutting prices for business
travelers had disastrous effects on revenue because the expected
195
growth in passenger volume never materialized. This was largely
because of competitive price matching. In a clear return to its previous strategy, the CEO stated, “You really have to have a differential
[between business and leisure travel]. We offer different products to
different customers based on their attributes. That’s better for an international carrier offering . . . different products on the same airplane.”6
Competition is a reality for business firms. Whether a company faces competitors that are
actively striving to erode its market share or potential new entrants to its market, nearly all
managers must grapple with how to compete. In some markets, competition is light because
firms are highly differentiated or because they face few rivals. In other markets, competition
can be very intense. In such markets, and as the opening case demonstrates, a company must
acknowledge the reality that competitors are watching and are likely to react to its strategic
actions. Had Delta realized how quickly its competitors would respond to its pricing moves,
the company might have tried a different strategy to improve its performance against lowfare carriers.
One of the key challenges of the strategist is to capture profits in the face of competitors
who want to steal them. A company might offer a unique value proposition in an attractive
market delivered with the right resources and capabilities, but if a competitor can enter that
market offering the same, or better, value proposition, then the advantage isn’t sustainable.
Or, if competitors can simply copy a company’s strategic moves, any advantages are fleeting.
The question of sustaining advantage—how to prevent other companies from offering the same
value—is the fourth key strategy question that must be answered as identified in Chapter 1.
How does a company know which actions to take in the face of competition? What kinds of
moves are most likely to provide sustainable competitive advantage for the firm? This chapter
provides answers to these questions by identifying a set of tools for competitive analysis along
with strategies for responding to competitors that are useful under a variety of market circumstances. The overall objective is to help strategists understand how a company can improve and
sustain its performance in the face of competition.
In order to effectively compete, a company must first know the competition and then it must
launch strategies to win against the competition. The first two sections of the chapter, “Understanding the Competitive Landscape” and “Evaluating the Competition,” address knowing
the competition. The latter three sections, “Principles of Competitive Strategy,” “Competitive
Actions for Different Market Environments,” and “Sustaining Competitive Advantage,” address
winning against the competition and sustaining competitive advantage.
Understanding the Competitive Landscape
In order to compete effectively, a firm must understand the structure of the competitive environment in which it operates. Most industries contain groups of companies that compete directly
against each other but only indirectly against companies in other groups. This situation arises
because of differences in customer needs and preferences, which give rise to various customer
segments. As companies pursue these segments, they develop business models that are wellsuited to serving one segment but not so well-suited to serving other segments in the market.
Firms with similar business models cluster together by pursuing the same segments of customers.
Strategic Groups and Mobility Barriers
An analysis that breaks down the structure of a market or industry into these constituent groups
is called a strategic group analysis. Visualizing this group structure is an important component
of competitive analysis because it identifies the major arenas of competition and who competes directly with whom.
strategic group A set of
companies that compete in similar
ways with similar business models
pursuing similar sets of customers.
C H A PT E R 11
Competitive Strategy and Sustainability
In the United States, Delta, United, and American Airlines compete in the full-fare segment
of the industry (see Animated Executive Summary, “Competitor Interaction”). Delta encounters American or United on many of its routes between pairs of cities because these companies
compete in Delta’s primary customer segment—business travelers. Among the companies in
this group, airlines compete head-to-head and watch the moves of their competitors closely.
They respond to one another’s competitive moves almost immediately in order to maintain a
valuable competitive position. Other airlines, such as Southwest, JetBlue, Frontier, or Spirit,
compete in the discounted or low-fare segment of the industry. They offer few frills, less popular
airports, or no reserved seating. These companies compete head-to-head with each other more
than they compete with the full-fare carriers.
Even though companies within groups compete head-to-head, and companies in other
groups are less of a threat, rivals in other groups cannot be completely ignored. Rivals could
begin targeting customer segments with new offerings or more favorable value propositions
and eventually steal customers. This is exactly what happened in the case at the opening of the
chapter. Low-fare carriers were gaining ground in the business traveler segment of the market
when Delta launched its effort to compete on price with these carriers.
Strategic group maps are constructed by identifying the main differences in the ways in
which firms in an industry compete to deliver value. These differences typically relate to value
chain activities such as relative price, geographic placement, product line breadth, extent of
vertical integration, niche or full-service offerings, and so forth. The factors that are relevant
vary based on the industry in question. In the airline industry, for example, clues about the
most important differences in how firms compete can be found in the opening case description.
Two of the important factors mentioned are price and whether airlines are flying to primarily
large or small airports (recall that Delta was losing business travelers to smaller airports near
Cincinnati). Therefore, to draw a strategic group map of the airline industry, you would place
these two factors on the horizontal and vertical axes of a simple two-dimensional chart and
plot the companies relative to these axes as outlined in Figure 11.1. If you observe clustering of
companies, you have identified strategic groups within the industry, at least along the dimensions chosen. The rule is to choose factors that are the most relevant in describing the differences in how companies compete for customers. In other words, choose the dimensions that
create the most distinctive clusters.
Large
Full-fare
group
Delta
Average Airport Size
196
American
United
Southwest
JetBlue
Low-fare
group
Spirit
Small
Low
High
Relative Fare Price
FIGURE 11.1
Strategic Group Map
Note: Company circle size relative to revenue
Understanding the Competitive Landscape
Companies find that switching strategic groups is difficult once they have built a history in
one. The reason is that companies in specific strategic groups choose particular ways to configure their activities and these activity systems do not change quickly or easily. This creates a
barrier to mobility between groups. After a firm is in a particular group, it is not mobile and
can’t simply leap to a different group.7 For Delta to effectively compete with low-fare carriers,
the company would have to acquire many of the business characteristics of the low-fare
carriers. For example, the company would have to change its cost structure, airline fleet,
routing, and airport locations, effectively abandoning much of its existing customer base. In
the opening case, Delta attempted to compete head-to-head with the low-fare carriers by
changing only its price. But the company would have had to change many more of its characteristics in order to be successful.
A strategic group map provides a basis for making competitive assessments not only
because it defines who a company’s competitors are but also because it can help to analyze
potential changes in the landscape. For example, it can indicate whether companies in one
group are beginning to appeal to the primary markets of another group. Such was the case
when low-fare carriers near Cincinnati began to steal business customers from Delta.
Relevant questions to ask include the following: Are firms in any group attempting to
change the value they offer and the basis of competition? Is this leading to any changes in the
boundaries of groups? Delta attempted to alter group boundaries when it launched a low-fare
pricing strategy. Are new firms entering the industry with fundamentally different business
models? Southwest certainly did when it first entered the Texas market in Dallas. Are there
“empty spaces” on the strategic group map that may invite successful entry? In Figure 11.1,
no firms currently operate with high fares at small airports, or with low fares at large airports.
If this is the case, does this fact suggest possible alternative competitive approaches to the
market? These types of questions can be asked and addressed effectively in the context of the
strategic group map (see Strategy in Practice: A Real World Strategic Group Map).
Strategy Canvas
Another way to evaluate differences among competitors is to employ a strategy canvas. This
idea was first introduced by W. Chan Kim and Renée Mauborgne as a way to assess relative
competitive strengths and weaknesses against specific purchase criteria.8 By rating firms on
various criteria that customers use to make purchase decisions, the analyst is able to quickly
grasp similarities and differences in how companies attempt to offer unique value to customers
relative to competitors.
Offerings
High
Other Airlines
Southwest
Car
Low
Price
FIGURE 11.2
Meals
Lounges
Hub
Friendly
Seating
choices connectivity service
Speed
Frequent
departures
Strategy Canvas of the Short-Haul Airline Industry
Source: Adapted from C. Kim and R. Mauborgne, “Charting Your Company’s Future,” Harvard Business Review (2002).
197
barrier to mobility Any factor
that limits the ability of a company
to move between strategic groups.
198
C H A PT E R 11
Competitive Strategy and Sustainability
Strategy in Practice
A Real-World Strategic Group Map
Ivanti is a provider of enterprise software solutions for IT administrators who manage the many devices on corporate computer
networks. When Ivanti wanted to gain strategic insight into the
dynamics of its competitive landscape, the company created a strategic group map (see Figure 11.3). First, the company chose two factors that seemed to distinguish the business models of firms in the
industry: relative price and product capabilities, especially around
scalability, or the ability of the software to handle very large corporate networks. All relevant competitors were placed on the chart
based on how they scored on these two dimensions. The circle size
for each company was scaled to represent revenues. Clear strategic
groups emerged, and these were circled (dotted black) and then
given a name for quick reference. Competitor bubbles were further
color coded with a proprietary Ivanti indicator.
The chart provided a clear view of which companies were on the
landscape, how the companies were competing with respect to price
and product capabilities, and which companies Ivanti primarily competes against. By examining the chart, it was also clear that some of
the companies were well positioned to present threats to companies
in other groups by changing products or pricing. For example, companies in the Alternative Delivery Providers and Small Business Segment
Full Suites groups seemed to be the biggest threat for encroaching
on Ivanti’s market share. Meanwhile, companies such as Novell, HP,
and CA, which offered similar software, seemed to have fallen out of
Ivanti’s strategic group. Still other firms, such as those in High-Growth
Niche Providers, seemed to be improving their product scalability.
These dynamics are represented on the chart with arrows. The strategic group map successfully informed the development of targeted
competitive strategies, but also helped identify potential acquisitions,
pricing, and product feature enhancements.
Full Suite–Large
Enterprise
High
VDI and Point
Players
High-Growth Niche
Providers
HP
Revenues/
Market Share
Declining
Novell
CA
Absolute
Relative Price
RES
Software
Medium
IBM
BigFix
Microsoft
(SCCM)
Symantec/
Altiris
Lumension
Ivanti
AppSense
Bomgar
JAMF
Dell/Kace
Wanova
Threats from
Below
Microsoft
(InTune)
Kaseya
Matrix
42
Full Suite—Enterprise
Numara
(BMC)
Low
Alternative Delivery Providers (Primarily
Small Business Segment)
Small Business Segment Full
Suite
Size of bubble reflects the size (revenue) of the organization
Product Capabilities/Scalability
FIGURE 11.3
Ivanti Software—Strategic Group Map and Competitive Landscape
For example, consider a strategy canvas analysis of Southwest Airlines and its unique value
proposition relative to full-fare airlines and automobile travel (see Figure 11.2). Various features
that customers care about when selecting among travel options are identified and placed on the
horizontal axis. These features include price, meals, lounges, seating choices, hub connectivity,
and so forth. Next, company performance is evaluated against these criteria and scored on the
Evaluating the Competition
199
vertical axis. This scoring can be based on rigorous quantitative scales, such as those obtained
from surveys or other market research, or on estimates. The completed strategy canvas provides
insight into how competitive offerings are differentiated.
In Figure 11.2, Southwest’s scores more closely resemble automobile travel than they do
the scores for other full-service airlines. This analysis uncovers a key point about Southwest’s
approach to the market. When Herb Kelleher founded the airline in 1971 at Love Field in Dallas
to fly passengers to Houston and San Antonio, he set out not to compete with airlines but,
rather, with automobile travel.
The strategy canvas is a useful tool not only for uncovering existing differences among
competitors, but also for identifying new ways to beat rivals. Imagine Figure 11.2 without
Southwest’s line drawn on it. If you were launching a new airline, or even if you were running
an existing airline, you might be able to identify new opportunities for competitive positioning
by studying the differences between how other airlines and cars are competing across relevant
purchase criteria.
Evaluating the Competition
Now that we’ve explored how to look at the competitive landscape, we can turn to examining
the motives and likely behavior of individual competitors. Anticipating the actions of rivals is an
important skill for companies because it helps them evaluate their own competitive moves to
identify those that will have the most advantageous effect. A useful way to examine a competitor is to develop a competitor response profile.9 A competitor response profile identifies characteristics of a competitor in order to assess how it might respond in the face of rival actions, as
outlined in Figure 11.4.
WHAT DRIVES THE
COMPETITOR
WHAT THE COMPETITOR
IS DOING OR IS
CAPABLE OF DOING
Objectives
Strategy
• Leverage the benefits of
international scale for overall
cost savings.
• Capture a greater share of
market by providing home
city to destination travel for
international passengers.
Delta
• Delta is likely to
largely ignore entry
into its international
city-to-city markets
by Southwest, as
long as these entries
remain few.
Assumptions
• Passengers want to fly the same
airline domestically and
internationally.
• Scale savings exist by having a
global footprint, which permits
competitive pricing on international
routes.
FIGURE 11.4
• Position as an international travel
choice to as many customers as
possible by building an extensive
travel network.
Resources & Capabilities
• Locations in major cities
• Airline partners that provide global
reach
• Fleet of large aircraft
• Reliable and service-oriented travel
Competitive Response Profile
Source: Adapted from M. E. Porter, Competitive Strategy (New York: The Free Press, 1980).
competitor response profile A
profile of a competitor that
identifies its objectives and
assumptions, its strategy, and its
resources and capabilities in order
to anticipate how the competitor
might respond to rival actions.
200
C H A PT E R 11
Competitive Strategy and Sustainability
What Drives the Competitor?
To illustrate how to build a profile, let’s return to the airline industry. Let’s assume that Southwest
Airlines wants to compete on international routes in Europe and is evaluating Delta as a comp
editor. The first question to ask is, “What drives the competitor?” Within this category, objectives and
assumptions are identified. An objective for Delta could be, “Leverage the benefits of international
scale for overall cost savings,” or, “Capture a greater share of market by providing home-todestination travel for international passengers.”
What assumptions reinforce these objectives? One is that passengers want to fly the same
airline domestically and internationally, possibly because of co-located terminals or easier baggage transfers. Another is that scale savings exist by having a global footprint, and that this permits competitive pricing on international routes (since scale savings lower costs). These kinds
of assumptions often point the way to potential rival moves. For example, if Southwest theorized that the scale savings from Delta’s global footprint were small, or that Southwest’s own
operating model gave it significant cost benefits, it could plan on using this as an advantage
against Delta and contest some of its rival’s more popular international routes.
What Is the Competitor Doing or Capable of Doing?
After identifying the objectives and assumptions that drive the competitor, the next question
would be: What is the competitor doing and capable of doing? Here is where a competitor’s
strategy and its resources and capabilities are identified. What is Delta’s strategy? Put simply,
Delta’s strategy is to position itself as an international travel choice to as many customers as
possible by building an extensive travel network.
What resources and capabilities does Delta use to accomplish this? Resources include its
locations in major US cities that are international gateways, such as New York, Atlanta, Seattle,
and San Francisco; airline partners that provide coverage where Delta is weak; and a fleet of
large planes that are characteristic of long-haul travel on international routes. Further, the
airline has built a capability for reliable, timely, and service-oriented international travel.
