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CHAPTER 4

Internal Analysis:

Resources, Capabilities, and Core Competencies

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Be sure to see the NEW Teacher’s Resource Manual located in the Connect Library under Instructor’s Resources.

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The AFI Strategy Framework

Exhibit 1.3

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Learning Objectives (1 of 2)

LO 4-1 Differentiate among a firm’s core competencies, resources, capabilities, and activities.

LO 4-2 Compare and contrast tangible and intangible resources.

LO 4-3 Evaluate the two critical assumptions behind the resource-based view.

LO 4-4 Apply the VRIO framework to assess the competitive implications of a firm’s resources.

LO 4-5 Evaluate different conditions that allow a firm to sustain a competitive advantage.

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Learning Objectives (2 of 2)

LO 4-6 Outline how dynamic capabilities can enable a firm to sustain a competitive advantage.

LO 4-7 Apply a value chain analysis to understand which of the firm’s activities in the process of transforming inputs into outputs generate differentiation and which drive costs.

LO 4-8 Identify competitive advantage as residing in a network of distinct activities.

LO 4-9 Conduct a SWOT analysis to generate insights from external and internal analysis and derive strategic implications.

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What Are Core Competencies?

Unique strengths

Embedded deep within a firm

Allows differentiation of products and services from rivals

Results in:

Creating higher value for the customer or

Offering products and services at lower cost

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Take Honda as an example of a company with a clearly defined core competency. Its life began with a small two-cycle motorbike engine. Through continuous learning over several decades, and often from lessons learned from failure, Honda built the core competency to design and manufacture small but powerful and highly reliable engines for which it now is famous. This core competency results from superior engineering know-how and skills carefully nurtured and honed over several decades. Honda’s business model is to find a place to put its engines. Today, Honda engines can be found everywhere: in cars, SUVs, vans, trucks, motorcycles, ATVs, boats, generators, snow blowers, lawn mowers and other yard equipment, and even small airplanes. Due to their superior performance, Honda engines have been the most popular in the Indy Racing League (IRL) since 2006. Not coincidentally, this was also the first year in its long history that the Indy 500 was run without a single engine problem.

Instructors:

The digital companion to this book McGraw-Hill Connect has an application exercise on this section of the textbook. It builds student confidence on the core competencies (LO 4-1).

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Examples of Core Competencies

IKEA

Designing modern functional home furnishings at low cost

Beats Electronics

Marketing: perception of coolness

Facebook

IT capabilities to provide reliable social network services globally on a large scale.

Netflix

Creating proprietary algorithms-based on individual customer preferences.

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Links to Competitive Advantage and Superior Firm Performance

Exhibit 4.3

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Resources, Capabilities and Activities

Help deliver core competencies

Resources:

Any assets that a firm can draw on

Capabilities:

Organizational and managerial skills

Activities:

Distinct and fine-grained business processes

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Resources: Any assets that a firm can draw on when formulating and implementing a strategy. Examples: cash, buildings, machinery, or intellectual property.

Capabilities: Organizational and managerial skills necessary to orchestrate a diverse set of resources and deploy them strategically. They find their expression in a company’s structure, routines, and culture.

Activities: Distinct and fine-grained business processes that enable firms to add incremental value by transforming inputs into goods and services. Examples include: order taking, the physical delivery of products, or invoicing customers.

Key point: core competencies that are not continuously nourished will eventually lose their ability to yield a competitive advantage. And second, in analyzing a company’s success in the market, it can be too easy to focus on the more visible elements or facets of core competencies such as superior products or services. While these are the outward manifestation of core competencies, what is even more important is to understand the invisible part of core competencies.

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The Resource Based View

Resources are key to superior firm performance

Aids in identifying core competencies

Resources fall into two categories:

Tangible

Resources that have physical attributes

Visible

Intangible

Resources that do not have physical attributes

Invisible

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Note that the resource-based view of the firm uses the term resource much more broadly than previously defined. In the resource-based view of the firm, a resource includes any assets as well as any capabilities and competencies that a firm can draw upon when formulating and implementing strategy.

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Tangible and Intangible Resources

Exhibit 4.4

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Example: Google’s headquarters provides examples of both tangible and intangible resources. The Googleplex is a piece of land with a futuristic building, and thus a tangible resource. The location of the company in the heart of Silicon Valley is an intangible resource that provides access to a valuable network of contacts and gives the company several benefits. It allows Google to tap into a large and computer-savvy work force and access graduates and knowledge spillovers from a large number of universities, which adds to Google’s technical and managerial capabilities.9 Another benefit stems from Silicon Valley’s designation as having the largest concentration of venture capital in the United States. This proximity benefits Google because venture capitalists tend to prefer local investments to ensure closer monitoring. Google received initial funding from the well-known venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital, both located in Silicon Valley.

