Part I: Introduction
Chapter 1: The concept of Strategy
1
Introduction and Objectives
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2
What is strategy and why is it important to success?
Distinguish strategy from planning:
o strategy is a unifying theme that gives coherence and
direction to actions and decisions
introducing a basic framework for strategy analysis
2 basic components: analysis of the external environment and the
internal environment of the firm.
The Role of Strategy in Success
Read the Strategy Capsules 1.1, 1.2 and 1.3 in order to understand the
cases better.
Common factors of Madonna, General Giap, Lance Armstrong:
 Success can not be attributed to overwhelmingly superior resources
 Success can not be attributed exclusively or primarily to luck.
 They recognized opportunities when they appeared
 They had the clarity of direction and the flexibility necessary to
exploit chances.
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 An effectively implemented strategy, a consistency of direction
based on a clear understanding.
Madonna: dedication, opportunism, well-coordinated multimarket
presence
Vietcong: sound strategy with total commitment over long period.
Armstrong: analyzing the requirement for success in the race.
 4 common factors stand out (figure 1.1, p7)
1.
Goals that are simple, consistent and long term.
Madonna: drive for stardom
Vietcong: reuniting Vietnam under communist rule and expelling a
foreign army from Vietnamese soil
Armstrong: winning the Tour
2.
Profound understanding of the competitive environment
Madonna: understanding the ingredients for stardom and the basis
of popular appeal.
Vietcong: understanding his enemy and the battlefield conditions
Armstrong: analysis of the requirements for success in the Tour
3.
Objective appraisal of resources: exploiting strengths,
protecting weaknesses.
Madonna: exploiting ability to develop and project her image.
Avoiding being judged simply as a rock singer or an actress
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Vietcong: exploiting commitment, protecting deficiencies in arms
and equipment
Armstrong: strengths are determination and team building
4.
Effective implementation
Effectiveness as leaders in terms of capacity to reach decision,
energy in implementing them and ability to foster loyalty and
commitment among subordinates.
The success of individuals and organizations is seldom the outcome of
a purely random process. Those who have achieved outstanding
success in their careers are seldom those who possessed the greatest
innate abilities. Success has gone to those who managed their careers
most effectively, typically by combining the 4 strategic factors.
 goal focused
 they know the environment within which they play
 They know themselves in terms of both strengths and weaknesses.
 They implement their career strategies with commitment,
consistency and determination.
The downside: no fulfilment in personal life.
3
The basic framework for Strategy Analysis
4 elements recast into 2 groups.
 The firm
o Goals and values
o Resources and capabilities
resources)
o Structure and system
 The industry environment
o Industry environment
environment)
o Relationship between firm and
(simple consistent goals)
(objective appraisal of
(implementation)
(profound understanding of the
customers, suppliers.
Strategy is the link between the 2. See figure 1.2, p12
3.1 What’s Wrong With SWOT?
SWOT: distinguishing between internal and external environment of the
firm. Classifies the various influences on a firm’s strategy into 4
categories:
 Internal
o Strengths
o Weaknesses
 External
o Opportunities
o Threats
In practical, distinguishing internal from external is difficult. Secondly, it
isn’t so important to classification the factors into strengths or
weaknesses. Key is to identification the factors followed by an appraisal of
their implications
3.2 Strategic Fit
Strategic fit: strategy as a link between the firm and its external
environment. A strategy can only be successful if it is consistent with the
firm’s external (needs of the market) and internal (goals, values,
resources, capabilities,) environment.
4. A Brief History of Business Strategy
4.1 Origins and Military Antecedents
The reason why enterprises need business strategies is the same why
armies need military strategies: to give direction and purpose, to deploy
resources in the most effective manner, to coordinate the decisions made
by different individuals.
 Strategy: the overall plan for deploying resources to establish a
favourable position. winning the war
o Strategy is important
o Strategy involves a significant commitment of resources
o Strategy is not easily reversible
 Tactic: a scheme for a specific action.  winning battles
Differences between business competition and military conflict
 Defeating the enemy  coexistence
From corporate Planning to Strategic Management
The summary on p18 is very clear…
The evolution of business strategy has been driven by the practical needs
of business.
 J ’50-‘60: difficulties in coordinating decisions and maintaining
control in growing companies.
o Financial budgeting as basic framework for annual financial
planning
o Discounted cash flow as new approach to appraising individual
investment projects.
o Macroeconomic forecasts: new corporate planning  5-year
format to set goals and objectives, forecast key economic
trends, establish priorities, and allocate capital expenditures.
 J ’60-‘70: corporate planning
o Diversification as major emphasis of corporate planning
 J ‘70-‘80: strategic management
o Diversification fail to deliver
o Oil shocks in ’74 en ‘79
o Increased international competition form Japan, Europe,
o  More turbulent business environment, 5-years plans aren’t
possible anymore.
o  Shift from planning to strategy making: focus on the
positioning of the company in markets and in relation to
competitors in order to maximize the potential for profit.
Competition as central characteristic of the business
environment. Competitive advantage as the primary goal of
strategy.
 Attention focuses on source of profit within the industry
environment.
 First analyzing of industry profitability.
 Profitability differences within industries
 J ’90: resource-based view of the firm
o Focus on the sources of profit within the firm.
 Resources and capabilities of the firm are main source of
competitive advantage and primary basis form
formulating strategy.
o Identifying how firms are different from their competitors and
design strategies that exploit these differences.
 Late j ‘90
o Knowledge-based post-industrial economy  unprecedented
entrepreneurial opportunities, firms reinvented themselves
o Quest for new business models: new approaches to the
creation and exploitation of value
 Early ‘00
o Stock market meltdown, demise of the stars of the
technology, media, telecomm sector
o Deflate optimism over the power of strategic innovation, nut
digital technologies have continued to be major drivers of
change and sources of new threats and opportunities.
o  increased interest in the application of real option thinking
to the management of flexibility
o  New interest in business ethics and corporate social
responsibility due to the awareness of the fragility of Earth’s
ecosystem,
See figure 1.3, p18 for a summary
5. Strategic Management Today
5.1 What Is Strategy?
In the broadest sense, strategy is the means by which individuals or
organizations achieve their objectives
There are a lot of different definitions for strategy; common to them is the
notion that strategy is
 focused on achieving certain goals
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critical actions that make up a strategy involve allocation of
resources
 Strategy implies some consistency, integration or cohesiveness.
The conception of firm strategy has changed greatly over the past half
century.
 less concerned with detailed plans
 And more about mission, vision, principles, guidelines and targets.
 Embrace flexibility and responsiveness.
 In an environment of uncertainty and change a clear sense of
direction is essential to the pursuit of objectives.
According to Porter, strategy is not about doing things better, it’s about
doing things differently; the essence of strategy is making choices.
 Where to compete?
 How to compete?
5.2 Corporate and Business Strategy
See figure 1.4 p 20
 Basic: the purpose of strategy is to achieve certain goals.
 For a firm: survive and prosper.
 On the long term: earning a rate of return on its capital that
exceeds its cost of capital.
 2 ways of achieving
o Locate the firm within an industry where overall rates of
returns are attractive
o Attain a position of advantage over its competitors within an
industry.
 Corporate strategy: defines the scope of the firm in terms of the
industries and markets in which it competes. Decisions include
investment in diversification, vertical integration, acquisitions, new
ventures, allocation of resources between the different business of
the firm and divestments
o Responsibility of the top management team
 Business strategy: concerned with how the firm competes within a
particular industry or market. If the firm is to prosper within an
industry, it must establish a competitive advantage over its rivals.
Also referred to as competitive strategy.
o Responsibility of the divisional management
5.3 Describing a Firm’s Strategy
Strategy resides primarily within the minds of top managers.
 Start up enterprise: written down in the business plan
 Established companies
o Vision: aspirational view of what the organization will be like
in the future. Mostly too idealized to offer clear guidance.
o Mission: what the organization seeks to achieve over the long
term. Offers a pointer to the overall direction in which strategy
will take the organization
o Business models: a statement of the basis on which a
business will generate revenue and profit. Mostly very simple
 supply a product that meets a consumer need and sell it at
a price that exceeds the cost of production.
A business model is a preliminary to strategy; it is only
concerned with the viability of the basic business concept. The
firm will still need a strategy that will allow it to survive
against competitors that have the same business model.
o Strategic plans: strategy in terms of performance goals,
approaches to achieving these goals, and planned resource
commitments over a specific time period.
If there isn’t an explicit strategy we start with asking these questions:
where is the firm competing, how is it competing?
5.4 How Is Strategy Made? Design vs. Emergence
 Intended strategy: strategy is conceived of the top management
team. Rationality is limited, this is the result of a process of
negotiation.
 Realized strategy: the actual strategy that is implemented. Only
partly related to that which was intended
 Emergent strategy: the decisions that emerge from the complex
processes in which individual managers interpret the intended
strategy and adapt to changing external circumstances.
Debate between those who view strategy making as a ration analytical
process of planning: design school.
And those that see strategy as emerging from a complex process of
organizational decision making: emergence or learning school.
 The debate rumbles on. The question is: how can the two views
complement one another to give us a richer understanding of how
strategy is made?
Mostly it’s a combination of the two:
 At the formal level: strategy is made in board meetings
 Strategy is being continually enacted through decisions that are
made by every member of the organization.
  The bottom-up process may lead to formal to-down strategy
formulations.
Planned emergence: corporate headquarters set guidelines in the form of
mission statements. Individual business units take the lead in formulating
strategic plans. Within the strategic plan, divisional managers have
freedom to adjust, adapt and experiment.
The optimal balance between design and emergence depends on the
stability of the external environment. Organizations whose environments
are fast changing must limit their strategic planning to a few guidelines;
the rest must emerge as circumstances unfold.
5.5 Multiple Roles of Strategy
Strategy making is a part of an ongoing management process. Viewing
strategy making as part of the management process helps us to see that
strategy plays multiples roles within organizations.
5.5.1 Strategy as Decision support
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Simplifies decision making by constraining the range of decision
alternatives considered.
Permits the knowledge of different individuals to be pooled and
integrated
Facilitates the use of analytic tools
5.5.2 Strategy as a Coordinating Device
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Communication device
Strategic planning can provide a forum in which views are
exchanged and consensus developed.
Mechanism to ensure that the organization moves forward in a
consistent direction.
5.5.3 Strategy as Target
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Is concerned with what the firm will become in the future.
Set aspirations that can motivate and inspire the members of the
organization.
6 The Role of Analysis in Strategy Formulation
The approach of this book is to emphasize analytic approaches to strategy
formulation. The challenge is to extend our analytic tools to take account
of the role of values and goals, the value of flexibility,…
We must recognize the nature of strategy analysis: it does not generate
solutions to problems, strategic questions are too complex to be
programmed. The book is designed to help understand the issues. The
techniques we use are frameworks.
7. Summary
This chapter has covered a great deal of ground. I hope that you are not
suffering from indigestion. If you’re feeling a little overwhelmed, not to
worry, we shall be returning to most of the themes and issued raised in
this chapter. The next stage is to delve further into the basic strategy
framework show in figure 1.2. Each element of this framework comprises
the basic components of strategy analysis.
II
THE TOOLS OF STRATEGY ANALYSIS
Chapter 2 Goals, Values, and Performance
2.1 Introduction and Objectives
Business strategy is primarily a quest for profit. Therefore, we could claim
that the main goal of a firm is to make money. However, the most
successful businesses are those that are not driven by the pursuit of
profit, but those with a clear mission statement. In this chapter, the
author focuses on that mission, which a firm attaches to its strategy.
2.2 Strategy as a Quest for Value
Businesses want to create value. They do so in two ways:
 Through production: using materials to create a product, which is
valued more than the individual materials (e.g. using clay to
produce coffee mugs)
 Through commerce: speculating and relocating products in time and
space to attach more value. A particular product might be valued
more in a particular place and time, than in another time and place.
In other words, firms add value. This “added value” is the difference
between the value of a firm’s output and the cost of its material input.
Value added = Sales revenue from output less Cost of material inputs =
Wages/Salaries + Interest + Rent + Royalties/License fees + Taxes +
Dividends + Retained profit
2.2.1
In Whose Interest? Shareholders vs.
Stakeholders
Companies can act in the interest of (i) stakeholders or (ii) shareholders.
(i)
The stakeholders view means that a company is a coalition of
interest groups (owners, employees, lenders, landlords,
government). Owners receive profit; employees receive salaries
and wages; lenders receive interests; landlords receive rent; the
government receives taxes.
(ii)
The shareholders approach implies that a company’s duty is to
render profit for the owners.
This, however, is highly culturally defined: in the Anglo-Saxon culture (UK,
US, Canada), companies make money for their owners; in France, the
priority is the national interest (government); in the Netherlands, the
main goal is the longevity of the company, etc. Consequently, this variety
results in totally different ethical and social codes.
However, the author chooses to ignore these different codes and focus
only on a companies’ goal to maximize profit for the owners over the long
term. He adds four arguments why he does so.
(1)
(2)
(3)
(4)
2.2.2
Competition. As competition increases, companies have to make
profit to survive, i.e. earning a rate of profit to cover the cost of
their capital.
The market for corporate control. If the management of a
company is not able to maximize its profit, there is a change the
company will be taken over by public companies (corporate
control). So, if management fails, they will be replaced.
Convergence of stakeholder interest. A company that focuses on
making profit will also cater for the stakeholders’ interests,
because it will gain the loyalty and trust of its employees,
supllies, comsumers, landlords, lenders, etc.
Simplicity. Focusing on one clearly defined goal (making profit) is
more simple than focusing on different goals (stakeholder
view),Of course, it is seldom that the main goal of a company is
of a financial nature. It is often the fulfillment of a vision and a
the desire to make a difference in the world that are the most
important motivations for the most successful companies.
However, it must be emphasized that this is seldomly possible
without being profitable.
What is Profit?
It is difficult to define “profit”. However, it is – of course – essential that
managers ask themselves some questions in order to be able to maximize
profit. Such questions are:
 Does profit maximization mean maximizing total profit or rate of
profit?
 Over what time period is profitability being maximized?
 How is profit to be measured?
From table 2.1, one can clearly see the differences, resulting from
different answers to the above questions.
2.2.3
From Accounting Profit to Economic Profit
Accounting profit = return on capital + economic profit
Economic profit = Net operating profit after tax – cost of capital
= Net operating profit after tax – (capital employed x
weighted
average cost of capital)
Usually, economic profit is preferred over accounting profit, because it
renders a more realistic impression of a company’s profitability.
2.2.4
Linking Profit to Enterprise Value
Just like the measurement of the value of an asset, the value of an
enterprise can be measured by the net present value of its return. For the
exact calculation of the value of an enterprise, see p. 39.
If we want to analyse the profitability of a company, we must consider the
company’s cash flow over a longer period of time (i.e. Discounted Cash
Flow (DCF) approach). When we focus on a relatively short period of time,
cash flows may give a misleading impression, since cash flows tend to be
negative in the growth fase of a company.
If we want to analyse the profitability of a company over one year, it is
advisible to focus on the economic profit. Economic profit shows the
surplus being generated by the firm in each year, whereas free chas flow
depends on management choices over the level of capital expenditure.
Enterprise Value and Shareholder Value
Obviously, enterprise value is closely related to shareholder value. As the
author argues, shareholder value is calculated by substracting the debt
(and other non-esuity financial claims) from the DCF value of the firm.
The rest of the chapter (and the book) will put emphasis on maximizing
enterprise value, rather than shareholder value. It gives us a more
realistic image of the underlying drivers (motivations) of a company.
2.2.5
Applying DCF Analysis to Valuing Companies,
Businesses and Strategies
Applying DCF to Uncertain Future Cash Flows
Here, the author re-writes the formula with which one can calculate the
value of a company in order to be able to make assumptions about the
future profit and value of a company.
Valuing Strategies
Using the DCF approach to estimate the value of a company makes it
possible to evualate individual strategies, by analysing the cash flows
under a specific strategy. Consesuently, we could also evaluate different
projects, company units, etc. As the author then states, applying
enterprise value to appraising business strategies involves several steps.
They are rather straightforward, so it may suffice to quote them:
 Identify strategy alternatives (the simplest approach is to compare
the current strategy with the preferred alternative strategy).
 Estimate the cash flows associated with each strategy.
 Estimate the implications of each strategy for the cost of capital –
according to the risk characteristics of different strategies and their
financing implications, different stragegies will be associated with a
different cost of capital.
 Select the strategy that generates the highest NVP (net present
value).
However, we are faced with a couple of problems here. First, of course,
there is the problem of forecasting (“predicting”) a future, which is
typically uncertain. Second, it might be misleading to use a quantitative
approac (like the above approach) to value strategies. Strategies are not
only portfolios of investments. They are often portfolios of options.
Therefore, a qualitative approach might be more in place.
2.3 Strategy and Real Options
It is difficult to attach value to particular options, which firms own.
However, it is obvious that options have a value (e.g. British Petrol, p.
42).
Consequently, a lot of companies use a so-called “phases and gates”approach to development processes, which implies that a company reassesses a project in its different phases. At the end of every phase, there
is the option to amend or abandon the project, taking in account new
circumstances.
Strategy as Options Management
Here, the author argues that using the “phases and gates”-approach
constitutes strategic flexibility, which adds to the value of an enterprise.
Moreover, a company can adopt several strategies to create option value
and opportunities (and therefore: more company value). For example
(quoted):
 “Platform investments” which are investments that create a stream
of additional options (e.g. 3M).
 Strategic alliances and joint ventures, which are limited
investements that offer options for the creation of whole new
strategies (e.g. Virgin Group).

