What strategic issues and problems merit front burner managerial attention

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chapter 4

Evaluating a Company’s Resources, Capabilities, and Competitiveness

©Roy Scott/Ikon Images/Getty Images

Learning Objectives

This chapter will help you

LO 4-1 Evaluate how well a company’s strategy is working.

LO 4-2 Assess the company’s strengths and weaknesses in light of market opportunities and external threats.

LO 4-3 Explain why a company’s resources and capabilities are critical for gaining a competitive edge over rivals.

LO 4-4 Explain how value chain activities affect a company’s cost structure and customer value proposition.

LO 4-5 Explain how a comprehensive evaluation of a company’s competitive situation can assist managers in making critical decisions about their next strategic moves.

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Organizations succeed in a competitive marketplace over the long run because they can do certain things their customers value better than can their competitors.

Robert Hayes, Gary Pisano, and David Upton—

Professors and consultants

Crucial, of course, is having a difference that matters in the industry.

Cynthia Montgomery—Professor and author

If you don’t have a competitive advantage, don’t compete.

Jack Welch—Former CEO of General Electric

company a lasting competitive advantage over rival companies?

3. What are the company’s strengths and weak- nesses in relation to the market opportunities and external threats?

4. How do a company’s value chain activities impact its cost structure and customer value proposition?

5. Is the company competitively stronger or weaker than key rivals?

6. What strategic issues and problems merit front- burner managerial attention?

In probing for answers to these questions, five analytic tools—resource and capability analysis, SWOT analysis, value chain analysis, benchmark- ing, and competitive strength assessment—will be used. All five are valuable techniques for revealing a company’s competitiveness and for helping com- pany managers match their strategy to the compa- ny’s particular circumstances.

Chapter 3 described how to use the tools of indus- try and competitor analysis to assess a company’s external environment and lay the groundwork for matching a company’s strategy to its external situ- ation. This chapter discusses techniques for evalu- ating a company’s internal situation, including its collection of resources and capabilities and the activities it performs along its value chain. Internal analysis enables managers to determine whether their strategy is likely to give the company a signifi- cant competitive edge over rival firms. Combined with external analysis, it facilitates an understand- ing of how to reposition a firm to take advantage of new opportunities and to cope with emerging competitive threats. The analytic spotlight will be trained on six questions:

1. How well is the company’s present strategy working?

2. What are the company’s most important resources and capabilities, and will they give the

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Before evaluating how well a company’s present strategy is working, it is best to start with a clear view of what the strategy entails. The first thing to examine is the company’s competitive approach. What moves has the company made recently to attract customers and improve its market position—for instance, has it cut prices, improved the design of its product, added new features, stepped up advertising, entered a new geographic mar- ket, or merged with a competitor? Is it striving for a competitive advantage based on low costs or a better product offering? Is it concentrating on serving a broad spectrum of cus- tomers or a narrow market niche? The company’s functional strategies in R&D, produc- tion, marketing, finance, human resources, information technology, and so on further characterize company strategy, as do any efforts to establish alliances with other enter- prises. Figure 4.1 shows the key components of a single-business company’s strategy.

A determination of the effectiveness of this strategy requires a more in-depth type of analysis. The three best indicators of how well a company’s strategy is working are (1) whether the company is achieving its stated financial and strategic objectives, (2) whether its financial performance is above the industry average, and (3) whether it is gaining customers and gaining market share. Persistent shortfalls in meeting company performance targets and weak marketplace performance relative to rivals are reliable

QUESTION 1: HOW WELL IS THE COMPANY’S PRESENT STRATEGY WORKING?

• LO 4-1 Evaluate how well a company’s strategy is working.

FIGURE 4.1 Identifying the Components of a Single-Business Company’s Strategy

E�orts to build competitively valuable partnerships and strategic alliances with other enterprises within its industry

Production strategy

Supply chain management strategy

Finance strategy

BUSINESS STRATEGY (The action plan for managing a single business)

E�orts to expand or narrow geographic coverage

K E

Y FU

N C

TIO NAL STRATEGIES

Human resource strategy

Information technology strategy

Sales, marketing, and distribution strategies

Moves to respond to changing conditions in the macro-environment or in industry and competitive conditions

R&D, technology, product design strategy

Initiatives to build competitive advantage based on

Superior ability to serve a market niche or specific group of buyers?

A better product or service (design, features, quality, wider selection, etc.)?

Lower costs and prices relative to rivals?

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warning signs that the company has a weak strategy, suffers from poor strategy execu- tion, or both. Specific indicators of how well a company’s strategy is working include

• Trends in the company’s sales and earnings growth. • Trends in the company’s stock price. • The company’s overall financial strength. • The company’s customer retention rate. • The rate at which new customers are acquired. • Evidence of improvement in internal processes such as defect rate, order fulfill-

ment, delivery times, days of inventory, and employee productivity.