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Two Critical Assumptions of the RBV

Resource Heterogeneity

A firm is a unique bundle of resources and capabilities

These bundles differ across firms

Resource Immobility

Resources don’t move easily from firm to firm

Resources are difficult to replicate

Resources can last for a long time

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Resource Heterogeneity: For example, Southwest Airlines (SWA) and Alaska Airlines both compete in the same strategic group (low-cost, point-to-point airlines). But they draw on different resource bundles. SWA’s employee productivity tends to be higher than that of Alaska Airlines, because the two companies differ along human and organizational resources. At SWA, job descriptions are informal and employees pitch in to “get the job done.” Pilots may help load luggage to ensure an on-time departure; flight attendants clean airplanes to help turn them around at the gate within 15 minutes from arrival to departure. This allows SWA to keep its planes flying for longer and lowers its cost structure, savings that SWA passes on to passengers in lower ticket prices.

Resource Immobility: Continental and Delta both attempted to copy SWA, with Continental Lite and Song airline offerings, respectively. Neither airline, however, was able to successfully imitate the resource bundles and firm capabilities that make SWA unique.

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The VRIO Framework

Tool for evaluating firm resource endowments

To be the basis of a competitive advantage, resources must be:

Valuable,

Rare,

Costly to Imitate, and the firm must be

Organized to capture the value of the resource

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According to this model, a firm can gain and sustain a competitive advantage only when it has resources that satisfy all of the VRIO criteria.

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The VRIO Decision Tree

Exhibit 4.5

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If the answer is “yes” four times to the attributes listed in the decision tree, only then is the resource in question a core competency that underpins a firm’s sustainable competitive advantage.

Instructors:

The digital companion to this book McGraw-Hill Connect has a brief case exercise on this section of the textbook. It builds student confidence on VRIO elements of the resource based view (LO 4-4).

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A Resource Is…

Valuable if:

Helps exploit an opportunity or offset a threat

Rare if:

Only one or a few firms possess it

Costly to Imitate if:

Competitors can’t develop the resource for a reasonable price

The firm is organized to capture value through:

Effective organizational structure and coordinating systems

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Example: Beats Electronics’ ability to design and market premium headphones that bestow a certain air of coolness upon wearers is a valuable resource. The profit margins for Beats designer headphones are astronomical: The production cost for its headphones is estimated to be no more than $15, while they retail for $150 to $450, with some special editions over $1,000. Thus, Beats’ competency in designing and marketing premium headphones is a valuable resource in the VRIO framework.

Beats Electronics’ ability and reach in product placement and celebrity endorsements that build its coolness factor are certainly rare. No other brand in the world, not even Apple or Nike, has such a large number of celebrities from music, movies, and sports using its product in public. Thus, this resource is not only valuable but also rare.

Beats’ core competency in establishing a brand that communicates coolness is built upon the intuition and feel for music and cultural trends of Dr. Dre, one of music’s savviest marketing minds. Although the sound quality of Beats headphones is good enough, they mainly sell as a fashion accessory for their coolness factor and brand image. Because its creator Dr. Dre relies on gut instinct in making decisions rather than market research, this resource is costly to imitate. Even if a firm wanted to copy Beats’ core competency—how would it go about it? The music and trend-making talent as well as the social capital of Dr. Dre and Jimmy Iovine, two of the best-connected people in the music industry, might be impossible to replicate.

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Isolating Mechanisms

Barriers to imitation

Prevents rivals from competing away firm advantage

Better expectations of future resource value

Path dependence

Causal ambiguity

Social complexity

Intellectual property (IP) protection

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BETTER EXPECTATIONS OF FUTURE RESOURCE VALUE. Sometimes firms can acquire resources at a low cost, which lays the foundation for a competitive advantage later when expectations about the future of the resource turn out to be more accurate. Example: obtain real estate / land at a low cost.

PATH DEPENDENCE. Path dependence describes a process in which the options one faces in a current situation are limited by decisions made in the past. Arthur, W.B. (1989), “Competing technologies, increasing returns, and lock-in by historical events,” Example; 80% of U.S. carpets are made in Dalton, GA.

CAUSAL AMBIGUITY. Causal ambiguity describes a situation in which the cause and effect of a phenomenon are not readily apparent. Example: it is difficult to determine the exact root cause of Apple’s success

SOCIAL COMPLEXITY. Social complexity describes situations in which different social and business systems interact. Example: the culture of Zappo’s leads to their excellence in customer service.