Organizational capabilities, which can also be viewed as options
offering the potential to create competitive advantage across
multiple products and businesses (e.g. Sharp).
2.4 Putting Performance Analysis Into Practice
This paragraph deals with 4 questions:
(1) 2.4.1 How can we best appraise overall firm (or business unit)
performance?
(2) 2.4.2 How can we diagnose the sources of poor performance?
(3) 2.4.3 How can we select strategies on the basis of their profit
prospects?
(4) 2.4.4 How do we set performance strategies?
2.4.1
Appraising Current and Past Performance
How can we best appraise overall firm (or business unit) performance?
First, we must take a look at the overall performance of a company. This
means identifying the current strategy of a company and assessing it.
Foward-Looking Performance Measures: Stock Market Value
Growth in the stock market value is a good indicator for assessing
expected cash flows. Of course, we must take into account that the stock
market is imperfect and volatile.
Backward-Looking Performance Measures: Accounting Ratios
Of course, the stock market has its base on financial reports, press
releases etc. which cannot be possibly issued at any given time.
Therefore, the stock market is based in history. However, there are some
accounting ratios with which we can get an impression of the overall
performance of a company: the profitability ratios (see table 2.2).
Through the combination of certain ratios (such as ROCE and WACC, etc.)
we can even get a more realistic measure.
2.4.2
Performance Diagnosis
How can we diagnose the sources of poor performance?
If the profitability ratios turn out to indicate poor performance, we can
investigate the sources of that poor performance. One way to do so is by
applying the Du Pont Formula, which dissegrates return on invested
capital into sales margin and capital turnover (see figure 2.1)
2.4.3
Evaluating Alternative Strategies
How can we select strategies on the basis of their profit prospects?
If a company is doing bad, it must consider alternative strageties. But,
also when it is doing well, it has to consider its options. Therefore, the
qualitative (and not: quantitative) analysis of alternative strategies is
important. This means analysing industry trends, sources of competitive
advantage, product market conditions, etc.
2.4.4
Setting Performance Targets
How do we set performance strategies?
Making profit and attaching more value to the company on the long run is
a rather vague and abstract starting point for the employees and others in
a company. Therefore, it is management’s task to translate this vague
goal in more concrete performance targets for the company’s staff, which
contribute to the overall goal of making profit.
Balanced Scorecards
In order not to let short-term financial goals get in the way of a long-term
strategy, the balanced scorecard (by Kaplan & Norton) is an excellent tool.
This method gives us a balanced performance measurement. The
performance measures combine the answers to four questions (quoted):
(1) How do we look to shareholders?
(2) How do customers see us?
(3) What must we excel at?
(4) Can we continue to improve and create value?
2.5 Beyond Profit: Values and Social
Responsibility
In this paragraph, the author focuses on the other goals of a company,
besides making profit (cfr. § 2.2.1).
2.5.1
The Paradox of Profit
As stated in the introduction, the companies that are not focused primarily
on profit are often more successful. Indeed, the pursuit of profit often
results in poor returns. Why? First, as pointed out in paragraph 2.2.2,
managers often do not kow how to define profit and how to create
profitability. A strategic goal, such as Ford, Boeing, Sony, etc. set for
themselves, often results in profitability. Second, a manager has to have a
motivated staff.
2.5.2
Values and Principles
Values and principles condition, constrain, and transcend the pursuit of
profit. Moreover, they influence employees’ motivation and sense of
identity and contribute to a organizational culture. These values and
principles are often translated in codes of conduct, specific rules or just
made explicit to the outside world. The values and principles are often
regarded as a timeless glue that holds the organization together.
2.5.3
The Debate Over Corporate Social Responsibility
Often, focusing too much on commitments results in poor commercial
succes (e.g. Body Shop). In more extreme cases, companies follow the
values and beliefs of a powerful leader (e.g. Hughes Aircraft, Howard
Hughes).
Consequently, there is a fierce debate on whether companies should
engage in social responsibility and deviate from the goal of maximizing
profit.
However, broadly generalised, social responsibility is believed to be
compatible with business survival and prosperity.
Chapter 3: Industry Analysis: The Fundamentals
3.1 Introduction & Objectives
This chapter explores the external environment of the firm = industry
analysis. We will identify the sources of profit in the firm’s proximate
environment.
Industry analysis is relevant on both corporate and business level.
- On a corporate level: deciding which industries the firm should engage in
and how it should allocate its resources.
- On a business level: establishing competitive advantage (what are the
key success factors?)
3.2 From Environmental Analysis to Industry Analysis
The business environment = all external influences that affect its decisions and
performance.
 Framework for organising information: will enable managers to manage
those influences
Principles to do this:
- Making profit = create value for customer
 Firm must understand its customers.
- Create value = acquire goods and services from supplier
 Firm must manage relationships with suppliers
- Profitability = intensity of competition
 understand competition
=> Firm’s business environment =
1) Customers
2) Suppliers
3) Competitors
BUSINESS ENVIRONMENT
But also more general, macro-level factors: economic trends, demographics,
social and political trends, etc. Some threats are important to a company; others
are not (depending on the kind of company).
E.g. global warming: affects some companies, but not a strategic issue for
all companies.
See p. 66, fig. 3.1
3.3 The Determinants of Industry Profit: Demand and
Competition
What determines the level of profit in an industry?
= the creation of value for the customer
o by production (transforming inputs into outputs)
o by commerce (arbitrage)
Value is created when the customer is willing to pay a price which exceeds
the costs incurred by the firm.
Value over cost is distributed between customers and producers by the forces of
competition.
Strong competition causes:
 customer surplus to rise (= the difference between the price the
customers pay and the maximum prices they would have been willing to
pay
 producer surplus/economic rent to drop (= surplus received by
producers).
e.g. If there’s only one supplier of a (necessary) product in the market,
customers are likely to buy the product at any price.
e.g. Supplier of bottled water on an all-night rave
But: not all producer surplus is entirely captured in profits! Produces have to
take into account their suppliers (especially when those are monopolistic) or
employees (especially in the case of strong unions), to whom a substantial part
of the producers surplus can be appropriated.
3 factors that determine the profits earned by the firms in an industry:
1. Value of the product to the customer
2. Intensity of competition
3. Bargaining power of the producers relative to their suppliers.
3.4 Analysing Industry Attractiveness
Rates of profit differ from one industry to another
E.g. high in industries like tobacco and pharmaceuticals. Low in airlines,
paper, food production, etc.
The level of profitability is
NOT random
NOT the result of entirely industry-specific influences.
= determined by the systematic influences of the industry’s structure:
different industries have different products and structures.
↓
High rates of profit < industry segments dominated by a single firm, often in
niche markets: MONOPOLY
Vs PERFECT COMPETITION, when any firms are supplying an identical product
without restrictions on entry/exit. The profit rate only just covers the costs of
capital.
So, the structure of an industry is somewhere on
the continuum between MONOPOLY and PERFECT
COMPETITION.
STRUCTURE
Monopoly
WHAT
One firm
BARRIERS
PRODUCT
INFORMATION
DIFFERENTIATION
AVAILABILITY
high
EXAMPLE
Pharmaceuticals,
dominates
US chewing
industry
tobacco
segment
Duopoly
Two firms
Potential for
dominate
differentiation
industry
Oligopoly
Small
Boeing & Airbus
Imperfect
Most
Significant
number of
manufacturing
major
industries.
companies
Perfect
Many
competition
none
Homogeneous
No
firms
product
impediments
supply an
(commodity)
on information
identical
Agriculture
flow
product
PORTER’S 5 FORCES OF COMPETITION FRAMEWORK
= a framework which classifies the features that determine the intensity of
competition and the profitability of an industry.
It identifies 5 sources of competitive pressure
Fig. 3.3 and
o 3 sources of ‘horizontal’ competition
3.4
- from substitutes
- from entrants
- from established rivals
o 2 sources of ‘vertical’ competition
- the power of suppliers
- the power of buyers
a) Competition from Substitutes
Substitute products can affect the prices customers are willing to pay. If there
are close substitutes to a certain product, customers will switch to those
substitutes if the price of the products goes up.
E.g. fuel, cigarettes: absence of close substitutes  consumers are
insensitive to price
E.g. internet: substitute for many organisations, like travel agencies,
newspapers, telecommunication providers, etc.
The effect of substitution depends on:
1. The propensity of buyers to substitute between the alternatives. This in
turn is depended on the price-performance of the different alternatives.
E.g. if travelling from A to B takes longer by train than by air, then
train fares should be cheaper than airline tickets.
2. The complexity of the product and difficulty to discern performance
differences. If a product is very complex, customers have more difficulties
determining valuable alternatives.
E.g. perfume: customers are unsure about the performance
characteristics of different fragrances, so they seldom buy lowpriced imitations of leading perfumes.
b) Threat of Entry
If ROCE > costs of capital, then new companies want to enter the industry.
BUT If competitors have unrestricted opportunities to enter the market, profits
fall towards its competitive level (= a CONTESTABLE industry)
Contestability depends on the absence of SUNK COSTS (=investments of which
the value cannot be recovered on exit). No sunk costs = ‘hit and run’ entry
whenever an established firm raises its prices above the competitive level.
Sometimes the threat of entry can even cause established firms to keep their
prices constantly at competitive level.
So: new entrants to market should be avoided
 barriers to entry
= any advantage that established firms have over entrants
The height of a barrier = measured as the unit cost disadvantage faced by
would-be entrants. Research shows that industries with high entry barriers
generally have high profit rates.
The effectiveness of entry barriers depends on the resources and capabilities that
the potential entrants possess: some barriers are indeed effective against new
companies, but ineffective against established companies that are diversifying
from other industries, because they circumvent the barriers.
Sources of entry barriers:
1. Capital Requirements
The larger, the more new entrants will be discouraged to enter.
E.g. the duopoly of Boeing and Airbus: huge capital costs of R&D,
production and service requirements.
E.g. companies launching commercial satellites
Examples of low entry barriers due to low capital requirements:
E.g. e-commerce, pizza outlets
2. Economies of Scale
In some industries, profitability can be enhanced by large-scale operation.
New entrants have to choose between entering small-scale, but having
high unit costs or entering large-scale, but having costs of underutilised
capacity.
E.g. Car manufacturing: cost efficiency = production of minimum 3
million vehicles a year.
E.g. Airbus/Boeing: product development costs are very high, so
scale economics have to be too.
3. Absolute Cost Advantages
This often results from the acquisition of low-cost sources of raw materials.
E.g. Saudi Aramco: oil company with most direct access to oil
reserves, rendering a significant cost advantage over competitors
like Shell, BP, etc.
But can also result from economies of learning. (cf. experience curve,
chapter 8)
E.g. LCD flat screens: companies that entered early have moved
down the experience curve faster and have considerable cost
advantages.
4. Product Differentiation
=> brand recognition and customer loyalty. New entrant have to invest
heavily in advertising.
E.g. Loyalty: typically high for products like toothpaste, cigarettes,
etc. Typically low for: batteries, canned vegetables, etc.
5. Access to channels of distribution
= the battle for supermarket shelf space. Internet allows new entrants to
circumvent these barriers.
6. Governmental / Legal Barriers
E.g. taxis, banking, telecommunications, broadcasting  often
requires licenses by public authorities
E.g. patents, copyrights in knowledge-intensive industries.
E.g. in more recent times: environmental and safety standards
7. Retaliation (by established firms)
E.g. aggressive price cuts, increased advertising, sales promotion,
litigation.
New entrants sometimes try to avoid retaliation by entering small-scale in
less visible segments of the market.
E.g. Japanese car manufacturers first entered the small car
segments.
c) Rivalry Between Established Competitors
In some industries very aggressive: sometimes even resulting in prices under the
level of costs. In other industries: little price competition (restricted to
advertising, innovation, etc).
6 factors interact and determine the intensity of competition:
1. Concentration of sellers
= the number and size distribution of firms competing within a market.
 Concentration ratio = the combined market share of the leading
producers.
However, these are mostly tendencies and not statistically proven
observations.
Monopolies: discretion over prices
Duopolies & oligopolies: price competition can be restrained, for
example by collusion or ‘parallelism’ of pricing decisions. So prices tend to
be similar and competition focuses on advertising, promotion and product
development.
E.g. batteries, soft drink, etc.
More companies = more competition, with the likelihood that one firm
initiates price-cutting
2. Diversity of Competitors
Differences in national origins, objectives, costs and strategies = more
chances to price competition.
E.g. OPEC: wants to achieve stable oil prices, but has to cope with
differences in origin, objectives, costs and strategies between
member countries.
3. Product Differentiation
The more similar the offering of rival firms, the more customers are likely
to buy substitutes  incentive for firms to cut prices.
Cf commodity products = small profit levels, price wars
4. Excess Capacity and Exit Barriers
Unused capacity = price cuts  attract new business  spread fixed costs
over greater volumes
Causes of overcapacity:
o Cyclical phenomenon
o Part of a structural problem: overinvestment and declining
demand
Solution: excess capacity has to leave the industry.
Barriers to exit = costs associated with capacity leaving the industry.
E.g. durable or specialised resources, job protection, etc
=> Overcapacity + high exit barriers = devastating for
profitability
=> Rapid demand growth = capacity shortages = boost margins
industry
5. Cost Conditions: Scale Economies and the Ratio of Fixed to Variable
Costs
Cost structure determines how low prices will go in case of overcapacity.
Fixed costs high relative to variable costs: firms taking marginal business
at any price that covers the costs  effects on profitability can be
disastrous.
E.g. airline tickets, hotels, etc.
+
Scale economies = often aggressive competition on price, to gain benefits
of high volumes.
d) Bargaining Power of Suppliers
A firm operates in two markets:
- Input markets = purchase raw materials/components/financial/labour.
Vs.
- Output markets = sell goods/services to customers (customers can be
distributors or other manufacturers).
 Buying power of firms depends on:
o Buyer’s price sensitivity = extent to which buyers are
sensitive to the process charged by the firms in an industry.
Depended on:
 Importance of item as proportion of total cost.
E.g. price of aluminium to beverage
manufacturers. Cans represent highest
cost for beverage manufacturers, so they
are sensitive to cost of aluminium.
 Differentiation of products (when high = likely to
switch supplier)
 Intensity of competition among buyers = price
reductions from sellers.
 The extent to which the industry’s product is critical
to the quality of the buyer’s product.
E.g. microprocessors are vital to manufacturers
of personal computers, so they are willing to pay
a high price.
o
Relative bargaining power = refusal to deal with the other
party. The balance of the power between two parties of a
transaction depends on credibility and effectiveness of both.
Key issue: the relative cost of each party as a result of the
transaction not being consummated.
Other issues:




Party’s expertise in managing its position.
Size and concentration of buyers relative to
suppliers (small number of buyers making large
purchases = large cost of losing one)
Buyer’s information (well informed about prices =
easier to bargain)
Ability to integrate vertically (doing it yourself is
alternative to find another supplier). Sometimes the
threat to make your own products is enough to gain
bargaining power.
e) Bargaining Power of Suppliers
The same system as previously, only now firms in the industry are the buyers.
Cartelisation = way to organise situations in which raw materials/semi-finished
products/components are supplied by small companies to large companies.
Cartelisation overcomes the problem of those small firms having little or no
bargaining power over the larger buyers.
E.g. OPEC, International Coffee Organisation
Cf. labour unions: source of supplier power. High unionisation = lower
profitability in the industry
Fig. 3.6, p.80
Conversely: suppliers of complex, technically complex
considerable bargaining power over their buyers.
E.g. Microsoft as supplier of operating systems
components
have
3.5 Applying Industry Analysis
3.5.1 Describing industry Structure
1. The players
= straightforward in manufacturing industries: producers, customers, suppliers,
suppliers of substitutes.
More difficult to determine in service industries (due to complex value chain).
E.g. television programming industry: what are buyers, seller and where
do boundaries lie?
=> Different players & their relationships = industry definition (value chain,
boundaries). See further.
3.5.2 Forecasting Industry Profitability
Current profitability = poor indicator of future profitability  learn from industry
structure and processes in that industry to make assumptions about the future.
3 stages of profitability analysis:
1. Examine how levels of competition and profitability are a consequence
of the industry’s structure.
2. Identify trends that are changing in the industry’s structure.
E.g. Presence of new entrants, increasing level of consolidation,
products becoming more differentiated/commoditised, etc.
3. Identify how the structural changes will affect the 5 forces of
competition (and thus profitability in the industry).
Caps. 3.2, p.
82
Profitability is undermined by 2 major forces in the last 20 years:
o increasing international competition
o accelerating technological change
Both increased competitive pressures, because of lower entry barriers and
convergence of industries.
Caps. 3.3, p.
E.g. the internet and other new means of telecommunication
83
3.5.3 Strategies to Alter Industry Structure
Structural characteristics determine intensity of competition + profitability 
identify opportunities for changing industry to mitigate competitive pressures.
1. Identify key structural features of an industry that are responsible for
depressing profitability.
2. Consider which of these structural features are amendable to change through
appropriate strategic initiatives.
E.g. European petrochemicals industry. Problem of overcapacity.  bilateral
plant exchanges  each company built a leading position within a particular
product area.
E.g. US airline industry. Lack of product differentiation
 frequent-flier schemes = customer loyalty
 hub-and-spoke route systems = dominance in
particular airports
 mergers/alliances = less competitors
3.6 Defining Industries: Where to Draw the Boundaries
3.6.1 Industries & Markets
What is an ‘industry’?
Economics definition (which we will use!!):
= a group of firms that supplies a market  industry analysis (5 forces):
looks at industry profitability determined by competition in 2 markets
(product markets + input markets).
Everyday usage:
Industry = broad sectors
Market = specific products
E.g. firms in packaging industry compete in many product markets:
glass containers, steel/aluminium cans, paper, etc.
Cf. geographical boundaries: depend on the geographical markets the firm
operates in (=economics) or depend on the geographical areas the firms reside
in (=everyday usage)?
Starting point to define industry = identify the relative market: which are the
groups of firms that compete to supply a particular service?  mirco-level
approach: customer choosing between rival offerings.
Caps. 3.4, p.
86
3.6.2 Defining Markets: Substitution in Demand and Supply
Market boundaries are defined by substitutability:
- on the demand side.
E.g. If customers are willing to substitute between Jaguars and other
luxury cars, then Jaguar’s relevant market is luxury cars rather than
the automobile market as a whole.
- on the supply side.
E.g. If manufacturers find it easy to switch their production from luxury
cars to family sedans, the supply-side substitutability suggests Jaguar
is competing in a broader automobile market.
Geographical boundaries work in the same way.
E.g. if customers are willing/able to substitute between cars from different
national markets  cars = global market.
To find this out: look at price differences. If demand-side and supply-side
tend to erode prices of the same product in different locations, then the
locations lie in one single market.
In practice: determining boundaries of markets/industries = purposes and
context of the analysis. The longer terms the decisions are to a firm, the more
broadly it will consider the markets, because substitutability is higher in the long
run than in short-term.
+ remain wary of external influences: market is a continuum
E.g. Disneyland: Closest competitor is Universal Studios. But
Disneyland is also a theme park (so, competition from Six Flags),
and even wider entertainment (so: competition from cinemas, video
games, etc).
3.7 From industry Attractiveness to
Advantage: Identifying key Success Factors
Competitive
5 forces framework = determine an industry’s potential for profit.
Now what are sources of competitive advantage within an industry?
To survive in an industry a company must:
1. supply what customers want to buy
= identify who the customers are, what their needs are and how they
choose between competing offers.
2. survive competition.
= examine basis of competition within industry. But also a strong financial
position, costs low enough to cover cost of capital.
Caps. 3.3, p.89
Fig.3.7, p. 90
Table 3.3, p.
91
Key success factors can be identified through direct modelling of profitability (cf.
5 forces framework).
Cf. chapter 2 (fig. 2.1) and Caps. 3.6, p. 92, Fig. 3.8, p. 93
Summary
Competitive environment = critical ingredient of a successful strategy.
Chapter 3 = systematic approach to analysing a firm’s industry environment 
evaluate industry’s profit potential and identify the sources of competitive
advantage.
Central: Porter’s 5 forces framework
= links industry’s structure to competitive intensity and profitability within
that industry.
= model to classify relevant features of an industry’s structure
However: has its limitations (in chapter 4).
Part II: The tools of strategy analysis
Chapter 4: Further Topics in Industry and
Competitive Analysis
1
Introduction and objectives
Things to consider when applying the Porter five forces model:
o We have considered the only relationship between products
substitute relations, but many goods and services are
complementary.
o In many sectors, industry structure may be much less stable than
envisaged by the Porter model. Competition (particularly
technological competition) may reshape industry structure.
o We have not explored the dynamic rivalry that characterizes
business competition in the real world. (e.g. Boeing’s competitive
environment is dominated by the strategy of Airbus)
o Because of heterogeneity of industries we shall disaggregate
industries into segments and analyze each segment as a separate
market.
2
Extending the Five Forces Framework
2.1
Does industry matter?
Criticism on Porters Five Forces Framework:
o Theoretical: structure-conduct-performance approach lacks rigor
Defence of industry analysis is that it is useful in allowing us to
understand competition and to predict changes in profitability on the
basis of changes in industry structure.
o Industry environment is a relative minor determinant of a firm’s
profitability. (studies disagree on the exact proportion but it varies
from 4% to 19,6% according to table 4.1)
 Need to more understanding of the determinants of competitive
behaviour and how competition influences industry-level
profitability.
 Need to examine competition at the level of particular segments
2.2
Complements: A Missing Force in the Porter Model?
While the presence of substitutes reduces the value of a product, complements
increase value. The availability of ink cartridges for my printer transforms its
value for me. With complements as sixth force the porter Five Forces Framework
looks like this:
Suppliers
Bargaining power of suppliers
The suppliers of
complements create value for
the industry and can exercise
bargaining power.
INDUSTRY
COMPETITORS
Complements
Potential
Entrants
Threat of
new entrants
Threat of
substitutes
Substitutes
Rivalry among
existing firms
Bargaining power of buyers
Buyers
The key of this bargaining position is to achieve monopolization, differentiation
and shortage of supply in your product, while encouraging competition,
commodization and excess capacity in the production of the complementary
product. An example is IBM, that tried to break the monopoly of Microsoft in
software by promoting open-source software to get a bigger share in profit
returns from systems of hardware and software.
2.3 Dynamic Competition: Creative Destruction and
Hypercompetition
J. Schumpeter (= Austrian school of economists): Competition is a “perennial
(eeuwigdurende) gale of creative destruction” , a dynamic process of rivalry that
constantly reformulates industry structure. By which they mean industry
structure is formed by competition rather than vice versa. The problem with this
quote is that industry structures do not change rapidly especially in established
industries.
In some industries however, because of rapid product innovation, this view is
applicable, the so called “Schumpeterian industries”.
Rich D’Aveni: Hypercompetition in industries with intense and rapid competitive
moves.
3
The Contribution of Game Theory
Whereas the five forces analysis doesn’t offer insight in competition as a process
of interaction the Game Theory offers valuable contributions on this field for
strategic management. Why?
1) It permits the framing of strategic decisions
- identity of the players
- specification of each player’s options
- specification of the payoffs from every combination of options
- the sequencing of decisions using game trees
2) It can predict the outcome of competitive situations and identify optimal
strategic choices.
The influence of game theory on strategic management remained limited until
the 1990s.
3.1
Cooperation
A key deficiency of the five forces framework is in viewing interfirm relations as
exclusively competitive in nature. You must always bear in mind that in an
industry different firms are partners in creating value, but also rivals in sharing
that value. In many business relationships competition results in a inferior
outcome for the players compared with cooperation (cfr Prisoners’ Dilemma
Strat.Capsule 4.1 page 103).
3.2
Deterrence
The principle is to impose costs on the other players for actions that we deem to
be undesirable. (e.g. Deserters in the army have the certainty they will be shot.)
The key of any deterrent is that it must be credible. A good deterrent for
discouraging entry is investing in excess capacity but in the end everything
depends on the willingness of the adversaries to be deterred. E.g. Ideologically
motivated terrorists are not susceptible to deterrence, so the “war on terror” did
not really make a difference.
3.3
Commitment
The credibility of a deterrent also means that it needs to be backed by
commitment which means accepting increased risk by eliminating strategic
options. There is a distinction between hard commitments (to scare off rivals and
be an aggressive competitor) and soft commitments (to moderate competition).
In price competition, soft commitments tend to have a positive impact on profits
in the industry. Under quantity adjustments, a hard commitment will tend to
have a positive effect on the profitability as it makes other firms reduce their
output.
3.4
Changing the Structure of the Game
By making alliances and agreements with competitors a firm can increase the
value of the game by increasing the size of the market and building strength
against possible entrants. In an extreme form it may be advantageous for a firm
to create competition for itself. E.g. Intel licensed its sources to AMD and gave
up its monopoly in x86 microprocessors but in return IBM and other computer
manufacturers were no longer concerned about overdependence on intel and
adopted the x86 architecture. (creating competition is typical in standards battles
as we will see in chapter 11)
3.5
Signaling
Signaling is used to describe the selective communication of information to
competitors designed to influence their perception and hence to provoke or avoid
certain types of reaction. Signals (just like deterrents) need to be credible.
Credibility here is dependent on the company’s reputation. Sometimes a
company even has a “killer reputation” that protects it from competition in
another market (Coca-cola, Procter&Gamble, AB-Inbev,…).
3.6
Is game theory usefull?
Although it provides a sound theoretical basis to strategy thinking, it is only
applicable to a limited number of real world situations. Game theory has not
developed to the point where it permits us to model real business situations in a
level of details that can generate precise predictions.
Empirically it is very accurate in explaining the past, but not in predicting
outcomes and designing strategies.
Game theory provides a set of tools that allows us to structure our view of
competitive interaction. By describing the structure of the game we are playing,
we have a basis for suggesting ways in changing the game and thinking through
the likely outcomes of such changes. The emphasis of this book will be more on
establishing competitive advantage through exploiting uniqueness rather than
managing competitive advantage by guessing the moves signals bluffs and
threats a rival poses.
4
Competitor Analysis
An empirical approach to competitors is more useful in everyday business
situations, so let us examine how information about competitors can help us
predict their behaviour.
4.1
Competitive Intelligence
This involves systematic collection and analysis of public information about rivals
for informing decision making.
o To forecast competitors’ future strategies and decisions
o To predict competitors’ likely reactions to a firm’s strategic initiatives
o To determine how competitors’ behaviour can be influenced to make it
more favourable
The field of competitive intelligence is growing with an increasing number of
books, journals, consulting firms, … . The only problem is the thin line between
legitimate competitive intelligence and illegal industrial espionage and the scope
of trade secrets law is murky.
4.2
A Framework for Predicting Competitor Behaviour.
The key is not collecting a lot of information, it is to know what information will
be used for what purpose. We offer a four-part framework to make predictions
about your competitors.
Strategy
How is the firm competing?
Predictions
Objectives
What are the competitor’s current
goals? Is performance meeting these
goals? How are its goals likely to
change?
Assumptions
What assumptions does the
competitor hold about the industry
and itself?
o What strategy changes
will the competitor
initiate?
o How will the competitor
respond to our strategic
initiatives?
Resources and Capabilities
What are the competitor’s key
strenghts and weaknesses?
1) Competitor’s Current Strategy
To predict a firm’s strategy in the future we have to look at what the firm does
and says in the present. The two are not necessarily the same. The key is to link
the content of top management communication with the evidence of strategic
actions. For both sources of information, company websites are invaluable.
2) Competitor’s Objectives
The key issue is whether a company is driven by financial goals or market goals.
A company whose primary goal is attaining market share is likely to be much
more aggressive a competitor than one that is mainly interested in profitability.
The most difficult competitors are those that are not subject to profit disciplines
at all - state owned enterprises in particular. The level of current performance in
relation to the competitor’s objectives is important in determining the likelihood
of strategy change. The more a company is satisfied with present performance,
the more likely it is to continue with its present strategy.
3) Competitor’s Assumptions about the Industry
The perceptions a competitor has about itself and the industry is likely to reflect
the beliefs that senior managers hold about their industry and usually converges
among the firms within the industry. Spender calls these beliefs “industry
recipes”. These beliefs may not be in line with reality, and sometimes it limits a
whole industry to respond to an external threat. (e.g. US automobile industry
that thought small cars weren’t profitable)
4) Competitor’s Resources and Capabilities
Asses the strengths and weaknesses of your competitor and initiate competition
to the weaknesses for it may be difficult for them to respond.
5
Segmentation Analysis
5.1
The uses of Segmentation
Segmentation is the process of disaggregating industries into specific markets. A
company can avoid some of the problems of an unattractive industry by judicious
segment selection. (e.g. Dell shifted towards higher margin products, consumers
and geographical areas). Key success factors also differ by segment.
5.2
Stages in Segmentation Analysis
The purpose of segmentation analysis is to identify attractive segments, to select
strategies for different segments, and to determine how many segments to
serve. The analysis proceeds in five stages (an example: strategy capsule 4.3
page 111):
1) Identify key segmentation variables
Segmentation variables relate to the characteristics of customers and the product
(figure 4.3 page 113). The most appropriate segmentation variables are those
that partition the market most distinctly in terms of limited substitutability
among both consumers (demand-side) and producers (supply-side). Distinct
market
analysis
or three
o
o
segments tend to be recognizable from price differentials. For the
to be manageable we need to reduce the segmentation variables to two
by:
Identifying the most strategically significant ones
Combining segmentation variables that are closely related
2) Construct a segmentation matrix
The segments may be identified using a two- or three-dimensional (e.g. car
industry by vehicle type and geographical region) matrix with the segmentation
variables and categories.
3) Analyse Segment Attractiveness
Porters five forces framework is equally effective in relation to a segment as to
an entire industry. There are only a few differences:
o Substitutes also include substitutes from other segments within the
industry
o The main source of entrants is likely to be producers established in
other segments within the same industry. The barriers between
segments are called barriers to mobility as opposed to barriers of entry
(for entrants outside the industry).When the barriers to mobility are
low, returns from high profit segments will be quickly eroded.
The segmentation matrix may reveal empty segments so that unexploited
opportunities in an industry can be identified.
4) Identify the Segment’s Key Success Factors
By analyzing buyers’ purchase criteria and the basis of competition within
Segmentation
& Industry
Profit Pools
individualVertical
segments,
we can identify
key success
factors for individual segments.
—The
US
Auto
Industry
(For an example: figure 4.4 page 115)
25
%
5) Select
Segment Scope
Finally, a firm needs to decide whether it wishes to be a segment specials, or
20
compete across multiple segments. The advantages of a broad over a narrow
Service
& repair
segment focus depend on Leasing
two main factors:
similarity
of key success factors
15
and the presence of shared costs. If key success factors are different across
Aftermarket and may have difficulties
segments, a firm will need to deployWarranty
distinct strategies
parts
Auto
10
in drawing
upon the same capabilities (e.g. Harley Auto
Davidson’s attempt in sport
manufacturing
Auto
rental
Auto
motorcycles with
was limited in insurance
success).
NewBuell
car
5
5.3
dealers
loans
Used car dealers
Vertical Segmentation: Profit Pools
Gasoline
0
Share of industry revenue
Figure 4.5: The US auto industry profit pool
0
100%
Segmentation can also be vertical, by identifying different value chain activities.
Bain&Company proposes profit pool mapping as a technique for analyzing the
vertical structure of profitability. To map this profit pool B&C identifies four
steps:
1. Define the pool’s boundaries (the range of value adding activities of the
sector)
2. Estimate the pool’s overall size (Total industry profit may be estimated
by applying the average margin earned by a sample of companies to an
estimate of industry total revenues)
3. Estimate profit for each value chain activity in the pool (This step is
difficult because you need to disaggregate data for “mixed players” and
need to gather data from “pure players” (companies specialized in a
single value chain activity)
4. Check en reconcile the calculations (Compare the profits of stage 3 with
the total of stage 2).
6
Strategic Groups
Strategic group analyses segments an industry on the basis of the strategies of
the member firms. A strategic group is “the group of firms in an industry
following the same or a similar strategy along the strategic dimensions.” These
strategic dimensions might include product range, level of product quality,
degree of vertical integration, choice of technology,… . By selecting the most
important strategic dimensions and locating each firm in the industry along
them, it is possible to identify groups of companies that have adopted more or
less similar approaches to competing within the industry. Most of the empirical
studies of strategic groups concentrate on differences in profitability, however,
empirical studies do not prove profitability differences within groups to be less
than differences between strategic groups. This may reflect the fact that
although having similar strategies, these firms are not necessarily in competition
with one another. (e.g. Low budget airlines on different routes)
So strategic group analysis is useful in identifying strategic niches within an
industry and the strategic positioning of different firms, but less useful to analyze
interfirm profitability differences.
7
Summary
Part II: Corporate strategy
Chapter 5: Analyzing Resources and Capabilities
(p. 123 – 165)
1
The role of resources and capabilities in Strategy
formulation
Shift from strategy and external environment towards strategy and internal
environment (resources and capabilities) (see figure 5.1. p 135)
1.1
Basing strategy on resources and capabilities
During the 1990s: development of the resource-based view of the firm.
Why impact on strategy thinking?