The stronger a company’s current overall performance, the more likely it has a well-conceived, well-executed strategy. The weaker a company’s financial perfor- mance and market standing, the more its current strategy must be questioned and the more likely the need for radical changes. Table 4.1 provides a compilation of the financial ratios most commonly used to evaluate a company’s financial perfor- mance and balance sheet strength.

Sluggish financial perfor- mance and second-rate market accomplishments almost always signal weak strategy, weak execution, or both.

Ratio How Calculated What It Shows

Profitability ratios

1. Gross profit margin

Sales revenues − Cost of goods sold _______________________________

Sales revenues

Shows the percentage of revenues available to cover operating expenses and yield a profit.

2. Operating profit margin (or return on sales)

Sales revenues − Operating expenses

________________________________ Sales revenues

or

Operating income

_____________ Sales revenues

Shows the profitability of current operations without regard to interest charges and income taxes. Earnings before interest and taxes is known as EBIT in financial and business accounting.

3. Net profit margin (or net return on sales)

Profits after taxes

____________ Sales revenues

Shows after-tax profits per dollar of sales.

4. Total return on assets

Profits after taxes + Interest

__________________________ Total assets

A measure of the return on total investment in the enterprise. Interest is added to after-tax profits to form the numerator, since total assets are financed by creditors as well as by stockholders.

5. Net return on total assets (ROA)

Profits after taxes

____________ Total assets

A measure of the return earned by stockholders on the firm’s total assets.

6. Return on stockholders’ equity (ROE)

Profits after taxes

__________________ Total stockholders’ equity

The return stockholders are earning on their capital investment in the enterprise. A return in the 12% to 15% range is average.

7. Return on invested capital (ROIC)— sometimes referred to as return on capital employed (ROCE)

Profits after taxes

_____________________________________ Long-term debt + Total stockholders’ equity

A measure of the return that shareholders are earning on the monetary capital invested in the enterprise. A higher return reflects greater bottom-line effectiveness in the use of long-term capital.

TABLE 4.1 Key Financial Ratios: How to Calculate Them and What They Mean

(continued)

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Ratio How Calculated What It Shows

Liquidity ratios

1. Current ratio Current assets

____________ Current liabilities

Shows a firm’s ability to pay current liabilities using assets that can be converted to cash in the near term. Ratio should be higher than 1.0.

2. Working capital Current assets − Current liabilities The cash available for a firm’s day-to-day operations. Larger amounts mean the company has more internal funds to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital.

Leverage ratios

1. Total debt-to- assets ratio

Total debt

________ Total assets

Measures the extent to which borrowed funds (both short-term loans and long-term debt) have been used to finance the firm’s operations. A low ratio is better—a high fraction indicates overuse of debt and greater risk of bankruptcy.

2. Long-term debt- to-capital ratio

Long-term debt _____________________________________

Long-term debt + Total stockholders’ equity

A measure of creditworthiness and balance sheet strength. It indicates the percentage of capital investment that has been financed by both long-term lenders and stockholders. A ratio below 0.25 is preferable since the lower the ratio, the greater the capacity to borrow additional funds. Debt-to-capital ratios above 0.50 indicate an excessive reliance on long- term borrowing, lower creditworthiness, and weak balance sheet strength.

3. Debt-to-equity ratio

Total debt

__________________ Total stockholders’ equity

Shows the balance between debt (funds borrowed both short term and long term) and the amount that stockholders have invested in the enterprise. The further the ratio is below 1.0, the greater the firm’s ability to borrow additional funds. Ratios above 1.0 put creditors at greater risk, signal weaker balance sheet strength, and often result in lower credit ratings.

4. Long-term debt- to-equity ratio

Long-term debt __________________

Total stockholders’ equity

Shows the balance between long-term debt and stockholders’ equity in the firm’s long-term capital structure. Low ratios indicate a greater capacity to borrow additional funds if needed.

5. Times-interest- earned (or coverage) ratio

Operating income

_____________ Interest expenses

Measures the ability to pay annual interest charges. Lenders usually insist on a minimum ratio of 2.0, but ratios above 3.0 signal progressively better creditworthiness.

Activity ratios

1. Days of inventory

Inventory _________________

Cost of goods sold ÷ 365

Measures inventory management efficiency. Fewer days of inventory are better.

TABLE 4.1 (continued)

(continued)

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Ratio How Calculated What It Shows

2. Inventory turnover

Cost of goods sold _____________

Inventory

Measures the number of inventory turns per year. Higher is better.

3. Average collection period

Accounts receivable

______________ Total sales ÷ 365

or

Accounts receivable

______________ Average daily sales

Indicates the average length of time the firm must wait after making a sale to receive cash payment. A shorter collection time is better.

Other important measures of financial performance

1. Dividend yield on common stock

Annual dividends per share _____________________

Current market price per share

A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2% to 3%. The dividend yield for fast-growth companies is often below 1%; the dividend yield for slow-growth companies can run 4% to 5%.

2. Price-to-earnings (P/E) ratio

Current market price per share _____________________

Earnings per share

P/E ratios above 20 indicate strong investor confidence in a firm’s outlook and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12.