INTELLECTUAL PROPERTY PROTECTION. Intellectual property (IP) protection is a critical intangible resource that can also help sustain a competitive advance. Examples: patents, designs, copyrights, trademarks, trade secrets.

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Core Rigidity

A former core competency

Turned into a liability

Result of an environment change

No longer fits in the external environment

Turns a resource from an asset to a liability

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A lack of strategic fit with a changing environment created at least two problems for Procter & Gamble in recent years (see Strategy Highlight 4.2). First, following the deep recession of 2008–2009, U.S. consumers moved away from higher-priced brands, such as those offered by P&G, to lower-cost alternatives. Moreover, P&G’s direct rivals in branded goods, such as Colgate-Palmolive, Kimberly-Clark, and Unilever, were faster in cutting costs and prices in response to more frugal customers.

P&G also fumbled recent launches of reformulated products such as Tide Pods (detergent sealed in single-use pouches) and the Pantene line of shampoos and conditioners. The decline in U.S. demand hit P&G especially hard because the domestic market delivers about one-third of sales, but almost two-thirds of profits for the company. Second, by focusing on the U.S. market, P&G not only missed out on the booming growth years that the emerging economies experienced during the 2000s, but it also left these markets to its rivals. As a consequence, Colgate-Palmolive, Kimberly-Clark, and Unilever all outperformed P&G in recent years.

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Dynamic Capabilities

A firm’s ability to:

Adapt resources over time

Create, deploy, modify, reconfigure, upgrade, leverage

In consideration of the external environment

The goal:

Develop resources, capabilities, and competencies

Create a strategic fit with the firm’s environment

Change in a dynamic fashion

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Apple’s dynamic capabilities allowed it to redefine the markets for mobile devices and computing, in particular in music, smartphones, and media content. For the portable music market through its iPod and iTunes store, Apple generated environmental change to which Sony and others had to respond. With its iPhone, Apple redefined the market for smartphones, again creating environmental change to which competitors such as Samsung, BlackBerry, Google (with its Motorola Mobility unit), or Microsoft (with its Nokia unit) must respond. Apple’s introduction of the iPad redefined the media and tablet computing market, forcing competitors such as Amazon and Microsoft to respond. With the introduction of the Apple Watch it is attempting to shape the market for computer wearables in its favor.

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The Dynamic Capabilities Perspective

A model that emphasizes a firm’s ability to:

Modify and leverage its resource base

Gain and sustain competitive advantage in a constantly changing environment

Dynamic markets are due to:

Technological change

Deregulation

Globalization

Demographic shifts

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Resource Stocks and Flows

Resource stocks

The firm’s current level of intangible resources

New product development

Engineering expertise

Innovation capability

Reputation for quality

Resource flows

The firm’s level of investments to maintain or build a resource

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The Bathtub Metaphor

Exhibit 4.6

SOURCE: Figure based on metaphor used in I. Dierickx and K. Cool (1989), “Asset stock accumulation and sustainability of competitive advantage,” Management Science 35: 1504–1513.

Jump to Appendix 5 long image description

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The amount of water in the bathtub indicates a company’s level of a specific intangible resource stock—such as its dynamic capabilities, new product development, engineering expertise, innovation capability, reputation for quality, and so on.

Intangible resource stocks are built through investments over time. These resource flows are represented in the drawing by the different faucets, from which water flows into the tub. These faucets indicate investments the firm can make in different intangible resources. Investments in building an innovation capability, for example, differ from investments made in marketing expertise. Each investment flow would be represented by a different faucet.

How fast the bathtub fills, however, also depends on how much water leaks out of the tub. The outflows represent a reduction in the firm’s intangible resource stocks. Resource leak-age might occur through employee turnover, especially if key employees leave. Significant re-source leakage can erode a firm’s competitive advantage. A reduction in resource stocks can occur if a firm does not engage in a specific activity for some time and forgets how to do this activity well.

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The Value Chain

Internal activities a firm engages in when transforming inputs into outputs

Through primary and support activities

Each activity adds incremental value

Raw materials  components  products

Each activity adds incremental costs

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A Generic Value Chain

Exhibit 4.7

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Retail chain American Eagle Outfitters, for example, needs to identify suitable store locations, either build or rent stores, purchase goods and supplies, manage distribution and store inventories, operate stores both in the brick-and-mortar world and online, hire and motivate a sales force, create payment and IT systems or partner with vendors, engage in promotions, and ensure after-sales services including returns.

A maker of semiconductor chips such as Intel, on the other hand, needs to engage in R&D, design and engineer semiconductor chips and their production processes, purchase silicon and other ingredients, set up and staff chip fabrication plants, control quality and throughput, engage in marketing and sales, and provide after-sales customer support.