These resources and capabilities point directly to what Delta can do on a competitive basis,
such as supplying international corporations with end-to-end travel services. These are the
strengths that Southwest, in our hypothetical example, must acknowledge if it is going to
challenge Delta.
How Will a Competitor Respond to Specific Moves?
After these four factors—objectives, assumptions, strategy, and resources/capabilities—are
laid out for a specific competitor, a company such as Southwest can anticipate how the competitor might respond to specific moves. For example, given this profile, how would Delta
respond to Southwest entering one of its existing city-to-city routes? Given that Delta differentiates, in part, by providing a broad set of international route options to customers, the
company will probably not react strongly to Southwest entering a single city-to-city route
or even several routes. Why? Think about Delta’s objectives, assumptions, strategy, and
resources/capabilities. These include international scale, cost savings based on this scale,
an end-to-end extensive travel network, and substantial global assets. Because Delta is adding value by being in as many places as possible and is building an extensive network, the
company is unlikely to view the entry of a competitor without these objectives and resources
as a threat to its broader strategy. In formulating its competitive strategy, Southwest can feel
confident that entering into markets already occupied by Delta will be accommodated, at
least while Southwest’s international travel network remains small. If it begins to grow large,
Southwest could wind up moving into Delta’s strategic group, which could then invite intensive competition.
Evaluating the Competition
201
Using Game Theory to Evaluate Specific Moves
A competitive response profile provides an extensive look at a particular rival and also lends
insight into how this rival might respond to specific strategic actions. When rivals are locked in
intensive back-and-forth competition, such as that experienced in the airline industry, a structured approach to analysis can lend even more insight. The tools of game theory provide such a
structured approach. The word game in game theory refers to strategic interaction among competitors and the word theory refers to a set of predictions about how competitors play games.
In most games, rivals are expected to make moves that deliver the greatest profit, called a
pay-off. Firms typically make their choices with this objective in mind. But rivals have choices,
too. With both firms facing choices, each must consider what the other will do in order to reach
their own best outcome. This logic of anticipating what is in a rival’s best profit interest before
making your own move is central in game theory. Had Delta considered this in the opening
case, the company might have anticipated how quickly rivals would respond to its price cut.
Game theory is especially useful in contexts in which only a few rivals exist (such as airlines) and these rivals are considering such moves as price changes, capacity adjustments, or
new product features, and are wondering how competitors are likely to respond. Let’s examine
the logic of game theory to see how it can be used to anticipate and respond to rival actions.
Simultaneous Move Games To illustrate the basic logic, let’s consider a simple game
with two players, each of whom has two choices. Assume the players make their moves simultaneously and they play the game only once. This set up is called a simultaneous move, one-shot
game. The most famous game of this type is the prisoner’s dilemma. The prisoner’s dilemma
is as follows:10 Two individuals, prisoner 1 and prisoner 2, rob a bank of $2 million and hide the
loot. They have been captured and are being held by police in separate cells. The police believe
that the two robbed the bank but lack sufficient evidence to convict. So they decide to separately offer to each prisoner the following deal: “If you implicate your partner, we will give you
leniency. But if your partner implicates you, you will get jail time.” The prisoners know that if
neither implicates the other, they will both go free.
Now consider the following 2 × 2 matrix representation of the game shown in Figure 11.5. It
shows that each prisoner has two choices. Prisoner 1’s choices are on the rows and prisoner 2’s
choices are on the columns. The numbers in the cells are payoffs. The payoff on the left in each
cell belongs to prisoner 1 while the payoff on the right belongs to prisoner 2.
To interpret payoffs, assume that one year of jail time is the equivalent of $1 million of the
loot. If neither prisoner implicates the other, they go free and share the loot. If both implicate,
they go to jail for one year each. If one implicates the other while not being implicated, he gets
off and takes all the loot for himself, while the other goes to jail for two years. Assuming that the
prisoners play the game only once, they either get off free and go their separate ways, or do so
after they get out of jail. If they both go to jail, assume the loot is recovered by the authorities.
Prisoner 2
Prisoner 1
Implicate
Do not
implicate
FIGURE 11.5
Prisoner’s Dilemma
Implicate
Do not
implicate
–1, –1
2,–2
–2, 2
1, 1
game theory A structured
approach to analysis of
competitor interaction that yields
predictions about which strategic
actions are most likely to be
chosen by rivals.
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C H A PT E R 11
Competitive Strategy and Sustainability
Nash equilibrium A set of moves
in a game that simultaneously
maximize each firm’s payoff, given
the choices of rivals, and from
which no player has an incentive
to defect.
dominant strategy In game
theory, a set of actions that is
always played no matter what a
rival chooses to do.
Since the prisoners are being held in separate interrogation rooms, they must make their
choices (“implicate” or “do not implicate”) without knowing the choice of their partner. This
is the simultaneous move aspect of the game. Assume both players know the structure of the
game and the payoffs accruing to their respective actions.
What is the predicted outcome for this game? John Nash, a famous game theorist, developed an equilibrium concept in games that has come to be known as the Nash equilibrium. The
Nash equilibrium is represented by a set of moves in a game that (1) maximizes each firm’s payoff
given the choices of rivals and (2) removes the incentive to defect in the sense that no player can
improve his payoffs by changing his choice. The first component of the definition reflects that
players are striving to achieve their best possible outcome while the second ensures that the
outcome is stable (i.e., the players have no incentive to change their action). The Nash equilibrium
is the solution concept used to predict the outcome of competitive interaction.11
To find the Nash equilibrium, think through what a player should do under each possible
move of its rival. Let’s look at the game from prisoner 1’s perspective. Suppose prisoner 1 thinks
that prisoner 2 might implicate (look at the implicate column for prisoner 2). Prisoner 1 has two
choices. He can implicate and receive −1, or not implicate and receive −2. Which does he prefer?
He prefers to implicate since we assume that players always prefer the better payoff.
Now let’s consider what prisoner 1 would do if he believes prisoner 2 will not implicate.
Under this scenario, prisoner 1 receives a payoff of 2 if he implicates and a payoff of 1 if he does
not implicate. Clearly, he prefers to receive 2 over 1, so he would implicate.
Notice that no matter what player 2 chooses to do, player 1 maximizes his payoff by
choosing “implicate.” Doing the analysis from prisoner 2’s perspective gives the same answer.
The intersection (cell) of any choices that are simultaneously preferred by the players of a game
is considered a Nash equilibrium, as long as there is no incentive to defect. In this game, each
player’s best choice is to implicate, and neither has an incentive to change this choice.
Implicate is also what is called a dominant strategy because it is the best choice under
every alternative choice of the rival. Searching for a dominant strategy makes finding a Nash
equilibrium easier in games where such strategies exist. In the prisoner’s dilemma, after discovering that “implicate” is a dominant strategy, the analyst can cross off both the row and column
associated with “do not implicate.” This choice would never be employed because it is always
dominated by the implicate choice.
Notice how the style of analysis that we used to solve the game resulted in the development
of a strategy for play. In game theory, a strategy is a set of best responses to every possible
rival action. We systematically analyzed prisoner 1’s prospects under each possible alternative
action of prisoner 2 and selected the best outcome. In the real world as well, this is a useful
approach for developing a competitive strategy. If the number of possible moves of a rival is
small, a potential response to each one of those possible rival actions can be planned. Having
done so, a company would have identified a competitive strategy.
The key lesson from the prisoner’s dilemma is that each player implicates and goes to jail
when a much better outcome exists. If they both play “do not implicate,” they share 1, or $1
million each. However, the competitive risk, the lack of trust, and the worry that a rival will take
advantage of the situation if he thinks the other will play “Do Not Implicate,” keep both players
going to jail. The reason this is important in real markets is that it suggests a truth about competitive behavior. Namely, competitors will play with their own best interests at heart. Furthermore, since in most markets cooperation between competitors is anticompetitive and illegal,
coordination typically does not exist—and neither does trust. Therefore, the prisoner’s dilemma
offers a compelling prediction about what happens in real markets when companies have
opposing interests.
Now consider a prisoner’s dilemma game in the business world. Let’s return to the opening
case and assume that Delta Airlines is playing a one-shot pricing game against American Airlines (we’ll make the one-shot assumption for now and relax it in a moment). Let’s assume that
in this game each firm has two choices. It can either maintain price or lower price. If both maintain price, each earns a profit of 5, or $5 million. If both lower price, each earns a profit of 2, or
Evaluating the Competition
American
Maintain
Lower
5, 5
–1, 10
10, –1
2, 2
Delta
Maintain
Lower
FIGURE 11.6
Delta and American Play Out the Prisoner’s Dilemma
$2 million. But if one company lowers price while the other maintains price, the first company
receives a profit of 10, or $10 million, while its rival loses 1, or $1 million. See Figure 11.6.
To solve this game, take the perspective of one firm and decide which move would be best
under each alternative action of the other firm. If Delta believes that American will maintain
price, it has a choice between payoffs of 5 and 10 for maintaining and lowering price, respectively. Clearly, Delta prefers to lower price. If Delta believes that American will lower price, then
it has a choice between a payoff of −1 and 2. It prefers to lower price to receive the payoff of 2.
The logic is similar from American’s perspective.
As in the traditional prisoner’s dilemma, both firms wind up with payoffs that are worse
than they might have received. Specifically, if both companies would maintain price, they
would each wind up with $5 million. However, in the one-shot game, the pull to try for $10
million is very strong. This leads both companies to a relatively poor outcome of $2 million.
This game illustrates how the prisoner’s dilemma can affect firms in real markets. Rivalrous
behavior can make both firms worse off than they might have been if they had been able to
cooperate. The example also illustrates how a simple game structure can be used for insight
into how players might respond to one another’s strategic moves.
Infinitely Repeated Games
Now let’s relax the assumption that competitors interact
just once as in the one-shot game. In the real world, most companies are in competition with
rivals each and every day, month, or year with no certain end date. Game theorists call these
games infinitely repeated games. Even though the games are not literally played forever,
they are treated this way since the competitors repeatedly interact and the ending period is
not known.
In infinitely repeated games, players always believe there is a future. This alters the way
they play. Specifically, they look for opportunities to get a larger amount of profit over a longer
period of time. In stable markets in which the players rarely change, firms play the game indefinitely. They know that they will be facing their rivals each and every period.
Delta and American play an ongoing pricing game in which they must decide whether to
maintain, lower, or increase price each and every period. (In fact, pricing games are played on
each and every route, often with multiple players). The companies do not know if or when the
games will cease to be played so treating their rivalry as an “infinite horizon” game is sensible.
To see how this affects the outcome of the game between Delta and American, consider
again Figure 11.6. We already know what happens in a one-shot game—both players choose to
lower prices, which makes them both worse off. However, both players know that they are not
playing a one-shot game. They can lower prices this period, but they have many future periods
to go. In this situation, we assume that the firms look at the payoffs and realize that they will be
better off over the long run if they maintain prices. Firms reason that this type of collusion is in
their mutual best interest, and they assume that their rival is thinking the same way. Therefore,
each decides to maintain price and expects rivals to do the same.
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Ethics and Strategy
Is Collusion Ethical?
Companies that consistently do battle with the same set of competitors eventually develop norms of competition that help them
avoid low profits. Although the companies are not communicating directly to develop these norms (which would be illegal), they
watch each other so closely that consistent patterns of behavior—
norms—can quickly emerge. The norms can influence pricing, product or service features, or certain kinds of restrictions on customers
that all companies impose.
For example, many people own a cell phone and have signed a
two-year contract for service with a telecommunications company.
All of the major cellular providers in the United States, AT&T, Verizon,
and Sprint, offer this two-year contract. How did this situation
arise? Simply put, the major telecommunications providers tacitly
colluded to set the contract requirement at two years. Whether
it’s airline pricing, in which airlines collude to keep prices high
and avoid price wars for themselves, airline service features such
as charging for bags on flights; the price of gasoline at the pump;
or the cost of an automobile or medication, large and powerful
companies—airlines, oil companies, auto companies, pharmaceutical companies, and so on—often collude to keep profits high.
tit-for-tat strategy A strategy
that responds in kind to the moves
of rivals.
On the one hand, by keeping profits high, these companies
are able to invest in research and development and continue to
come out with great products. Such products can even improve the
quality of life. In the pharmaceutical industry, for example, companies would not be willing to invest billions of dollars in research
and development without a reasonable assurance of recouping this
cost through high prices.
On the other hand, high prices of drugs or other products limit
access. Through collusion, many products are priced out of reach
of less-affluent consumers. As large companies use their power to
raise prices, higher proportions of economic resources are directed
toward their products and away from other products or causes in
the economy. Some would say that this misallocates resources in
ways that make consumers worse off and unfairly channels profits
to shareholders.
What do you think? Should the legal form of collusion practiced in markets by large firms be allowed? Should restrictions be
imposed? If so, how would such collusion be monitored and controlled? Are you willing to accept collusion in exchange for betterquality products in some cases? Does your view change if you are a
shareholder of a company that practices collusion?
In effect, companies in this situation enter into a style of play called “tit-for-tat.” In a
tit-for-tat strategy, companies watch each other closely and choose actions that mimic what
their rivals are doing. As long as a rival is “cooperating,” the firm chooses to cooperate. If a rival
defects from a cooperative stance, the firm responds in kind. In the game between Delta and
American, each firm chooses to maintain price unless it observes its rival choosing to lower
price. If at any time the rival lowers price, the firm will “punish” by lowering its own price. After
a few periods of this kind of “punishment,” it’s possible that the rivals could return to collusion,
but doing so could grow increasingly difficult in the presence of repeated defections (see Ethics
in Strategy: Is Collusion Ethical?).
One question that arises in these types of repeated games is whether playing the one-shot
Nash equilibrium is ever in a firm’s best interest. The answer depends on the differences in cash
flows between collusion and defection (defection here means playing the one-shot action).
The value of these cash flows, in turn, depends on the time value of money since payoffs are
received each period in perpetuity. (See the Strategy Tool: When Does Defecting from Collusion
Make Sense?) Typically, however, ongoing collusion is the best approach, and it is what most
firms in long-standing stable competition practice. As explained in the chapter opening case,
when Delta chose to lower prices, its rivals immediately followed suit. The logic of game theory
that we have just reviewed shows why. In fact, rivals did not even wait for Delta to obtain a temporary advantage; they lowered prices immediately. They reacted quickly with their tit-for-tat
strategies, refusing to allow Delta to use price as a competitive advantage.