3. Dividend payout ratio

Annual dividends per share ___________________

Earnings per share

Indicates the percentage of after-tax profits paid out as dividends.

4. Internal cash flow After-tax profits + Depreciation A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or funding capital expenditures.

5. Free cash flow After-tax profits + Depreciation − Capital expenditures − Dividends

A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, taxes, dividends, and desirable reinvestments in the business. The larger a company’s free cash flow, the greater its ability to internally fund new strategic initiatives, repay debt, make new acquisitions, repurchase shares of stock, or increase dividend payments.

TABLE 4.1 (continued)

QUESTION 2: WHAT ARE THE COMPANY’S STRENGTHS AND WEAKNESSES IN RELATION TO THE MARKET OPPORTUNITIES AND EXTERNAL THREATS? An examination of the financial and other indicators discussed previously can tell you how well a strategy is working, but they tell you little about the underlying reasons—why it’s working or not. The simplest and most easily applied tool for gaining some insight into the reasons for the success of a strategy or lack thereof is known as

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SWOT analysis. SWOT is an acronym that stands for a company’s internal Strengths and Weaknesses, market Opportunities, and external Threats. Another name for SWOT analysis is Situational Analysis. A first-rate SWOT analysis can help explain why a strategy is working well (or not) by taking a good hard look a company’s strengths in relation to its weaknesses and in relation to the strengths and weaknesses of com- petitors. Are the company’s strengths great enough to make up for its weaknesses? Has the company’s strategy built on these strengths and shielded the company from its weaknesses? Do the company’s strengths exceed those of its rivals or have they been

overpowered? Similarly, a SWOT analysis can help determine whether a strategy has been effective in fending off external threats and positioning the firm to take advantage of market opportunities.

SWOT analysis has long been one of the most popular and widely used diagnostic tools for strategists. It is used fruitfully by organizations that range in type from large corporations to small businesses, to government agencies to non-profits such as churches and schools. Its popularity stems in part from its ease of use, but also because it can be used not only to evaluate the efficacy of a strategy, but also as the basis for crafting a strategy from the outset that capi- talizes on the company’s strengths, overcomes its weaknesses, aims squarely at capturing the company’s best opportunities, and defends against competitive and macro-environmental threats. Moreover, a SWOT analysis can help a company with a strategy that is working well in the present determine whether the company is in a position to pursue new market opportunities and defend against emerging threats to its future well-being.

Identifying a Company’s Internal Strengths An internal strength is something a company is good at doing or an attribute that enhances its competitiveness in the marketplace.

One way to appraise a company’s strengths is to ask: What activities does the company perform well? This question directs attention to the company’s skill level in performing key pieces of its business—such as supply chain management, R&D, pro- duction, distribution, sales and marketing, and customer service. A company’s skill or proficiency in performing different facets of its operations can range from the extreme of having minimal ability to perform an activity (perhaps having just struggled to do it the first time) to the other extreme of being able to perform the activity better than any other company in the industry.

When a company’s proficiency rises from that of mere ability to perform an activ- ity to the point of being able to perform it consistently well and at acceptable cost, it is said to have a competence—a true capability, in other words. If a company’s com- petence level in some activity domain is superior to that of its rivals it is known as a distinctive competence. A core competence is a proficiently performed internal activ- ity that is central to a company’s strategy and is typically distinctive as well. A core competence is a more competitively valuable strength than a competence because of the activity’s key role in the company’s strategy and the contribution it makes to the company’s market success and profitability. Often, core competencies can be leveraged to create new markets or new product demand, as the engine behind a company’s growth. Procter and Gamble has a core competence in brand man- agement, which has led to an ever increasing portfolio of market-leading consumer products, including Charmin, Tide, Crest, Tampax, Olay, Febreze, Luvs, Pampers,

• LO 4-2 Assess the company’s strengths and weaknesses in light of market opportunities and external threats.

CORE CONCEPT SWOT analysis, or Situational Analysis is a popular, easy to use tool for sizing up a company’s strengths and weaknesses, its market opportunities, and external threats.

Basing a company’s strategy on its most competitively valuable strengths gives the company its best chance for market success.

A distinctive competence is a capability that enables a company to perform a par- ticular set of activities better than its rivals.

CORE CONCEPT A competence is an activity that a company has learned to perform with proficiency.

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and Swiffer. Nike has a core competence in designing and marketing innovative athletic footwear and sports apparel. Kellogg has a core competence in developing, producing, and marketing breakfast cereals.

Identifying Company Internal Weaknesses An internal weakness is something a company lacks or does poorly (in comparison to others) or a condition that puts it at a disadvantage in the marketplace. It can be thought of as a competitive deficiency. A company’s internal weaknesses can relate to (1) inferior or unproven skills, expertise, or intellectual capital in competi- tively important areas of the business, or (2) deficiencies in competitively important physical, organizational, or intangible assets. Nearly all companies have competi- tive deficiencies of one kind or another. Whether a company’s internal weaknesses make it competitively vulnerable depends on how much they matter in the market- place and whether they are offset by the company’s strengths.