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Primary Activities

Firm activities that add value directly

Transform inputs into outputs as the firm moves a product or service horizontally along the internal value chain.

Supply chain management

Operations

Distribution

Marketing and sales

After-sales service

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Support Activities

Firm activities that add value indirectly

Necessary to sustain primary activities

Research and development (R&D)

Information systems

Human resources

Accounting and finance

Firm infrastructure

Processes, policies, and procedures

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Strategic Activity Systems

A network of interconnected activities

Socially complex and causally ambiguous

Enhance likelihood of sustained competitive advantage

Characteristics:

Elements can be easily observed

How activities are managed is not easily observed

Difficult to imitate

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Strategic Activity Systems Must Evolve

External environment changes

Competitors develop their activity systems

How activity systems are updated:

Add new activities

Remove activities that are no longer relevant

Upgrade activities that have become stale

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The Vanguard Group’s Activity System - 1997

Exhibit 4.8

Source: Adapted from N. Siggelkow (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 146.

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In 1997, The Vanguard Group had less than $500 million of assets under management. It pursued its mission of being the highest-value provider of investment products and services through its unique set of interconnected activities. The six larger ovals depict Vanguard’s strategic core activities: strict cost control, direct distribution, low expenses with savings passed on to clients, offering of a broad array of mutual funds, efficient investment management approach, and straightforward client communication and education. These six strategic themes were supported by clusters of tightly linked activities (smaller circles), further reinforcing the strategic activity network.

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The Vanguard Group’s Activity System - 2017

Exhibit 4.9

Source: Adapted from N. Siggelkow (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 146.

Jump to Appendix 8 long image description

©McGraw-Hill Education.

The system evolved over time as Vanguard’s management added a new core activity—customer segmentation—to the six core activities already in place in 1997 (still valid in 2017). Vanguard’s managers put in place the customer-segmentation core activity, along with two new support activities, to address a new customer need that could not be met with its older configuration. Its 1997 activity system did not allow Vanguard to continue to provide quality service targeted at different customer segments at the lowest possible cost. The 2017 activity-system configuration allows Vanguard to customize its service offerings: It now separates its more traditional customers, who invest for the long term, from more active investors, who trade more often but are attracted to Vanguard funds by the firm’s high performance and low cost.

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Appendices Descriptions of Visual Graphics to Support Student Accessibility Needs

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Appendix 1 The AFI Strategy Framework

The important inside circle is titled "Gaining and Sustaining a Competitive Advantage" that is at the very center of the image, with five different circles on the outside of it. Arrows go back and forth from the center circle to each of the five outer circles. The five outer circles are labeled: (1) Getting Started, (2) External and Internal Analysis, (3) Formulation: Business Strategy, (4) Formulation, Corporate Strategy, and (5) Implementation.

Each of these outer five circles have a brief description beside them to explain what the circle means:

Under the first outer circle titled "Getting Started," it says: Part 1, Strategy Analysis, "What is Strategy (Chapter 1)" and "Strategic Leadership: Managing the Strategy Process (Chapter 2)."

Under the second outer circle titled "External and Internal Analysis," it says: Part 1, Strategy Analysis, "External Analysis: Industry Structure, Competitive Forces and Strategic Groups (Chapter 3)," "Internal Analysis: Resources, Capabilities and Core Competencies (Chapter 4)," and "Competitive Advantage, Firm Performance, and Business Models (Chapter 5)."

Under the third outer circle titled "Formulation: Business Strategy," it says: Part 2, Strategy Formulation, "Business Strategy: Differentiation, Cost Leadership and Integration (Chapter 6)" and "Business Strategy, Innovation and Entrepreneurship (Chapter 7)."

Under the fourth outer circle titled "Formulation: Corporate Strategy," it says: Part 2, Strategy Formulation, "Corporate Strategy: Vertical Integration and Diversification (Chapter 8)," "Corporate Strategy: Strategic Alliances, Mergers and Acquisitions (Chapter 9)," and "Global Strategy: Competing Around the World (Chapter 10)."

Under the fifth outer circle titled "Implementation," it says: Part 3, Strategy Implementation, "Organizational Design: Structure, Culture and Control (Chapter 11)," and "Corporate Governance and Business Ethics (Chapter 12)."