Game theory is a useful tool for analyzing and predicting rival actions in any context in
which discreet actions are clear and payoffs can be specified. Constructing a game scenario
is useful even when it represents a simplification of a real-world setting. The reason is that
solving a simple game can provide insight into how competitors are likely to play more complex games, as we saw in the games illustrated by Figure 11.6. To construct payoffs for game
scenarios, conduct detailed financial modeling or simply rank the value of conditional actions
for each competitor, with more valuable actions ranked higher. Even if conditional payoffs had
been only ranked in Figure 11.6, the insights would have been the same. By setting up simple
game scenarios, analysts can quickly predict the outcome of competitive interaction, and specifically, how a firm’s rivals may react to specific moves. This can contribute to successful evaluations of the competition.
Principles of Competitive Strategy
Principles of Competitive Strategy
Now that we know how to evaluate the competition and to analyze the dynamics between
competitors, let’s turn to identifying competitive moves that are most likely to be effective.
Four general principles of competitive strategy should be followed as a company looks for successful competitive moves.12 These principles, when applied, strengthen a company’s ability
to compete:
1. Know your strengths and weaknesses
2. Bring strength against weakness
3. Protect and neutralize vulnerabilities
4. Develop strategies that cannot be easily imitated or copied (go where the competitor is not)
Know Your Strengths and Weaknesses
The first principle is to know your strengths and weaknesses. A company’s strengths are the
resources and capabilities that deliver unique value (see Chapter 3 for a detailed discussion
about resources and capabilities). A company must work to develop these strengths through
focus, investment, and effort. A key strength of Apple is product design. But it is the relentless
focus on developing and investing in that strength that turns it into a strong and sustainable
source of competitive advantage.
A company’s weaknesses are the resources and capabilities that are subject to rapid obsolescence, easy imitation, or high cost not recouped by value. Apple has strengths in product
design, but its products are subject to rapid obsolescence because of the rapid pace of technological change. Similarly, Starbuck’s atmosphere is easily imitated so the company cannot rely
on this alone as a source of competitive advantage.
A company must make a careful and accurate assessment of its strengths and weaknesses
because these form the foundation of competitive strategy as the next two principles illustrate.
Bring Strength Against Weakness
Second, bring strength against weakness. After a company’s key strengths are identified, they
should be targeted to competitor weaknesses. Bringing strength against weakness can have
devastating effects on the competition. When Google launched Android in 2007 as a mobile
operating system for smartphones, Microsoft was already limping along in mobile phones,
having suffered rapid market share declines because of products from Apple and Research
in Motion (RIM, now Blackberry). Google leveraged its formidable strength in software engineering innovation and then built a coalition of manufacturers who would adopt Android (the
open handset alliance) to deliver a strong body blow to Microsoft, whose rapidly decaying
resource investments and declining market share made the company vulnerable in this area.
Sometimes competitor weaknesses may be masquerading as strengths, so any apparent
competitor strength that can be undermined or eroded through direct competitive action can
be considered a weakness. Therefore, in their hunt for competitor weaknesses, companies
should not be afraid of attacking competitive strengths. As Kmart struggled to stay afloat amid
bankruptcy, Walmart attacked what was considered one of Kmart’s few areas of success by
introducing a knockoff of Kmart’s Martha Stewart product line.13 This strong blow contributed
to Kmart’s downfall.
Protect and Neutralize Vulnerabilities
Third, protect and neutralize vulnerabilities. A company’s own weaknesses, once identified,
must either be strengthened or truly neutralized; that is, made irrelevant so that they don’t
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become targets of competitors. Starbucks neutralizes the effect of an easily imitable atmosphere by also introducing a large variety of great tasting coffee blends, food items, store convenience, and brand positioning.
In the last story, Microsoft might have assessed its weakness in mobile earlier than Google
did and made moves to strengthen this vulnerability by investing much earlier in a new mobile operating system. As another example, some regard Apple’s closed, proprietary mobile
operating system, iOS, as a competitive vulnerability since other companies are not allowed
to deploy it on their devices. This could limit its market potential. In fact, Google attacked this
weakness by making Android an open platform. However, Apple has been highly effective at
neutralizing this weakness through strong design of its products and development of an extensive developer network in which developers of applications share in the value of the proprietary system.
Develop Strategies That Cannot Be Easily Copied
Lastly, develop strategies that cannot be easily imitated or copied. This seems obvious, but
often companies are so busy copying competitors’ moves that they fail to see how they could
do something altogether different. The principle might be best captured in the idea of going
to where the competitor is not. Sun Tzu, the great Chinese strategist, once said, “To be certain
to take what you attack is to attack a place the enemy does not protect.”14 Whether a company
is pursuing special market niches, reconfiguring the sequence of its activities along the value
chain, or recombining and leveraging resources of themselves and partners in ways that deliver
value, competitive strategy flourishes when companies are doing something unique.15
In fact, most long-time competitors have found a way to occupy distinctive positions in
their markets so that they can coexist with other companies profitably. Returning to the airline industry, even though American, Delta, and United compete in the same strategic group in
the United States, each has carved out distinctive hubs within their nationwide hub-and-spoke
system so that they don’t completely overlap as they compete. Delta has hubs in Salt Lake City
and Atlanta. United has hubs in Chicago and Denver. American has hubs in Dallas and Chicago.
So although there is some overlap between the cities to which they fly, each of the major competitors has staked out a somewhat distinctive position relative to rivals.
In summary, these four competitive principles may be used to develop strong and unique
competitive positions that improve the likelihood of long-term competitive success.
Competitive Actions for Different Market
Environments
market structure The way rivals
in a market interact and bargain
for advantage. In its simplest
terms, it’s the number of rivals in a
particular market.
Clearly, not just any competitive move will work against a target competitor. A firm’s circumstances define which competitive actions are available and likely to be effective. Market context
strongly influences the scope of competitive action. One particular aspect of market context,
market structure, is highly influential. Think of market structure in its simplest terms as the
number of rivals in a particular market. Market structures typically fall into one of three categories: monopoly, oligopoly, or perfect competition (sometimes referred to as just “competition”).16 Each of these market structures creates certain competitive conditions that lead to
particular sets of strategy choices when facing competitors.
Competition Under Monopoly
A monopoly is a market of one firm or one highly dominant firm, such as Sirius XM in satellite
radio or Microsoft in word-processing software for personal computers.17 The basic strategic
objective of a monopolist is to reinforce its monopoly. It does so in several ways, such as by
Competitive Actions for Different Market Environments
207
(1) raising entry barriers, (2) limiting competitive access to scarce resources, (3) innovating and
patenting, and (4) introducing new products frequently. If a monopolist has new competitors
threatening to enter its market, these are among the competitive actions they should consider
taking as a response. On the flipside, the competitor attempting to enter the monopolist’s market can expect these kinds of retaliatory actions from the monopolist.
Raise Entry Barriers A barrier to entry is any factor that increases the costs, lowers the
profit margins, or limits the market share of entrants to a market. For example, a monopolist
may choose to practice limit pricing, which means to set the market price of a product just low
enough so that a new entrant cannot pay the cost of entry to come into a market and be profitable. Investing in heavy advertising or advertising over long periods of time also raises entry
barriers. Coca-Cola’s brand equity, worth billions, was built through long-term consistent
advertising, and it is a formidable barrier to entry for any firm looking to get into the cola market.
Limit Competitive Access to Scarce Resources If a monopolist can place a
lock on the resources that it uses to produce its product, it can effectively bar competition. The
monopolist might hire the most valuable scientists or other experts; it might secure the most
advantageous geographic or real estate positions; or it might procure all of the capacity available in a market for some particular input. For example, when JetBlue launched its regional
jet strategy, the company entered into contracts with Embraer, the Brazilian manufacturer
of regional jets, to purchase all of Embraer’s planes for three years. This effectively blocked
any other competitors from procuring the same regional jets and implementing the same
strategy.18
Innovate and Patent To maintain its competitive position, a monopolist is often
required to innovate and patent.19 Indeed, in many monopolies both the monopolist and
would-be entrants are in an innovation race. Potential competitors can bring down a monopolist by making the monopolist’s product obsolete through innovation, while monopolists
can stay ahead of potential market entrants by innovating themselves. As already mentioned,
Microsoft lost its hold on the mobile operating system market in 2008 after failing to innovate
sufficiently.
Introduce New Products Frequently
By introducing new products frequently,
monopolists can maintain the customer demand associated with their products and stay ahead
of potential entrants who are trying to get into their markets. Apple Inc. dominated the market
for handheld music players (the iPod) in the early days. Other firms attempted to get into this
market, and certainly other devices appeared, but these devices obtained only a small fraction
of the total share of market. Apple kept would-be entrants off balance by consistently and frequently releasing new product upgrades and enhancements. As already noted, this was also a
way for Apple to overcome a potential weakness of rapid obsolescence.
Competition Under Oligopoly
Oligopolies are markets of a few firms, typically two to five, though in some cases the number
could be as high as 10. The upper bound is difficult to define because the oligopoly designation depends on whether firms in these markets are monitoring and reacting to specific rival
behavior. If there are few enough firms for each to monitor the others effectively, then they are
probably operating in an oligopoly.
Because the firms in oligopolies are locked in tight competition with only a few other firms,
they must make their moves carefully, knowing that rivals will detect their actions and respond
accordingly. We saw this as we analyzed infinitely repeated games and looked at an illustration
of the competition between Delta Airlines and American Airlines. From a competitive perspective, oligopolists monitor and mimic rival behavior, particularly in price and product features,
and they employ tit-for-tat strategies.
barrier to entry Any factor that
increases the costs, lowers the
profit margins, or limits the market
share of entrants to a market.
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Monitor and Mimic Rival Behavior
Oligopolists try to avoid the negative effects
of competition by monitoring and matching rival behavior. In this process, norms emerge in
competition around particular approaches to the market. For example, pricing norms are very
common. Companies know that they could dramatically cut their price and possibly pick up
market share in the short run, but they realize that this move would be quickly detected and
matched, leading to lower profits for all firms in the market.
We analyzed this scenario using game theory. In the opening case, Delta airlines violated
the pricing norm of its strategic group by matching prices with the low-fare carriers. This led
to immediate retaliation by rivals so that almost no advantage was obtained and the whole
industry suffered. This is a clear example of how trying to beat the norm rarely pays. Thus, for
the good of long-term profits, firms usually simply respond to one another’s pricing and product features at levels that are profitable for all (also see infinitely repeated games).
Although the firms in oligopoly almost always respond to one another’s pricing moves, they
don’t always match price, since some companies position their products at a premium. Coke
and Pepsi are oligopolistic rivals, but Coke has staked out a price position that is slightly higher
than Pepsi. Even so, if Pepsi raises its price, Coke will too in order to maintain the differential.
Price is not the only area of mimicking and matching among oligopolists. The behavior
can also be seen in product or service-feature competition. When one airline announces a
new frequent-flier program or significant new upgrades to its existing plan, so do the others.
When one hardware manufacturer, such as Apple, introduces a new touch-screen device, rivals
quickly follow suit. When Chevron adds a new detergent additive to its gasoline, Texaco does
the same (the two companies have now merged). By matching product and service features,
oligopolists ensure that they do not fall behind. In this way, oligopolists protect their profits
and command higher margins from the market overall.
Finally, oligopolists may tacitly respond to one another in ways that carve up the market
so that all can profitably coexist. The airlines do this with major hubs in different cities as
described above. But the behavior can also be seen in the ways that oligopolists sometimes
choose to appeal to particular market segments, with one providing price leadership in one
segment and another providing it in a different segment (see Strategy in Practice: Tacit Collusion Between AT&T and Verizon).
Employ Tit-for-Tat Strategies
As previously discussed, tit-for-tat strategies are those
that respond in kind to the moves of rivals, including the meting out of punishments for behavior
that violates norms (e.g., price wars, lawsuits, etc.). Because of the threat of this type of punishment, defections from tacit collusion are reasonably rare among oligopolists. When defections do occur, they are often accompanied by a signal that communicates the parameters of the
action, such as length of time, in a way that rivals can clearly read. For example, airlines may run
sales discounts on certain city-to-city routes, but these discounts are almost always accompanied by specific dates for which discounted fares are available. This provides an explicit signal to
rivals so that they can interpret the parameters of the discount and avoid a price war.
“Perfect” Competition
“Competitive” markets are markets with many firms. In competitive markets, firms are price
takers rather than price setters because attempts to use price strategically, as is done in
monopolies or oligopolies, are not effective and wind up hurting the firm that tries. The logic
goes like this: Because a firm sells a homogeneous good in a market of many firms, raising price
leads to a dramatic drop in sales as customers go elsewhere. On the other hand, lowering price
can backfire because firms are assumed to operate at full capacity. If firms are at full capacity,
dropping price reduces total margin by more than it increases sales, leaving the firm worse
off. If firms are not yet at full capacity, then price will typically fall until they are, and further
attempts by individual firms to cut price will have negative effects. This is why firms in perfectly competitive markets set prices at the market prevailing price and largely avoid strategic
manipulation of price.
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209
Strategy in Practice
Tacit Collusion Between AT&T and Verizon
From 2007 to 2011, AT&T enjoyed a monopoly on the iPhone since
it was the only cellular carrier that Apple, Inc. allowed to provide
services for the phone. But in January 2011, Verizon was also finally
permitted to carry the iPhone, setting up an oligopoly between
AT&T and Verizon (Sprint was added in October of that year). Following a short period of offering unlimited data plans, both AT&T
and Verizon eliminated their unlimited data plans for new users.20
In addition to matching one another’s moves in this way, the
companies’ pricing behavior took on a collusive flavor. AT&T priced
slightly lower than Verizon for data plans up to 4 GB and Verizon
priced slightly lower than AT&T for data plans above 4 GB. In addition, the slope of the pricing curve (the rate at which price rises as
additional data is added to a plan) was almost exactly the same for
the two companies at key GB levels (see Figure 11.7). In other words,
as AT&T’s price rose, so did Verizon’s as the companies sought to
maintain a consistent pricing differential. Notice in Figure 11.7
how the companies were not necessarily matching prices, but their
pricing structures were very similar. An understanding seemed to
exist between the two, in which AT&T, who historically served more
business customers, would charge higher rates for customers using
more data, while Verizon would charge higher rates for customers using less data. The matching behavior of the cellular carriers
in pricing and plan structure, and the different targeting of market segments, demonstrate how oligopolists collude to maintain
profitability.
$120
Verizon Cheaper
AT&T Cheaper
Implied Cost
$100
$80
$80
$60
$50
$60
$50
$40
$40 $30
$30
$65
$55
$30
$45
$35
$20
$0
$105
$15
0.2
$25
$25
1.0
2.0
3.0
AT&T
4.0
5.0
6.0
Verizon
10.0
Monthly Data (GB)
FIGURE 11.7 Smartphone Monthly Wireless Data Cost Comparison—AT&T Cheaper
at the Low End, Verizon Cheaper at the Higher End
Source: Barclays Capital, company reports and websites.