Table 4.2 lists many of the things to consider in compiling a company’s strengths and weaknesses. Sizing up a company’s complement of strengths and deficiencies is akin to constructing a strategic balance sheet, where strengths represent competitive assets and weaknesses represent competitive liabilities. Obviously, the ideal condition is for the company’s competitive assets to outweigh its competitive liabilities by an ample margin!

Identifying a Company’s Market Opportunities Market opportunity is a big factor in shaping a company’s strategy. Indeed, managers can’t properly tailor strategy to the company’s situation without first identifying its market opportunities and appraising the growth and profit potential each one holds. Depending on the prevailing circumstances, a company’s opportunities can be plenti- ful or scarce, fleeting or lasting, and can range from wildly attractive to marginally interesting or unsuitable.

Newly emerging and fast-changing markets sometimes present stunningly big or “golden” opportunities, but it is typically hard for managers at one company to peer into “the fog of the future” and spot them far ahead of managers at other companies.9 But as the fog begins to clear, golden opportunities are nearly always seized rapidly— and the companies that seize them are usually those that have been staying alert with diligent market reconnaissance and preparing themselves to capitalize on shifting mar- ket conditions swiftly. Table 4.2 displays a sampling of potential market opportunities.

Identifying External Threats Often, certain factors in a company’s external environment pose threats to its profit- ability and competitive well-being. Threats can stem from such factors as the emer- gence of cheaper or better technologies, the entry of lower-cost foreign competitors into a company’s market stronghold, new regulations that are more burdensome to a company than to its competitors, unfavorable demographic shifts, and political upheaval in a foreign country where the company has facilities.

External threats may pose no more than a moderate degree of adversity (all companies confront some threatening elements in the course of doing business), or they may be imposing enough to make a company’s situation look tenuous. On rare occasions, market shocks can give birth to a sudden-death threat that throws a

CORE CONCEPT A core competence is an activity that a company per- forms proficiently and that is also central to its strategy and competitive success.

CORE CONCEPT A company’s strengths represent its competitive assets; its weaknesses are shortcomings that constitute competitive liabilities.

Simply making lists of a company’s strengths, weak- nesses, opportunities, and threats is not enough; the payoff from SWOT analysis comes from the conclusions about a company’s situa- tion and the implications for strategy improvement that flow from the four lists.

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Strengths and Competitive Assets Weaknesses and Competitive Deficiencies

• Ample financial resources to grow the business • Strong brand-name image or reputation • Distinctive core competencies • Cost advantages over rivals • Attractive customer base • Proprietary technology, superior technological skills,

important patents

• Strong bargaining power over suppliers or buyers • Superior product quality • Wide geographic coverage and/or strong global

distribution capability

• Alliances and/or joint ventures that provide access to valuable technology, competencies, and/or attractive geographic markets

• No distinctive core competencies • Lack of attention to customer needs • Inferior product quality • Weak balance sheet, too much debt • Higher costs than competitors • Too narrow a product line relative to rivals • Weak brand image or reputation • Lack of adequate distribution capability • Lack of management depth • A plague of internal operating problems or obsolete

facilities

• Too much underutilized plant capacity

Market Opportunities External Threats

• Meet sharply rising buyer demand for the industry’s product

• Serve additional customer groups or market segments

• Expand into new geographic markets • Expand the company’s product line to meet a broader

range of customer needs

• Enter new product lines or new businesses • Take advantage of falling trade barriers in attractive

foreign markets

• Take advantage of an adverse change in the fortunes of rival firms

• Acquire rival firms or companies with attractive technological expertise or competencies

• Take advantage of emerging technological developments to innovate

• Enter into alliances or other cooperative ventures

• Increased intensity of competition • Slowdowns in market growth • Likely entry of potent new competitors • Growing bargaining power of customers or suppliers • A shift in buyer needs and tastes away from the industry’s

product

• Adverse demographic changes that threaten to curtail demand for the industry’s product

• Adverse economic conditions that threaten critical suppliers or distributors

• Changes in technology—particularly disruptive technology that can undermine the company’s distinctive competencies

• Restrictive foreign trade policies • Costly new regulatory requirements • Tight credit conditions • Rising prices on energy or other key inputs

TABLE 4.2 What to Look for in Identifying a Company’s Strengths, Weaknesses, Opportunities, and Threats

company into an immediate crisis and a battle to survive. Many of the world’s major financial institutions were plunged into unprecedented crisis in 2008–2009 by the after- effects of high-risk mortgage lending, inflated credit ratings on subprime mortgage securities, the collapse of housing prices, and a market flooded with mortgage-related investments (collateralized debt obligations) whose values suddenly evaporated. It is management’s job to identify the threats to the company’s future prospects and to evaluate what strategic actions can be taken to neutralize or lessen their impact.