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Appendix 2 Links to Competitive Advantage and Superior Firm Performance

The first box is titled "Resources" and has an arrow pointing towards the second box titled "Core Competencies." The third box is titled "Capabilities" and has an arrow pointing towards the second box titled "Core Competencies." The second box titled "Core Competencies" has an arrow pointing towards a fourth box titled "Activities." The fourth "Activities" box has an arrow pointing towards a fifth box titled "Competitive Advantage." The fifth box titled "Competitive Advantage" has an arrow pointing towards a sixth box titled "Superior Firm Performance." The sixth box titled "Superior Firm Performance has two arrows coming out of it, one pointing towards the first box titled "Resources," and one pointing towards the third box titled "Capabilities." Labels along these arrow lines are titled "Reinvest, Hone, and Upgrade."

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Appendix 3 Tangible and Intangible Resources

This image shows a box, titled "Resources" that points to two boxes, one titled "Tangible" and the other titled "Intangible." Tangible resources include visible, physical attributes such as labor, capital, land, buildings, plant, equipment, and supplies. Intangible resources include invisible, non-physical attributes such as culture, knowledge, brand equity, reputation, and intellectual property such as patents, designs, copyrights, trademarks and trade secrets.

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Appendix 4 The VRIO Decision Tree

It is a decision tree to decide if the resource, capability, or competency under consideration fulfills the V R I O requirements. Each of the attributes accumulate. Only if a firm’s managers are able to answer “yes” four times to the attributes listed in the decision tree is the resource in question a core competency that underpins a firm’s sustainable competitive advantage.

Is the Resource Capability or Competency Valuable? If no, then there is a Competitive Disadvantage. If yes...

Is the Resource Capability or Competency Rare? If no, then there is a Competitive Parity. If yes...

Is the Resource Capability or Costly to Imitate? If no, then there is a Temporary Competitive Advantage. If yes...

Is the Resource Capability or Competency Organized to Capture Value? If no, then there is a Temporary Competitive Advantage. If yes, then there is a Sustainable Competitive Advantage.

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Appendix 5 The Bathtub Metaphor

This image shows a bathtub that is being filled with water. The amount of water in the bathtub indicates a company’s level of a specific intangible resource stock—such as its dynamic capabilities, new product development, engineering expertise, innovation capability, reputation for quality, and so on.

Intangible resource stocks are built through investments over time. These resource flows are represented in the drawing by the different faucets, from which water flows into the tub. These faucets indicate investments the firm can make in different intangible resources. Investments in building an innovation capability, for example, differ from investments made in marketing expertise. Each investment flow would be represented by a different faucet.

How fast the bathtub fills, however, also depends on how much water leaks out of the tub. The outflows represent a reduction in the firm’s intangible resource stocks. Resource leak-age might occur through employee turnover, especially if key employees leave. Significant resource leakage can erode a firm’s competitive advantage. A reduction in resource stocks can occur if a firm does not engage in a specific activity for some time and forgets how to do this activity well.

Return to slide

©McGraw-Hill Education.

Appendix 6 A Generic Value Chain

The primary activities add value directly as the firm transforms inputs into outputs—from raw materials through production phases to sales and marketing and finally customer service, specifically:

•Supply chain management.

•Operations.

•Distribution.

•Marketing and sales.

•After-sales service

Other activities, called support activities, add value indirectly. These activities include:

•Research and development (R&D).

•Information systems.

•Human resources.

•Accounting and finance.

•Firm infrastructure including processes, policies, and procedures

Return to slide

©McGraw-Hill Education.

Appendix 7 The Vanguard Group’s Activity System - 1997

This image represents the unique set of interconnected activities of The Vanguard Group in 1997. There are six larger ovals which depict Vanguard’s strategic core activities: strict cost control, direct distribution, low expenses with savings passed on to clients, offering of a broad array of mutual funds, efficient investment management approach, and straightforward client communication and education. These six strategic themes are supported by clusters of tightly linked activities (smaller circles), further reinforcing the strategic activity network.

Return to slide

©McGraw-Hill Education.

Appendix 8 The Vanguard Group’s Activity System - 2017

This image represents the unique set of interconnected activities of The Vanguard Group in 2017. The system had evolved over time as Vanguard’s management added a new core activity—customer segmentation—to the six core activities already in place in 1997 (still valid in 2017). Vanguard’s managers put in place the customer-segmentation core activity, along with two new support activities, to address a new customer need that could not be met with its older configuration. Its 1997 activity system did not allow Vanguard to continue to provide quality service targeted at different customer segments at the lowest possible cost. The 2017 activity-system configuration allows Vanguard to customize its service offerings: It now separates its more traditional customers, who invest for the long term, from more active investors, who trade more often but are attracted to Vanguard funds by the firm’s high performance and low cost. Twenty years later, The Vanguard Group had grown some eight times in size, from a mere $500 billion (in 1997) to $4 trillion (in 2017) of assets under management.