In mission statement: formulation of company’s identity and maxims for
the strategy .
Conventionally, firms have answered the question ‘what is our business?’
in terms of the market they serve: Who are our customers? Which needs
do we serve?
However: customer’s preferences are volatile and the identity of customers
and the technologies for serving them are changing
Therefore a market-focused strategy may not provide the stability and
constancy of direction to guide strategy over a long time
Resources and capabilities may be more stable basis on which to define
identity (examples: see figure 5.2. p. 127)
In general, the greater the rate of change in a firm’s external environment, the
more likely it is that internal resources and capabilities will provide secure
foundation for long-term strategy.
1.2. Resources and capabilities as sources of profit
Sources of superior profitability:


Industry attractiveness
Competitive advantage (more important): establishing competitive
advantage through development and deployment of resources or
capabilities became the primary goal for the strategy
Resource-based view has profound implications for companies’ strategy
formulation: It emphasizes the uniqueness of each company and suggests that
they key to profitability is not through doing the same as other firms (cfr. Focus
on external environment), but through exploiting the differences
To establish competitive advantage is to formulate and implement a strategy
exploiting the uniqueness of resources and capabilities.
Crucial for a resource-based approach is a profound understanding of the
resources and capabilities. Such understanding provides a basis for:
1. Selecting a strategy that exploits an organization’s key strengths
2. Developing th firm’s resources and capabilities. Resource analysis is not
just about deploying existing resources, it is also concerned with filling
resource gaps and building capability for the future
2
The resources of the Firm
Resources: the productive assets owned by a firm  Capabilities: what the firm
can do, resources do not confer competitive advantage, they must work together
to create organizational capability. (See figure 5.4 p. 131: links among
resources, capabilities and competitive advantage)
2.1. Tangible resources
Easiest to identify: financial resources and physical assets (financial statements).
However, the primary goal of resource analysis is not to value a company’s
assets, but to understand their potential for creating competitive advantage.
Once we have more information n a company’s tangible resources we explore
how we can create additional value from them. This requires an answer on 2
questions:
1. What opportunities exist for economizing on their use? (e.g. use fewer
resources to support same level of business etc.)
2. What are the possibilities for employing existing assets more profitably?
2.2. Intangible resources
For most companies more valuable than tangible resources, but largely invisible
in financial statements. The divergence between companies’ balance sheet
valuations and their stock market valuations is mainly due to the exclusion or
undervaluation ofthese intangible resources. The most important of these
undervalued resources are brand names:
Brand names:
 Are a reputational asset: their value is in the confidence they instill in
customers (reflected in the price premium)
 The value can be increased by extending the product/market scope over
which the company markets those brand (e.g. Harley Davidson: clothing,
cofee mugs, etc.)
Reputation may be attached to a company as well as to its brands.
Like reputation, technology is an intangible asset whose value is not evident
from most companies’ balance sheets: intellectual property (patents, copyrights,
trade secrets and trademarks) comprise technological and artistic resources
where ownership is defined in law.
2.3. Human resources
Human resources: the expertise and effort offert by its employees (not on
balance sheets because not ‘owned’)
Human resource appraisal has become far more systematic and sophisticated.
Competency modeling: identifying the set of skills, content knowledge, attitudes
and values associated with superior performers withing a particular job category,
then assessing each employee against that profile. (used in hiring, identify
training needs..) Recent interest in emotional intelligence: growing recognition of
the importance of social and emotional skills.)
The ability of employees to harmonize their efforts and integrate their separate
skills depends not only on their interpersonal skills but also on the organizational
context. This organizational context as it affect internal collaboration but also the
organizational collaboration is determined by a key intangible resource: the
culture of the organisation. It relates to an organization’s values, traditions
and social norms. Firms with sustained superior financial performance typically
are characterized by a strong set of core managerial values that define the ways
they conduct business.
3
Organizational Capabilities
Organizational capability: A firm’s capacity to deploy resources for a desired end
result. (capability = competence)
Which capabilities can establish competitive advantage?
Distinctive competence (Selznick): those things that a company does particularly
well relative to its competitors.
Core competences (Prahalad and Hamel): capabilities fundamental to a firm’s
strategy and performance:
 Core competences make a disproportionate contribution to ultimate
customer value, or efficiency with which that value is delivered
 Provide a basis for entering new markets
3.1
Classifying Capabilities
Two approaches:
1. A functional analysis identifies organizational capabilities in relation to
each of the principal functional areas of the firm (see table 5.3. p. 136)
2. A value chain analysis separates the activities of the firm into a
sequential chain. Porter’s representation of the value chain distinguishes
between primary acitvities (those involved with the transformation of
inputs and interface with the customer) and support activities (see figure
5.5. p. 136)
3.2. The Architecture of capability
3.2.1. Capability as Routine
How does the integration of different resources occur?
Organizational routines (Nelson & Winter):
 regular and predictable patterns of activity made up of a sequence of
coordinated actions by individuals. Such routines form the basis of most
organizational capabilities.
 Develop through learning-by-doing: just like skills, they become rusty
when not excercised. A limited reportoire of routines can be performed
highly efficiently with near-perfect coordination
Routinization is an essential step in translating directions and operating practices
into capabilities.
3.2.2. The Hierarchy of Capabilities
We can observe a hierarchy of capabilities where more general, broadly defined
capabilities are formed from the integration of more specialized capabilities. At
the highest level of integration are those capabilities which integrate across
multiple functions. (figure 5.6 p. 138)
4
Appraising Resources and Capabilities
Main focus of the book: the pursuit of profits:The pofits that a firm obtains from
its resources and capabilities depend on 3 factors: Their abilities to establish a
competitive advantage, to sustain that advantage and to appropriate the
returns to that competitive advantage. (figure 5.7 p. 139)
4.1. Establishing Competitive Advantage
Two conditions:
1. Scarcity: only if the resource or capability is not widespread, competitive
advantage van be established
2. Relevance: Scarcity is not enough to establish competitive advantage, the
resource or capabilty also has to be relevant to the key success factors in
the market.
4.2. Sustaining Competitive Advantage
Conditions:
1. Durability: Some resources are more durable than others thus providing
a secure basis for competitive advantage ( technological equipment,
proprietary technologies fast pace of technological pace < durable Brand
Names)
2. Transferability: The ability to buy a resource or capability depends on
its transferability: The extent to which it is mobile between companies.
Sources of immobility:
a) Geographical immobility of natural resources, large items
of capital equipment and some types of employees.
b) Imperfect information about the quality and productivity of
resources creates risks for buyers. (especially in relation to
human resources: hiring decisions based on few knowledge)
c) Complementarity: The detachment of a resource fom its ‘home
team’ causes it to lose productivity and value (brand names &
change of ownership)
d) Organizational capabilities are less mobile than individual
resources because they are based on teams of resources.
3. Replicability: If a firm cannot buy a resource or capability, it must build
it. Less easy replicable are capabilities based on complex organizational
routines. Some capabilities appear simple but prove difficult to replicate.
(JIT-principle, etc.)
Even where replication is possible, incumbent firms may benefit from the
fact that the resources and capabilities that have been accumulated over a
long period can only be replicated at disproportionate cost by imitators.
Two major sources of incumbency advantage:
a) Asset mass efficiencies occur where a strong initial position in
technology, distribution channels or reputation facilitates the
subsequent accumulation of these resources.
b) Time compression diseconomies are the additional costs
incurred by immitators when attempting to accumulate rapidly
a resource or a capability (e.g. ‘blitz’ advertising campaigns
tend to be less productive than similar expenditures made
over a longer period)
4.3 Appropriating the Returns to Competitive Advantage
Who gains the return generated by superior capabilites? Normally: the owners
But Ownership is not always clear-cut: capabilities depend heavily on the skills
and efforts of employees who are not owned by the firm. In companies
dependent on human ingenuity and know-how, the mobility of key employees is
a constant threat to their competitive advantage. In investment banks and other
human capital-intensive firm, the struggle between employees and shareholders
to appropriate rents (profits) is reminiscent of the war for surplus value between
labor and capital Marx analyzed.
The more deeply embedded are individual skils and knowledge within
organizational routines and the more they depend on corporate systems and
reputation, the weaker the employee is. Conversely: The closer an organizational
capability is identified with expertise of individual employees, and the more
effective those employees are at bargaining power, the better able employees
are to appropriate rents. If individual employee’s contribution to productivity is
clearly identifiable, if the employee is mobile and if the employee’s skilss offer
similar productivity to other firms, the employee is in a strong position to
appropriate most of his or her contribution to the firm’s value added.
5
Putting Resource and Capability Analysis to Work: A
Practical Guide
5.1. Step 1: Identify the Key Resources and Capabilities
Startpoint = external focus:
1. Identify the key succes factors: why are some firms more succesful than
others and on what resources and capabilities are these success factors
based?
2. To organize and categorize these various resources and capabilities, it is
helpful to switch from an external to internal focus. How is everything
organized in our company?
5.2. Stept 2: Appraising Resources and Capabilities
Resources and capabilities need to be appraised against 2 criteria:
1. Importance: Which resources and capabilities are most important in
conferring sustainable competitive advantage?
2. Where are our strengths and weaknesses as compared with
competitors?
3. Bringin together Importance and Relative Strength
5.2.1. Assessing importance
Primary goal: making superior profits thtough establishing a sustainable
competitive advantage. Therefore, we need to look beyond customers choice. We
need to focus on the underlying characteristics of resources and capabilities. To
do this we need to look at the set of appraisal criteria (see 4). We need to
identify those resources and capabilities that makes us able to win, not only to
play. Resources that cannot easily be acquired or internally developed are critical
to establish and sustain advantage.
5.2.2. Assessing Relative Strengths
Objectively appraising the comparative strengths and weaknesses is difficult
because companies fequently fall victim to past glories, hopes for the futures and
own wishful thinking. The tendency of hubris among companies (and their senior
managers) means that business success often sows the seeds of its own
destruction
Subjective level: To identify and appraise a company’s capabilities, managers
must look inside and outside. Internal discussion can be valuable in sharing
insights and evidence and building consensus regarding the organisation’s
resource and capability profile. One can also look to past successes in the
history: Do any patterns appear?
Objective level: Benchmarking: a tool for quantitative assessment of
performance relative to that of competitors. Benchmarking is the process of
identifying, understanding and adapting outstanding practises from organizations
anywhere in the world to help your organization improve its performance.
Benchmarking allows companies to make objective assessments of their
capabilities relative to competitors and, second, to put into place programs to
imitate other companies’ superior capabilities.
Ultimately, appraising resources is not about data, it is about understanding and
insight. To be successful, companies have to recognise what they can do well and
base their strategies on their strengths.
5.2.3. Bringing Together Importance and Relative Strength
Putting together ‘importance’ and ‘relative strength’ allows us to highlight a
company’s key strengths and weaknesses. (see figure 5.8 p. 147)
5.3. Step 3 Developing Strategy Implications
5.3.1. Exploiting Key Strenghts
After identifying resources and capabilities that are important and after
identifying where our company is strong relative to competitors, they key taks is
to formulate the strategy to ensure these resources are deployed to the greatest
effect. Because each company in a particular industry has its own strengths, one
can expect different strategies.
5.3.2. Managing Key Weaknesses
Converting weakness into strength is most likely a long-term task. The most
decisive solution to weaknesses in key functions is to outsource. Through clever
strategy formulation a firm may be able to negate the impact of its key
weaknesses (e.g. Harley & technology => made virtue out of outmoded
technology and traditional designs).
5.3.3. What about superfluous strenghts
What about those resources and capabilities where a company has particular
strengths, but these don’t appear to be important sources of sustainable
competitive advantage? One response: lower the level of investment.
It is, however, possible to develop innovative strategies that turn apparently
inconsequential strengths into valuables resources and capabilities (e.g. MBA p
149)
6
Developing Resources and Capabilities
6.2. The relationship between Resources and Capabilities
Most difficult problem in developing capabilities is that we know little about the
linkage between resource and capabilities. Just like in sports teams, the firms
that demonstrate the most outstanding capabilities are not necessarily those with
the greatest resource endownments.
According to Hamel and Prahalad, it is not the size of a firm’s resource base that
is the primary determinant of capability, but the firm’s ability to leverage its
resources
Resources can be leveraged in the following ways:




Concentrating resources through the processes of converging resources on
a few clearly defined and consistent goals; focusing the efforts of each
group, department and business unit on individual priorities in a sequential
fashion; tageting those activities that have the biggest impact on
customers’ perceived value.
Accumulating resources through mining experience in order to achieve
faster learning and borrowing from other firms (accessing the resources
and capabilities through allinces, outsourcing, etc.)
Complementing resources involving increasing their effectiveness through
linking them with contplementary resources and capabilities. This may
involve blending different capabilities and balancing to ensure that limited
resources and capabilities in one area do not hold back the effectiveness of
resources and capabilities in another
Conserving resources involves utilizing resources and capabilities to the
fulles by recycling them through different products, markets and product
generations; and co-opting resources through collaborative arrangements
with other companies.
6.2. Replicating Capabilities
Growing capabilities requires that the firm replicates them internally (e.g.
replicate the capability in different products and markets: IKEA, Starbucks).
If routines develop learning-by-doing, and the knowledge that underpins them is
tacit, replication is far from easy. Replication requires systematization of the
knowledge that underlies the capability (through the formulation of standard
operating procedures) (e.g. Mc Donalds: training manuals that govern the
operation and maintenance of every aspect of its restaurant)
6.3. Developing New Capabilities
If capabilities are based on routines that develop through practice and learing,
what can the firm do to establish such routines within a limited time period? We
know that capabilities involve teams of resources working together, but, even
with the tools of business process mapping, we typically have sketchy
understanding of how people, machines, technology and organizational culture fit
together to achieve a particular level of performance.
6.4. Capability as a Result of Early Experiences
Organizational capability is path dependent: a company’s capabilities today are
the result of its history. More importantly, this history will constrain what
capabilities the company can perform in the future. To understand the origin of a
company’s capabilities, a useful starting point is to study the circumstances that
existed and events that occurred at the time of the company’s founding and early
development. (e.g. Wal-Mart’s efficient syste of warehousing and distribution 
has its origins in the founder’s (Sam Walton) personality and obsession with cost
cutting and efficiency + the initial rural conditions of company.) (other examples
see table 5.5. p 153)
6.5. Organizational Capability: Rigid or Dynamic?
The more highly developed a firm’s organizational capabilities are, the narrower
its repertoire and the more difficult it is for the firm to adapt them to new
circumstances. Dorothy Leonard argues that core capabilities are simultaneously
core rigidities because they inhibit the firm’s ability to access and develop new
capabilities. Nevertheless, some companies appear to have the capacity to
continually upgrade, extend and reconfigure their organizational capabilties.
David Theece has referred to dynamic capabilities ‘the firm’s ability to integrate,
build and reconfigure internal and external competences to address rapidly
changing environments. However, there’s no consensus in the literature about
the meaning of these dynamic capabilities. What is agreed is that these
capabilities are far from common. For most companies highly developed
capabilities in existing products and technologies create barriers to developing
capabilities in new products and new technologies. In most new industries, the
most succesful companies tend to be startups rather than established firms.
6.6. Approaches to capability development
How do companies develop new capabilities? 3 approaches
Acquiring Capabilities: Mergers and acquisitions
If new capabilities can only be developed over long periods, then acquiring a
company that has already developed the desired capabilty can be a solution. In
technologically fast-moving environments, established firms typically use
acquisitions as a means of acquiring specific technical capabilities. (e.g. Microsof
& Cisco Systems)
Cons: Once the acquisition has been made, the acquiring company must find a
way to integrate the acquiree’s capabilities with its own. All too often, culture,
clashed, personality clashed between senior managers, or incompatibility of
management systems can result in degradation or destruction of the very
capabilities that the acquiring company was seek.
Accessing Capabilities: Strategic Alliances
A strategic alliance is a cooperative relationship between firms involving the
sharing of resources in pursuit of common goals. (+ more targeted and cost
effective means to acces another company’s capabilties than acquisitions)
Strategic alliances comprise a wide variety of collabiratuve relationships, which
include joint research, technology-sharing arrangements, vertical partnership,
shared manufacturing etc. Alliances may involve formal agreements or they may
entirely be informal: They may or they may not involve ownership links. Alliances
may also be for the purpose of acquiring the partner’s capabilties through
organizational learning
Cons: Where both alliace partners are trying to acquire one another’s
capabilities, the result may well be a ‘competition for competence’ that ultimately
destabilizes the relationship
Creating Capabilities
Creating organizational capability requires, first, acquiring the necessary
resources and, second, integrating these resources. With regard to the resource
acquisition, particular attention must be given to Organizational culture - values
and behavioral norms are critically important influences on motivation and
collaboration. In general, it’s the integration that causes the most problems. We
know that capabilities are based on routines – coordinated patterns of activity –
but we know little about how routines are established. The assumption has been
that they emerge as a result of learning-by-doing. Recent research, however,
has emphasized the role of management in developing organizational capability
through motivation and deliberate learning. Organizational structure and
management systems are of particular importance:


Capabilities need to be housed
within dedicated organizational units if organizational members are to
achieve high levels of coordinations. Thus, product development is
facilitated when undertaken within product development units rather than
through a sequence of ‘over-the-wall’ transfers from one functional
department to another. Inevitably, aligning organizational structure with
multiple capabilities creates organizational complexity. However, many
capabilities are suited to informal structural arrangements.
Organizations need to take
systematic approaches to capability development – the need to create,
develop and maintain organizational capabilities must be built into the
design of management systems. The literature emphasizes the roles of
search, experimentation and problem solving in capability development. In
most organisations the emphais is on maintaining current operations
whereby limited attention is given to explicit capability development.
Organizations often discover that the organizational structure, management
systems, and culture that support existing capabilities may be unsuitable for
new capabilities. To resolve this problem, companies may find it easier to
develop new capabilities in new organizational units that are geographically
seperated from the main company.
Given the complexity and uncertainty of programs to develop new
capabilities, an indirect approach may be preferable. If we cannot design new
capabilities from scratch, but if we know what types of capabilities are
required for different products, then by pushing
the development of
particular products can pull the development of the capabilities that those
products require. For such an approach to be succesful it must be systematic
and incremental. Developing complex capabilities over a significant period of
time requires a sequencing of products, where each stage of the sequence
has specific capability development goals. (see strategy capsule 5.6. p. 155)
Ultimately, developing organizational capabilities is about building the knowhow of the company, which requires integrating the knowledge of multiple
organizational members. One of the most powerful tools for managing such a
process is knowledge management. (see appendix p. 159)
Chapter 6: Organization Structure and
Management Systems
1.
The evolution of the corporation
1.1 Firms and markets
Most of the world’s production of goods and services is undertaken by
corporations (= enterprises with a legal identity that is distinct from the
individuals that own the enterprise).
 One of the central features of modern economic development.
 Capitalist economy: production organized in 2 ways
- Markets (by the price mechanism)
- Firms (by the managerial direction)
1.2 Emergence of the Modern Corporation
Modern corporation as a result of 2 “critical transformations” (A.
Chandler).
 Line-and-staff structure: geographically separate operating units managed
by an administrative headquarters.
 The multidivisional corporation: separation of operating responsibilities,
which are vested in general managers at the divisional level, from
strategic responsibilities, which are located in the head office.
1.3 Organizational change since the mid-twentieth century
Multidivisional form -> matrix organization (= separate hierarchies
coordinate around products, functions, and geographical areas)
Quest for flexibility and responsiveness has resulted in:
- Delayering of hierarchies
2.
-
Shift from functionally organized headquarters staff to
shared services organization
-
Creation of flexibility and responsiveness trough alliances,
networks and outsourcing partnerships
The organizational problem: Reconciling
specialization with coordination and cooperation
2.1 Specialization and division of labor
Fundamental source of efficiency in production
(especially the division of labor into separate tasks).
=
specialization
2.2 The coordination problem
In order to achieve efficiency, individuals within organizations need to
coordinate their efforts.
 4 different coordination-mechanisms:
-
PRICE: in the market coordination is achieved through the
price mechanism
-
RULES AND DIRECTIVES: authority is exercised by means
of general rules and specific directives
-
MUTUAL ADJUSTMENTS: mutual adjustments of individuals
engaged in related tasks
-
ROUTINES:
routines
coordination
must
become
embedded
in
Relative roles of these mechanisms depend on the types of activity and
the intensity of collaboration required.
2.2 The cooperation problem: incentives and control
Cooperation problem = different organizational members having
conflicting goals (in economics literature ~ agency problems)
Within the firm, the major agency problem is between shareholders and
managers (= the problem of ensuring that managers operate companies
to maximize shareholders wealth).
Agency problems exist throughout the hierarchy, between different
functions.
 Mechanisms to avoid agency problems:
-
CONTROL
MECHANISMS:
managerial
supervision
monitoring behavior and performance. This control rests
both on positive (promotion) and negative (dismissal)
incentives.
-
FINANCIAL INCENTIVES: performance-related incentives
-
3.
+ : high powered; reward directly related to output
Economize on the need for costly supervision
-: teamwork -> output is difficult to measure
SHARED VALUES: commonality between organizational
members. For example: churches, charities, …
Hierarchy in organizational design
Hierarchal structures are essential for creating efficient and flexible
coordination in complex organizations. The question is: how should
hierarchy be structured?
3.1 Hierarchy as coordination: modularity
2 key advantages to hierarchical structures
 Economizing on coordination: (see figure 6.2)
 Adaptability: hierarchical systems are able to evolve more rapidly
than unitary systems that are organized into subsystems. Such
adaptability requires some degree of decomposability (ability of each
component subsystem to operate with some measure of
independence from the other subsystems.). Such hierarchical
systems are referred to as “loosely coupled”.
3.2 Hierarchy as a control: bureaucracy
Administrative hierarchies operate as bureaucracies.
Bureaucracy is based on following principles:
- Specialization through a “systematic division of labor”
-
Hierarchical structure
-
Coordination and control
-
Standardized employment rules and norms
-
Separation of management and ownership
-
Separation of jobs and people
-
Rational-legal authority
-
Formalization in writing of “administrative acts, decision
and rules”
3.3 Mechanistic and organic forms
’50-’60: coordination and cooperation is about social relationships as well
as bureaucratic principles.
2 organizational forms (see table 6.1):
 Mechanistic forms (characterized by bureaucracy)
Mainly in stable markets
 Organic forms (more flexible, less formal)
Mainly in unstable markets with rapid technological change
3.4 Rethinking hierarchy
As long as there are benefits from the division of labor, hierarchy is
inevitable. The critical issue is to reorganize hierarchies in order to
increase responsiveness to external change. The organizational changes
that have occurred in some corporations, have retained the basic
multidivisional structures of the companies, but reduced the number of
hierarchical layers, decentralized decision making and shrunk
headquarters staff.
4.
Applying the principles of organizational design
The fundamental problem of organizations is reconciling specialization with
coordination and cooperation. The basic design for complex organizations
is hierarchy.
4.1 Defining organizational units
In creating a hierarchy, a company should decide whether they should be
structured around
- Tasks
-
Products
-
Geography
-
Process (product
process, …)
development
process,
manufacturing
4.2 Organization on the basis of coordination intensity
Once created organizational units, the next challenge is to create
hierarchical control that permits effective coordination while giving as
much operational autonomy as possible to the subordinate units (=
principle of hierarchical decomposition).
To organize according to coordination needs requires understanding the
nature of interdependence within an organization.
3 levels of interdependence:
 Pooled interdependence: individuals operate independently but
depend on one another’s performance
 Sequential interdependence: output of an individual is input of
another individual
 Reciprocal interdependence: individuals are mutually dependent
4.3 Other factors influencing the definition of organizational units
- Economies of scale:
- Economies of utilization
- Learning
- Standardization of control systems
5.
Alternative structural forms
5.1 The functional structure (see figure 6.3)
Grouping together functionally similar tasks is conducive to exploiting
scale economies, promoting learning and capability building and deploying
standardizes control systems. However functional structures are subject to
problems of cooperation and coordination. Different functional
departments develop their own goals, values, … which makes crossfunctional integration difficult.
5.2 The multidivisional structure (see figure 6.4)
The multidivisional structure is the classic example of a loosed-coupled ,
modular organization where business-level strategies and operating
decisions can be made at the divisional level, while the corporate
headquarter concentrates on corporate planning, budgeting, and providing
common services.
5.3 Matrix structures ( see figure 6.5)
= organizational structures that formalize coordination and control across
multiple dimensions. The problem of the matrix organization is that this
multiple coordination is over-formalized, resulting in excessive corporate
staffs and over-complex systems that slow decision making and dull
entrepreneurial initiative.
5.4 Beyond hierarchy?
There have been substantial changes in the way in which corporate
hierarchies have been organized. Yet, hierarchy remains as the basic
structural form of almost all companies.
Alternative organizational forms:
 Adhocracies: presence of shared values, mutual respect, motivation
and willingness to participate -> high level of coordination with little
need for hierarchy or authority.
 Team-based and project-based organizations: projects of limited
duration (sectors such as construction, consultin…) -> adaptability
and flexibility.
 Networks: localized networks of small, closely interdependent firms.
Often these networks feature a central firm that acts as a “system
integrator”.
Common characteristics of these organizational forms:
- A focus on coordination rather than control
6.
-
Reliance on coordination by mutual adjustments
-
Individuals in multiple organizational roles
Management systems for coordination and control
4 management systems are of primary importance:
- Information systems
-
Strategic planning systems
-
Financial planning and control systems
-
Human resource management systems
6.1 Information systems
Administrative hierarchies are founded on vertical information flows: the
upward flow of information to the manager and the downward flow of
instructions.
6.2 Strategic planning systems
Whether formal or informal, the strategy formulation process is an
important vehicle for achieving coordination within a company. The
system through which strategy is formulated varies from company to
company. Strategic plans tend to be for 3 to 5 years and combine topdown initiatives and bottom-up business plans.
Strategic planning cycle (see figure 6.6) -> strategic plan:
- A statement of the goals: company seeks to achieve over
the planning period with regard to both financial targets
and strategic goals
-
A set of assumptions or forecasts (about key developments
in the external environment)
-
A qualitative statement (how will the shape of the business
be changing in relation to geographical and segment
emphasis? On which basis will the company be establishing
and extending its competitive advantage?)
-
Specific action steps
-
A set of financial projections: a capital expenditure budget
and outline operating budgets
The most important aspect of strategic planning is the strategy process.
Increasing turbulence in the business environment has caused strategic
planning process to become less formalized and more flexible.
6.3 Financial planning and control systems
Budgets are in part an estimate of incomes and expenditures for the
future, in part a target of required financial performance in terms of
revenues and profits, and in part a set of authorizations for expenditure
up to specified budgetary limits.
2 types of budget:
 The capital expenditure budget:
-
Top-down: strategic plans establish annual capital
expenditure budgets for the planning period both for the
company as a whole and for individual decisions.
-
Bottom-up: capital expenditures are determined by the
approval of individual capital expenditures projects.
 The operating budget: a pro forma profit and loss statement for the
company as a whole and for individual divisions and business units
for the upcoming year. The operating budget is part forecast and
part target.
6.4 Human resource management systems
How can a company induce employees to do what it wants? The problem
is that employment contracts give the right to the employer to terminate
the contract for unsatisfactory performance by the employee, but the
threat of the termination is an inadequate incentive. The principal
incentives available to the firm for promoting cooperation are
compensation and promotion. The key to designing compensation systems
is to link pay either to the inputs required for effective job performance.
The simplest form of output-linked pay is piecework or commission.
6.5 Corporate culture and control mechanism
Corporate culture comprises the beliefs, values, and behavioral norms of
the company, which influence how employees think and behave. One of
the advantages of culture as a coordinating device is that it permits
substantial flexibility in the types of interactions it can support. However,
culture is far from being a flexible management tool. Cultures take a long
time to develop and cannot easily be changed.
Part III: The Analysis of Competitive
Advantage
Chapter 7: The Nature and Sources of Competitive
Advantage
1
Introduction and objectives
Chapter 7 integrates and develops the elements of competitive advantage that
were analyzed in prior chapters:
-
-
Chapter 1 : the primary goal of a strategy is to establish a position of
competitive advantage for the firm
Chapter 3 : analysis of the external sources of competitive advantage =
customer requirements and the nature of competition determine the key
success factors within the market
Chapter 5 : analysis of the internal sources of competitive advantage =
the potential for the firm’s resources and capabilities to establish and
sustain competitive advantage
Chapter 7 focusses on the relationship between competitive advantage and the
competitive process.
2
The Emergence of Competitive Advantage
“When two or more firms compete within the same market, one firm possesses a
competitive advantage over its rivals when it earns (or has the potential to earn)
a persistently higher rate of profit.” (basic definition)
But : competitive advantage may not be revealed in higher profitability
2.1
External Sources of Change
An external change must have differential effects on companies because of their
different resources and capabilities or strategic positioning. The extent of this
external change depends on the magnitude of the change and the extent of
firm’s strategic differences.
The more turbulent an industry’s environment, the greater the number of
sources of change, and the greater the differences in firm’s resources and
capabilities, the greater the dispersion of profitability within the industry.
(tobacco industry  toy industry = small  big competitive advantages)
2.2
Competitive Advantage from Responsiveness to Change
Any external change creates opportunities for profit. The ability to identify and
respond to opportunity we call entrepreneurship.
Responsiveness = speed of response and anticipating changes
= information (key resource) and flexibility (key capability)
Information is necessary to identify and anticipate external changes, whereas
speed and flexibility enable the company to respond in real time to changing
market circumstances, so it doesn’t need to forecast the future.
2.3
Competitive
Strategies
Advantage
from
Innovation:
“New
Game”
Innovation = generated by internal change
= overturns the competitive advantage of other firms
= new approaches to do business (=strategic innovation)
Strategic innovation
= involves creating value for customers from novel experiences,
products, or product delivery or bundling
= also based upon redesigned processes and novel organizational
designs (e.g.: Apple’s reinvention of the recorded music business by
combining an iconic MP3 player with its iTunes download service)
There are several approaches of formulating new innovative strategies:
- new game strategy: reconfigures the industry value chain in order to
change the “rules of the game”
- delivering unprecedented customer satisfaction through combining
performance dimensions that where previously viewed as conflicting
- blue ocean strategy: emphasizes the attractions of creating new markets
- innovations in management are the strongest foundation for competitive
advantage
3
Sustaining Competitive Advantage
Competitive advantage
= subject to erosion by competition
= undermined by imitation or innovation
Imitation is the most direct form of competition; thus, for competitive advantage
to be sustained over time, barriers to imitation must exist.
Isolating mechanisms are such barriers. The more effective these isolating
mechanisms are, the longer competitive advantage can be sustained against the
onslaught of rivals.
To identify the sources of isolation mechanisms, we need to examine the process
of competitive imitation. A successful imitation implies 4 conditions:
- identification (of the competitive advantage of a rival)
- icentive (belief that investing in imitation implies superior returns)
- diagnosis (of the features of a rival’s competitive advantage)
- resource acquisition (of the resources and capabilities for imitation)
3.1
Identification: Obscuring Superior Performance
A simple barrier to imitation is to obscure the firm’s superior profitability.
Avoiding competition through avoiding disclosure of a firm’s profits is much
easier for a private than a public company.
The desire to avoid competition may be so strong as to cause companies to forgo
short-run profits. The theory of limit pricing postulates that a firm in a strong
market position sets prices at a level that just fails to attract entrants.
3.2
Deterrence and Preemption
A firm may avoid competition by undermining the incentives for imitation. If a
firm can persuade rivals that imitation will be unprofitable, it may be able to
avoid competitive challenges.
Reputation is critically important in making threats credible. A firm can also deter
imitation by preemption – occupying existing and potential strategic niches to
reduce the range of investment opportunities open to the challenger. Preemption
can take many forms :
- product proliferation (leaving entrants and rivals with the few
opportunities for establishing a market niche)
- market opportunities preemption (investing largely in production capacity
ahead of the growth of market demand)
- patent proliferation (protecting technology-based advantageby limiting
competitor’s technical opportunities)
The ability to sustain competitive advantage through preemption depends on the
presence of two imperfections of the competitive process:
- the market must be small relative to the minimum efficient scale of
production, such that only a very small number of competitors is viable
- there must be first-mover advantage that gives an incumbent preferential
access to information and other resources, putting rivals at a disadvantage
3.3
Diagnosing Competitive Advantage: “Causal Ambiguity” and
“Uncertain Imitability”
Imitating the competitive advantage of another, implies understanding the basis
of rival’s success. In most industries, there is a serious identification problem in
linking superior performance to the resources and capabilities that generate that
performance.
This problem is causal ambiguity: the more multinational a firm’s competitive
advantage and the more each dimension of competitive advantage is based on
complex bundles of organizational capabilities rather than individual resources,
the more difficult it is for a competitor to diagnose the determinants of success.
The outcome of causal ambiguity is uncertain imitability: where there is
ambiguity associated with the causes of a competitor’s success, any attempt to
imitate that strategy is subject to uncertain success.
3.4
Acquiring Resources and Capabilities
Acquiring resources and capabilities: buy them or build them. Sustaining
competitive advantage depends critically on the time it takes to acquire and
mobilize the resources and capabilities needed to mount a competitive challenge.
Even if resources are mobile, the market for a resource may be subject to
transaction costs – costs of buying and selling arising from search costs,
negotiation costs, contract enforcement costs, and transportation costs.
The alternative is creating it through internal investment. Businesses that require
the integration of a number of complex, team-based routines may take years to
reach the standards set by industry leaders.
Conversely, where a competitive advantage does not require such applications,
imitation is likely to be easy and fast.
3.5
First-mover Advantage
= gaining access to resources and capabilities that a follower cannot match
The simplest form is patent or copyright. First movers can also gain preferential
access to scarce resources and may also be able to use the profit streams from
their early entry to build resources and capabilities faster.
4
Competitive Advantage in Different Market Settings
4.1
Efficient Markets: The Absence of Competitive Markets
= perfect competition
An efficient market is one in which prices reflect all available information.
Because all available information is reflected in current prices, no trading rules
based on historical price data or any other available information can offer excess
returns: it is not possible to “beat the market”; competitive advantage is absent.
4.2
Competitive Advantage in Trading Markets
For competitive advantage to exist, there must be imperfections.
Imperfect Availability of Information
Competitive advantage depends on superior access to information, most likely
priviledged information. Though insider information creates advantage, such
competitive advantage tends to be of short duration, because it is fastly and
easily imitated.
Transaction Costs
If markets are efficient except for the transaction costs, then competitive
advantage accrues to the traders with the lowest transaction costs.
Systematic Behavioral Trends
If the current prices in a market fully reflect all available information, then price
movements are caused by the arrival of new information and follow a random
walk. If, however, other factors influence price movements, there is scope for a
strategy that uses an understanding of how prices really do move.
Systematic behavioral trends do occur in most markets, which implies that
competitive advantage is gained by traders with superior skill in diagnosing such
behavior.
Overshooting
Overreacting to new information causes prices to overshoot. On the assumption
that overshooting is temporary and is eventually offset by an oppositi movement
back to equilibrium, then advantage can be gained through a contrarian
strategy: doing the opposite of the mass-market participants.
4.3
Competitive Advantage in Production Markets
In a production market each producer possesses a unique combination of highly
differentiated resources and capabilities. The greater the heterogeneity of firms’
endowment of resources and capabilities, the greater the potential for
competitive advantage.
Where resource bundles are highly differentiated, competition is likely to be less
direct. Using different resources and capabilities, a firm may substitute a rival’s
competitive advantage. The key is to persuade potential competitors that
substitution is unlikely to be profitable, through committing the firm to
continuous improvement, locking in customers and suppliers, and market
deterrence.
Industry Conditions Conducive to Emergence and Sustaining of
Competitive Advantage
Establishing competitive advantage in production markets depend on the sources
of change in the business environment. The more unpredictable external
changes, the more opportunities for competitive advantage.
The extent to which competitive advantage is eroded through imitation will also
depend on the characteristics of the industry. For example:
- information complexity: the more difficult it is to diagnose the basis of the
competitor’s success, the more difficult it is to imitate COST
his success.
- opportunities for deterrence and preemption: only in small markets
ADVANTAGE
- difficulties of recource acquisition: the more difficult to acquire, the more
difficult for a competitive advantage to be eroded
5 COMPETITIVE
Types
of
Competitive
Differentiation
ADVANTAGE
Advantage:
Cost
and
Cost leadership = supply an identical product or service at lower cost
Differentiation = when a firm provides something unique that is valuable to
buyers beyond simply offering a lower price
(Figure 7.4)
DIFFERENTIATION
ADVANTAGE
There are differences between the two approaches in terms of market
positioning, resources and capabilities, and organizational characteristics.
(Figure 7.2)
Generic
strategy
Cost leadership
Differentiation
Key strategy elements
Scale-efficient plants
Design for manufacture
Control of overheads and
R&D
Process innovation
Outsourcing (especially
overseas)
Avoidance of marginal
customer account
Emphasis on branding
adverstising, design,
service, quality, and new
product development
Resource and organizational
requirements
Access to capital
Process engineering skills
Frequent reports
Tight cost control
Specialization of jobs and
functions
Incentives linked to quantitative
targets
Marketing abilities
Product engineering skills
Cross-functional coordination
Creativity
Research capability
Incentives linked to qualitative
performance targets
Porter’s generic strategies: cost leadership, differentiation and focus. A firm that
attempts to pursue both cost leadership and differentiation is “stuck in the
middle”. (Figure 7.5)
Industry-wide
COMPETITIVE SCOPE
Single Segment
SOURCE OF COMPETITIVE ADVANTAGE
Low Cost
Differentiation
COST
DIFFERENTIATION
LEADERSHIP
FOCUS
In most industries, market leadership is held by a firm that maximizes customer
appeal by reconciling effective differentiation with low cost.
Chapter 8: Cost Advantage
1. Strategy and cost advantage
Historically strategic management had emphasized cost advantage as the
primary basis for competitive advantage in an industry. In 1968, there
was a profound shift in thinking about cost analysis and the ‘experience
curve’ emerged (capsule 8.1). Recently cost advantage had shifted to
companies benefiting from low labor costs and those taking advantage of
new technologies. (the result = more dramatic and innovating approaches
involving outsourcing, process reengineering and organizational delayering
+ recognition that cost advantage is the result of multiple factors).
The key to analyzing cost advantage is to identify the key cost drivers
within a particular industry.
2. The sources of cost advantage
There are seven principal determinants of a firm’s unit costs (cost per unit
of output) relative to its competitors = cost drivers. (figure 8.1, p 227).
The relative importance of these different cost drivers varies across
industries, across firms within an industry and across different activities
within a firm.
By examining the cost drivers, we can:

Analyze a firm’s cost position relative to its competitors and
diagnose the sources of inefficiency.

Make recommendations as to how a firm can improve its cost
efficiency.
Let’s examine the nature and the role of each of these cost drivers.
2.1 Economies of scale
Economies of scale exist wherever proportionate increases in the amounts
of inputs employed in a production process result in lower unit costs.
Scale economies arise from three principal sources:

Technical input-output relationships: in many activities increases in
output do not require proportionate increases in input.

Indivisibilities: Many resources and activities are unavailable in small
sizes.

Specialization: Increased scale permits greater task specialization
that is manifest in greater division of labor. Specialization promotes
learning, avoids time loss from switching activities and assists in
mechanization and automation.
Scale enonomies and industry concentration
Scale economies are a key determinant of an industry’s level of
concentration. However the critical scale advantages of large companies
are seldom in production. The economies of scale in marketing are the key
factor causing world markets to be dominated by a few giant companies.
Limits to scale economies
Small and medium companies continue to survive and prosper in
competition with much bigger rivals because:



They can differentiate their offerings more effectively.
They have a greater flexibility.
Large units have a greater difficulty of achieving motivation and
coordination.
2.2 Economies of learning
The experience curve is based primarily on learning-by-doing on the part
of individuals (improvements in dexterity and problem solving) and
organisations (development and refinement of organizational routines).
The more complex a process or product, the greater the potential for
learning.
2.3 Process technology and process design
For most goods and services, alternative process technologies exist. New
process technology may radically reduce costs. The full benefits of new
processes typically require system-wide changes in job design, employee
incentives, product design, organizational structure and management
controls.
Business process reengineering
During the 1990s, recognition that the redesign of operational processes
could achieve substantial efficiency gains stimulated a surge of interest in
a new management tool called ‘business process reengineering’ (BPR).
BPR = the fundamental rethinking and radical redesign of business
processes to achieve dramatic improvements in critical contemporary
measures of performance, such as cost, quality, service and speed.
2.4 Product design
Designing products for ease of production rather than for functionality and
esthetics can offer substantial cost savings, especially when linked to the
introduction of new process technology.
2.5 Capacity utilization
Over the short and medium term, plant capacity is more or less fixed and
variations in output cause capacity utilization to rise or fall.

Underutilization raises unit costs because fixed costs must be spread
over fewer units of production.
o In businesses where virtually all costs are fixed (e.g. airlines)
profitability is highly sensitive to shortfalls in demand.

Pushing output beyond capacity operation increases unit costs due
to overtime pay, premiums for night and weekend shifts,…

In cyclical industries, the ability to speedily adjust capacity to
downturns in demand can be a major source of advantage.

It is critical to distinguish cyclical overcapacity (common to al
cyclical
industries)
from
structural
overcapacity
(affects
automobiles,..)
2.6 Input costs
There are several sources of lower input costs:
o Locational differences in input prices: the prices of inputs may vary
between locations.
o Ownership of low-cost sources of supply
o Nonunion labor: cost leaders are often the firms that have avoided
unionization.
o Bargaining power
2.7 Residual efficiency
Even after taking all these cost drivers into account, unit cost differences
between firms remain. These residual efficiencies relate to the extent to
which the firm approaches its efficiency frontier of optimal operation.
Eliminating excess costs is difficult.
3. Using the value chain to analyze costs
In most value chains each activity has a distinct cost structure determined
by different cost drivers. Analyzing cost requires disaggregating the firm’s
value chain to identify:
zie boek p 235
3.1 The principal stages of value chain analysis
zie figuur 8.4 p 237
Chapter 9: differentiation advantage
1 Introduction and objectives






differentiation = providing something unique that is valuable to
buyers beyond low prices
range of differentiation depends on characteristics product
not simply offering different product features  identifying and
understanding every interaction with customers
understanding customers + meeting their needs
differentiation requires creativity
two requirements for creating diff.:
 be aware of resources and capabilities that can create
uniqueness
 key insight in customer needs and preferences
2 The nature of differentiation and differentiation
advantage
2.1 Differentiation variables






potential for diff. partly determined by physical characteristics
for technically simple products diff opportunities are constrained by
technical and market factors
technically complex products have much greater scope for diff.
diff. extends beyond physical characteristics to encompass
everything that increases value of product
diff. infuses all activities within organizations and is built into the
identity and culture
2 sorts of differentiation:
 Tangible:
 observable characteristics product or service
relevant to customer preference and choice
process (e.g. size)
 performance of product in terms of reliability,
consistency,…
 products and services that complement
product in question
 Intangible:
 social, emotional, psychological and esthetic
considerations
 desires for status, exclusivity, individuality
and security
 image differentiation especially important for
experience goods such as cosmetics
2.2 Differentiation and segmentation
2.2.1 Differentiation




how a firm competes
ways in which to offer uniqueness (e.g. consistency for Mcdonald’s)
strategic choice by firm
firm’s positioning within market in relation to product
2.2.2 Segmentation



where a firm competes in terms of customer groups, localities and
product types
feature of market structure
segmented market partitioned according to characteristics of
costumers and their demand
2.2.3 Comparison



locating within segment does not imply differentiation from
competitors within that segment
diff decisions closely linked to segment choices in which firm
competes
diff. imitated by competitors can result in emergence of new market
segments
2.3 The sustainability of differentiation advantage



low cost offers less secure basis for competitive advantage than
does diff.
growth of international competition revealed fragility of cost
advantages
cost advantage highly vulnerable to:
 unpredictable external forces
 new technology and strategic innovation
 sustained high profitability associated more with diff. than cost
leadership
3 Analysing differentiation: The demand site



matching customers’ demand for diff. to firm’s capacity to supply
diff.
key to differentiation is understanding customers and why they buy
your product
insight into customer requirements and preferences more
illuminating than market research data
Look at strategy capsule 9.1 on p.245 for an example of the value of simplicity
and directness in probing customer requirements
3.1 Product attributes and positioning


all product and services serve multiple customer needs
 understanding customer requires analysis of multiple attributes
4 techniques for analysis:
 multidimensional scaling:
customers’ perceptions of competing products’ similarities and
dissimilarities are represented graphically and dimensions can be
interpreted in terms of key product attributes
 conjoint analysis:
requires an identification of the underlying attributes and market
research to rank hypothetical products
 hedonic price analysis
demand for a product may be viewed as the demand for the
underlying attributes that the product provides
 value curve analysis
graphical mapping of competitive offerings according to a set of
basic performance characteristics that deliver value to customers
3.2 Role of social and psychological factors
Problem with analysing product differentiation is that it does not delve into
underlying motivations of customers.
 Very few goods satisfy basic needs for survival
 most buying reflects social goals and values
 Customers need that a product satisfies self-identity and socialaffiliations
companies need to analyse the product and its characteristics but
also customers
 Companies need to listen to the consumers as well as observe them
and analyse their behavior
4 Analyzing differentiation: the supply side
Creating differentiation advantage depends on a firm’s ability to offer
differentiation. To identify the firm’s potential to supply differentiation.
4.1 The drivers of uniqueness
Differentiation is concerned with the provision of uniqueness. Porter identifies a
number of drivers of uniqueness that are decision variables for the firm:








Product features and product performance
Complementary services ( credit delivery)
Intensity of marketing
Technology embodied in design and manufacture
Quality of purchased inputs
Procedures influencing the conduct of each of the activities
Skill and experience of employees
Location
 Degree of vertical integration
In analyzing the potential for differentiation we can distinguish between the
product (hardware) and ancillary services (software). Four transaction categories
can be identified (see figure 9.3)
Merchandise
Support
Differentiated Undifferentiated
Differentiated
Undifferentiated
SYSTEM
SERVICE
PRODUCT
COMMODITY
(Fig 9.3)
As markets mature, so systems comprising both hardware and software tend to
unbundle. Products become commoditized while complementary services become
provided by specialized suppliers. Eg. Service stations for petrol used to offer
more than just gasoline. They serviced the cars: car repair, oil change,…. More
and more of these services were delivered by specialized providers oil
companies looked for new bundles of retail services (shop, bakery, diner,…).
4.2 Product integrity
Establishing a coherent and effective differentiation position requires that the
firm assemble a complementary package of differentiation measures.
Product integrity refers to the consistency of a firm’s differentiation, it is the
extent to which a product achieves:
 total balance of numerous product characteristics
 internal integrity: consistency between function and structure of the
product
 external integrity: measure of how well a product fits the customers
objectives
in the automotive industry it is very complex to achieve external and internal
integrity at the same time. It requires linking close cross-functional collaboration
with intimate consumer contact.
Maintatining integrity of differentiation is ultimately dependent on a company’s
ability to live the values embodied in the images with which its products are
associated.
Look at strategy capsule 9.2 on p.251 for an example of the role of values in
differentiation
4.3 Signaling and reputation
Differentiation is only effective if it is communicated to customers. Information
about qualities and characteristics is not always available.
 Search goods: qualities and characteristics can be verified after inspection

Experience goods: can only be recognised after consumption (medical
services) even after purchase these goods can take a while before their
performance attributes reveal themselves (finding out your dentist is
awfull after a couple of years)
Companies can signal the value of their products by investing in signals of quality
such as: brand name, expensive packaging, warranties, money-back guarantees.
Their effectiveness stems from the fact that they represent investments by
manufacturer that will be devalued if the product proves unsatisfactory.
The more difficult it is to ascertain performance prior to purchase, the more
important signaling is.
Strategies for reputation building that arose from research are the following:
 Quality signaling is primarily important for experience goods
 Expenditure on advertising is an effective means of signaling superior
quality; if a product is low-quality investments in advertising are
meaningless because customer will not repeat purchase
 Combination of premium pricing and advertising is likely to be superior in
signaling quality than either price or advertising alone
 The higher the sunk cost required for entry and the greater the total
investment, the greater the incentive for the firm not to cheat customers
by offering low quality at high prices
4.4 Brands
Brand names are especially important as a signal of quality and consistency, a
brand is a valuable asset. It fulfills multiple roles:
 Provides a guarantee of quality
 Identifies the producer of a product
 Represents an investment  incentive to maintain quality and customer
satisfaction
 Reduces uncertainty and search costs for consumer
 Traditional role as a guarantee of reliability ( Microsoft, Yahoo,…)
 Modern role as a embodiment of identity and lifestyle (nike, coca-cola,
mercedes)
Consumer goods companies are seeking new approaches to brand development
focussing less on product characteristics and more on “brand experience”, “tribal
identity”, “shared values” and “emotional dialogue”.
4.5 The costs of differentiation
Direct costs of differentiation include:
 Higher quality inputs
 Better trained employees
 Higher advertising
 Better service after sales
To reconcile differentiation with cost effeciency companies can postpone
differentiation to later stages in the value chain.
Economies of scale and cost advantages of standardization greatest in
manufacturing of basic components.
New manufacturing technology and internet have redefined traditional trade-offs
between efficiency and variety:
 Flexible manufacturing systems and JIT scheduling have increased
versatility of many plants
 Model changeovers less costly
 Goal of economic order quantity of one increasingly realistic
 Multiple models can be produced on single assembly line
5 Bringing it all together: the value chain in
differentiation analysis
The key to succesful differentiation is matching the firm’s capacity for creating
differentiation to the attributes that customers value most.
5.1 Value chain analysis of producer goods
Using the value chain to identify opportunities for differentiation advantage
involves four principal stages:
1. construct a value chain for the firm and the customer: useful to consider
not only immediate customers but also firms further downstream the value
chain. If the companie supplies different types of customers  value chain
for each categorie
2. identify the drivers of uniqueness in each activity: identify variables and
actions through which the firm can achieve uniqueness in relation to
competitors’ offerings.
Look at figure 9.5 on p.256 for Porter’s generic value chain!
3. select the most promising differentiation variables for the firm: which
drivers of uniqueness to select? On the supply side there are 3 important
considerations:
 where does the firm have a greater potential for differentiation
from rivals
 identify linkages among activities, product reliability is often the
outcome of several linked activities (monitoring inputs from
suppliers, skill and motivation of production workers, quality
control and product testing)
 the ease with which different types of uniqueness can be
sustained must be considered. The more resources or skills are
specific to your company, the harder for competitors to copy or
imitate.
4. locate linkages between the value chain of the firm and that of the buyer:
creating value for customers requires either that the firm lowers
customers’ costs, or that the customers’ own product differentiation is
facilitated. Eg. By reorganizing its products distribution around quick
response technologies P&G has radically reduced distribution time and
increased delivery reliability. To identify means to create value for
customers a company must locate linkages between differentiation of its
own activities and cost reduction and diff. within the customers’ activities.
Analysis of thes linkages can also evaluate the potential profitability of
differentiation.
Look at strategy capsule 9.3 on p.257 for a demonstration of the use of value
chain analysis in identifying differentiation opportunities
5.2 Value chain analysis of consumer goods
Few consumer goods are consumed directly; in most cases consumers are
involved in a chain of activities invovling acquisition and purchase of the product.
Even when the customer is a consumer it is possible to draw a value chain
showing the activities the consumer engages in when purchasing and consuming.
In the case of consumer durables customers are involved in a long chain of
activities (search, financing, operation, acquisition,…). Complex consumer value
chains offer many potential linkages with the manufacterer’s value chain, with
considerable opportunity for innovative differentiation. Harley Davidson has been
particularly effective at achieving differentiation advantage through careful
examination of the activities customers undertake in selecting, purchasing, using
and maintaining their motorcycles. The company creates value for the customers
through providing different services (such as test ride facilities, financing, driving
instruction,…)
Even nondurables (TV dinner) involve the consumer in a chain of activities. They
have to be purchased, taken home, removed from package. Producers of such
products can identify ways in which the product could be formulated, packaged
and distibuted to assist the consumer in performing this chain of acitivities.
6 Summary
Part IV: Business strategies in different
industry contexts
Chapter 10: Industry Evolution and Strategic
Change
10.1 Introduction and Objectives
Everything is in a state of constant change. Change can be massive and
unpredictable (e.g. telecommunications) or gradual and more predictable (food
industry). Change can be driven by technology, consumer preference, economic
growth, competition
Understanding patterns of change and life cycles of industry can help to predict
evolution of industry. Life cycles of firms = shorter then life cycles of industry,
changes in industry can pass through the end of an existing firm and the birth of
a new firm, rather ten through continuous adaptation of same firms. The
Management has to adapt the firm to changes.
10.2 The industry Live Cycle
The best known marketing concept = life cycle of product in 4 faces
- introduction (emergence)
- growth
- maturity
- decline
Industry life cycle = same concept but longer duration
Driving factors of industry evolution:
- demand growth
- creation and diffusion of knowledge
10.2.1 Demand Growth
Introduction stage:
- small sales, low rate of market penetration
< unknown products, few customers
- high costs & low quality
< new technology, small scale production, lack of experience
growth stage
- accelerating market penetration
< technology becomes standardized, prices fall
maturity stage
- market saturation = replacement demand
< direct replacement (old products replaced by new ones)
< indirect replacement (old customers replace by new ones)
decline stage
new industries produce superior substitute products
10.2.2 Creation and Diffusion of Knowledge
In introduction stage, a product technology advances rapidly, there is no
dominant product technology and no rival technologies.
Dominant designs and technical standards
Dominant design = a product architecture that defines the look, functionality and
production method for the product and becomes accepted by industry as a
whole. e.g. Mac Donald’s restaurants. Can also apply to business models. It is
not an intellectual property, there is no profit advantage.
Technical standard = network effects: customers choose the same technology to
avoid being stranded
From Product to Process Innovation
Once there is an dominant design, there is a shift from radical to incremental
product innovation = inauguration products growth phase. As product innovation
slows, process innovation takes off
Process innovation + design modifications + scale economies result in falling
costs + greater availability > increase market penetration
Knowledge diffusion: the more the customer is informed, the more he becomes
price sensitive
10.2.3 How General is the Life Cycle Pattern?
Life cycle varies greatly from industry to industry. Over time, life cycles have
been compressed: US railroad <-> US automobile industry <-> PC <-> MP3
players. Patterns of evolution also differ. Basic necessities industries (food,
clothing) may never enter decline.
Some industries experience rejuvenation of their life cycle (TV). This is not a
natural phenomena, but results of company resisting maturity phase by product
innovations. An industry can be in different stages in different countries.
Automobile industry in US <-> China, India & Russia
10.3 Structure, Competition and Success Factors over the
Life Cycle
The changes in demand growth and technology have implications for industry
structure, competition and sources of competitive advantage
10.3.1 Product differentiation
Introduction stage:
- wide variety of product types, diversity of technologies
growth stage
- standardization, product uniformity > evolve to commodity status
except when: new dimensions for differentiation
maturity stage
decline stage
10.3.2 Organizational Demographics and Industry Structure
Industry evolution= high entry & exit of firms = change in firm population.
Organizational ecology= evolution of industries :
size & composition of firms = determined by process of foundation and selection
for survival
Introduction stage:
Few firms
growth stage
new entrants :
- startup companies (new firms),
- established firms diversifying
maturity stage
number of firms declines : intensive acquisition, merger and exit
average : 29 years of industry & number of producers is halved
decline stage
mass market
new entries : in niche markets e.g. microbreweries & brew pubs
Different industries have different evolutionary paths. Some industries start as
monopolies, then become competitive e.g. paper copiers : Xerox. Mature
markets can be transformed by a wave of mergers e.g. petroleum industry 19982001 & steel industry 2001-2006.
10.3.3 Location and International Trade
Life cycle of trade & investment : based on 2 assumptions
- demand for new products first in advanced industrialized countries
- with maturity products require fewer input of technology and skills
Introduction stage:
New industries in High-income countries
< presence of market
< availability of technical & scientific resources
growth stage
other countries served by export
maturity stage
production in newly industrialized countries
advances industrialized countries import
decline stage
production to developing countries where labor costs are lowest
e.g. consumer electronics : US & Germany to Japan to Korea, Hong Kong to
China, Philippines
10.3.4 The Nature and Intensity of Competition
Competition changes in 2 ways in course of industry life cycle
- shift from non price to price competition
- intensity of competition grows, causing margins to narrow
Introduction stage:
Competition focuses on technology & design:technological leadership
Gross margins, but heavy investments : return on capital : low
growth stage
better profitability < market demand is bigger than industry capacity
maturity stage
product standardization > price competition
decline stage
strong price competition (price wars) dismal profit performance
10.3.5 Key Success Factors and Industry Evolution
Changes in structure, demand and technology have implications for sources of
competitive advantage at each stage of industry evolution
Introduction stage:
Product innovation = basis for initial entry
Capabilities in product development need to be matched by capabilities in
manufacturing, marketing and distribution
growth stage
key challenge = scaling up
adapt product design to large scale production
access to distribution (see chapter 11)
maturity stage
cost efficiency through scale economies, low wages & low overheads
decline stage
potential destructive price competition
maintain stable industry environment : orderly exist
Table 10,1 The evolution of industry structure and competition over the
life cycle
Demand
Introduction
Growth
Maturity
Decline
Limited to early
Rapidly increasing
Mass market,
Obsolescence
adopters, high-
market
replacement/ repeat
income, avant-
penetration
buying. Customers
garde
knowledgeable and
price sensitive
Technology
Competing
Standardization
Well-diffused
Little product or
technologies. Rapid
around dominant
technical know-how:
process innovation
product innovation
technology. Rapid
quest for
process innovation
technological
improvements
Products
Poor quality. Wide
Design and quality
Trend to
Commodities the
variety of features
improve.
commoditization.
norm:
and technologies.
Emergence of
Attempts to
differentiation
Frequent design
dominant design.
differentiate by
difficult and
branding, quality,
unprofitable
changes
bundling.
Manufacturing Short production
& distribution runs. High skilled
Capacity
Emergence of
Chronic
shortages. Mass
overcapacity. De-
overcapacity.
labor content.
production.
skilling of
Re-emergence of
Specialized
Competition for
production. Long
specialty channels.
distribution
distribution.
production runs.
channels
Distributors carry
fewer lines.
Trade
Competition
Producers and
Exports from
Production shifts to
Exports from
consumers in
advances
newly industrializing
countries with
advanced countries
countries to the
then developing
lowest labor costs
rest of world
countries
Entry, merges and
Shakeout. Price
exits
competition
Few companies
Price wars, exits
increases
Key success
factors
Product innovation.
Design for
Cost efficiency
Low overhead.
Establishing
manufacture.
through capital
Buyer selection.
credible image of
Access to
intensity, scale
Signaling
firm and product
distribution. Brand
efficiency and low
commitment.
building. Fast
input costs
product
Rationalizing
capacity
development.
Process innovation
10.4 Organizational Adaptation and Change
Importance of “fit”
To be successful, companies need to align their strategies and organizational
structures with their industry environments. Strategy and structure must adapt
to keep pace with changes in external environment = challenge to managers.
10.4.1 Evolutionary Theory and Organizational Change
Cfr. biological theories of evolution
A company has to adapt to change through variation, selection & retention
Organizational ecologists : change = at industry level
Individual organisations are so resistant to change, no individual changes
Selection mechanism: organizations whose characteristics match the new
environment survive, the others don’t.
> Changing population of companies
evolution < changes in the composition of firms, than by adaptation to external
change
Evolutionary theorists (Nelson & Winter)
Changes occur within individual organizations at level of organizational routine.
Companies have to look for new routines : imitate successful routines and
abandon unsuccessful routines
10.4.2 The Sources of Organizational Inertia
Change is difficult and painful for organizations (as for individuals). It upsets
patters.
Organizational capabilities and routines
Capabilities are developed through routines = repeated patterns
The more developed routines, the more difficult to develop new ones
Social and political structures
Social patterns of interaction > stress during change
Stable system of political power > those who have power = resistant to change
Conformity
External pressure and risk aversion encourages companies to adopt similar
strategies and structures as their peers
Complementarities between strategy, structure and systems
As there is a fit between an organization’s structure, strategy, management
systems, culture & employee skills : when change is required, all these elements
has to change = barrier to change. Punctuate equilibrium = long periods of
stability altered with radical and comprehensive change.
Limited search and blinkered perceptions
Limit search to areas close to existing activities
Incremental changes < bounded rationality (limited info constraints people in
search activities)
Satisficing (search for satisfactory rather than optimal performance)
Preference for exploitation of existing knowledge, rather than new
10.4.3 Empirical evidence on Organization Adaptation
Few companies have been leaders in their industries for a century or more
(Exxon Mobile, Shell, General Electric). The ability of a firm to adapt to external
change depends on the nature of that change (evolutionary or radical change)
Adapting to changes over the life cycle
Life cycle involves changes that are predictable. Different changes are
undertaken by different companies: The innovative firms that create new
products are rarely the ones (consolidators) that scale them into mass markets.
Skills, competences needed for discovery & invention <-> those needed for
commercialization
Adapting to technological change
The ability of firms to adapt to technological change depends on whether the
change involves a single process or product feature, or a new configuration of
the product.
e.g. banks & grocery store on internet = new distribution channel
more radical change
> difficulty to adapt, startups = more successful
but customer relationships, sales networks can support established f
> can give new comers chance to unseat market leaders
because established firms are behind new comers
technological changes that create new industries
new startups compete with established firms (diversification)
- when the resources and capabilities of one industry are close to the new
industry : established firms have advantage over startups
10.4.4 Managing Organizational Change
Given the many barriers to change, managers have to recognize the sources of
the inertia (existing routines, power structures, entrenched perceptions regarding
the nature of the business).
Dual Strategies and Separate Organizational Units
It is easier to create new organizational units, rather than change existing
organization . This may create difficulties to manage simultaneously multiple
strategies, but a large number of companies were already successful in doing so.
Dual strategies require dual planning systems : short term (strategic fit and
performance) + long term (develop vision, redefine & reposition businesses)
Bottom-up Processes of Decentralized Organizational Change
Simply decentralizing decision making is not enough to speed the processes of
organizational adaption.
- if there is satisficing behaviour, top management needs to stimulate
performance by raising performance expectations
- Top management have to challenge divisional and business unit managers to
seek new opportunities by specific company wide initiatives
- be alert to strategic dissonance, created by divergent strategic directions within
the company. It can signal “strategic inflection point”, = fundamental change in
industry dynamics
- by periodically changing organizational structure: stimulate local initiatives
Imposing Top-down Organizational Change
Most large companies exhibit periodic restructuring involving simultaneous
changes in strategy, structure, management systems and top management
personnel; orchestrated from the top.
The challenge is to do it before declining performance.
Using scenarios to prepare for the future
A company’ ability to adapt to changes depends on its capacity to anticipate such
changes.
Scenario analysis = systematic way of thinking and communicating about the
future. It is not a forecasting technique.
The multiple scenario approach constructs several distinct, internally consistent
views of how the future may look five to 25 years ahead.
Scenario can either be qualitative or quantitative or a combination.
It is used to explore likely paths of industry evolution.
Shaping the future
The key to organizational change is not to adapt to external change but to create
the future.
Companies that adapt to change, always have to catch-up
Role of strategy is to give a systematic an concerted approach to redefining the
company and its industry environment in the future
What about radical change in established companies:
- some = success (Nokia from paper & rubber into mobile phones)
- for most companies radical change = disaster (Enron)
Competitive advantage depends on the deployment of superior organizational
capabilities and these capabilities develop slowly.
Chapter 11: Technology-based Industries and the
Management of Innovation (p. 288 – 319)
1
Introduction
Chapter 10: impact of innovation
Chapter 11: innovation and technology as weapons of competitive strategy.
Innovation and the application of new technologies are important sources of
competitive advantage.
In this chapter, we concentrate on the strategic management of innovation and
technological change.
2
Competitive advantage in technology-intensive industries
Innovation, if successful, creates competitive advantage.
2.1. The innovation process
Invention: the creation of new products and processes through the development
of new knowledge or from new combinations of existing knowledge.
Innovation: the initial commercialization of invention by producing and marketing
a new good or service or by using a new method of production.
An innovation may:
 Be the result of a single invention;
 Combine many inventions
! Not all invention progresses into innovation
! Innovations may involve little or no new technology
2.2. The profitability of innovation
Intensity and frequency of new product introductions tend to be negatively
associated with profitability,
BUT: innovation is no guarantor of fame and fortune
e.g.: the imitators of the personal computer earned more in total profits than the
innovators.
Who gets the benefits from innovation?  figure 11.2., p. 292
Regime of appropriability: term that describes the conditions that influence the
distribution of returns to innovation;


Strong regime of appropriability: innovator is able to capture a substantial
share of the value created
Weak regime of appropriablility: other parties derive most of the value
Property rights in innovation
Appropriating the returns to innovation depends, to a great extent, on the ability
to establish property rights in the innovation.
Law provides several areas of intellectual property:


Patents: exclusive rights to a new and useful product, process, or design.
Copyrights: exclusive rights to the creators of artistic, literary, dramatic,
or musical works
 disadvantage: make information public


Trademarks: words, symbols, … to distinguish the goods or services
supplied by a firm. They provide the basis for brand identification.
Trade secrets: offer a modest degree of legal protection for recipes,
formulae, and other knowledge acquired in the course of business.
Effectiveness depends on the type of innovation being protected.
Tacitness and complexity of the technology
Absence of effective legal protection through patents and copyrights:
 the extent to which an innovation can be imitated by a competitor depends on
2 important characteristics:


Codifiable knowledge: a codifiable technology is easily copied in absence of
legal protection. E.g. Coca-Cola’s recipe
Complexity: simple ideas are easily copied in absence of legal protection.
E.g. Hula-hoop
Lead-time
Tacitness and complexity do not provide lasting barriers to imitation,
BUT: they offer the innovator time.
Innovations creates a temporary competitive advantage that offers a window of
opportunity for the innovator to build on the initial advantage.
Lead-time: the time it will take followers to catch up
The ability to turn lead-time into cost advantage is thus a key aspect of the
innovator’s advantage.
Complementary resources (figure 11.3., p. 295)
Innovation requires more than invention. It requires:
Complementary resources: diverse resources and capabilities needed to finance,
produce, and market the innovation.
Innovation and resources supplied by different firms:
 division of value between them depends on their relative power.
Key determinant: complementary resources:
 Specialized
 Unspecialized
2.3. Which mechanisms are effective at protecting innovation

How effective are these different mechanisms in protecting innovations?
See figure 11.1., p. 296
 Patent protection is of limited effectiveness as compared with lead-time,
secrecy and sales/service resources.