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What Do the SWOT Listings Reveal? SWOT analysis involves more than making four lists. In crafting a new strategy, it offers a strong foundation for understanding how to position the company to build on its strengths in seizing new business opportunities and how to mitigate external threats by shoring up its competitive deficiencies. In assessing the effectiveness of an exist- ing strategy, it can be used to glean insights regarding the company’s overall business situation (thus the name Situational Analysis); and it can help translate these insights into recommended strategic actions. Figure 4.2 shows the steps involved in gleaning insights from SWOT analysis.

The beauty of SWOT analysis is its simplicity; but this is also its primary limi- tation. For a deeper and more accurate understanding of a company’s situation, more sophisticated tools are required. Chapter 3 introduced you to a set of tools for analyzing a company’s external situation. In the rest of this chapter, we look more deeply at a company’s internal situation, beginning with the company’s resources and capabilities.

FIGURE 4.2 The Steps Involved in SWOT Analysis: Identify the Four Components of SWOT, Draw Conclusions, Translate Implications into Strategic Actions

Identify company strengths and competitive assets

Identify company weaknesses and competitive deficiencies

Identify market opportunities

Identify external threats

Conclusions concerning the company’s overall business situation: What are the underlying reasons for the success (or lack

of success) of the company's strategy?

What are the attractive and unattractive aspects of the company’s situation?

Implications for improving company strategy: Use company strengths as the foundation for the

company’s strategy. Shore up weaknesses that are interfering with the success

of the strategy. Use company strengths to lessen the impact of important

external threats. Pursue those market opportunities best suited

to company strengths. Correct weaknesses that impair pursuit of important

market opportunities. Repair weaknesses that heighten vulnerability of external

threats.

What Can Be Gleaned from the SWOT Listings?

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QUESTION 3: WHAT ARE THE COMPANY’S MOST IMPORTANT RESOURCES AND CAPABILITIES, AND WILL THEY GIVE THE COMPANY A LASTING COMPETITIVE ADVANTAGE?

CORE CONCEPT A company’s resources and capabilities represent its competitive assets and are determinants of its competi- tiveness and ability to suc- ceed in the marketplace.

• LO 4-3 Explain why a com- pany’s resources and capabilities are critical for gaining a competi- tive edge over rivals.

CORE CONCEPT A resource is a competi- tive asset that is owned or controlled by a company; a capability (or competence) is the capacity of a firm to perform some internal activ- ity competently. Capabilities are developed and enabled through the deployment of a company’s resources.

An essential element of a company’s internal environment is the nature of resources and capabilities. A company’s resources and capabilities are its competitive assets and determine whether its competitive power in the marketplace will be impres- sively strong or disappointingly weak. Companies with second-rate competitive assets nearly always are relegated to a trailing position in the industry.

Resource and capability analysis provides managers with a powerful tool for siz- ing up the company’s competitive assets and determining whether they can provide the foundation necessary for competitive success in the marketplace. This is a two- step process. The first step is to identify the company’s resources and capabilities. The second step is to examine them more closely to ascertain which are the most competitively important and whether they can support a sustainable competitive advantage over rival firms.1 This second step involves applying the four tests of a resource’s competitive power.

Identifying the Company’s Resources and Capabilities A firm’s resources and capabilities are the fundamental building blocks of its com-

petitive strategy. In crafting strategy, it is essential for managers to know how to take stock of the company’s full complement of resources and capabilities. But before they can do so, managers and strategists need a more precise definition of these terms.

In brief, a resource is a productive input or competitive asset that is owned or con- trolled by the firm. Firms have many different types of resources at their disposal that vary not only in kind but in quality as well. Some are of a higher quality than others, and some are more competitively valuable, having greater potential to give a firm a competitive advantage over its rivals. For example, a company’s brand is a resource, as is an R&D team—yet some brands such as Coca-Cola and Xerox are well known, with enduring value, while others have little more name recognition than generic products. In similar fashion, some R&D teams are far more innovative and productive than oth- ers due to the outstanding talents of the individual team members, the team’s composi-

tion, its experience, and its chemistry. A capability (or competence) is the capacity of a firm to perform some internal

activity competently. Capabilities or competences also vary in form, quality, and competitive importance, with some being more competitively valuable than others. American Express displays superior capabilities in brand management and market- ing; Starbucks’s employee management, training, and real estate capabilities are the drivers behind its rapid growth; Microsoft’s competences are in developing operating systems for computers and user software like Microsoft Office®. Organizational capa- bilities are developed and enabled through the deployment of a company’s resources.2 For example, Nestlé’s brand management capabilities for its 2,000 + food, beverage, and pet care brands draw on the knowledge of the company’s brand managers, the expertise of its marketing department, and the company’s relationships with retailers in nearly

Resource and capability analysis is a powerful tool for sizing up a company’s competitive assets and determining whether the assets can support a sustainable competitive advantage over market rivals.

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200 countries. W. L. Gore’s product innovation capabilities in its fabrics and medical and industrial product businesses result from the personal initiative, creative talents, and technological expertise of its associates and the company’s culture that encourages accountability and creative thinking.