Since a typical assumption of competitive markets is that products are largely homogeneous, very little differentiation is assumed to exist in these markets. This leads to a very
specific set of competitive strategies that are likely to be successful. The list includes (1)
consolidate markets, (2) pursue low cost, or (3) pursue differentiation strategies.
Merge or Consolidate Markets
Firms in competitive markets often suffer from the
superior bargaining power of buyers or suppliers (forces that are part of Michael Porter’s five
forces model discussed in Chapter 2). Because many firms in the market are selling a homogeneous product, bargaining power is difficult to obtain. This feature of the market also creates
intense rivalry among firms.
One strategic remedy to this problem is for firms in the market to merge. As they merge, the
overall market consolidates, reducing the number of firms and strengthening the bargaining
power between the firms’ upstream suppliers and downstream customers. This merger and
consolidation process is the way that industries evolve toward oligopoly.21 Merging before a
competitor might be a way to obtain advantages in cost (owing to scale) or bargaining power.
A competitive market of “mom-and-pop” video rental stores gave way to a consolidated
oligopoly of Blockbuster and Hollywood Video stores in the 1990s and 2000s. Hollywood Video,
in particular, began as a local video rental family business and, through the vision of its CEO,
Mark Wattles, eventually expanded to 2000 stores nationwide. In the face of this consolidation,
most of the mom-and-pop video rental stores disappeared.
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In this example, the consolidators built new stores and the old stores disappeared, but with
enough foresight, the old mom-and-pop stores might have merged in local markets and retained
their hold on the business. This is a particularly good illustration of how firms in a competitive
market can fail to anticipate the kinds of moves that could save them from obsolescence.
Pursue a Low-Cost Strategy Since companies in competitive markets are price
takers, they have little control over price. Therefore, in order to realize profit, they must drive
down their costs. In fact, it might be said that companies in such markets will live or die on their
ability to get costs down. Especially in markets for which differentiation is difficult, rivals can
expect other firms to aggressively lower costs. They must respond in kind in order to remain
competitive. Chapter 4 details strategies for reducing costs, and any of those strategies can
help the firm in a competitive market be successful.
Pursue a Differentiation Strategy
When possible, companies in competitive markets should pursue a differentiation strategy. To separate themselves from the pack, they can
add product features, store locations, bundled services, or other variations to create unique
value for customers. However, in markets with many firms selling homogeneous products, this
is often easier said than done. Consider book selling on the Internet. For any given title, a book
may be obtained from multiple different sources, including Amazon, Barnesandnoble.com,
Walmart, Target, or a host of smaller sellers or even used booksellers such as eBay. The firms
sell the same book. How can they differentiate? The product is the same no matter where it is
bought. In this case, firms are left to differentiate on other aspects of the buying experience,
such as the look and feel of the website, its ease of use, or the checkout process. Early in its history, after realizing it could not make money on discounted bookselling, Amazon expanded its
business into many other product lines. The fact that a customer can go to Amazon and buy not
only a book but also many other items now helps Amazon differentiate its buying experience
for books alone. Chapter 5 details differentiation strategies, and these may be especially useful
for firms in competitive markets.
Dynamic Environments
The strategies discussed so far apply to stable market structures. However, some competitive
environments are very dynamic, with competition constantly changing. Perhaps technology is
changing at a very rapid pace; or new entrants with new technologies, products, or approaches
are entering markets very quickly; or market consolidation is changing the landscape in unexpected ways. In such environments, industry incumbents may not be able to raise entry barriers or limit access to scarce resources rapidly enough to stave off competition.
What companies must do in these environments is reconfigure their processes and capabilities to emphasize both innovation and speed. Imagine a company without these characteristics. Even if such a company were able to erect barriers to entry or secure access to scarce
inputs, these advantages are likely to be fleeting because new competitors will rapidly innovate
around them. Without capabilities of speed and innovation, companies in dynamic environments are rapidly left behind. The smartphone industry provides an example. In an important
growth era, the innovations and speed of Samsung, Google, and Apple quickly outpaced the
market positions of companies such as RIM, Nokia, and Microsoft. To stay in the game, these
companies too must be innovative and quick to market with value creating products. This will
depend on their capacity to build effective internal processes.
Sustaining Competitive Advantage
Many of the above strategies can help a firm create and sustain a competitive advantage. Nevertheless, the advantages offered by most strategies will almost always erode in time. What may be
useful in various contexts are several additional tactics or mechanisms that can extend the timeframe of sustainability. Five specific sustainability tactics and mechanisms are illustrated below.
Sustaining Competitive Advantage
Create or Preempt Rare Resources
The first tactic for sustaining advantage is to
first possess and then preempt others from acquiring scarce resources. These could be raw
materials, land, locations, or any other resource in limited supply. For example, DeBeers has
sustained its advantage in diamond production by owning a large percentage of the world’s
limited diamond mines. By controlling the limited supply of real diamonds, DeBeers is able
to keep prices of diamonds high for jewelry like necklaces or wedding rings. Land can be a
source of advantage in various industries like oil and natural gas. Energy companies that are
able to locate energy resources and then purchase the land where they reside can sustain their
advantage. Locations can also be a source of sustainable advantage. Walmart’s high profits in
its early history was due in large part because it was the first discount retailer to put stores in
smaller rural towns. It’s low prices and broad product variety was impossible for the smaller
mom and pop stores to imitate. Its advantage was sustainable because large discount competitors like Target, Sears, and K-Mart rationally refused to enter the same rural towns since
a second discount store would create substantial overcapacity. In similar fashion, when Starbucks built a large number of stores in premium locations throughout downtown Seattle it created a barrier to imitation for other coffee houses. This strategy prevented other coffee shops
from acquiring similar premium locations; moreover, if competitors tried to imitate Starbuck’s
strategy of building multiple stores there would be too many coffee shops to make money.
Companies that are the first to secure scarce resources are often described as benefiting from
“first mover advantages.”
Secure Government-Sanctioned Barriers
The second tactic is to secure
government sanctioned barriers to imitation in the form of patents, regulations, tariffs, etc. For
example, most pharmaceutical and biotechnology companies prevent imitation of their products—at least for a period of time—through patents. In the United States, Blockbuster drugs
like Adderall (for hyperactivity) and Viagra (for erectile dysfunction) were granted the standard
20 years protection from the date the patent application was filed. Government tariffs and
other regulations can also protect certain companies. For example, US tariffs on imported steel
help protect U.S. steel producers.
Create Buyer Switching Costs A third way to prevent imitation is to create buyer
switching costs. One source of switching cost is investment or learning on the part of a buyer. For
example, competitors of software companies like Microsoft have a hard time capturing Microsoft’s customers because users have invested significant time in learning how to effectively use
and navigate their Microsoft Office Suite (e.g., Word, PowerPoint, Excel). Buyers don’t want to
have to learn a new software program. Another way to prevent buyer switching is through loyalty
programs. Airline and hotel companies frequently get travelers to continually use their services
because the traveler has accumulated “miles” or “points” with a specific company and they
want to continue to build on their prior totals. Coke has long term contracts with key restaurant
chains like McDonalds that prevent competitors from getting access to Coke’s business.
Leverage Network Effects
A fourth way to prevent imitation is to offer a product or
service that benefits from “network effects.” A network effect is a phenomenon whereby a product or service gains additional value as more people use it. For example, Facebook wasn’t particularly valuable as a social media site when there were only a small number of users. But the
value of Facebook increased as more people joined the community. This kicked in a positive
feedback cycle whereby Facebook’s value increased exponentially as more users joined the
community.
Markets characterized by network effects are sometimes called “winner take all” markets
because the first mover to ignite the network effect often dominates the market. eBay (auctions),
LinkedIn (professional networks), and Skype (Internet calls), all benefit from network
effects. Companies that compete in “two sided markets” or “transaction platforms” also benefit
from network effects. For example, Uber (ride hailing), Airbnb (lodging), and PayPal (money
transactions) all benefit as more customers join their networks. Not surprisingly, a firm that
benefits from network effects becomes hard to dislodge by competitors who cannot replicate
the network effect.
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Leverage Rare Intangible Assets
Fifth, companies can prevent imitation through
valuable intangible assets such as branding, loyalty, and customer habit. Customers buy Tide
detergent because they know the brand and have just been using it for years. Former Procter &
Gamble CEO A. G. Lafley refers to this as Cumulative Advantage, a reservoir of goodwill among
customers that predisposes them to purchase new versions of Tide and not even look at competing brands.22 Competitors could create an iPhone knock off but due to the Apple brand, customer loyalty, and habit, Apple can effectively prevent imitation even if a competitor’s product
is functionally equivalent.
Generating and sustaining profits is a key challenge in the face of competition. Companies
should choose strategies and tactics that create long-term sustainability of their advantages.
Summary
• To effectively compete, a strategist should know the competition,
including understanding the competitive landscape and how to
evaluate specific competitors and their potential moves.
• Competitive actions depend on the market environments in which
firms compete, with some actions being more effective for certain
environments than for others.
• The tools of game theory can lend insight into competitive interaction by helping the strategist think systematically about how a company’s moves affect competitors, and vice versa.
• Sustainability tactics and mechanisms can be used to extend the
time horizon of sustainability of competitive advantage for companies.
• Principles of competitive strategy, such as knowing strengths and
weaknesses, bringing strength against weakness, protecting and
neutralizing vulnerabilities, and developing inimitable strategies, are
useful for identifying successful competitive options.
Key Terms
barrier to entry 207
barrier to mobility 197
competitor response profile 199
dominant strategy 202
game theory 201
market structure 206
Nash equilibrium 202
strategic group 195
tit-for-tat strategy 204
Review Questions
1. Name two frameworks for understanding the competitive landscape.
8. What are the strategies most likely to be useful for a monopolist?
2. What is a strategic group analysis, and how is it useful?
9. What are the strategies most likely to be useful for an oligopolist?
3. What factors might limit a company’s ability to switch strategic
groups?
10. Why do firms in an oligopolistic environment often hesitate to
make moves that will take them outside of the status quo?
4. What is a competitor response profile, and how is it useful in evaluating competitors?
11. What strategies are most likely to be useful for firms in perfectly
competitive markets?
5. Define the Nash equilibrium used in game theory to predict the outcome of competitive interaction.
12. What types of strategies are most useful for firms operating in
dynamic markets?
6. Identify the four general principles of competitive strategy.
13. Name five tactics that can be used to sustain competitive
advantage.
7. What are the three types of market structures?
References 213
Application Exercises
Exercise 1: Choose an industry and construct a strategic group map.
Do this by identifying some of the major players and some of the key
differences in how they compete. Select two factors for the two axes
and plot the firms. Do you observe a group structure? Explain.
Using the same industry as above, identify three companies that sell a
similar product. List some of the product attributes. Now evaluate each
company’s product on those attributes (it’s OK to do this qualitatively)
and plot the data using a strategy canvas view. What insights do you gain?
car; or two stores in a mall deciding whether to raise prices on men’s
clothing. Sketch a game matrix. Estimate or rank the conditional
payoffs (higher values more valuable) for each player for each choice.
Treat the moves in the game as simultaneous and find the Nash
equilibrium outcome if the game is played once (one-shot game). Now
consider how the game would change if it is played repeatedly forever
(infinite horizon game). What insights do you gain into the competitive
situation you chose?
Exercise 2: Identify a company whose products you use frequently.
Now identify one of its competitors. Imagine that you are the chief
strategist for the first company. Using the principles of competitive
strategy, list several strategic moves that you think could be effective
against the competitor that you identified.
Exercise 4: Identify a company whose products you use frequently.
Determine whether this company operates in a monopoly, oligopoly,
or competitive market. What does this imply about the competitive
strategies most likely to be successful? List some specific strategies the
company could use against competition.
Exercise 3: Choose a competitive situation and model it as a game.
Identify at least two players and two actions. Possible examples could
include two banks that are considering whether to offer free checking;
Google and Apple in the decision about whether to launch a self-driving
Exercise 5: Identify a company whose products you use frequently.
Choose and apply one or more of the tactics of sustainability and
explain how the company could employ the tactic to extend their
competitive advantage.
Strategy Tool
When Does Defecting from Collusion Make Sense?
In long-standing, stable oligopolies, most firms repeatedly play the
collusive outcome. (Collusion here is legal since the companies are not
explicitly coordinating or price-fixing.) However, we can use the payoff
structure to calculate the point at which firms would find defection to
be preferable to collusion. To do so, we simply compare the string of
payoffs under each alternative.
In the Delta and American game (Figure 11.6), maintaining price
delivers a stream of $5 million in perpetuity. The value of this stream
can be calculated as 5 + 5/ i (5 received now and a stream of 5s received
in perpetuity). The value of defection can be calculated as $10 million
received now, plus a stream of $2 million each year in the future. This
is because if either firm knows that its rival will maintain price, it can
initially grab a profit of $10 million by lowering price. But then the firm
knows it will be punished by its rival, and both firms will lower price in
future periods. The value of the collusion stream is 10 + 2/ i. We want to
know what discount rate on capital i will make cooperation a superior
strategy. In other words, what value of i solves the following equation?
5
2
5 + _i ≥ 10 + _i
Applying add and subtract operations to both sides and rearranging yields
3
__
≥5
i
3
i ≤ __5 ,
or 60%
Therefore, in this example, as long as Delta or American’s cost of
capital or discount rate stays equal to or below 60 percent, the company should continue to maintain prices.
References
1
E. Perez, “New Pressure to Simplify Airfare; Delta Details Plan to Cut
Some Prices by Up to 50%; Boston to Key West for $389,” The Wall
Street Journal (January 5, 2005).
5
S. Warren and E. Perez, “Southwest’s Net Rises by 41%; Delta Lifts
Cap on Some Fares,” The Wall Street Journal, Eastern edition (July 15,
2005): A.3.
E. Perez, “Business Fares Fall by One-Third; Delta’s Reductions Spread
Beyond Its Flight Network Following Cuts by American,” Wall Street
Journal (January 26, 2005).
S. McCartney, “The Middle Seat: Airlines Are Increasing Minimum-Stay
Rules; Step Is Effort to Force Business Travelers to Pay More for a Trip,”
The Wall Street Journal (August 19, 2008).
Perez, “New Pressure to Simplify Airfare.”
R. E. Caves and M. Porter, “From Entry Barriers to Mobility Barriers,”
Quarterly Journal of Economics 91 (2) (1977): 241–262.
2
3
S. W. Ames Bernstein, “Delta’s Prices Reach the Sky, Soaring Fuel Costs
Force a Stunning $100 Fare Hike; United, Continental and US Airways
Follow Suit,” Newsday (July 15, 2005).
4
6
7
C. Kim and R. Mauborgne. “Charting Your Company’s Future,” Harvard
Business Review (2002).