Why do firms continue to engage in patenting?
See figure 11.2., p. 297
 Much patenting activity appears to be strategic; it is directed towards
blocking the innovation efforts of other companies and establishing
property rights in technologies that an then be used in bargaining with
other companies for access to their proprietary technologies.
3.
Strategies to exploit innovation: how and when to enter
3.1. Alternative strategies to exploit innovation
Alternative strategies to maximize the returns to innovation (figure 11.4., p 298)
 Licensing
 Outsourcing
 Alliance
 Joint venture
 Internal commercialization
The choice of strategy mode depends on 2 sets of factors:


The characteristics of the innovation
The resources and capabilities of the firm
Characteristics of the innovation
Licensing is only viable where ownership in an innovation is clearly defined by
patent or copyrights.
E.g. in pharmaceuticals, licensing is widespread because patents are clear and
defensible.
Advantages of licensing:
 It relieves the company of the need to develop the full range of
complementary resources and capabilities needed for commercialization.
 It allows the innovation to be commercialized quickly
Disadvantages of licensing:
 The success of the innovation in the market is totally dependent on the
commitment and effectiveness of the licensees.
E.g. To companies that met difficulties in licensing their inventions:
 Dyson vacuum cleaner
 Raisio and Benecol
Resources and capabilities of the firm
Different strategic options require very different resources and capabilities.
Business startups and other small firms possess few of the complementary
resources and capabilities needed to commercialize their innovations.
Inevitably they will be attracted to licensing or to accessing the resources of
larger firms through outsourcing, alliances, or joint ventures.
A two-stage model for innovation is common:
 the technology is developed initially by a small, technology-intensive
startup…

…which then licenses to, or is acquired by, a larger concern.
3.2. Timing innovation: to lead or to follow
To gain competitive advantage in emerging and technologically intensive
industries, is it best to be a leader or a follower in innovation?
See figure 11.3., p. 301  the evidence is mixed:


In some products the leader has been the first to grab the prize;
In others the leader has succumbed to the risks and costs of pioneering
Advantages and disadvantages of pioneering depend on:



The extent to which innovation can be protected by property rights or
lead-time advantages; if an innovation is appropriable through f.e. a
patent, there is advantage in being an early mover.
The importance of complementary resources; the more important are
complementary resources in exploiting an innovation, the greater the costs
and risks of pioneering.
(followers are favored by the fact that, as an industry develops, specialist
firms emerge as suppliers of complementary resources.)
The potential to establish a standard; the greater the importance of
technical standards, the greater the advantages of being an early mover in
order to influence those standards and gain the market momentum
needed to establish leadership.
Different companies have different strategic windows:
Periods in time when their resources and capabilities are aligned with the
opportunities available in the market.
3.3. Managing risks
There are two main sources of uncertainty:


Technological uncertainty: arises from the unpredictability of technological
evolution;
Market uncertainty: relates to the size and growth rates of the markets for
new products  forecasting
If reliable forecasting is impossible, the keys to managing risk are:


alertness and responsiveness to emerging trends;
limiting vulnerability to mistakes through avoiding large-scale
commitments.
Useful strategies for limiting risk include:
 Cooperating with lead users;
 Limiting risk exposure: minimize exposure to adversity + limited debt
financing;
 Flexibility: respond quickly to market signals (who are difficult to forecast)
4.
Competing for standards
4.1. Types of standard
A standard is a format, an interface, or a system that allows interoperability.
Standards can be public or private:


Public (or open): standards who are available to all either free or for a
nominal charge. They are set by public bodies and industry standards E.g.
The GSM mobile phone standard.
Private (or proprietary): standards where the technologies and designs are
owned by companies or individuals.
Standards can also be mandatory or de facto:

Mandatory: standards who are set by government and have the force of
law behind them.

De facto: standards who emerge through voluntary adoption by producers
and users (examples: table 11.4., p. 305).
A problem with those standards is that they may take a long time to
emerge, resulting in delayed development of the market. Delayed
emergence of a standard may kill the technology altogether.
4.2. Why standards appear: network externalities
Why do standard emerge in some product markets and not in others?
 Basically, standards emerge because suppliers and buyers want them. They
want standards for those goods and services subject to network externalities.
Network externality: exists whenever the value of a product to an individual
customer depends on the number of other users of that product.
E.g. the value of a telephone to each user depends on the number of other users
connected to the same telephone system
! Some products have negative network externalities: the value of the product is
less if many other people purchase the same product.
! Network externalities do not require everyone to use the same product or even
the same technology, but rather that the different products are compatible with
one another through some form of common interface.
E.g. in the case of wireless telephone service, it doesn’t matter whether we
purchase service from AT&T or T-Mobile. The key issue is that each supplier’s
system is compatible to allow connectivity.
Network externalities arise from several sources:



Products where users are linked to a network;
Availability of complementary products and services;
Economizing on switching costs
Network externalities create positive feedback, a process called tipping:
Once a market leader begins to emerge, the leader will progressively gain
market share at the expense of rivals.
 result: tendency toward a winner-takes-all market.
4.3. Winning standards war
In markets subject to network externalities, control over standards is the basis of
competitive advantage, and may be essential for survival.
The lesson that has emerged from the classic standards battles of the past is that
in order to create initial leadership and maximize positive feedback effects, a
company must share the value created by the technology with other parties
(customers, competitors, complementors and suppliers).
Achieving compatibility with existing products is a critical issue in standards
battles. Advantage typically goes to the competitor that adopts an
 Evolutionary strategy, rather than one that adopts a…
 …Revolutionary strategy.
Key resources needed to win a standards war:
 Control over an installed base of customers;
 Owning intellectual property rights in the new technology;
 The ability to innovate in order to extend and adapt the initial
technological advance;
 First-mover advantage;
 Strength in complements;
 Reputation and brand name.
! However, even with such advantages, standards wars are costly and risky
5. Implementing technology strategies:
creating the conditions for innovation
The most crucial challenge facing firms in emerging and technology-based
industries is: how does the firm create conditions that are conducive to
innovation?
5.1. Managing creativity
The conditions for creativity
Invention:




Is an act of creativity requiring knowledge and imagination;
Is an individual act;
Depends on the organizational environment in which you work;
Is stimulated by human interaction.
Balancing creativity and commercial direction
A central challenge is balancing the creative freedom of individuals with the need
for direction, discipline and integration
The most important discipline for ensuring that creativity is productive, is to
maintain linkage between creative processes and market need.
“Necessity is the mother of invention”
Organizing for creativity
Creativity requires management systems that are quite different from those
appropriate to pursuing cost efficiency. (Table 11.5., p. 313)
5.2. From invention to innovation: the challenge of cross-functional
integration
The commercialization of new technology requires linking creativity and
technological expertise with capabilities in production, marketing, finance,
distribution and customer support.
Tension between the operating and the innovating parts of organizations is
inevitable. The organizational challenge is to reconcile these two.
Organizational innovations being introduced by large corporations to improve
new product development and the exploitation of new technologies are the
following.
 Cross-functional product development teams;
 Product champions;
 Buying innovation;
 Incubators.
Part V: Corporate strategy
Chapter 13 Vertical Integration and the Scope of
the Firm (p. 339– 360)
1
Introduction and objectives
Corporate strategy: is concerned primarily with the decisions over the scope of
the firm’s activities, where competes a firm. Different dimensions of scope are:
 Product scope (diversification):
o Specialized companies = engaged in a single industry sector: Cocacola (soft drinks), Gap (fashion retailing), …
o Diversified companies = a number of different industries: Samsung,
General Electric
 Geographical scope (multinationality): optimal geographical spread:
McDonalds in 121 countries
 Vertical scope (vertical integration): vertically linked activities: Walt
Disney Companies produces movies, distributes them itself to cinemas and
through its own tv networks and uses the movies’ characters in its retail
stores and theme parks
 Concepts as economies of scope in resources and capabilities, transaction
costs, costs of corporate complexity are common to all three dimensions.
Business strategy (competitive strategy): is concerned with how a firm competes
within a particular market.
2
Transaction Costs and the Scope of the Firm
2.1
Firms, Markets, and Transaction Costs
Market economy (capital economy) comprises 2 forms of economic organization:
 Market mechanism: individuals and firms make independent decisions that
are guided and coordinated by market prices
o Adam Smith named it the invisible hand because its coordinating
role does not require conscious planning
 Administrative mechanism: decisions over production, supply, purchases
of inputs are made by managers (hierarchy).
o Alfred Chandler named it visible hand because it is dependant on
coordination through active planning.
Firm = an organization that consists of a number of individuals bound by
employment contracts with a central contracting authority.
 Not essential for conducting complex economic activity (ex: you employed
a builder how subcontracted a plummer, painter,… This is a market
contract.
What determines which activities are undertaken within a firm, or between,
individuals or firms coordinated by market contracts?
= relative costs = markets are not costless
 Transaction costs: fe: purchases involves search costs, costs of negotiation
or drawing up a contract, costs of monitoring
 Administrative costs
  if transactions costs associated with organizing across markets >
administrative costs of organizing within firms.  we can expect the
coordination of productive activity to be internalized within firms.
Three independent companies
or having all three stages of
fe. production in one company?
2.2 The shifting
Boundary between Firms
and Markets
19th-20th century: companies grew in size and scope, absorbing transactions that
had previously taken place across markets. Companies that were localized and
specialized grew vertically, geographically and across different industry sectors.
Effect of the trend: less administrative costs compared with the transaction costs
of markets. Better efficiency of firms organizing devices through:
 technology:
telegraph,
telephone
and
computer

facilitated
communication and expanded the decision-making capacity of managers
 management techniques: developments in the principles and techniques of
management expanded organizational and decision-making effectiveness
of managers (19th century: double-entry bookkeeping, 20th century:
scientific management)
Although large companies have continued to expand internationally, the
dominant trends of the past 20 years have been ‘downsizing’ and ‘refocusing’ as
large industrial companies reduced both their product scope through focusing on
their core business, and their vertical scope through outsourcing. The result was
that the largest companies began to play a declining role in the US economy.
This chapter gives an answer to (based on Oliver Williamson’s analysis of
transaction costs): Is it better to be vertically integrated or vertically specialized?
3
The Costs and Benefits of Vertical Integration



Most of the 20th century: vertical integration was beneficial because it
allowed superior coordination and security.
The past 20 years: benefits of outsourcing in terms of flexibility and the
ability to develop specialized capabilities in particular activities.
 most of the coordination benefits associated with vertical integration
can be achieved through interfirm collaboration.
(See strategy capsule 13.1 on page 345: Vertical Integration in the Media Sector)
3.1
Defining Vertical Integration
Vertical integration is a firm’s ownership of vertically related activities. The
greater the firm’s ownership and control over successive stages of the value
chain for its product, the greater its degree of vertical integration.
Fe: Highly integrated companies, such as major oil companies that own and
control their value chain from exploring for oil down to the retailing of gasoline,
tend to have low expenditures on bought-in goods and services relative to their
sales.
Vertical integration can have two directions:
 backward: the firm takes over ownership and control of producing its own
components or other inputs
 forward: the firm takes over ownership and control of activities previously
undertaken by its customers
Vertical integration can be full or partial:
 Full: exists between two stages of production when all of the first stage’s
production is transferred to the second stage with no sales or purchases from
third parties.
 Partial: exists when stages of production are not internally self-sufficient. Ex:
o crude-rich companies (Statoil) produce more oil than they refine and are
net sellers of crude
o crude-poor companies (Exxon Mobil) have to supplement their own
production with purchases of crude to keep their refineries supplied
3.2 Technical Economies from the Physical Integration of
Processes
Benefits of vertical integration: technical economies: cost savings that arise from
physical integration of processes. Examples:
 producing steel sheet: first produce steel, then roll hot steel into sheet.
Linking the two stages of production at a single location reduces
transportation and energy costs
 pulp and paper production
But why is vertical integration necessary in terms of common ownership? Pulp
and paper production, why not separate firms? We need to consider the
implications of linked processes for transaction costs.
3.3
The Sources of Transaction Costs in Vertical Exchanges
Figure 13.2: value chain for steel cans starting
from mining iron ore to delivering cans to food
companies
Between the production of steel and
steel strip, most production is vertically
integrated. Between production of steel
strip and steel cans there is little
vertical integration. There specialist
packaging companies that purchase steel strip from steel companies on
contracts. The predominance of market contracts between steel strip and can
production is a result of low transaction costs in the market for steel strip: there
are many buyers and sellers, information is easily available and the switching
costs for buyers and suppliers are low. Other ex: few jewelry companies own
gold mines.
The vertical integration between steel and steel strip production is logical
because there are technical economies from hot-rolling steel as soon as it is
poured from the furnace, steel makers and strip producers must invest in
integrated facilities. A competitive market is impossible. The market becomes a
series of bilateral monopolies.
Relationship between steel and steel strip producer problematic, why? If a single
supplier negotiates with a single buyer, there is no equilibrium price, it depends
on bargaining power.  is costly  opportunism and strategic misrepresentation
rises as each company seeks both enhance and exploit its bargaining power at
the expense of the other. Going from competitive market to close bilateral
relationships between buyers and sellers, the efficiencies of the market system
are lost.
Culprits are transaction-specific investments. When a canmaker buys steel strip,
both parties don’t need to invest in equipment that is specific to the needs of the
other party. Once transaction-specific investments are specific then (even if
there are buyers and sellers in the market – it is no longer a competitive market)
each seller is tied to a single buyer, which gives opportunity to ‘hold up’ the
other.
If both companies make investments, a market contract will be inefficient due to
administration costs. Vertical integration is bringing both sides of the transaction
into a single administrative structure, so the transaction costs may be avoided.
Transaction-specific investments give rise to opportunism. Why don’t they write
a contract that eliminates the potential for opportunism and misrepresentation
by specifying prices, quality and terms of supply? It is impossible to anticipate all
the circumstances that might arise over the 30-year life of the plant. A contract
would be incomplete.
3.4
Administrative Costs of Internalization
Vertical integration avoids the costs of using the market, but internalizing the
transactions means that there are now costs of administration. The efficiency of
administration depends on several factors.
Differences in Optimal Scale between Different Stages of Production
Fe. Federal express needs delivery vans and the manufacturer must make
transaction-specific investments to meet Fedex its particular needs. If FedEx
makes is own vans they avoid ensuing transaction costs. Efficient? No. the
transaction costs avoided by FedEx are not important compared with the
inefficiencies in manufacturing its own vans.
Fe. small brewers simply do not possess the scale needed for scale efficiency in
can manufacture. (Een klein biertje moet zich niet focussen op canmaking).
Developing Distinctive Capabilities
A company specialized in a few activities has the advantage to develop
distinctive capabilities in those activities. A technology-based company such as
Kodak, Philips cannot maintain IT capabilities like IBM. This assumes that
capabilities in different vertical activities are independent of one another. Where
one capability builds on capabilities in adjacent activities, vertical integration may
help develop distinctive capabilities.
Managing Strategically Different Businesses
Problems of differences results in the problem of managing vertically related
businesses that are strategically very different. If Fedex also owns a truckmanufacturing company, they will have the problem that management systems
and organizational capabilities required for truck manufacturing are very different
from those required for express delivery. Integrated design, manufacturing and
retailing companies such as Zara and Gucci are rare. Most retailers (Carrefour,
Wall Mart, Gap) do not manufacture because it requires different strategic
planning systems, different approaches to control, HR management, Different top
management styles and skills.  Strategic dissimilarities between businesses
have encouraged many companies to vertically de-integrate.
The incentive Problem
Vertical integration changes the incentives between vertically related businesses.
Profit incentives ensure that the buyer is motivated to get the best possible deal
and seller is motivated to attract buyer through efficiency and service.
- High-powered incentives: exists with market contracts. Supplier-customer
relationship governed by corporate management systems.
- Low-powered incentives: performance incentives. If you open internal
divisions to external competition you create stronger performance
incentives.
Shared service companies: exists in many large companies: internal suppliers of
corporate services (IT, training…) compete with external suppliers of the same
services to serve internal operating divisions.
Competitive Effects of Vertical Integration
Monopolistic companies have used vertical integration for extending their
monopoly positions from one stage of the industry to another. Fe Standard Oil
used its power in transportation and refining to foreclose markets to independent
oil producers  rare situation. Once a company monopolizes one vertical chain of
an industry, there is no further monopoly profit to be extracted by extending that
monopoly position to adjacent vertical stages of the industry. Big concern is that
vertical integration may make independent suppliers and customers less willing
to do business with the vertically integrated company (it is now competitor).
Flexibility
Vertical integration can have a negative effect on the rapid responsiveness to
uncertain demand. It may also be disadvantageous in responding quickly to new
product development opportunities that require new combinations of technical
capabilities. Fe Ipod, Xbox have been produced by contract manufacturers.
Extensive outsourcing has been a key feature of fast-cycle product development
throughout the electronics sector.
Vertical integration is good where system-wide flexibility is required. American
apparel is the fastest growing clothing manufacturer because of a super-fast
design-to-distribution cycle. (see 13.4 p 351). Also Zara cut cycle times and
maximized market responsiveness through vertical integration. (see strategy
capsule 13.2 p. 351: Making Vertical integration work: Zara)
Compounding Risk
Vertical integration ties a company to its internal suppliers. Compounding risk if
there are any problems at one stage of production threatens production and
profitability at all other stages.
3.5
Assessing the Pros and Cons of Vertical Integration
Is vertical integration beneficial? It al depends. There are costs and benefits with
both vertical integration and with market contracts between firms. Even in the
same industry, different companies can be successful with very different degrees
of vertical integration. Zara is more vertically integrated than H&M. (table p.354)
How many firms are there in the
The fewer the companies, the greater vertically related
activity?
the attraction of VI.
Do transactions-specific investments
The greater the requirements for specific
need to be made by either party?
investments, the more attractive is VI.
Does limited availability of information
The greater the difficulty of specifying provide
opportunities to the contracting
and monitoring contracts, the greater firm to behave
opportunistically (i.e.,cheat)?
the advantages of VI.
Are market transactions subject to
VI is attractive if it can circumvent taxes and
Taxes and regulations?
regulations.
How much uncertainty exists with regard
Uncertainty raises the costs of writing and
to the circumstances prevailing over the
monitoring contracts, and provides opportunities for
period of the contracts?
cheating, therefore increasing the attractiveness of VI.
How uncertain is market demand?
The greater the demand uncertainty- the more costly VI
Are the two stages similar in terms of
The greater the dissimilarity in scale-the
optimal scale of operations?
the more difficult is VI.
How strategically similar are the different
The greater the strategic dissimilarity stages in terms of
And the resources and capabilities
key success factors the more difficult is VI.
required for success?
Does VI increase risk through requiring
The heavier the investment requirements and the
heavy investments in multiple stages
greater the independent risks at each stage – the more
and compounding otherwise independent
risky is VI
risk factors?
4
Designing Vertical Relationships
There
are
a
variety
of
relationships
through
which
buyers and sellers can interact
and coordinate their interests.
They can be classified in relation
to two characteristics.

arm’s-length nature
spot
contracts:
of
no

4.1



4.2
significant commitment. Vertical integration involves substantial
investment
The formalization of the relationship: long-term contracts and franchising
require complex written agreements, spot contract little docs but bounded
by law.
Different Types of Vertical Relationship
Long-term contracts
o Long-term contracts: series of transactions over a period of time
and specify the terms of sales and the responsibilities of each party.
 +: necessary to avoid opportunism and to provide security if
transaction-specific investments are necessary
 -: can’t anticipate all the possible circumstances that may
arise during the life of the contract. Risk of being to
restrictive or so loose  opportunism and conflicting
interpretation.
 -: of inflexibility especially in IT outsourcing (±10 year)
o  Spot contracts: buying a cargo of crude oil on the Rotterdam
petroleum market
 +: work well under competitive conditions where there is no
need for transaction-specific investments.
Vendor partnerships
o Big difficulties of specifying long-term contracts complete then
vendor partnership. Based on mutual understanding & trust.
o It’s a relational contract, no written contract (fe Japanese
automakers have close collaboration in technology, design…)
o +: can provide security for transaction-specific investments,
flexibility to meet changing circumstances, incentives to avoid
opportunism
Franchising
o Is a contractual agreement between the owner of a trademark and a
business system (the franchiser) that permits the franchisee to
produce and market the franchiser’s product or service in a specified
area. (fe: Mc Donalds, Twice as nice..)
o +: facilitate close coordination and investment in transactionspecific assets that vertical integration permits with the highpowered incentives, flexibility and cooperation between strategically
dissimilar businesses.
Choosing between Alternative Vertical Relationships
Not a make or buy choice. Between full vertical integration and spot market
contracts, there is a broad spectrum of alternative organizational forms. Most
suitable vertical integration depends on:
- economic characteristics of the activities involved
- legal and fiscal circumstances
- strategies and resources of the firms
What is best for one company will not make sense for another company whose
strategy and capabilities are different. (fe most food and beverage chains
franchise bur Starbucks on the other hand owns and manages its retail outlets.
Design of vertical relationships needs to take account of:
 Allocation of risk: you cope with uncertainties over the course of the
contract. Contract involves allocation of risk between the parties. Fe:
franchisee’s capital is at risk and the franchisee pays franchiser a flat
royalty based on sales revenue.
 Incentive structures: for a contract to minimize transaction costs it must
provide an appropriate set of incentives to the parties. But completeness
in the specification of contracts also costs a lot. Very often, the most
effective incentive is the promise of future business.
4.3