Types of Company Resources A useful way to identify a company’s resources is to look for them within categories, as shown in Table 4.3. Broadly speaking, resources can be divided into two main categories: tangible and intangible resources. Although human resources make up one of the most important parts of a company’s resource base, we include them in the intangible category to emphasize the role played by the skills, tal- ents, and knowledge of a company’s human resources.

Tangible resources are the most easily identified, since tangible resources are those that can be touched or quantified readily. Obviously, they include various types of physical resources such as manufacturing facilities and mineral resources, but they also include a company’s financial resources, technological resources, and organizational resources such as the company’s communication and control systems. Note that tech- nological resources are included among tangible resources, by convention, even though some types, such as copyrights and trade secrets, might be more logically categorized as intangible.

Intangible resources are harder to discern, but they are often among the most important of a firm’s competitive assets. They include various sorts of human assets and intellectual capital, as well as a company’s brands, image, and reputational assets.

Tangible resources

• Physical resources: land and real estate; manufacturing plants, equipment, and/or distribution facilities; the locations of stores, plants, or distribution centers, including the overall pattern of their physical locations; ownership of or access rights to natural resources (such as mineral deposits)

• Financial resources: cash and cash equivalents; marketable securities; other financial assets such as a company’s credit rating and borrowing capacity

• Technological assets: patents, copyrights, production technology, innovation technologies, technological processes • Organizational resources: IT and communication systems (satellites, servers, workstations, etc.); other planning,

coordination, and control systems; the company’s organizational design and reporting structure

Intangible resources

• Human assets and intellectual capital: the education, experience, knowledge, and talent of the workforce, cumulative learning, and tacit knowledge of employees; collective learning embedded in the organization, the intellectual capital and know-how of specialized teams and work groups; the knowledge of key personnel concerning important business functions; managerial talent and leadership skill; the creativity and innovativeness of certain personnel

• Brands, company image, and reputational assets: brand names, trademarks, product or company image, buyer loyalty and goodwill; company reputation for quality, service, and reliability; reputation with suppliers and partners for fair dealing

• Relationships: alliances, joint ventures, or partnerships that provide access to technologies, specialized know-how, or geographic markets; networks of dealers or distributors; the trust established with various partners

• Company culture and incentive system: the norms of behavior, business principles, and ingrained beliefs within the company; the attachment of personnel to the company’s ideals; the compensation system and the motivation level of company personnel

TABLE 4.3 Types of Company Resources

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While intangible resources have no material existence on their own, they are often embodied in something material. Thus, the skills and knowledge resources of a firm are embodied in its managers and employees; a company’s brand name is embodied in the company logo or product labels. Other important kinds of intangible resources include a company’s relationships with suppliers, buyers, or partners of various sorts, and the company’s culture and incentive system. A more detailed listing of the various types of tangible and intangible resources is provided in Table 4.3.

Listing a company’s resources category by category can prevent managers from inadvertently overlooking some company resources that might be competitively impor- tant. At times, it can be difficult to decide exactly how to categorize certain types of resources. For example, resources such as a work group’s specialized expertise in developing innovative products can be considered to be technological assets or human assets or intellectual capital and knowledge assets; the work ethic and drive of a com- pany’s workforce could be included under the company’s human assets or its culture and incentive system. In this regard, it is important to remember that it is not exactly how a resource is categorized that matters but, rather, that all of the company’s different types of resources are included in the inventory. The real purpose of using categories in identifying a company’s resources is to ensure that none of a company’s resources go unnoticed when sizing up the company’s competitive assets.

Identifying Capabilities Organizational capabilities are more complex entities than resources; indeed, they are built up through the use of resources and draw on some combination of the firm’s resources as they are exercised. Virtually all organizational capabilities are knowledge-based, residing in people and in a company’s intellectual capital, or in organizational processes and systems, which embody tacit knowledge. For example, Amazon’s speedy delivery capabilities rely on the knowledge of its fulfillment center managers, its relationship with the United Postal Service, and the experience of its merchandisers to correctly predict inventory flow. Bose’s capabilities in auditory sys- tem design arise from the talented engineers that form the R&D team as well as the company’s strong culture, which celebrates innovation and beautiful design.

Because of their complexity, capabilities are harder to categorize than resources and more challenging to search for as a result. There are, however, two approaches that can make the process of uncovering and identifying a firm’s capabilities more systematic. The first method takes the completed listing of a firm’s resources as its starting point. Since capabilities are built from resources and utilize resources as they are exercised, a firm’s resources can provide a strong set of clues about the types of capabilities the firm is likely to have accumulated. This approach simply involves look- ing over the firm’s resources and considering whether (and to what extent) the firm has built up any related capabilities. So, for example, a fleet of trucks, the latest RFID tracking technology, and a set of large automated distribution centers may be indica- tive of sophisticated capabilities in logistics and distribution. R&D teams composed of top scientists with expertise in genomics may suggest organizational capabilities in developing new gene therapies or in biotechnology more generally.