8
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Competitive Strategy and Sustainability
M. E. Porter, Competitive Strategy (New York: The Free Press, 1980).
9
The description of the prisoner’s dilemma employed here is adapted
from D. Kreps, A Course in Microeconomic Theory (Princeton: Princeton
University Press, 1990).
10
Some games have more than one Nash equilibrium and some
have no Nash equilibria. In these cases, game theorists have developed more complex rules and techniques to predict game outcomes.
Describing these rules and techniques is beyond the scope of the
current overview.
11
For a look at different approaches to competitive strategic moves,
see G. Stalk and R. Lachenauer, “Hardball: Five Killer Strategies for
Trouncing the Competition,” Harvard Business Review (2004).
12
Ibid.
13
S. Tzu, The Art of War. In Classics of Strategy and Counsel: The Collected Translations of Thomas Cleary (Shambhala, 2000).
14
D. J. Bryce and J. H. Dyer, “Strategies to Crack Well-Guarded Markets,”
Harvard Business Review (2007).
15
Falling into a fourth category are markets of many firms in which
firms are sharply differentiated, or heterogeneous. These are called
monopolistically competitive. Although this term sounds like an oxymoron, it refers to the idea that if the firm is differentiated it has a
local monopoly on customers who uniquely prefer its differentiated
product. Also, since the firm operates in a market of many other firms
that are likewise differentiated, the market gets the “competitive” title.
Consider a local restaurant market. All restaurants serve food and meet
the dining needs of their customers but the differences among these
restaurants in food variety, flavor, price, quality, ambience, service,
and so forth are stark. Competitive strategy in monopolistically competitive markets typically follows the strategies, noted below, of a
monopolist.
16
For many years, analysts considered Microsoft to be a monopolist in
operating systems. Microsoft was not the only firm in this market, but
it owned such a dominant market share, and other players owned so
little, that it was able to behave as if it was a monopolist. (This ultimately invited federal antitrust lawsuits.)
17
Bryce and Dyer.
18
Innovating and patenting is a way to maintain competitive position
for firms in so-called Ricardian monopolies. These monopolies are
based on knowledge and invention and the fact that these firms possess unique intellectual capital. Other monopolies are based instead
on unique resource positions in which the monopolist owns the vast
majority of inputs required to produce the product. Here, monopolists may maintain their position by restricting output, which drives up
price and profits.
19
L. Dignan, “AT&T vs. Verizon Wireless: How Tiered Plans Will Shake
Out,” blog, for Between the Lines (July 18, 2011), http://www.zdnet
.com/blog/btl/at-and-t-vs-verizon-wireless-how-tiered-plans-will
-shake-out/52556.
20
A well-known example is the pharmaceutical industry, whose consolidation of the past few decades has starkly reduced the number
of firms competing. Consolidation has created huge pharmaceutical
conglomerates such as GlaxoSmithKline or Bristol-Myers Squibb.
These firm names bear the remnants of previous firms (e.g., Glaxo
Wellcome, and SmithKline Beecham), whose firm names, in turn,
often bear the remnants of still previous firms. See also S. Klepper,
“Firm Survival and the Evolution of Oligopoly,” RAND Journal of Economics 33(1) (2002): 37–61.
21
A. G. Lafley and R. L. Martin, “Customer Loyalty Is Overrated,”
Harvard Business Review, January-February, 2017, 47–54.
22
CHAPTER 12
Implementing Strategy
LEARNING OBJECTIVES
Studying this chapter should provide you with the knowledge to:
1. Describe how the 7 S model can be used to determine
the level of alignment within a company and between
the company and its environment.
3. Discuss how creating effective line-of-sight
measures can assist managers in the strategy
implementation process.
2. Evaluate a strategic change effort and explain the
underlying reasons why the effort succeeded or failed.
Chris Jackson/Chris Jackson Collection/Getty Images
Alphabet: Reorganizing to Create Value at Google
Google’s stock has always been a high flyer. Since the company
went public in the summer of 2004 until the close of 2016, its shares
generated a total return of 1,440%, a 23.4% compound annual
growth rate.1 Even for a company with such strong share price
appreciation, the gains surrounding the announcement on July
16, 2015, of Google’s second quarter earnings stand out. During the
next two trading days, Google’s shares rose a little more than 20%,
a gain not seen since the earliest days of Google as a public company. On that July day, Google announced solid, but not spectacular, revenue growth of 11% (year over year), and earnings of $6.99
per share, which topped expectations of $6.75.2 Investors liked top
line and bottom line growth, but what lit a fire under the shares
was buried in the mid-section of the income statement: Google’s
newfound ability to control costs.3 Cost control had never been a
high priority at Google; however, with its search business maturing,
a system that kept costs in line would only become more valuable.
The person behind that system was new CFO Ruth Porat.
Porat, the daughter of a Stanford physics professor and a psychologist, had been taught to aim high her entire life. Her academic pedigree lists degrees from Stanford, Wharton, and the London School
of Economics. She went to work for Morgan Stanley and rose to
become the CFO in 2010, where she would earn the moniker “the
most powerful woman on Wall Street.”
What did Porat bring to Google? First, a wealth of experience in
helping tech companies deal with the financial world, based on her
experiences as the lead banker on the IPOs of tech startups Amazon,
eBay, Netscape, and Priceline. Second, a deep knowledge of
accounting, finance, and investor relations—and how to drive financial change—in a large company environment. Third, she brought
the cachet of a seasoned Wall Street veteran, including a stint advising the US Treasury department during the financial crisis.4
In hiring Porat, Google CEO Larry Page outlined her role:
“We’re tremendously fortunate to have found such a creative,
experienced, and operationally strong executive. . . . I look forward
to learning from Ruth as we continue to innovate in our core—
from search and ads, to Android, Chrome, and YouTube—as well
as invest in a thoughtful, disciplined way in our next generation
of big bets.”5 Google had become two businesses: a revenue- and
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Implementing Strategy
profit-producing search business and a set of revenue- and profitconsuming businesses, including projects such as a self-driving car
and wearable “Google glasses” that would allow users a unique
Internet experience. Google executives hoped that Porat could help
the company balance the need for fiscal discipline in the core while
investing prudently in new and exciting product categories.
Less than a month after issuing its earnings report, Google
restructured the company. Announced as “G is for Google,”
Google unveiled a new corporate parent, Alphabet, that would
act as an umbrella for all of Google’s varied businesses, from
Android to the X lab, home of many moonshot products.6 Each
unit of Alphabet would report its own financial performance,
which pleased investors hungry for more transparency in the
company’s investment strategy. Investors drove up Google’s
shares another 4% on the day of the announcement. Alphabet
aimed to improve performance in another way: By separating
business units that had different strategic imperatives, Alphabet
hoped to create strategic ambidexterity across business units.7
Mature businesses, such as Search and YouTube, would need to
focus on current business performance and had to be managed
by a different set of rules than the “big bets” about which Page
spoke. Revenues and costs mattered in the core, but the logic of
potential and investment would determine which of the big bets
paid off in future growth.
Google’s activities during the spring and summer of 2015, and investors’ positive reaction,
highlight the reality that how a company delivers its unique value—our third fundamental
question of strategy—contributes to its ability to earn superior returns. From July to
December 2015, Google (Alphabet) shares appreciated 44%, but the company introduced
no new products of note, nor did it acquire another company that fueled growth. The
company created shareholder value by acquiring the human capital it needed to manage
in the rapidly changing world of technology, and because it aligned its organization and
processes with the emerging demands of its strategy. Put simply, Google’s executive team
focused on strategy implementation, which proved to be just as valuable as strategy formulation. A primary objective of this chapter is to introduce you to three important skills
strategists must possess if they hope to implement strategies: forging alignment between
the key elements of the organization and its strategy, leading effective change to accomplish that alignment, and creating measurement systems to refine the strategy and ensure
its implementation.
At one level, implementation is about action, or execution. The successful execution
of a strategy requires a process that translates broad strategic objectives into clearly
definable, everyday actions that make the strategy real, and then creates systems where
people take those actions. Executive Larry Bossidy learned how to execute strategy
working for General Electric’s CEO Jack Welch. Bossidy ran GE’s capital division and
guided that business through a flurry of acquisitions. He then went on to successfully run
Allied Signal and eventually Honeywell. Bossidy was known for his ability to execute. His
recipe for execution—outlined in his book The Discipline of Getting Things Done—involves
four steps: (1) create a set of clear goals for people to follow; (2) find ways to accurately measure
performance; (3) hold people accountable for their performance; and (4) richly reward those
who perform well.8
Ruth Porat came to Google with a clear objective for change: help Google, now Alphabet,
control costs in a world where search became a mature business and to provide greater
transparency to Wall Street. The way she executed on those goals, at least in the early stages,
centered around the firm’s accounting and financial reporting systems—the essence of measurable performance in any organization. With clear budget targets and rules for managing
the different business units that make up Alphabet, Porat and other executives could hold
individual managers accountable for business performance. Finally, Google had always
rewarded high performers, and Porat’s own compensation package proved that Alphabet
would continue to reward those who executed well.9
Many strategies fail because people in organizations just don’t execute well. The strategy
doesn’t translate into a clear set of measurable goals and, for whatever reason, people either
don’t have to answer for their actions or receive no rewards, or punishments, for excellent,
or poor, performance.
Alignment: The 7 S Model
217
Alignment: The 7 S Model
Execution matters, but as you saw in the opening case, effective implementation requires forging alignment among the external environment, the strategy, and the internal elements of the
firm. Most strategy researchers focus on strategy formulation, what you’ve spent most of this
course learning about. Little attention typically gets paid to implementation, as it seems to be
a matter of execution.10 Implementation is as much a matter of alignment as it is of execution.
Alignment means that the important elements of the organization are in the proper relationship with each other—which means they fit well together and reinforce each other. In an aligned
organization all the elements support the strategy. This raises the question: which elements?
A strategist can answer this question in many different ways. The authors’ experience with
the 7 S model of organizational alignment leads us to recommend this model. Introduced by
consultants at McKinsey and Company in the early 1980s, the model provides a broad yet succinct way to capture the key strategic elements of an organization.11 The model identifies seven
important organizational elements that must be aligned in order to ensure effective implementation of the firm’s strategy. The seven Ss are strategy, structure, systems, staffing, skills, style,
and shared values.12 Figure 12.1 displays each S.
alignment A condition where
organizational elements fit
together and reinforce each other.
Strategy
Strategy is the plan, process, and related activities that create and sustain a competitive
advantage for a firm in its target markets. Strategy represents the most important S. The ultimate goal of any organization is excellent performance, whether it is a business, government,
or not-for-profit. Strategy enables an organization to perform well by guiding resource allocation decisions that result in competitive advantage. Google’s original strategy focused on creating software to facilitate Internet searches, and moved into related applications such as Google
Maps and Gmail. Google’s strategy shifted over time to include hardware as well as software
with investments in activities and products such as a self-driving vehicle.
strategy The plan or process that
creates and sustains a competitive
advantage for a firm.
Structure
Structure answers two critical questions for an organization: Who does what? Who reports to
whom? Structure divides labor and tasks within the organization into separate units and, by
doing so, defines the reporting or authority structure of the firm. This is important because it
assigns accountability for particular tasks and allows for the measurement of performance by
a particular organizational unit. Managers can use structure to help align goals, skills, and environmental needs.13
If you want to understand an organization’s structure, look at its organization chart.
The horizontal boxes that run across the page describe the division of labor. For example,
a company might have vice presidents for geographic regions, with functional managers for
Strategy
Systems
Structure
Shared
Values
Staffing
Skills
Style
FIGURE 12.1
The 7 S Model
structure The set of
organizational arrangements that
divide labor and tasks. Structure
also defines reporting or authority
relationships.
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Strategy in Practice
How to Use the 7 S Model
The 7 S model represents a tool that can guide effective strategy
implementation for the organization as a whole, as well as for its
divisions, groups, or departments. To use this tool most effectively,
follow these five steps:
1. Identify the current state of the organization and misalignments.
Appendix A at the end of the book provides a list of resources
that consultants and managers can use to understand the
current 7 S model. For managers, interviews and surveys will
be powerful tools. Consultants or other outsiders will rely on
a mix of interviews and other sources. The goal is to create an
“as it is today” picture of the 7 Ss in the company.
2. Rank order misalignments based on the importance of misalignment with strategy. When step one is done well, managers will see a number of misalignments, both within the 7 Ss
themselves and between the different elements in the model.
It’s easy to get frustrated or feel overwhelmed! Managers
need to ask, “Which misalignments keep us from reaching our
strategic goals? Which ones dissipate rather than build competitive advantages?” This question will cull the list of misalignments down to the few that really need to be changed.
3. Develop plans to create alignment. While some of the misalignments will be company specific (particularly those that involve
the soft square), managers and consultants should be open
to looking at how other companies have solved these problems. There is no need for an executive team to reinvent the
wheel in terms of compensation, for example. Benchmarking
other companies, or divisions within their own company, provides a starting point from which companies can customize
their own solutions.
4. Understand how the proposed change affects other elements
in the model. How will changes in one S affect others? For
example, moving a sales force from pure commission to a
salary structure represents a huge change in what motivates
the staff.22 How will the company attract and retain a sales force
to fit the new pay scheme? What new skills will existing salespeople need to learn? Where will the new system conflict with
shared values? It’s rarely the change of compensation alone
that dooms the program, it’s the pushback from the other Ss.
5. Adjust plans accordingly. After managers see the effort to create realignment within the entire model, they need to adjust
their plans. In the previous example, changing the compensation system may need to follow skill training for the existing
sales force. Work on new hiring and retention plans may need
to happen at the same time, and the new system may precede
and signal a change in shared values. In any case, managers
come to understand that piecemeal changes rarely create
alignment; a more complex and sophisticated approach is
usually necessary.
each of those regions. This regional structure presumes that the important differences in the
firm’s market depend on geography and the strategy is best served by tailoring operations to
each region.
Alternatively, a company may organize by function and have a vice president of marketing,
vice president of operations, vice president of finance and accounting, and so on. The next level
down might include titles such as director of marketing or western regional director. With the
formation of Alphabet, a holding company, Google moved from a functional structure to one
that created separate business units that were focused on particular technologies or product
markets. The restructuring offered better transparency about operating performance, but it
also increased focus on the demands of each market.
Companies may also want to structure using one of two Ms: a matrix structure or an
M-form corporation. In a matrix structure, firms give significant decision-making authority,
and the responsibility for profits and losses, to two managers. The most common matrix
structure shares responsibility between a functional manager (e.g., marketing or sales)
and product managers (e.g., laptop computers). The matrix builds on the assumption
that both strong functional expertise and nuanced product knowledge play vital roles in
creating competitive advantage. The matrix makes life more complicated for managers
and employees, but the structure hopes to create more value by combining expertise in
decision making.