Recent Trends
Growing diversity of hybrid vertical relationships that have attempted to
reconcile the flexibility and incentives of market transactions with the close
collaboration provided by vertical integration
Collaborative vertical relationships are viewed as a recent phenomenon
The success of Japanese manufacturing companies with their close
collaborative relationships with suppliers has a powerful influence on
American and European companies over the past two decades
Massive shift from arm’s-length supplier relationships to long-term
collaboration with fewer suppliers
Competitive tendering and multiple sourcing have been replaced by singlesupplier arrangements
Outsourcing has been intensified by companies. Most companies have
specialized in fewer activities within their value chains. They outsource not
only components, but also payroll, IT, training, customer service, support
The extent of outsourcing and vertical de-integration has given rise to a
new organizational form: the virtual corporation, where the primary
function of the company is coordinating the activities of a network of
suppliers.
Extreme outsourcing reduces the strategy role of the company to that of a
systems integrator. Can the company retain architectural capabilities
needed to manage the component capabilities of the various partners and
contractors?
RISK: virtual company may degenerate into “hollow Corporation”, where it
loses the capability to evolve and adapt to changing circumstances.
Loosing the core business.
5 Summary
Chapter 14: Global Strategies and the
Multinational Corporation
1
Implications of International Competition for
Industry Analysis
1.1
Patterns of Internationalization
Internationalization occurs through trade (=the sale and shipment of goods and
services from one country to another) and direct investment (=building or
acquiring productive assets in another country). Different types of
internationalization are:
- sheltered industries: served exclusively by indigenous (= inheemse) firms.
They are sheltered from international competition by regulation, public
ownership, barriers to trade, or because the goods and services they offer
are more suited to small local operators than to large, multinational
corporations. Examples: service industries (f.e. dry cleaning), small-scale
manufacturing (f.e. homebuilding) and industries producing products that
are nontradable because they are perishable (=bederfelijk) or difficult to
move (f.e. beds)
- trading industries: where internationalization occurs primarily through
imports and exports. If a product is transportable, not nationally
differentiated and subject tot substantial scale economies, exporting from
a single location is the most efficient means to exploit overseas markets.
Trading industries also include products whose inputs are available only in
a few locations. Examples: aerospace, military hardware, diamond mining,
agriculture
- Multidomestic industries: those that internationalize through direct
investment-either because trade is not feasible (=realiseerbaar) or
because products are nationally differentiated. Examples: packaged
groceries, investment banking, hotels and consulting
- Global industries: those in which both trade and direct investment are
important. Examples: large-scale manufacturing (f.e. automobiles, oil,
beer, pharmaceuticals).
Also look at page 364, figure 14.1
1.2 Implications for Competition
Mostly, internationalization means more competition and lower industry
profitability. This impact of internationalization can be analyzed within the
context of Porter’s five forcers of competition framework.
Competition from Potential Entrants
Barriers to entry into most national markets have fallen. Reasons:
- tariff reductions
- falling real costs of transportation
- removal of exchange controls
-
internationalization of standards
convergence between customer preferences
entry barriers effective against potential domestic entrants may be
ineffective against potential foreign entrants
 this made it much easier for producers in one country to supply customers in
another.
Rivalry among existing firms
Internationalization increases internal rivalry within industries in three ways:
- lowering seller concentration: international trade typically means that
more suppliers are competing for each national market
- increasing diversity of competitors: the increasing international diversity of
competitors implies differences in goals, strategies and cost structures- all
of which cause them to compete more vigorously while making
cooperation more difficult
- increasing excess capacity: when internationalization occurs through direct
investment, the result is likely to be increased capacity. To the extent that
direct investment occurs through investment in new plants, industry
capacity increases with no corresponding increase in market size.
Increasing the Bargaining Power of Buyers
Large customers can exercise their buying power far more effectively. Global
sourcing provides a key tool for cost reduction by manufacturers. The growth of
internet-based markets for components and materials enhances the power of
industrial buyers.
2
Analyzing Competitive Advantage in an
International Context
Look at page 366 figure 14.2
When firms are located in different countries, their potential for achieving
competitive advantage depends not only on their internal stocks of resources and
capabilities, but also on the conditions of their national environments-in
particular the resource availability within the countries where they do business.
2.1
National Influences on Competitiveness: Comparative
Advantage
The role of national resource availability on international competitiveness is the
subject of the theory of comparative advantage:
A country has a comparative advantage in those products that make intensive
use of those resources available in abundance within that country. The term
comparative advantage refers to the relative efficiencies of producing different
products. So long as exchange rates are well behaved, then comparative
advantage translates into competitive advantage. Comparative advantages are
revealed in trade performance (look at page 367 table 14.1).
Trade theory initially emphasized the role of natural resource endowments, labor
supply and capital stock in determining comparative advantage. More recently
emphasis has shifted to the central role of knowledge (technology, human skills
and management capability) and the resources needed to commercialize
knowledge (capital markets, communication facilities and a legal system).
A large home market facilitates the development and exploitation of capital,
technology and infrastructure. In most capital- and technology-intensive
industries, large countries (f.e. US) are at an advantage over small countries. A
similar logic motivates the creation of free trade areas such as the European
Union, Mercosur and Nafta.
2.2
Porter’s National Diamond
Look at page 368 figure 14.3!
Porter has extended our understanding of comparative advantage by examining
the dynamics through which specific industries in particular countries develop the
resources and capabilities that confer international competitive advantage.
Factor Conditions
Porter’s analysis emphasizes first “home-grown” resources and second, the role
of highly specialized resources. Also, resource constraints may encourage the
development of substitute capabilities. (f.e. restrictive labor laws have stimulated
automation)
Related and Supporting Industries
National competitive strengths tend to be associated with “clusters” of industries
(f.e. chemicals, synthetic dyes, textiles, and textile machinery)
Demand conditions
Demand conditions in the domestic market provide the primary driver of
innovation and quality improvement.
Strategy, Structure and Rivalry
National competitive performance in particular sectors is inevitably related to the
strategies and strategies of firms in those industries. Porter puts particular
emphasis on the role of intense domestic competition in driving innovation,
efficiency, and the upgrading of competitive advantage.
2.3.
Consistency between Strategy and National Conditions
Establishing competitive advantage in global industries requires congruence
between business strategy and the pattern of the country’s comparative
advantage.
The linkage between the firm’s competitive advantage and its national
environment also includes the relationship between firms’ organizational
capabilities and the national culture and social structure. National culture has
been shown to exert a powerful influence on management practices in general
and on the capability profiles of firms in particular.
3.
Appluying the Framework: International
Location of Production
Each firm is based within its home country. In fact, an important motive for
internationalization is to access the resources and capabilities available in other
countries. Traditionally, multinational companies either concentrated production
in their home country or located manufacturing plants to serve each of the
countries where they marketed their products. Increasingly, decisions as to
where to produce are being separated over decisions as to where to sell.
3.1. Determinants of Geographical Location
The decision of where to manufacture requires consideration of three sets of
factors:
- National resource availability: Where key resources differ between
countries in their availability or cost, then firms should manufacture in
countries where resource supplies are favorable
- Firm-specific competitive advantages: For firms whose competitive
advantage is based on internal resources and capabilities, optimal location
depends on where those resources and capabilities are situated and how
mobile they are
- Tradability: The ability to locate production away from markets depends
on the transportability of the product. Production within the local market is
favored when transportation costs are high, local customers have
differentiated preferences and governments create barriers to trade.
3.2. Location and the Value Chain
The production of most goods and services comprises a vertical chain of activities
where the input requirements of each stage vary considerably. Hence, different
countries offer differential advantage at different stages of the value chain. In
principle, a firm can identify the resources required by each stage of the value
chain, then determine which country offers these resources at the lowest cost.
However, when companies are making decisions to shift certain activities outside
their home country (= offshoring), it is important to look beyond comparisons of
current costs and consider the underlying resources and capabilities available in
different locations. Cost advantages are vulnerable to exchange rate changes and
wage inflation. Moreover, noncost aspects of operational performance may
ultimately be more important (f.e. technology, know-how, speed,…).
The benefits from fragmenting the value chain must be traded off against the
added costs of coordinating globally dispersed activities. Important factors to
consider are:
- transportation costs
- increased inventory costs
- increased time
- just-in-time scheduling often necessitates that production activities are
carried out in close proximity to one another
The tradeoff between cost and time depends on the strategy of the company.
Companies that compete on speed and reliability of delivery typically forsake the
cost advantages of a globally dispersed value chain in favor of integrated
operations with fast access to the final market.
Look at page 373 figure 14.4
4.
Applying the Framework: Foreign Entry
Strategies
Many of the considerations relevant to locating production activities also apply to
choosing the mode of foreign market entry. A firm enters an overseas market
because it believes it will be profitable. This assumes not only that the overseas
market is attractive but also that the firm can establish a competitive advantage
vis-à-vis local producers and other multinational corporations.
In exploiting an overseas market opportunity, a firm has a range of options with
regard to mode of entry. The basic distinction is between market entry by means
of transaction and market entry by means of direct investment.
Look at page 374 figure 14.5
How does a firm weigh the merits of different market entry modes? Five key
issues are relevant:
1. IS THE FIRM’S COMETITIVE ADVANTAGE BASED ON FIRM-SPECIFIC OR
COUNTRY-SPECIFIC RESOURCES?
If the firm’s competitive advantage is country based, the firm must exploit an
overseas market by exporting.
If the firm’s competitive advantage is company specific, then assuming that
advantage is transferable within the company, the firm must exploit the market
either by exports or by direct investment.
2. IS THE PRODUCT TRADABLE AND WHAT ARE THE BARRIERS TO TRADE?
If the product is not tradable because of transportation constraints or import
restrictions, then accessing that market requires entry either by investing in
overseas production facilities or by licensing the use of key resources to local
companies within the overseas market.
3. DOES THE FIRM POSSESS THE FULL RANGE OF RESOURCES AND
CAPABILITIES FOR ESTABLISHING A COMPETITIVE ADVANTAGE IN THE
OVERSEAS MARKET?
Competing in an overseas market is likely to require that the firm acquires
additional resources and capabilities, particularly those related to marketing and
distributing in an unfamiliar market. Accessing such country-specific resources is
most easily achieved by establishing a relationship with firms in the overseas
market. The form of relationship depends on the resources and capabilities
required.
4. CAN THE FIRM DIRECTLY APPROPRIATE THE RETURNS TO ITS
RESOURCES?
Whether a firm licenses the use of its resources or chooses to exploit them
directly depends partly on appropriability considerations. With all licensing
arrangements, key considerations are the capabilities and reliability of the local
licensee. This is particularly important in licensing brand names where the
licenser must carefully protect the brand’s reputation.
5. WHAT TRANSACTION COSTS ARE INVOLVED?
A key issue that arises in the licensing of a firm’s trademarks or technology
concerns the transaction costs of negotiating, monitoring, and enforcing the
terms of such agreements as compared with internationalization through a fully
owned subsidiary.
Issues of transaction costs are fundamental to the choices between alternative
market entry models. Barriers to exporting in the form of transport costs and
tariffs are forms of transaction costs; other costs include exchange rate risk and
information costs. Transaction cost analysis has been central to theories of the
existence of multinational corporations. In the absence of transaction costs in the
markets either for goods or for resources, companies exploit overseas markets
either by exporting their goods and services or by selling the use of their
resources to local firms in the overseas markets. Thus multinationals tend to
predominate in industries where:
- firm-specific intangible resources such as brands and technology are
important
- exporting is subject to transaction costs
- customer preferences are reasonably similar between countries
4.1. International Alliances and Joint Ventures
The traditional reasons for cross-border alliances and joint ventures were:
- the desire by multinational companies to access the market knowledge
and distribution capabilities of a local company
- the desire by local companies to access the technology, brands, and
product development of the multinationals.
The success of cross-border joint ventures and other forms of international
strategic alliance has been mixed. Joint ventures that share management
responsibility are far more likely to fail than those with a dominant parent or with
independent management. The greatest problems arise between firms that are
also competitors. Disagreements over the sharing of contributions to and returns
from an alliance are a frequent source of friction. When each partner seeks to
access the other’s capabilities, “competition for competence” results. However, in
long-term partnerships there is the potential for the benefits to flow in both
directions.
The effective strategic management of international alliances depends on a clear
recognition that collaboration is competition in a different form. How the alliance
benefits are shared depends on three key factors:
- The strategic intent of the partners: the clearer a firm is about its strategic
goals in entering an alliance, the more likely it is to achieve a positive
result from the alliance.
-
-
5
Appropriability of the contribution: the ability of each partner to capture
and appropriate the skills of the other depends on the nature of each
firm’s skills and resources. Where skills and resources are tangible and
explicit, they can easily be acquired. Where they are tacit and people
embodied, they are more difficult to acquire.
Receptivity of the company: the more receptive a company is in terms of
its ability to identify what it wants from the partner, to obtain the required
knowledge or skills, and to assimilate and adapt them, the more it will
gain from the partnership. In management terms, this requires the setting
of performance goals for what the partnership is to achieve for the
company and managing the relationship to ensure that the company is
deriving maximum learning from the collaboration.
Multinational Strategies: Globalization vs.
National Differentiation
In this section, we explore whether and under what conditions firms that operate
on an international basis are able to gain a competitive advantage over nationally
focused firms.
5.1. The Benefits of a Global Strategy
A global strategy is one that views the world as a single, if segmented, market.
The superiority of global strategies rests on two assumptions:
- Globalization of customer preferences: national and regional preferences are
disappearing in the face of homogenizing forces of technology, communication,
and travel
- Scale economies: firms that produce for the world market can access scale
economies in product development, manufacturing, and marketing that offer
efficiency advantages that nationally based competitors cannot match
There are five major benefits from a global strategy:
Cost Benefits: Scale and Replication
In most global industries, the most important source of scale economy is product
development.
However, for most internationalizing firms, the major cost advantage from
multinational operation derives from economies in the replication of knowledgebased assets. When a company has created a knowledge-based asset or product
(f.e. a recipe, piece of software,…) creating the original knowledge was costly
but, once created, subsequent replication is typically cheap.
Exploiting National Resources Efficiencies
Global strategy does not necessarily involve production in one location and then
distributing globally. Global strategies also involve exploiting the efficiencies from
locating different activities in different places. As we have seen, companies
internationalize not just in search of market opportunities but also in search of
resource opportunities. This means not only a quest for raw materials and lowcost labor, but also for knowledge.
Serving Global Costumers
In several industries (f.e. investment banking, audit services, advertising), the
primary driver of globalization has been the need to service global customers.
Learning Benefits
If competitive advantage involves innovation and the constant deepening and
widening of capabilities, then learning plays a central role in developing and
sustaining competitive advantage. If learning involves communicating and
interacting with one’s proximate environment, then multinationals have the
advantage of working within multiple national environments. The critical
requirement is that the company possesses some form of global infrastructure
for communication and knowledge transfer that permits new experiences, new
ideas and new practices to be transferred and integrated. A growing stream of
research suggests that the most important advantage of multinationals over
domestic companies is their ability to access knowledge in multiple locations, to
synthesize that knowledge and to transfer it efficiently across national borders.
Competing strategically
Multinationals can fight aggressive competitive battles in individual national
markets using their cash flows from other national markets. This crosssubsidization of competitive initiatives in one market using profits from other
markets involves predatory pricing (= cutting prices to a level that drives
competitors out of business). More usually, cross-subsidization involves using
cash flows from other markets to finance aggressive sales and marketing
campaigns.
Strategic competition between multinationals presents more complex
opportunities for attack, retaliation and containment. The most effective
response to competition in one’s home market may be to retaliate in the foreign
multinationals own home market. To effectively exploit such opportunities for
national leveraging, some overall global coordination of competitive strategies in
individual national markets is required. In industries that are dominated by
multinationals (f.e. automobiles, investment banking,…), companies should seek
to position themselves in all three of the world’s major industrial centers: North
America, Europe and Japan.
5.2. The Need for National Differentiation
National differences in customer preferences continue to exert a powerful
influence in most markets: products designed to meet the needs of the global
customer tend to be unappealing to most consumers (f.e. washing machines).
Moreover, cost of national differentiation can be surprisingly low if common basic
designs and common major components are used. These reasons provide an
interesting refutation of the globalization hypothesis.
Apart from customer demand, several other factors encourage national
differentiation:
- Laws and government regulations: Governments are the most important
sources of obstacles to globalization.
- Distribution channels: Differences between the distribution systems of
different countries are among the biggest barriers to global marketing
strategies.
- Presence of lead countries: Countries differ in their levels of sophistication
and acceptance of innovation on a product-by-product basis. These
differences in market progressiveness encourage a sequential approach to
global strategy in which products are introduced first in the lead market,
followed by a global rollout. Sequential product launches allow firms to
learn from experiences in the lead market and exploit that learning in
subsequent country launches.
- National cultures: Many of the problems of international expansion
encountered by companies can be linked to problems of cultural
adjustments. Culture comprises assumptions, values, traditions and
behavioral norms. The need to adapt to local cultures may influence the
mode of internationalization chosen.
5.3
Reconciling Global Integration with National Differentiation
Choices about internationalization strategy have been viewed as a tradeoff
between the benefits of global integration and those of national adaptation. Look
at figure 14.7 page 381
Industries where scale economies are huge and customer preferences
homogeneous call for a global strategy (f.e. jet engine). Industries where
national preferences are pronounced and where customization is not prohibitively
expensive favor a multidomestic strategy (f.e. retail banking). However, some
industries may be low on most dimensions (f.e. car repair services). Conversely,
other industries offer substantial benefits from operating at global scale , but
national preferences and standards may also necessitate considerable adaptation
to the needs of specific national markets (f.e. telecommunication).
Reconciling conflicting forces for global efficiency and national differentiation
represents one of the greatest strategic challenges facing multinationals. Global
localization involves standardizing product features and company activities where
scale economies are substantial and differentiation where national preferences
are strongest and where achieving them is not over-costly.
Different functions also have different positioning with regard to global
integration and national differentiation. R&D, purchasing, IT and manufacturing
have strong globalization potential because of scale economies; sales, marketing,
customer service and human resource management tend to require much more
national differentiation. These differences have important implications for how
the multinationals is organized.
6
Strategy and Organization within the
Multinational Corporation
Managing business activities that cross national frontiers is complex. As a result,
the success of international strategies depends critically on the effectiveness with
which they are implemented.
6.1. The Evolution of Multinational Strategies and Structures
Multinationals, because of their complexity, face particular difficulty in adapting
quickly to external change. Radical changes in strategy and structure are
difficult: once an international distribution of functions, operations, and decisionmaking authority has been determined, reorganization is slow, difficult and
costly. This administrative heritage of a multinational constrains its ability to
build new strategic capabilities.
Leadership in the internationalization business has been held by companies from
different countries at different times. There are three different eras and for the
companies of each era, their management challenges today are still shaped by
their historical experiences (also look figure 14.8. page 385):
- early 20th century: Era of the European multinational: Because of the
conditions at the time of internationalization (poor transportation and
communications, highly differentiated national markets) the companies
created multinational federations: each national subsidiary was
operationally autonomous and undertook the full range of functions,
including product development, manufacturing and marketing.
- Post-World War 2: Era of the American multinational: US economic
dominance was the basis for the preeminence of US multinationals. While
their overseas subsidiaries were allowed considerable autonomy, this was
within the context of the dominant position of their US parent. US-based
resources and capabilities where their primary competitive advantages in
world markets.
- The 1970s and 1980s: The Japanese challenge: Japanese multinationals
pursued global strategies from centralized domestic bases. R&D and
manufacturing were concentrated in Japan; overseas subsidiaries were
responsible for sales and distribution. Globally standardized products
manufactured in large-scale plants provided the base for unrivalled cost
and quality advantages. Over time, manufacturing and R&D were
dispersed.
The different administrative heritage of these different groups of multinationals
continues to shape their organizational capabilities today.
European multinationals:
- Strength: Adaptation to the conditions and requirements of individual
national markets.
- Challenge: Achieve greater integration of their sprawling international
empires
US multinationals:
- Strength: ability to transfer technology and proven new products from
their domestic strongholds to their national subsidiaries.
-
Challenge: nurturing the ability to tap their foreign subsidiaries for
technology, design, and new product ideas
Japanese multinationals:
- Strength: efficiency of global production and new product development
- Challenge: become true insiders in the overseas countries where they do
business
6.2. Reconfiguring the Multinational: The Transnational
Corporation
Changing Organization Structure
For North American and European-based multinationals, the principal structural
changes of recent decades have shifted from organization around national
subsidiaries and regional groupings to the creation of worldwide product
divisions. For most multinationals, country and regional organizations are
retained, but primarily for the purposes of national compliance and customer
relationships.
New Approaches to reconciling localization and global integration
The formal changes in structure are less important than the changes in
responsibilities, decision powers, and modes of coordination within these
structures. The fundamental challenge for multinationals has been reconciling the
advantages of global integration with those of national differentiation.
The simultaneous pursuit of responsiveness to national markets and global
coordination requires a very different kind of management process than existed
in the relatively simple multinational or global organizations. This is the
transnational organization. The distinguishing characteristic of the transnational
is that it becomes an integrated network of distributed and interdependent
resources and capabilities (see Figure 14.9 page 387). This necessitates that
- each national unit is a source of ideas, skills and capabilities that can be
harnessed for the benefit of total organization
- national units access global scale economies by designating them the
company’s world source for a particular product, component or activity
- the center must establish a new, highly complex managing role that
coordinates relationships among units but does so in a highly flexible way.
The key is to focus less on managing activities directly and more on
creating an organizational context that is conducive to the coordination
and resolution of differences. Creating the right organizational context
involves establishing clear corporate objectives, developing managers with
broadly based perspectives and relationships and fostering supportive
organizational forms and values.
Balancing global integration and national differentiation requires that a company
adapts to the differential requirements of different products, different functions
and different countries.
The transnational firm is a concept and direction of development rather than a
distinct organizational archetype. It involves convergence of the different
strategy configurations of multinationals.
Multinationals are increasingly locating management control of their global
product divisions outside their home countries.
Organizing R&D and New product development
Probably the greatest challenges facing the top managers of multinationals are
organizing, fostering and exploiting innovation and new product development.
Innovation is stimulated by diversity and autonomy, while its exploitation and
diffusion require critical mass and coordination. The traditional European
decentralized model is conducive to local initiatives but not to their global
exploitation.
By assigning national subsidiaries global mandates it is possible for them to take
advantage of local resources and develop distinctive capabilities while exploiting
globally the results of their initiatives.
Where local units possess unique capabilities, they can be identified as centers of
excellence as a means of assigning them specific responsibilities and signaling
this leadership to the rest of the organization.
Part V: Corporate strategy
Chapter 15: Diversification Strategy
1
Introduction and objectives
Defining “what business are we in?” is the starting point of strategy and
the basis for defining the firm’s identity. Some companies define their
mission and vision broadly, other more narrowly. A firm’s business scope
may change over time. Most companies have refocused on core business
during the past 25 years (RJR Nabisco). Some have moved in the opposite
direction (Microsoft) and other have totally transformed their businesses
(Nokia).
Diversification is a conundrum (raadselachtige kwestie). It represents the
biggest single source of value destruction ever perpetrated by CEOs and
their strategy advisers at the expense of their unwitting shareholders.
Diversification decisions by firms involve to issues:
 How attractive is the industry to be entered?
 Can the firm establish a competitive advantage within the new
industry?
The primary focus is on the latte question: under what conditions does
operating multiple businesses assist a firm in gaining a competitive
advantage in each? This leads into exploring linkages between different
businesses within the diversified firm, synergy.
2
Trends in Diversification Over Time (figure 15.1)
2.1
The Era of Diversification, 1950 – 1980
Diversification is the major aspect of the widening scope of the modern
corporation during most of the 20th century. Between 1950 and 1980,
diversification was an especially important source of corporate growth in
all the advanced industrial nations. The 1970s saw the height of the
diversification boom with the emergence of a new corporate form: the
conglomerate.
2.2 Refocusing, 1980 – 2006
After 1980, the diversification trend went sharp reverse. Unprofitable
‘noncore’ businesses were increasingly divested during the later 1980s,
and a number of diversified companies fell prey to leveraged buyouts.
The refocusing trend was strongest in the US, but was also evident in
Canada, Europe and, to a lesser extent, in Japan. This trend towards
specialization was the result of three principal factors:
Emphasis on Shareholder Value
The most important factor driving the retreat from diversification and the
refocusing around core businesses was the reordering of corporate goals
from growth to profitability. Economic downturns and interest-rate spikes
of the early 1980s and 1989-90 revealed the inadequate profitability of
many large, diversified companies. The tendency for the stock market to
apply a ‘conglomerate discount’ has added a further incentive for
breakups.
Turbulence and Transaction Costs
The relative costs of organising transactions within firms and across
markets depend on the conditions in the external environment.
Administrative hierarchies are very efficient in processing routine
transaction, but in the turbulent conditions the pressure of decision
making on top management results in stress, ineffiency and delay. As
business environment becomes more volatile, specialized companies are
more agile than large diversified companies. At the same time, external
factor markets have become increasingly efficient. One reason for the
continued dominance of large conglomerates in emerging market
countries may be higher transaction costs associated with their less
sophisticated and efficient markets for finance, information and labor.
Trends in Management Thinking
The major change is that strategic analysis has become more precise
about the circumstances in which diversification can create value from
multibusinessactivity. Mere linkages between businesses are not enough:
the key to creating value is the ability of the diversified firm to share
resources and transfer capabilities more efficiently than alternative
institutional arrangements.
3
Motives for Diversification
Diversification is driven by three major goals: growth, risk reduction and
profitability.
3.1 Growth
Without diversification firms are prisoners of their own industry. For firms
in stagnant or declining industries this is a daunting prospect. The critical
issue for top management is whether the pursuit of growth is consistent
with quest for profitability.
The agency problem: managers have incentives to pursue growth rather
then profitability, one of the most serious consequences of which is the
propensity to undertake unprofitable diversification. Companies in lowgrowth, cash-flow rich industries such as tobacco and oil have been
especially susceptible to the temptations of diversification. When the
underperforming companies are threatened by investor discontent or a
corporate raider, they frequently resort to selling off diversified
businesses.
3.2
Risk Reduction
To isolate the effects of diversification risk, consider the case of ‘pure’ or
‘conglomerate’ diversification.
Does this risk reduction create shareholder’s value?
The only possible advantage could be if firms can diversify at lower cost
than individual investors. The capital asset pricing model (CAPM): the risk
that is relevant to determining the price of a security is not the overall risk
(variance) of the security’s return, but systematic risk. The systematic risk
is measured by the beta coefficient.
The simple act of bringing businesses under common ownership does not
create value through risk reduction.
So long securities markets are efficient, diversification whose sole purpose
is to spread risk will not benefit shareholders. However risk spreading
trough diversification may benefit other shareholders. The reduction in
risk that bondholders derive from diversification is the coinsurance effect.
3.3
Profitability
Two sources of superior profitability: industry attractiveness and
competitive advantage. Michael Porter proposes three ‘essential tests’ to
be used when you want to see if diversification will create shareholder
value:
 The attractiveness test
 The cost-of-entry test
 The better-off test
The attractiveness and Cost-of-entry Tests
A critical realization in Porter’s ‘essential tests’ is that industry
attractiveness is insufficient on its own. Although diversification is a
means by which the firm can access more attractive investment
opportunities than are available in its own industry, it faces the problem of
entering the new industry.
The second test, Cost-of-entry test recognizes that the attractiveness of
an industry to a firm already in an industry may be different from its
attractiveness to a firm seeking to enter the market.
The Better-off Test
Porter’s third criterion for successful diversification addresses the basic
issue of competitive advantage: if two businesses producing different
products are brought together under the ownership and control of a single
enterprise, is there any reason why they should become any more
profitable? Combining different, but related, businesses can enhance the
competitive advantages of the original business, the new business, or
both.
For example: Procter & Gamble’s acquisition of Gillette.
4.
Competitive Advantage from Diversification
The primary means by which diversification creates competitive advantage
is trough the sharing of resources and capabilities across different
businesses.
4.1 Economies of Scope
Economies of scope exist for similar reasons as economies of scale. The
key difference is that the economies of scale relate to cost economies
from increasing output for a single product, economies of scope are cost
economies from increasing output across multiple products.
The nature of economies of scope varies between different types of
resources and capabilities:
Tangible resources
Tangible resources offer economies of scope by eliminating duplication
between businesses trough creating a single shared facility. The greater
the fixed costs of these items, the greater the associated economies of
scope.
Economies of scope also arise from the centralised provision of
administrative and support services by the corporate centre to the
different businesses of the corporation. Shared service organizations
supply common administrative and technical services to the operating
businesses.
These economies of scope can also arise in finance by combining an
industrial company with a financial service.
Intangible Resources
Intangible resources offer economies of scope from the ability to extend
them to additional businesses at low marginal cost. Brand extension:
exploiting a strong brand across additional products.
Organizational Capabilities
Organizational capabilities can also be transferred within the diversified
company. For example: LVMH, Sharp Corporation.
Some of the most important capabilities in influencing the performance of
diversified corporations are general management capabilities.
4.2 Economies from internalising Transactions
Economies of scope in resources and capabilities can be exploited simply
by selling or licensing the use of the resource or capability to another firm.
A firm can exploit proprietary technology by licensing it to other firms.
Technology and trademarks are licensed across national frontiers as an
alternative to direct investment. Even tangible resources can be shared
across different businesses trough market transactions.
Relative efficiency is the key issue: what are the transaction costs of
market contracts, as compared with the administrative costs of a
diversified enterprise? Transaction costs include the costs involved in
drafting, negotiating, monitoring and enforcing a contract. The costs of
internalization consists of the management costs of establishing and
coordinating the diversified business. But much depends on the
characteristics of the resources or capabilities.
The mire deeply embedded a firm’s capabilities within the management
systems and the culture of the organization, the greater the likelihood that
these capabilities can only be deployed internally within the firm.
4.3
The Diversified Firm as an Internal Market
Internal Capital Markets
Diversified companies have two key advantages:
 By maintaining a balanced portfolio of cash-using business, the
company can avoid the costs of using the external capital market,
including the margin between borrowing and lending rates and the
heavy costs of issuing new debt and equity.
 They have better access to information on the financial prospects of
their different businesses than that typically available to external
financiers.
Against these advantages is the critical disadvantage that investment
funds within the diversified company are allocated solely on the basis of
potential returns.
Internal labor Markets
Efficiencies also arise from the ability of diversified companies to transfer
employees between their divisions, and to rely less on hiring and firing.
The costs associated with hiring include advertising, the time spent in
interviewing and selection, and the costs of ‘head-hunting’ agencies. The
costs of dismissing employees can be very high where severance
payments must be offered. A diversified corporation had a pool of
employees and can respond to the specific needs of any one business
trough transfer from elsewhere within the corporation.
The informational advantages of diversified firms are especially important
in relation to internal labor markets. A key problem of hiring from the
external market is the limited information. The diversified firm that is
engaged in transferring employees between business units and divisions
has access to much more detailed information on the abilities,
characteristics, and the past performance of each of its employees.
5
Diversification and Performance (Table 15.2)
5.1
The findings of Empirical Research
Empirical research into diversification has concentrated up two major
issues:
How do diversified firms perform relative to specialized firms?
Does related diversification outperform unrelated diversification?
The Performance of Diversified and Specialized Firms
Despite the large number of empirical studies over four decades, no
consistent systematic relationships have emerged between performance
and the degree of diversification. However there was some evidence that
high levels of diversification are associated with deteriorating profitability (
because of the problems of complexity that diversification creates).
Diversification makes sense when a company has exhausted growth
opportunities in his existing markets and can match its existing
capabilities to emerging external opportunities. As with most studies
seeking to link strategy to performance, a key problem is distinguishing
association from causation. It also is likely that performance effects of
diversification depend on the mode of diversification.
The Performance of Diversified and Specialized Firms
Given the importance of economies of scope ins hared resources and
capabilities, it seems likely that diversification into related industries
should be more profitable that diversification into unrelated industries.
The lack of clear performance differences between related and unrelated
diversification is troubling. Three factors can help explain the confused
picture:
Related diversification may offer greater potential benefits, but many also
pose more difficult management problems for companies such that the
potential benefits are not realised.
The tendency for related diversification to outperform unrelated
diversification might be the result of poorly performing firms rushing into
unrelated diversification.
The distinction between “related” and “unrelated” diversification is not
always clear. Relatedness refers to common resources and capabilities,
not similarities in products and technologies.
5.2 The Meaning of Relatedness in Diversification
 Relatedness on the operating level: fe.: marketing and distribution.
Typically activities where economies from resource sharing are small
and achieving them is costly in management terms.
 Relatedness on the strategic level: some of the most important
sources of value creation within the diversified firm are the ability to
apply common general management capabilities, strategic
management systems, and resource allocation processes to different
businesses. This is more difficult to appraise.
6
Summary
Page 409
Chapter 16: Managing the multibusiness corporation
1. The structure of the Multibusiness Company
Within the multibusiness company, corporate management takes primary responsibility
for corporate strategy, and divisional management take primary responsibility for
business strategy. This corporate/divisional distinction is the basic feature of the
multibusiness corporation. Wether we are referring to multiproduct company, a
multinational company or a verically integrated corporation, almost all multibusiness
companies are organized as multidivisional structures where business decisions are
located at the business level and the corporate center exercises overall coordination and
control.
The allocation of decision making between corporate and divisional levels has shifted
over time. During recent decades, more strategic decision making has been devolved to
the devisional and business unit levels, while corporate headquarters have taken
responsibility
for
corporate
strategy
and
the
management
of
overall
corporate
performance. Our primary focus is to analyze and understand the role of the corporate
center in managing the multibusiness company.
1.2 The theory of the M-form
Oliver Williamson identified four key efficiency advantages of the divisionalized firm or in
his terminology, the M-form.
1. Adaptation to “bounded rationality”
If managers are limited in their cognitive, information-processing, and decision-making
capabilities, the top management team cannot be responsible for all coordination and
decision making within a complex organization. The M-form permits decision making to
be dispersed.
2. Allocation of decision making
Decision-making responsibilities should be separated according to the frequency with
which different types of decisions are made. The M-form allows high frequency decisions
to be made at divisional level and decisions that are made infrequently to be made at
corporate level.
3. Minimizing coordination costs
In the functional organization, decisions concerning a particular product or business area
must pass up to the top of the company where all the relevant information and expertise
can be brought to bear. In the devisionalized firm, so long as close coordination between
different business areas is not necessary, most decisions concerning a particular business
can be made at the divisional level. This eases the information and decision-making for
the top management.
4. Avoiding goal conflict
In functional organizations, department heads emphasize functional goals over those of
the organization as a whole. In multidivisional companies, divisional heads, as general
managers, are more likely to pursue profit goals that are consistent with the goals of the
company as a whole.
As a result, the multidivisional firm can help solve two key problems of large,
managerially controlled corporations:

Allocation of resources: To the extent that the multidivisional company can create
a competitive internal capital market in which capital is allocated according to
financial and strategic criteria, it can avoid much of the politicization inherent in
purely hierarchical systems. The multidivisional company can achieve this through
operating an internatl capital market where budgets are linked to past and
projected divisional profitiability, and individual projects are subject to a
standardized appraisal and approval process.

Resolution of agency problems: A related shortcoming of the modern corporation
is that owners (shareholders) wish to maximize the value of the firm, while their
agents (top managers) are more interested in salaries, security and power. Given
the limited power of shareholdes to discipline and replace managers, and the
tendency for top managers to dominate the board of directors, the multidivisional
form may act as a partial remedy to the agency problem. The rationale is : by
actin as an interface between the stockholdes and the divisional managers,
corportate management can enforce adherence to profit goals. So long as
corporate management is focused on shareholder goals, the multidivisional
structure can support a system for enforcing profit maximization at the divisional
level. Examples: General Electric, Emeron Electric.
1.3 Problems of Divisionalized Firms
Henry Mintzberg points out that the multidivisional structure suffers from two important
rigidities that limit decentralization and adaptability:

Constraints on decentralization: Although operational authority in the M-form is
dispersed to the divisional level, the individual divisions often feature highly
centralized power that is partly a reflection of the divisional president’s personal
accountability
to
the
head
office.
The
operational
freedom
of
divisional
management exists only so long as the corporate head office is satisfied with
divisional performance.

Standardization of divisional management: The devision for permits divisional
management to be differentiated by their business needs. In practice, there are
powerful forces for standardizing control systems and management styles which
my inhibit individual divisions from achieving their potential. The difficulties that
many large, mature corporations experience with new business development often
result from applying to new businesses the same management systems designed
for existing businesses.
2. The role of Corporate Management
How does the corporate headquarters create value within the multibusiness corporation?
If the multibusiness corporation is to be viable, then the additional profits generated by
bringing several business under common ownership and control must exceed the costs of
the corporate headquarters. We must consider the role and the functions of corporate
managers.
We have identified corporate headquarters primarily with corporate strategy: determing
the scope of the firm and allocating resources between its different parts. In fact, the
responsibilities of corporate management also include administrative and leadership roles
with regard to implementing corporate strategy, participating in overall cohesion, identity
and direction within the company. These functions also have carry the name “corporate
strategy”. Campbell and Alexander refer to the role of the corporate headquartes in the
multibusiness company as “corporate parenting”.
There are three main activities through which corporate manaement adds value to the
multinational company:

Managing the corporate portfolio, including acquisitions, divestments and
resource allocation.

Exercisin guidance and control over individual businesses, including influencing
business strategy formulation and managing financial performance.

Managing linkages amond businesses by sharing and transferring resources and
capabilities.
3. Managing the Corporate Portfolio
Basic question: What business are we in? Hence, corporate strategy is concerned with
the composition and balance of a company’s portfolio of businesses. The key decision
relate to extensions of the portfolio (divestment), and changes in the balance of the
portfolio through the allocation and reallocation of capital and other resources. Recource
allocation
among businesses is an
ongoing
strategic responsibility of corporate
management. Portfolio planning models are useful techniques for formulating
stragegies for the individual businesses.
3.1 GE and the development of Strategic Planning
General Electric, EG, has been a leading source of corporate strategy concepts and
innovations. To manage the sprawling industrial empire more effectively, GE launched a
series of initiatives. The result was three innovations that would transform corporate
strategy formmulation in multibusiness companies:

Portofolio planning models: Two-dimensional, matrix-based frameworks to
evaluate business unit performance, formulate the business unit strategies and
assess the overall balance of the corporate portfolio.

The strategic business unit (SBU): The basic organizational unit for which it is
meaningful to formulate a separate competitive strategy. An ASB is a business
consisting of a number of closely related products and for which most costs are
not shared with other businesses.

The PIMS database: An internal database comprising strategic, market and
performance data on individual business units.
3.2 Portfolio Planning: The GE/McKinsey Matrix
The basic idea was to represent the businesses of the diversified company within a
simple graphical framework that would be used to guide strategy analysis in four areas:
1. Allocating resources: Portfolio analysis examines the position of a business unit
in relation to the two primary sources of profitability: industry attractiveness and
the competitive advantage of the firm. These indicate the attractiveness of the
business for future investment.
2. Formulating business unit strategy: The current positioning of the business in
relation to industry attractiveness and potential competive advantage indicates
the strategic approach that should be taken with regard to capital investment and
can point to opportunities for repositioning the business.
3. Analyzing portfolio balance: The primary usefulness of a single dagrammatic
representation of th company’s different businesses is the ability of corporate
management to take an overall view of the company. This permits planning the
overall balance of: cash flows and growth.
4. Setting performance targets: To the extent that positioning with regard to
industry attractiveness and competitive position determine profit potential,
portfolio-planning matrices can assist in setting performance targets for individual
businesses.
The two axes of te GE/McKinsey matrix (figure 16.1) are the familiar sources of
superior profitability for a firm: industry attractiveness and competitive advantage.
Industry attractiveness combines the following factors: market size and growth rate,
industry profitability, inflation recovery etc. Business unit competitive advantage is
computed on the basis of the following variables: market share, competitive position,
technology etc.
Strategy recommendations are show on figure 16.1:

Business units that rank high on both dimensions have excellent profit potential
and should be grown.

Those rank low on both dimensions have poor prospects and should be harvested
(managed to maximize cash flow with a small new investement).

In-between business are candidate for a hol strategy.
3.3 Portfolio Planning:BCG’s Growth- Share Matrix
The Boston Consulting Group’s matrix is similar: it also uses industry attractiveness and
competitive position to compare the strategic positions of different businesses. It uses
single variables for each axis: industry attractiveness is measured by rate of market
growth, competive advantage by relative market share.
The four quadrants of the matrix predict patterns of profits and cash flow and offer
strategy recommendations (Figure 16.2).
The matriw provides a first cut analysis, simplicity is important:

Because information on only two variables is required, the analysis can be
prepared easily and quickly.

It assists senior managers in cutting through the vast quantities of detailed
information.

The analysis is versatile-it can be also applied to analyze the positioning and
performance potential different products, brands etc.

It provides a useful point of departure for more detailed analysis and discussion of
the competitive positions and strategies.
The value of combining several elements of strategically useful information in a single
graphical display is illustrated by the application af the BCG matrix (see figure 16.3).
This shows each business’s positioning with regard to market growth and market share.
It also indicates the relative size of each business and the movements in its stragegic
positions.
But the matrix also has weaknesses:

Both are gross oversimplifications of the factors that determine industry
attractiveness and competitive advantage.

The positioning of businesses wihtin the matrix is highly susceptible to
measurement choices. Relative market share dpends critically on how markets are
revealed.

The approach assumes that every business is completely independent.
3.4 Value Creation through Corporate Restructuring
The major theme of corporate strategy has been refocusing and divestment. As a result,
the key issue for portfolio analysis is whether the market value of the company is greater
with a particular business or without it. Applying the techniques of shareholder value
analysis, McKinsey & Co. has proposed a systematic framework for increasing the market
value of corporate businesses through corporate restructuring: pentagon framework.
(see figure 16.4):
1. The current market value of the company. This is the starting point of the
pentagon and comprises the value of equity plus the value of debt.
2. The value of the company as is.
3. The potential value of the company with internal improvements. The
corporate head office has opportunities for increasing the overall value of the
companu by making strategic and operational improvements.
4. The potential value of the company with external improvements. The key
issue whether an individual business could be sold for a price that is greater than
its potential value to the company.
5. The optimum restructured value of the company. This is the maximum value
of a company once all the potential gains from changing invester perceptions,
making internal improvements and taking advantage of external opportunities
have been exploited.
4. Managing Individual Businesses
There are two primary means by which the corporate headquarters can exert control
over the different businesses of the corporation. It can control decisions, through
requiring that particular categories of decision who are referred upward for corporate
approval. Alternatively, corporate headquarters may seek to control business through
controlling performance targets, backed by incentives and penalties to motivate the
attainment of these targets. The distinction is between input (the decisions) and
output ( the performance) controls. Most companies use a combination. Corporate
influence over business strategy formulation is primarily a form input control; corporate
financial control is a form of output control.
4.1
The Strategic Planning System
We identified corporate strategy as being set at the corporate level and business strategy
as set at the business level. In reality, business strategy are formulated jointly by
corporate and divisional managers. In most diversfied, divisionalized companies, business
strategies are initiated by divisional managers and the role of corporate managers is to
probe, appraise, and approve divisional strategy proposals. The critical issue for
corporate management is to create a strategy-making process that reconciles the
decentralized decision making essential to fostering flexibility, responsiveness and a
sense of ownership at the business level, and responsibility for the shareholder interest.
4.2 Rethinking the Strategic Planning System
Two features of corporate strategic planning received criticism:

Strategic planning systems don’t make strategy. Strategic planning systems
have been castigated as ineffective for formulating strategy, in particular,
formalized strategic planning. The central feature of the process is that the top
management team- the executive committee-becomes the key drivers of the
strategy-making process.

Weak strategy execution. A major theme of recent years has been the need
for more effective strategy execution by large companies. This means a more
effective linkage between strategic planning and operational management.
Kaplan and Norton argue that strategy maps are used to plot the relationships
between strategic actions and overall goals. To ensure a close linkage between
strategic planning and strategy implementation they recommend that companies
establish an office of strategy management. The key is that the office is
responsible for the annual strategic planning cycle and also oversee the execution
of the strategic plans.
4.3 Performance Control and Budgeting Process
Most multidivisional companies operate a dual planning process: strategic planning
concentrates on the medium and long term, financial planning controls short-term
performance.
The corporate head office is responsible for setting and monitoring performance targets
for the individual divisions. Performance targets may be financial, strategic or
operational. They are primarily annual.
Perfomance targets are supported by incentives including financial returns and sanctions.
Some companies have combined demanding performances and powerful incentives to
create an intensely motivating environmetn for divisional managers. Creating an intense,
performance-driven culture requires unremitting focus on a few quantitive performance
targets that can be monitored on a short-term basis. Even in businesses where
interdependence is high and investement gestation periods are long, as in oil and gas,
shor-or medium-term performance targets can be highly effective. The key feature of
BP’s (Porter) performance-orientated culture is a system of performance contracts in
which each busness unit general manager agrees a set of financial, strategic and
operational targets with the CEO.
Linking individual incentives to company perfomance goals has proved to be more
difficult than most of performance mangagement envisaged. Over time, top management
compensation has become increasingly closely tied to company performance through
performance related bonuses.
4.4 Balancing Strategic Planning and Financial Control
One implication of the tradeoff between input control ( controlling decisions) and
output control (controlling performance) is that companies must choose how far to
emphasize strategic planning reative to financial planning as their primary control
system. Strategic planning emphasized the longer term development of the businesslevel planning. Financial control implied limited involvement by corporate management in
business strategy formulation, which was the reponsibility of divisional and business
managers. The primary influence of headquarters was through short-term budgetary
control and the establishment of ambitious financial targets that were rigorously
monitored by heasquarters. Table 16.1 summarizes key features of the two styles. It
appears tha financial control has become increasingly important.
4.5 Using
Appraisal
PIMS
in
Strategy
Formulation
and
Performance
Some of the most sophisticate techniques for strategy development and performance
appraisal have been those based on the PIMS ( Profit Impact of Market Strategies)
database. It comprimes information on over 5000 business units that is used to estimate
the impact of strategy and market structure on business-level profitability. Table 16.2
shows an estimated PIMS equation.
PIMS
is used
by multibusiness companies
to assist
Three
areas
of
corporate
management:

Setting performance targets for business units

Formulating business unit strategy.

Allocating investement funds between businesses. PIMS “Strategic Attractiveness
Scan” indicates investment attractiveness based on estimated future real growth
of the market and the “Par ROI” of the business.
5. Managing Internal Linkages
The main opportunities for creating value in the multibusiness company arise from
sharing resources and transferring capabilities among the different businesses wihtin the
company. This sharing occurs both through the centralization of common services at the
corporate level and through direct linkages between the businesses.
5.1 Common Corporate Services
The simplest form of resource sharing in the multidivisional company is the centralized
provision of common services and functions. These include corporate management
functions such as strategic planning, financial control, cash and risk management,
internal audit etc.
In practice, the benefits of centralized provision of common services tend to be smaller
than many corporate managers anticipate. Centralized provision can avoid costs of
duplication, but there is little incentive among headquarters staff and specialized
corporate units to meet the needs of their business-level customers. The experience of
many companies is that corporate staffs tend to grow under their own momentum with
few obvious economies from central provision and few benefits of superior services.
As a result, many companies separated their corporate headquarters into two groups: a
corporate management unit responsible for supporting the corporate management
team in activities such as planning, finance; and a shared services organization
responsible for supplying common services such as research, engineering, training etc.
Business Linkages and Porter’s Corporate Strategy Types
Exploiting economies of scope doesn’t necessarily mean centralizing resources at the
corporate level. Resources and capabilities can also be shared between the businesses.
Porter has argued that the way in which a company manages these linkages determines
its potential to create value for shareholders. He identifies four corporate strategy types:

Portofolio management. It is the most limited form. The parent company
simply acquires a portfolio of attractive managed companies, allows them to
operate autonomously and links them through an efficient internal capital market.
The typical organizational structure for the portfolio management is the holding
company-a parent company that owns controlling stakes in a number of
subsidiaries, but does not exert significant management control.

Restructuring. The company tries to create value by restructering: acquiring
poorly managed companies, then interventing to appoint new management,
dispose of underperfoming business, restructure liabilities and cut costs.

Transferring skills. Organizational capabilities can be transferred between
business units. Creating value by sharing skills requires that the same capabilities
are applicable to the different businesses, and also that mechanisms are
established to transfer these skills through personnel exchange and best practice
transfer.

Sharing activities. Porter argues that the most important source of value arises
from exploiting economies of schope in common resources and activities.
Corporate management must play a key coordinating role, including involvement
in formulating business unit strategies and intervention in operational matters.
5.3 The Corporate Role in Managing Linkages
The closer the linkages among businesses, the greater the opportunities for creating
value from sharing resources and transferring capabilities, and the greater the need for
corporate headquarters to coordinate across businesses. In more closel related
companies such as the vertically integrated oil companies, or companies with close
market or technological links (IBM) corporate management uses a “strategic planning”
style,
which
also
involves
operational
coordination.
Corporate
involvement
in
interdivisional affairs has implications for the size of the corporate headquarters. Goold
and Campbell note that the companies that are closely involved wiht their business
through “ value added corporate parenting” tend to have significant numbers of
headquarters staff involved.
Opportunities for sharing and transferring resources and capabilities may require ad hoc
organizational arrangements such as cross-divisional task forces. CEO’s can launch
corporate wide initiatives to encourage divisional managers to exploit interbusiness
linkages.
The success with which the corporate headquarters manages linkages between
businesses depends on top management’s understanding of the commonalities among its
different businesses. For a diversified business to be successful, there must be sufficient
strategic similarity among the different businesses so that the top management can
administer the corporation with a single dominant logic.
6. Leading Change in the Multibusiness Corporation
Today the focus is on value creation in an intensely competitive, fast changing world.
Corporate headquarters are more concerned with the problem of identifying and
implementing the means for creating value within and between their individual
businesses.
Changes
in
the
management
of
multibusiness
corporations
have
included
decentralizations of decision making from corporate to divisional levels, a shift from
formal to informal coordination, and a more multidimensional role for the headquarters.
Managing transition has been a key issue for chief executives. Managing a large-scale
organizational change is not simply about top-down decison making. A key component is
fostering change processes at lower levels of the organization. A critical feature of
organizational design is building structures and systems that permit adaptation. It is
important for a CEO to identify strategic inflection points- instances where seismic
shifts in a firm’s competitive environment require a fundamental redirection of strategy.
Above all, CEOs need to be adept at managing contradiction and dilemma. For example:
-Companies must strive tof efficiency which requires financial controls; they must also be
innovative and etrepreunical, which requires autonomy and flexible controls.
Resolving
a
dilemma
requires
that
organizations
operate
in
multiple
modes
simultaneously. They need to combine both decentralized flexibility and initiative and
centralized purpose and integration. Flexible integration cannot be hierarchically decreed.
It must happen through horizontal collaboration among businesses units, not at the level
of the headquarters. This requires that business-level general managers identify not only
with their particular businesses, but also wiht the corporation as a whole. The CEOs need
“ cultural glue” between these diprate businesses.
Reconciliation and pursuit of multiple performance goals requires differentiation and
integration across the different levels of management. Management roles need to be
distributed within the company. Bartlett and Ghoshal identify Three central management
processes:

Entrepreneurial process= decisions about the opportunities to exploit and the
allocation of resources.

Integration process= how organizational capabilities are built and deployed.

Renewal process= the shaping of organizational purpose and the initiation of
change
Bartlett and Ghoshal propose a distribution of thes functions between three levels of the
firm: corporate( top management), the business and geographical levels ( middle
management) and the business units ( front-line management). The relationship between
these elements forms a social structure based on cooperating and learning. Figure 16.5.