The second method of identifying a firm’s capabilities takes a functional approach. Many capabilities relate to fairly specific functions; these draw on a limited set of resources and typically involve a single department or organizational unit. Capabilities in injection molding or continuous casting or metal stamping are manufacturing- related; capabilities in direct selling, promotional pricing, or database marketing all connect to the sales and marketing functions; capabilities in basic research, strate- gic innovation, or new product development link to a company’s R&D function. This

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approach requires managers to survey the various functions a firm performs to find the different capabilities associated with each function.

A problem with this second method is that many of the most important capabili- ties of firms are inherently cross-functional. Cross-functional capabilities draw on a number of different kinds of resources and are multidimensional in nature—they spring from the effective collaboration among people with different types of exper- tise working in different organizational units. Warby Parker draws from its cross- functional design process to create its popular eyewear. Its design capabilities are not just due to its creative designers, but are the product of their capabilities in market research and engineering as well as their relations with suppliers and manu- facturing companies. Cross-functional capabilities and other complex capabilities involving numerous linked and closely integrated competitive assets are sometimes referred to as resource bundles.

It is important not to miss identifying a company’s resource bundles, since they can be the most competitively important of a firm’s competitive assets. Resource bun- dles can sometimes pass the four tests of a resource’s competitive power (described below) even when the individual components of the resource bundle cannot. Although PetSmart’s supply chain and marketing capabilities are matched well by rival Petco, the company continues to outperform competitors through its customer service capa- bilities (including animal grooming and veterinary and day care services). Nike’s bun- dle of styling expertise, marketing research skills, professional endorsements, brand name, and managerial know-how has allowed it to remain number one in the athletic footwear and apparel industry for more than 20 years.

Assessing the Competitive Power of a Company’s Resources and Capabilities To assess a company’s competitive power, one must go beyond merely identifying its resources and capabilities to probe its caliber.3 Thus, the second step in resource and capability analysis is designed to ascertain which of a company’s resources and capa- bilities are competitively superior and to what extent they can support a company’s quest for a sustainable competitive advantage over market rivals. When a company has competitive assets that are central to its strategy and superior to those of rival firms, they can support a competitive advantage, as defined in Chapter 1. If this advantage proves durable despite the best efforts of competitors to overcome it, then the com- pany is said to have a sustainable competitive advantage. While it may be difficult for a company to achieve a sustainable competitive advantage, it is an important strategic objective because it imparts a potential for attractive and long-lived profitability.

The Four Tests of a Resource’s Competitive Power The competitive power of a resource or capability is measured by how many of four specific tests it can pass.4 These tests are referred to as the VRIN tests for sustainable competitive advantage—VRIN is a shorthand reminder standing for Valuable, Rare, Inimitable, and Nonsubstitutable. The first two tests determine whether a resource or capability can support a competitive advantage. The last two determine whether the competitive advantage can be sustained.

1. Is the resource or capability competitively Valuable? To be competitively valuable, a resource or capability must be directly relevant to the company’s strategy, mak- ing the company a more effective competitor. Unless the resource or capability contributes to the effectiveness of the company’s strategy, it cannot pass this first

CORE CONCEPT A resource bundle is a linked and closely inte- grated set of competitive assets centered around one or more cross-functional capabilities.

CORE CONCEPT The VRIN tests for sustain- able competitive advantage ask whether a resource is valuable, rare, inimitable, and nonsubstitutable.

CORE CONCEPT Recall that a competitive advantage means that you can produce more value (V) for the customer than rivals can, or the same value at lower cost (C). In other words, your V-C is greater than the V-C of competitors. V-C is what we call the Total Economic Value produced by a company.

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test. An indicator of its effectiveness is whether the resource enables the company to strengthen its business model by improving its customer value proposition and/ or profit formula (see Chapter 1). Google failed in converting its technological resources and software innovation capabilities into success for Google Wallet, which incurred losses of more than $300 million before being abandoned in 2016. While these resources and capabilities have made Google the world’s number-one search engine, they proved to be less valuable in the mobile payments industry.

CORE CONCEPT Social complexity and causal ambiguity are two factors that inhibit the ability of rivals to imitate a firm’s most valuable resources and capabilities. Causal ambi- guity makes it very hard to figure out how a complex resource contributes to competitive advantage and therefore exactly what to imitate.

CORE CONCEPT The Total Economic Value produced by a company is equal to V-C. It is the differ- ence between the buyer’s perceived value regarding a product or service and what it costs the company to produce it.

2. Is the resource or capability Rare—is it something rivals lack? Resources and capabilities that are common among firms and widely available cannot be a source of competitive advantage. All makers of branded cereals have valuable marketing capabilities and brands, since the key success factors in the ready-to-eat cereal indus- try demand this. They are not rare. However, the brand strength of Oreo cookies is uncommon and has provided Kraft Foods with greater market share as well as the opportunity to benefit from brand extensions such as Golden Oreos, Oreo Thins, and Mega Stuf Oreos. A resource or capability is considered rare if it is held by only a small number of firms in an industry or specific competitive domain. Thus, while general management capabilities are not rare in an absolute sense, they are relatively rare in some of the less developed regions of the world and in some business domains.