The M-form is a corporate-level structure, and it builds on the idea of a corporate parent and business unit children. M-form stands for multidivisional form. In this structure, each
division is a separate business, and includes all the functions needed to run that business.
Managers of M-form organizations can structure their business units in different ways; some
may be functional, others product, and still others a matrix. The M-form creates substantial
Alignment: The 7 S Model
219
redundancy across the corporation (think of 20 separate accounting groups). The advantage
of the M-form lies in accountability. Because managers of an M-form run their own business,
their successes and their failures can be traced back to their decisions. No one can claim that
“corporate made me do it,” or use other excuses.
Systems
The systems category describes key processes that span a firm’s organizational structure.
Systems play two important roles: They coordinate and control work of the different units
within the organization.14 Information systems such as inventory control allow sales people
in the field to know which products are in stock, and which products are overstocked. At the
same time, the inventory control system lets the manufacturing division plan its production
schedule based on those same stock levels. Finally, information about which products are
selling will help the accounting and finance department create accurate profit and loss
reports, and they’ll help the firm’s managers decide which products and services to add or
drop from the firm’s offerings. Part of Google’s logic in bringing Ruth Porat in from Morgan
Stanley lay in her knowledge about how to create and implement sophisticated financial
control systems.
systems Mechanisms, policies,
or processes that coordinate and
control the work of the different
units of the organization.
Staffing
Staffing refers to the human resource management processes in the organization: recruitment,
hiring, training, deployment, performance measurement, promotion, and compensation.
Some companies recruit only at elite universities, while others target public universities, job
fairs, or websites such as Monster.com. Each model has its own advantages and drawbacks,
depending on the skills and personality types companies want to attract. Companies such as
Marriott require managers to engage in training every year, but other hotel chains expect people to learn on the job. Finally, some companies promote from within, while others tend to hire
from the outside.
Ruth Porat represented a very high-profile outside hire for Google. She lacked skills and
knowledge in the technology sector, but she brought a unique set of valuable skills that Google
needed to continue to grow profitably.
staffing The processes in the
organization for recruiting,
hiring, training, and deploying
human capital.
Skills
Skills refer to the abilities of individuals within the firm, as well as how the firm has combined those individual talents to build capabilities (processes), to create a competitive
advantage. The relationship between skills and staffing is shown as companies either hire
people who have the skills they need or develop workers in-house through training. Google,
for example, considers itself primarily a software company, and if you want to get hired
you’d better have outstanding software engineering skills. In fact, Google screens 20,000
software engineers each year through a software-programming tournament called Google
Code Jam.16
Software engineers compete with each other in a timed software-coding tournament,
and the top 50 get job offers at Google. Apple also wants employees with strong software
engineering skills. However, because Apple creates hardware products, it also values design
skills because the company believes design is critical to its competitive advantage. In
running its retail business, Apple had to look far beyond its traditional skill sets to find the
right executive. The company hired Angela Ahrendts to run its retail operation. Ahrendts
had been the CEO of fashion firm Burberry and had very few of Apple’s traditional skills in
hardware, software, or technology.17 Skills, such as staffing, involve long-term investments
by firms to make sure they have the right employees who will help the company gain competitive advantage.
skills The abilities of individuals,
groups, or organizations to
perform tasks.
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Ethics and Strategy
Creating an Ethical Climate and Culture Through
the 7 S Model
James McNerney became CEO of Boeing, one of the world’s largest
aerospace companies in July 2005, capping a long and successful
executive career that began after he received his MBA from Harvard
Business School in 1975. His career included stints at Procter &
Gamble and McKinsey and Company, 19 years at General Electric,
and a term as chairman and CEO of 3M. McNerney came to Boeing
as the company was trying to emerge from three major ethics crises.
In March of 2005, Boeing fired then CEO Henry Stonecipher for
having an illicit affair with a female Boeing executive.18 Stonecipher
had become CEO to replace Phillip Condit, who had his own checkered career as Boeing’s CEO. Troubles at the top weren’t the only
problems Boeing faced. After its acquisition of McDonnell Douglas,
Boeing began to compete more fiercely, and less ethically, for huge
defense contracts. Boeing’s former Chief Financial Officer Michael
Sears and Manager Darleen Druyun were fired from the company
for ethics violations on an $18 billion fighter jet contract; Sears
served prison time for his crimes. That scandal followed revelations
that a Boeing employee stole and inappropriately disclosed more
than 25,000 pages of confidential documents belonging to competitor Lockheed Martin.
McNerney saw his first and most important job as building an
ethical culture at Boeing, and he had his work cut out for him. With
more than 150,000 employees, global operations, and infighting
between divisions resulting from Boeing’s acquisition of McDonnell
Douglas, Boeing was a large, bureaucratic behemoth resistant to
change. McNerney chose an interesting place to begin the cultural
change: He relied on his personal style and what he referred to as
“tone at the top.”
Rather than holding the annual executive retreat at a posh
resort, McNerney held a shorter retreat at a modest hotel. McNerney
spoke directly and forcefully about the ethics lapses, and he
encouraged managers throughout the company to do the same.
The culture of secrecy had to be changed. McNerney chided leaders
for a culture and environment where “‘management had gotten
carried away with itself,’ that too many executives had become
used to ‘hiding in the bureaucracy,’ that the company had failed
to ‘develop the best leadership.’”19 Before Boeing could solve the
problems, the company had to admit that problems existed and
determine the extent of unethical behavior. McNerney used his
position and personal style to model the open communication and
concern for ethics he expected throughout the company.
Style mattered, but McNerney used other elements of the
7 S model as well. The company also changed its structure.
Boeing raised the profile of compliance officers and set up an ethics
hotline so that employees could report violations without fear of
management reprisal. The company required ethics training for
employees, which meant changes in its staffing protocols and
skill development programs. Importantly, McNerney changed the
compensation system for Boeing’s managers; it now paid to make
the ethical choice. Managers would now receive part of their annual
bonus based on compliance with ethics standards and for living,
teaching, and displaying the core Boeing values of candor, openness, business performance, and ethical conduct.
Style
style The interpersonal
relationships and patterns of
interaction that organizational
members consider appropriate
and legitimate.
Style refers to the interpersonal relationships between people in the organization and, along
with shared values, comprises the culture of the organization. Style generally falls into one of
two categories: formal or informal. In most German companies, for example, people usually
dress up for work and refer to each other as Mr. or Ms., and respect each other’s work environment by keeping office doors closed. Many Silicon Valley start-ups, by contrast, find people
showing up to work in shorts, T-shirts, and flip-flops, call each other by first names or nicknames, and work in large, open spaces to maximize interactions. We suspect that Ruth Porat
experienced classic “culture shock” when she moved from the buttoned-down style of New
York’s Morgan Stanley to the casual style of Silicon Valley.
Shared Values
shared values The priorities,
values, and virtues that members
of the organization see as
important.
superordinate goals Highlevel, abstract goals that all
stakeholders agree on to guide
organizational action.
Shared values refer to the priorities, values, and virtues that members of the organization see
as important. Some people use the term superordinate goals, a set of high-level goals that all
stakeholders agree on, to capture the same thing as shared values. For example, Nordstrom
strives to create shared values by focusing on respect for the individual and extraordinary customer service. One way that Nordstrom works to create these shared values is by sharing stories with its associates and managers that provide examples of the behavior they want to
encourage—such as the story of an employee accepting a customer’s returned tires when
Nordstrom doesn’t even sell tires. The shared values of respect for the individual and extraordinary customer service are both values and overarching goals for the company and representative of the organizational aspect of the culture.
Alignment: The 7 S Model
221
Strategy in Practice
How to Develop a Mission Statement
A strong mission statement begins with the answers to three questions that leaders ask:
What business are we in? Defining the business means more
than identifying the industry the firm competes in, or the products/
services it sells. It begins by listing the primary stakeholder groups
the firm cares about (customers, employees, investors, etc.), and
then asking what specific stakeholder needs are met by the company. In other words, what job is to be done for that stakeholder?
Finally, leaders articulate how that job is done, whether it is through
products, services, after-sales support, brand, or some other business asset or activity.
What do we want to achieve? The answer to this question
should not be too focused, such as “our mission is to grow earnings
per share by 15% each year.” That goal works fine for a year, but
might not be sustainable over time. A better goal might be “we work
to create sustained growth in shareholder value.” Good mission
statements may focus on outcomes (e.g., market share, growth),
processes (innovation, quality, speed, etc.), or a particular feeling
they hope to evoke (such as premiere brand, best place to work,
most loved by our customers). A good mission focuses on only one
or two goals for each important stakeholder group.
What values and principles guide us? Here’s where a mission
really connects with shared values, and where a mission helps
an organization talk about the foundational layer of its Company
Diamond. Consultant Patrick Lencioni talks about three types
of values every company has. Every company has two to three
core values that everyone believes, such as the value of customer
connection, exciting innovation, or disciplined investing and cost
control. Companies also have aspirational values, or what they
want to be in the future. Aspirational values may include building a
better community or society, or providing development opportunities for employees. Finally, every company has permission-to-play
values, things like honest interactions, respect, punctuality, or hard
work. People without these values don’t stick around long, whether
they be investors, employees, suppliers, or even customers.21
The answers to these three questions provide the basic inputs
from which a mission statement, or a vision and values statement,
will be written. The exact wording will be unique to each company,
but including this foundational content helps a mission statement
become a sustainable, living document for the organization.
The 7 S model deals with ethical values as well as other business priorities. Our Ethics and
Strategy feature describes how one leader, James McNerney of Boeing, used the 7 S model to
realign the ethical values at his company.
Many companies choose to make their shared values explicit in a mission statement,
or a statement of vision and values. These documents have been maligned by critics, and a
mission statement can be a waste of time if organizational leaders do not live by the mission or
values. When done well, however, a mission statement provides a long-term, high-level guide
to corporate action. As leaders learn to “walk the talk” of their mission, vision, and values,
these documents become powerful summaries of the company’s shared values and superordinate goals. Surveys indicate that more than half of executives used the mission development
process in 2015 as a core element of strategy development.20 Our Strategy in Practice feature
describes how a company (or an individual) can develop a mission statement.
If you look back to Figure 12.1, you’ll notice that strategy, structure, and systems form a
triangle, and that style, shared values, staffing, and skills form a soft square. This is no accident.
Strategy, structure, and systems constitute the hard triangle of the model. The hard triangle
represents a set of “hard” levers that managers can quickly pull to create alignment, or realignment. Hard doesn’t refer to difficulty, but, rather, tangibility. Structure appears on paper,
strategy in a formal plan or document, and systems in policy manuals, computer programs, or
equipment.
The other four represent the soft square, the elements that are often difficult to codify,
such as style, or that take a long time to influence and change, such as shared values. Strategists can change structure in a day, strategy in a week, or systems in a quarter. That doesn’t
mean the organization practices the new strategy, works well in the new structure, or actually
uses the new systems. How well those changes actually work depends on what happens in the
soft Ss. Changing the organization’s skill set can take several months. Changing the style or
shared values may take decades. See the Strategy in Practice for a discussion about how managers can use the 7 S model to implement change.
Figures 12.2 and 12.3 illustrate the concept of creating alignment. Notice that each figure
has two Ss in addition to the 7 Ss of the core model: Stakeholders and Situation. Stakeholders
hard triangle The elements of
strategy, structure, and systems in
the 7 S model. The hard triangle
represents a set of “hard” levers
that managers can quickly pull to
create alignment or realignment.
soft square The elements of
style, staffing, skills, and shared
values. Soft square elements are
often difficult to codify and usually
take a long time to influence
and change.
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Strategy
Structure
Systems
Shared
Values
Staffing
Skills
Style
Situation/Stakeholders
FIGURE 12.2
Misalignment
Strategy
Structure
Systems
Shared
Values
Staffing
Skills
Style
Situation/Stakeholders
FIGURE 12.3
Alignment
are those individuals and groups who affect, and are affected by, the firm and its activities.
When stakeholder needs or preferences change, the firm may find itself out of alignment. The
Situation describes the market and industry environment, social and technological trends,
government regulations, or any other element outside the firm where change will affect alignment. It is important to remember that a firm may have solid internal alignment, and yet be out
of alignment with the situation or stakeholders. When the organization finds itself out of alignment, it must change something in order to get back to alignment. That involves the second
important process of implementation: strategic change.
Strategic Change
In this section, we’ll explain how managers effectively lead strategic change to move their
organizations forward. We’ll also discuss how the tools of strategic change apply to individuals,
since the most important firm we all manage is one called “Me, Inc.” Managers who can’t lead
change, in their own or their organization’s lives, find it difficult to thrive, and even survive, in a
world of turbulent change.
The first time an entrepreneur sets a strategy to create unique value for customers in
a particular market, she aligns the organization with that strategy. At every other point in a
company’s history, a change in strategy requires realigning the organization with the new
direction. Realigning strategy entails changing the other six Ss, and that’s not an easy thing to
do. Recent evidence puts the failure rate for organizational change at 60 percent to 70 percent,
Strategic Change
223
and that percentage has not changed for several decades.23 Change seems to be even harder
for individuals. One study found that, out of a group of people who had experienced coronary
artery bypass surgery to save their lives, 90 percent failed to change their lifestyle to avoid a
repeat of the trauma.24 Part of the problem is that individuals and leaders don’t realize that
change is a process with three distinct phases.
The Three Phases of Change
Most of us think of change as the need to start doing something new, whether that’s eating
healthier or, in the case of an organization, focusing on a new market segment, such as Google’s
Project X. What most don’t realize, however, is that effective change requires moving through
three stages of a well-defined process. We must first stop the activity, or set of activities, we
want to change, then adopt new behaviors, and finally ingrain those new behaviors into our
routines. Pioneering social psychologist Kurt Lewin used ice as a metaphor for change, and his
three-step model of change is outlined in Figure 12.4.25
Unfreezing
Unfreezing begins the change process as individuals and groups within the
organization recognize and publicly admit that the current situation is not working. Unfreezing
entails moving away from certain actions, policies, or strategies before adopting anything new.
When individuals, groups, or companies make a “stop doing” list, they have begun the process
of unfreezing.26 The process of unfreezing provides the fundamental motivation for change.
unfreezing The first step in
organizational change. It begins
when leaders recognize and
publicly admit that the current
situation is not producing
acceptable or adequate results.
Changing
change process The middle step
in organizational change that a
company engages in to adapt to
its environment and learn new
behaviors.
The change process is how a company adapts to its environment and learns
new behaviors, and is the most difficult part of the process. Most individuals resist change
because of our innate desire to be good at what we do. Change means that we’ll adopt new
behaviors we’re not good at, and very few people enjoy that feeling. In addition, few organizations encourage or reward their people to leave a zone of competence and try new behaviors.
Successful change efforts must overcome these barriers. Change means moving from one set of
behaviors and activities to another.
Refreezing
Have you ever gone on a diet? For longer than a couple of weeks? Well, companies are like people in that they can adopt almost any new behavior for a short period of
time. To make change permanent, individuals and companies have to do the hard work of
aligning the rest of their activities to support the change. They have to refreeze around the
new activity set. Successful companies embed the desired changes in hiring and training
decisions, reward and compensation systems, and the shared values of the company’s culture.
Refreezing allows organizations to maintain the progress they made through change.
The three phases of change provide a broad overview of the process, but real-world strategists want to know how they can unfreeze their organization, encourage productive change,
Motivating
Moving
Maintaining
Unfreezing
Change
Refreezing
• Make a public
admission that
current state
isn’t working
• Develop new
behaviors
• Engage in trial-anderror process
• Make a clear
break with past
actions or
processes
FIGURE 12.4
Three Key Phases of Change
• Creating alignment
• Embed new
behaviors in
training,
compensation,
culture
refreeze The last phase of
organizational change. This
step involves formalizing and
institutionalizing new behaviors,
methods, processes, or routines.
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and then refreeze the gains and move ahead. Each of the three larger phases of change contains
discrete elements that help managers lead their organizations and people through the difficult
process of change. Eight discrete tasks must be accomplished for change to succeed.
The Eight Steps to Successful Change
Strategic changes, such as implementing a major shift in strategy, don’t happen overnight. In
fact, these changes can take many years, and even up to a decade to successfully implement.27
The eight key tasks are:
1. Generate a sense of urgency
2. Build a guiding coalition
3. Create a vision
4. Communicate the vision
5. Empower individuals to act
6. Garner short-term wins
7. Consolidate gains and move on for more change
8. Institutionalize the change
Generate Urgency People and organizations won’t change without a reason. In fact,
organizations have been designed to ensure stability and that the same regular processes
will happen over and over again. Those processes and activities eventually fail to work effectively, usually because they fail to align with changes in the market or operating environment.
Managers must work to help their teams and organizations see the need for change. That means
looking at larger environmental trends, spending time with customers, suppliers, employees,
or stakeholders to gather data, and then creating a compelling case that will help people see,
understand, and also feel the need to change. Our Strategy in Practice feature describes a compelling story of generating urgency.
guiding coalition A group of
influential people from all levels in
the organization that support and
lead the change effort.
Build a Coalition
Effective change requires that many people see and feel the urgency,
and those with the power to change the organization grasp the sense of urgency and actively
work to create change. Managers tasked with leading change need to create a guiding coalition,
a group of influential people from all levels in the organization who work to lead the change
Strategy in Practice
Work Gloves Create Change28
A middle-level manager at a large, multiplant company had been
assigned to cut costs by consolidating the company’s purchasing
process. The manager identified several areas where costs could be
reduced by about $1 billion, but no one took his analysis seriously.
To get the attention of the key decision makers in the organization,
this manager identified a single product—work gloves—that he
thought would highlight the purchasing problem.
The manager discovered that the company was purchasing
more than 400 different brands of work gloves. One plant would pay
$5 for a pair of gloves and another plant would pay $17 for the same
pair of gloves, but a different brand or from a different supplier. To
make his case of wasteful purchasing, the manager bought 424 different pairs of gloves, and tagged each pair with the price each factory paid for it. He reported what happened next:
[We] put them in our boardroom one day. Then we
invited all the division presidents to come visit the room.
What they saw was a large, expensive table, normally clean
or with few papers, now stacked high with gloves. Each
of our executives stared at this display for a minute. Then
each said something like, “We really buy all these different
kinds of gloves?” “Well, as a matter of fact we do.” . . . It’s a
rare event when these people don’t have anything to say.
But that day, they just stood with their mouths open.29
Needless to say, the manager received a mandate from top
management to move ahead with his changes to purchasing. He
had created urgency so that decision makers could see, feel, and
understand the real impact of the problem. Once they saw and felt
the need for change, top managers lent their energy and support to
the change effort.
Strategic Change
225
effort. Some members come from top management, but most will not. All members have power
within their own work groups, either as formal managers or directors, or informally having
earned the respect, admiration, and ears of their peers.30
Create a Vision
A meaningful vision is a clear statement of where the organization wants
to go, and what life will be like when the change has been successful. Urgency helps prepare
people to move, and the coalition provides examples to follow. However, without a clear vision
of where they are going, people are either unable to move or they move in many different directions all at once.
Perhaps the best example of a clear and compelling vision came from President John F.
Kennedy in response to the urgency generated when the Soviet Union placed a man in orbit in
the spring of 1961. Kennedy created this vision:
vision A clear statement of
desired outcomes and endpoints
for organizational change.
I believe that this nation should commit itself to achieving the goal, before this decade
is out, of landing a man on the moon and returning him safely to the Earth. No single
space project in this period will be more impressive to mankind, or more important for the
long-range exploration of space; and none will be so difficult or expensive to accomplish.31
The first three tasks—generating an urgency, building a coalition, and creating a vision—
help the organization unfreeze. A sense of urgency and the development of a coalition signal an
unmistakable admission that past actions won’t work in the future. A vision creates a clear break
with the past and is an exciting call to move forward. When done well, these first steps usually
take 6 to 18 months for managers to work through.32 The next three tasks—communicating the
vision, empowering action, and garnering short-term wins—help organizational members alter
their behaviors and work patterns and create the change.
Communicate the Vision How do most companies communicate their vision? Many
managers don’t communicate that vision clearly enough or often enough. They might communicate through a memo or a post on the company’s intranet site. If the change is considered
central to a larger group within the organization, they might create a video and distribute it
throughout the company.
How did Kennedy’s stirring vision get communicated? First, his speech was recorded on
video and played over and over again on the nightly news programs. Kennedy used every
emerging technology and platform to share his vision. The administration made sure the text
of his speech was picked up and reprinted by hundreds of newspapers. Simply put, Kennedy’s
vision took hold because it was communicated through a variety of channels, and repeated
over and over again. Managers who successfully lead change overcommunicate their vision.
They keep repeating the message even after they are sure most people have heard it.33
Empower Action
A paradox exists in most organizations, from business firms to university classrooms. Leaders and managers want creative behavior and new solutions, but many
organizational cultures and systems punish creative behavior or new solutions that don’t work.
For example, many performance reviews reward successful actions by employees, but fail to
reward innovations and experimentation that doesn’t succeed.34
Empowering people to act certainly means giving them authority to try new practices, but
it also means giving them the knowledge and resources they need to engage in new practices.
Empowerment also means providing a safety net for people should they fail, and a system in
place to learn from those failures. For example, Google has built in a number of mechanisms to
promote innovation, including Google cafes where employees can meet to share ideas, direct
email access to company leaders, and its policy of allowing engineers to spend 20 percent of
their work week on projects that interest them.35
Garner Short-Term Wins Many people inside the organization may be supportive or
even excited about the change, but they may be unwilling to commit their own time, energy,
and resources until they see evidence that the change will produce positive results. Wise managers begin with projects that require the least change and have a high probability of success.
empowerment A grant of
authority, formal or informal, that
allows organizational members to
try new practices. Empowerment
includes giving members the
knowledge and resources they
need to engage in new practices
successfully. It also includes a safety
net for people should they fail.
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The manager in our previous Strategy in Practice feature began by solving a small problem,
consolidating the purchase of work gloves. Work gloves alone wouldn’t save the company
more than $1 billion, but solving the work gloves problem would show those waiting to commit
to the change that their efforts would likely succeed. Short-term wins create both credibility
and momentum that encourages key organizational members to get off the fence and work to
make the change successful.36
The three tasks that accomplish the bulk of the change, communicating the vision,
empowering action, and creating short-term wins, can take one to two years.37 Managers can
begin communicating early and often, and employees can be easily empowered; however, following through to make communication and empowerment effective tools of change requires
sustained effort. Short-term wins should come quickly because they are, after all, short term.
The task of pressing ahead, tackling the tough challenges, and reaping the real rewards of
change takes patient and persistent effort.
Consolidate Gains and Press On Many organizations would stop after solving the
work gloves problem because they might mistakenly believe that solving the surface symptoms
of a problem is the same as solving the root cause. The clever manager might be honored at
a company dinner and given a nice bonus, and people would assume the change effort was
complete. What would remain would be the tough, hidden, and unglamorous purchasing problems that would really save the company a great deal of money. If a company stops after creating a few high-profile wins and fails to press ahead to work on the deeply rooted behaviors,
policies, and practices that must change for a true realignment to occur, much of the value of
the change effort will have been wasted. This is the least glamorous and longest task of successful change, but the one that truly prepares the organization to refreeze. The challenging
projects help the organization embed the change deeply in its operating routines and represent
an important part of making change stick, or refreezing.
institutionalize When an
organizational element or practice
becomes so essential that its value
is taken for granted.
Institutionalize Change
To institutionalize something is to make it so essential
that it is taken for granted and becomes part of the central values of the culture.38 Managers
institutionalize changes primarily through three of the 7 Ss: systems, staffing, and shared
values. Change becomes permanent when the routines of sales methods, accounting procedures, or operating processes embody the new set of behaviors and activities. Compensation
systems that reward the new behaviors further ingrain the notion that the change represents
“the new way things are done around here.” In terms of staffing, change becomes institutionalized as the firm looks for, hires, and retrains a new type of employee. Recruiting and
ongoing training reinforce changes as a new generation of employees sets the standard
for behavior.
Finally, strategic changes always alter the shared values of the organization.39 Google’s hiring
of Ruth Porat represented a shift in shared values as well as style and skills. Porat brought a set of
“corporate America” values to Google about the importance of understanding and communicating
with the public how each business unit was performing. Porat will also help make cost control
a new shared value at the Silicon Valley giant. Institutionalizing the change takes the longest of
all the stages and can take an additional four to seven years before the old ways are forgotten.
The bottom line for managers is that successful strategic change takes substantial and sustained
energy, commitment, and attention. Managers should keep in mind that others in the organization
need the time, resources, and energy to go through their own change. Change takes time because
people have to learn new skills and ways of acting, but also new mindsets and ways of seeing
the world.40
Figure 12.5 summarizes effective strategic change. You can see how the eight tasks
relate to the three phases of change, and how long each phase may take. Strategic change
takes a long time and a dedicated effort by strategic managers who are trying to enact
change while dealing with day-to-day issues of running their firms. How do they maintain
a focus on the overall change project? One way is to set up solid measurement systems
to assess the degree to which efforts help the firm align its internal resources around its
strategy.41 Setting up robust and effective measurement systems will be the final topic we
consider in this chapter.
Measurement 227
Generate
urgency
Share
Vision
Consolidate
Gains
FIGURE 12.5
Build
Coalition
Create
Vision
The Silent Phase
(Unfreezing)
½–1½ years
Empower
Action
Garner ShortTerm
Wins
The Active Phase
(Change)
1-2 years
Institutionalize
Changes
Completion
(Refreezing)
4-7 years
Summarizing the Change Process
Measurement
Given that strategic change and realignment takes such a long time to successfully implement, strategic managers need a way to effectively measure their organization’s progress. In
fact, measurement represents a general need for assessing whether any strategy, new or existing, works. As you learned in Chapter 3, strategies often depend on the complex combination
of a firm’s underlying values, its resource base, capabilities, and the actions and activities of
large numbers of individuals and groups. Those complex internal interactions all take place in
markets and industry contexts characterized by constant, sometimes radical, change. Effective
measurement becomes an essential element of solid strategy implementation.
Individual employees, managers, and the executives who run the firm face a challenge that
measurement helps overcome. That challenge arises because members of an organization
have limited perspective.42 Employees and managers see clearly those activities and elements
of the environment with which they most closely interact. Salespeople can see the organization
from a customer’s perspective but have a hard time accepting the perspective of manufacturing managers or research scientists. All people see things that are further away less clearly,
both in terms of distance but also organizational level, and time horizon. Similarly, it’s easier for
employees or managers to see what needs to be done to improve short-term performance, but
they rarely have the perspective, or incentive, to act in ways that further the long-term interests
of the firm. An effective measurement system helps everyone, from top management to
front-line employees, understand how their daily work contributes to strategic success. The
principle of line of sight helps managers create measurement systems to overcome the limited
perspectives of individual organizational members.
Line of Sight
Put yourselves in the shoes of the following division manager. It’s 9:15 a.m. on Monday morning. You arrived late at your office, delayed by a nasty freeway accident. Your 9:30 a.m. meeting is a critical new product design decision meeting. The company’s development team and
supplier partners have cleared their busy schedules to help you make the final decision on an
important new product. Before you head into the meeting, you quickly check your messages.
You received one text from a high-level, important employee expressing deep dissatisfaction
over his bonus. He’s threatening to quit on the spot unless he meets with you this morning.
As you scroll down your text messages, you see that your division’s largest customer texted
two hours earlier, very angry about a delayed critical shipment. As you open your office door,
the director of operations informs you that a power outage last night has left a large quantity of
perishable product beginning to spoil. Moving the product will require your direct intervention
to find/arrange a suitable costly cold-storage facility. The question is NOT what should you do,
for you should do all of them. The relevant question is, what do you do first?
principle of line of sight The
notion that individual members in
an organization should be able to
connect their daily work and tasks
to the overall strategic goals of the
organization.
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The idea behind line of sight is to answer those questions quickly and effectively. Each of
these demands in our fictitious case is urgent—if you don’t act immediately, you’ll lose out on the
design project, the skill of an important employee, a valuable customer, or profit since product
spoiled. If you have a very clear idea of the company’s overall strategy, and understand your role
in furthering that strategy, you would have the tools to help decide which of the many urgent tasks
is the most important. If the company strategy revolves around some vague notion of creating
shareholder value or increasing earnings, then you have little direction. If, however, the strategy
is clear and explicit about creating value through low cost, a customer-centric differentiation, or
bold product innovation, then you have more guidance and you can make a better decision.
Line of sight links day-to-day organizational behaviors and decisions to their impact on
the overall strategy.43 For example, if the company’s strategy relies on relentless low-cost production and control, then you should postpone the meeting, leave the customer and employee
in limbo, and spend time preserving the product. In contrast, a clearly customer-centric focus
tells you to call the customer first. Finally, you can see that a clear strategy of winning through
innovation means the design meeting will take place as scheduled or the employee will be contacted if he contributes important innovation skills to the team.
The line of sight principle recognizes that grand strategies don’t just happen, they come to
fruition only as individual managers and employees make decisions about how to allocate the
valuable resources they control.44 The ability to formulate a clear and direct strategy, our goal
throughout this book, provides the point of reference to establish line of sight. The next step in
creating a line of sight involves translating the overall strategy into a set of specific objectives for
divisions or large work groups. Line of sight tells manufacturing managers whether quality comes
before costs. With a clear line of sight, marketing and sales staff know which customers to focus on,
how deeply to discount prices to win deals, and what levels of personal attention and service each
account should receive. Line of sight helps human resource professionals design compensation
systems to encourage and reward those behaviors that actually create strategic value. Our final
Strategy in Practice feature outlines the steps individuals and managers can use to develop line
of sight systems and create measures to know when they are effectively implementing strategy.
Strategy in Practice
Creating Line of Sight Measures
Turning the principle of line of sight into useful measures requires
individuals and managers to determine which of their actions contribute to realizing a strategy and which activities to do first. To create a clear line of sight, move sequentially through the following
steps. As you can see, these steps build on the company diamond
introduced in Chapter 3.
Step 1: Begin with the end in mind. What’s most important? This is
the time to list the abstract and broad goals and objectives
the company cares about. Is it the creation of shareholder
value? Cutting-edge innovation? World-class customer service, or a great place to work? Answers to these questions
can be found in the company’s mission statement.
Step 2: Identify the tangible strategy that reaches that objective. For
example, does the company intend to create shareholder
value through a premium price (the top line of the income
statement), or through cost leadership (the mid-section
and balance sheet)? Each of those larger strategic positions
requires a company to align and combine its resources to
achieve meaningful differentiation or low cost. For division
or functional managers, which resources and capabilities
are under my direct control? How does my division or function help the company implement its strategy? This establishes the line of sight for this level of the organization.
Step 3: At the work group level, what specific activities do we
perform that use and strengthen these resources? A large
part of the daily work in most organizations keeps the
doors open, pays bills, and makes sales, but does little
to develop and enhance strategic capabilities. The key
for work groups, as for higher levels, is to sort through
the daily activity set and sort activities that really need
to come first. Work group tasks can then be subdivided
into individual tasks. Individuals should be able to see the
chain that connects their personal work with the company’s strategy.
Step 4: Determine which single measure captures the way the
work should be done. Take a call center as an example.
Many call centers are seen as cost centers for providing
customer support and help lines. A common metric most
employees understand is to get the customer off the line as
quickly as possible so they can handle the greatest number
of calls per shift. This works well if the strategy is cost leadership, but not if the strategy is differentiation and a key
resource is brand.
Getting customers off the phone quickly does little to build
brand, and may harm it as customers see the company as uninterested in after-sales support. If brand matters, then the line of sight
measure is the number of problems resolved, and the number of
satisfied customers per shift.
Measurement 229
Strategy and Your Career
How to Use Line of Sight to Advance Your Career
The main idea behind the line of sight concept is to create a
strong link between an individual’s behavior and organizational
goals. You can use line of sight to help you find and advance in
your first posting, as well as to manage your long-term career.
The line of sight principle, along with the Personal Diamond you
developed in Chapter 3, can contribute to your personal competitive advantage.
As you look for jobs, and when you land that first position,
make a line of sight map that connects you with the company.
When most people begin working, they are overwhelmed with the
day-to-day work they have been assigned to do. It’s easy to lose
focus on which tasks are most important and focus on those tasks
that are most urgent. A line of sight map will help you avoid this
problem and be more productive. You should identify the company’s competitive advantages and key resources (a Company Diamond will prove quite helpful here). Then ask, what activities in my
division (and eventually work group) contribute to that competitive
advantage? Which activities build and strengthen resources and
capabilities? The next step is easy: What activities should you focus
on to contribute to competitive advantage, or to deepen the firm’s
resources and capabilities?
Once you have identified the three or four critical activities,
make sure these get attention every day you are at work. You will
find yourself on the road to improved performance and you’ll be
more valuable to your organization. They’ll pay you more, promote
you, and work to keep you employed.
As you think about your career, use the Personal Diamond
model to identify your personal competitive advantages, and the
resources and capabilities you have, or ones you need to develop,
in order to grow and sustain that competitive advantage. Make a
list of the key personal activities you need to engage in to deepen
your own resource-base. This will probably include your work tasks,
but it may suggest other projects or jobs you ought to consider
within your current organization to enhance your skills. This list
will almost certainly include activities that occur outside of work,
or outside your current organization. This may be spending time
learning spreadsheet or data analytics skills, or it may involve volunteering at a local non-profit.
When you identify these activities, make a plan to engage
in them every week, month, or quarter. These activities, when
engaged in consistently over time, will strengthen your personal
resources and capabilities in ways that are most important to you.
As time passes, you’ll find yourself qualified for your “dream jobs,”
the ones that allow you to leverage your strengths and grow.
Measurement marks the last of the three primary tools of strategy implementation.
Measurement systems such as the balanced scorecard45 can serve as an early warning sign for
misalignments among the 7 Ss or between the firm and its environment. Figure 12.6 shows you
the elements of a balanced scorecard a firm can use. Measurement can help managers monitor
progress toward strategic objectives and also help them manage the process of change and
realignment. Tools such as line of sight help managers decide where, when, and how much to
allocate resources to different activities. The most important resource they allocate will be
their own time.
Financial Metrics
How well are we meeting
shareholder/investor demands?
Current Performance
External
Performance
Customer Metrics
How well are we satisfying
Strategy
customer needs and desires?
Internal
Performance
Process Metrics
How well are we performing
our key business processes?
Future Performance
Innovation Metrics
How well are we learning to
ensure future growth?
FIGURE 12.6
Elements of a Balanced Scorecard
Source: Adapted from R. S. Kaplan and D. P. Norton, The Balanced Scorecard (Cambridge: HBS Press, 1996).
balanced scorecard A tool that
measures four broad areas of
organizational performance:
financial results, customer goals,
internal business processes, and
learning and growth.
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Summary
• This chapter introduced you to the challenges of implementing
strategy, or moving it from a grand design to a set of day-to-day
activities that actually create competitive advantage. Sometimes
implementation is simply a matter of execution. There are four steps
to consider when execution is the issue:
1. Create a set of clear goals for people to follow
2. Find ways to accurately measure performance
3. Hold people accountable for their performance
4. Reward those who perform well
• Effective implementation relies on three key processes: the ability
to forge alignment among the different elements of the organization, the capacity to lead strategic change over a long period of time,
and the creation of a set of measures and assessments that monitor
performance and help suggest changes.
• The 7 S model provides a powerful way to think about how organizations can create alignment. The 7 Ss are:
1. Strategy—the organization’s plan for creating competitive
advantage.
2. Structure—the set of organizational arrangements that divide
labor and tasks. Structure also defines reporting or authority
relationships.
3. Systems—mechanisms, policies, or processes that coordinate
and control work of the different units of the organization.
4. Staffing—the human resource management processes in the
organization for recruiting, hiring, training, and deploying
human capital.
5. Skills—the abilities of individuals, groups, or organizations to perform tasks.
6. Style—the interpersonal relationships and patterns of interaction that organizational members consider appropriate and
legitimate.
7. Shared values—the priorities, values, and virtues that members
of the organization see as important.
• At a high level, organizational change involves three phases:
1. Unfreezing—when leaders recognize and publicly admit that
the current situation is not producing acceptable or adequate
results.
2. Change—the middle step in organizational change that a
company engages in to adapt to its environment and learn new
behaviors.
3. Refreezing—this step involves formalizing and institutionalizing
new behaviors, methods, processes, or routines.
• When implementing change, managers should use principles
such as line of sight and measurement tools such as the balanced
scorecard to help individuals understand their role in the change
process.
Key Terms
alignment 217
balanced scorecard 229
change process 223
empowerment 225
guiding coalition 224
hard triangle 221
institutionalize 226
principle of line of sight
refreeze 223
shared values 220
skills 219
soft square 221
staffing 219
strategy 217
227
structure 217
style 220
superordinate goals 220
systems 219
unfreezing 223
vision 225
Review Questions
1. When using the 7 S model to create alignment, why do managers
need to make sure all the Ss align with the organization’s strategy?
What problems follow misalignment?
2. What tools do managers have to realign the hard triangle? The
soft square?
3. Is it true that the “soft stuff is the hard stuff” in creating alignment?
Why or why not?
4. If change projects seem to stall and fail to progress, which of the
eight steps of successful change have not received enough attention?
5. What does it mean to institutionalize change? How long will this process take? Why?
6. Define line of sight. List three examples from your own career or
educational experience where the principle of line of sight helped you
make a better decision.
References 231
Application Exercises
Exercise 1: Applying the 7 S framework.
1. Select a company you would like to work for. Using the 7 S model
and the framework provided in this chapter as a template, audit that
company. Describe each S for the company and determine the degrees
of alignment among the Ss. Make suggestions as to how the company
can improve its level of alignment.
Exercise 2: Understanding change.
1. Think about two change efforts you have been a part of, one
that succeeded and one that did not. What did success mean? Use
the three-step model of change and the eight key tasks of change
management to identify key differences between the successful and
failed efforts. What lessons would help you initiate and guide change
in your career?
Exercise 3: Personalizing your line of sight.
1. Create your own line of sight measure. Are you doing the most
important things to move your strategy forward? Which activities contribute most, and what measures tell you how you are doing on those
activities? Use the eight tasks of change management to help you identify a plan to improve your effectiveness.
References
1
Data about Google (and Alphabet) share prices available at
https://www.google.com/finance/historical?q=NASDAQ:GOOG,
accessed March 1, 2017.
A. Bylund, “Why Google, Inc. Stock Soared 22% in July,” Motley Fool,
August 5, 2015, https://www.fool.com/investing/general/2015/08
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27, 2017.
2
Bylund.
3
Information about Ruth Porat taken from Jillian D’Onfro, “The Incredible Rise of Ruth Porat, CFO at One of the Most Valuable Companies in the
World,” Business Insider, August 17, 2016, http://www.businessinsider
.com/ruth-porat-google-alphabet-biography-2016-7/#the-story-starts
-in-england-where-frieda-and-dan-porat-had-their-second-child-ruth
-in-1957-1, accessed March 1, 2017, and Maggie McGrath, “Google
Lures CFO Ruth Porat from Morgan Stanley,” Forbes, March 24, 2015,
https://www.forbes.com/sites/maggiemcgrath/2015/03/24/google
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1, 2017.
4
McGrath, op cit.
5
6
H. Kelley, “Meet Google Alphabet—Google’s New Parent Company,”
CNNTech, August 11, 2015, http://money.cnn.com/2015/08/10/technology
/alphabet-google/, accessed March 1, 2017.
M. Reeves, “Google Couldn’t Survive with One Strategy,” Harvard
Business Review, August 18, 2015, https://hbr.org/2015/08/google
-couldnt-survive-with-one-strategy, accessed March 1, 2017.
7
L. Bossidy, R. Charan, and C. Burck, Execution: The Discipline of Getting
Things Done (New York: Crown Business, 2002).
8
M. J. Moore and B. Womack, “Google to Pay New CFO Ruth Porat More
Than $70 Million,” Bloomberg Technology, March 26, 2015, https://
www.bloomberg.com/news/articles/2015-03-26/google-agrees
-to-pay-new-cfo-ruth-porat-70-million-by-2016, accessed March 7, 2017.
9
C. H. Noble, “The Eclectic Roots of Strategy Implementation Research,”
Journal of Business Research 45 (2) (June 1999): 119–134.
10
R. H. Waterman Jr., T. J. Peters, and J. R. Phillips, “Structure Is Not
Organization,” Business Horizons 23 (3) (June 1980): 14.
11
J. Weber, A Leader’s Guide to Understanding Complex Organizations:
An Expanded 7 S Perspective (Charlottesville: University of Virginia
Darden School Foundation, 1998).
12
P. R. Lawrence and J. W. Lorsch, Organization and Environment ([S.l.]:
Harvard Business Bks., 1967).
13
K. M. Eisenhardt, “Control: Organizational and Economic Approaches,”
Management Science 31 (2) (1985): 134–149.
14
Zweig, pp. 549–554.
15
For information on the Google code jam, see https://code.google.com
/codejam/, accessed November 7, 2013.
16
A. Carr, “Apple Hires Burberry CEO Angela Ahrendts to Rejuvenate Retail
Stores,” Fast Company (October 15, 2013), http://www.fastcompany
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-retail-stores.
17
“Cleaning Up Boeing,” Bloomberg Businessweek (March 12, 2006),
http://www.businessweek.com/stories/2006-03-12/cleaning-up
-boeing.
18
Ibid.
19
D. Rigby and B. Bilodeau, “Management Tools and Trends, 2015,”
http://www.bain.com/publications/articles/management-tools-and
-trends-2015.aspx, accessed January 13, 2017.
20
P. Lencioni, The Advantage (Hoboken NJ, 2012).
21
D. H. Pink, Drive: The Surprising Truth about What Motivates Us
(New York: Riverhead Books, 2011).
22
See a recent study by Consulting firm McKinsey and Company. J. Isern,
M. Meaney, and S. Wilson, “Corporate Transformation Under Pressure,”
Insights and Publications (April 2009), http://www.mckinsey.com
/insights/organization/corporate_transformation_under_pressure,
accessed May 21, 2013.
23
A. Deutschman, “Change or Die,” Fast Company Magazine (May 1,
2005), http://www.fastcompany.com/52717/change-or-die.
24
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25
K. Lewin, “Frontiers in Group Dynamics,” in Field Theory in Social
Science, ed. D. Cartwright (London: Harper & Brothers, 1951).
36
26
J. C. Collins, Good to Great: Why Some Companies Make the Leap . . .
and Others Don’t (New York: Random House Business, 2001).
37
27
The eight tasks come from J. P. Kotter, Leading Change (Boston:
Harvard Business School Press, 1996).
38
P. Selznick, Leadership in Administration: A Sociological Interpretation
(Berkeley: University of California Press, 1984).
Material taken from J. P. Kotter, The Heart of Change: Real-Life Stories
of How People Change Their Organizations (Boston: Harvard Business
School Press, 2002), p. 29.
39
28
Ibid.
29
J.P. Kotter, The Balancing Act: Mastering the Competing Demands of
Leadership, 2nd ed. (Provo: Vitality Alliance, 1999).
30
31
J. F. Kennedy, Address before a joint session of Congress, May 25,
1961. Text available at http://www.jfklibrary.org/Asset-Viewer/xzw1gaee
TES6khED14P1Iw.aspx.
Author’s experience in working with different organizations working
to change.
32
Kotter, Leading Change.
33
For examples of how structure and culture affect innovation, see
F. Flynn and J. Chatman, “Strong Cultures and Innovation: Oxymoron
or Opportunity?” In S. Cartwri