3. Is the resource or capability Inimitable—is it hard to copy? The more difficult and more costly it is for competitors to imitate a company’s resource or capability, the more likely that it can also provide a sustainable competitive advantage. Resources and capa- bilities tend to be difficult to copy when they are unique (a fantastic real estate loca- tion, patent-protected technology, an unusually talented and motivated labor force), when they must be built over time in ways that are difficult to imitate (a well-known brand name, mastery of a complex process technology, years of cumulative experience and learning), and when they entail financial outlays or large-scale operations that few industry members can undertake (a global network of dealers and distributors). Imitation is also difficult for resources and capabilities that reflect a high level of social complexity (company culture, interpersonal relationships among the managers or R&D teams, trust-based relations with customers or suppliers) and causal ambigu- ity, a term that signifies the hard-to-disentangle nature of the complex resources, such as a web of intricate processes enabling new drug discovery. Hard-to-copy resources and capabilities are important competitive assets, contributing to the longevity of a company’s market position and offering the potential for sustained profitability.

4. Is the resource or capability Nonsubstitutable—is it invulnerable to the threat of substitution from different types of resources and capabilities? Even resources that are competitively valuable, rare, and costly to imitate may lose much of their ability to offer competitive advantage if rivals possess equivalent substitute resources. For example, manufacturers relying on automation to gain a cost-based advantage in production activities may find their technology-based advantage nullified by rivals’ use of low-wage offshore manufacturing. Resources can contribute to a sustainable competitive advantage only when resource substitutes aren’t on the horizon.

The vast majority of companies are not well endowed with standout resources or capabilities, capable of passing all four tests with high marks. Most firms have a mixed bag of resources—one or two quite valuable, some good, many satisfactory to medio- cre. Resources and capabilities that are valuable pass the first of the four tests. As key contributors to the effectiveness of the strategy, they are relevant to the firm’s competi- tiveness but are no guarantee of competitive advantage. They may offer no more than competitive parity with competing firms.

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Passing both of the first two tests requires more—it requires resources and capabilities that are not only valuable but also rare. This is a much higher hurdle that can be cleared only by resources and capabilities that are competitively superior. Resources and capabili- ties that are competitively superior are the company’s true strategic assets. They provide the company with a competitive advantage over its competitors, if only in the short run.

To pass the last two tests, a resource must be able to maintain its competitive superi- ority in the face of competition. It must be resistant to imitative attempts and efforts by competitors to find equally valuable substitute resources. Assessing the availability of substitutes is the most difficult of all the tests since substitutes are harder to recognize, but the key is to look for resources or capabilities held by other firms or being devel- oped that can serve the same function as the company’s core resources and capabilities.5

Very few firms have resources and capabilities that can pass all four tests, but those that do enjoy a sustainable competitive advantage with far greater profit potential. Costco is a notable example, with strong employee incentive programs and capabilities in sup- ply chain management that have surpassed those of its warehouse club rivals for over 35 years. Lincoln Electric Company, less well known but no less notable in its achieve- ments, has been the world leader in welding products for over 100 years as a result of its unique piecework incentive system for compensating production workers and the unsur- passed worker productivity and product quality that this system has fostered.

A Company’s Resources and Capabilities Must Be Managed Dynamically Even companies like Costco and Lincoln Electric cannot afford to rest on their laurels. Rivals that are initially unable to replicate a key resource may develop better and better substi- tutes over time. Resources and capabilities can depreciate like other assets if they are managed with benign neglect. Disruptive changes in technology, customer preferences, distribution channels, or other competitive factors can also destroy the value of key strategic assets, turning resources and capabilities “from diamonds to rust.”6

Resources and capabilities must be continually strengthened and nurtured to sus- tain their competitive power and, at times, may need to be broadened and deepened to allow the company to position itself to pursue emerging market opportunities.7 Organizational resources and capabilities that grow stale can impair competitiveness unless they are refreshed, modified, or even phased out and replaced in response to ongoing market changes and shifts in company strategy. Management’s challenge in managing the firm’s resources and capabilities dynamically has two elements: (1) attending to the ongoing modification of existing competitive assets, and (2) cast- ing a watchful eye for opportunities to develop totally new kinds of capabilities.

The Role of Dynamic Capabilities Companies that know the importance of recalibrating and upgrading their most valuable resources and capabilities ensure that these activities are done on a continual basis. By incorporating these activi- ties into their routine managerial functions, they gain the experience necessary to be able to do them consistently well. At that point, their ability to freshen and renew their competitive assets becomes a capability in itself—a dynamic capability. A dynamic capability is the ability to modify, deepen, or augment the company’s existing resources and capabilities.8 This includes the capacity to improve existing resources and capabilities incrementally, in the way that Toyota aggressively upgrades the company’s capabilities in fuel-efficient hybrid engine technology and constantly fine-tunes its famed Toyota production system. Likewise, management at BMW developed new organizational capabilities in hybrid engine design that allowed the company to launch its highly touted i3 and i8 plug-in hybrids. A dynamic capability

CORE CONCEPT A dynamic capability is an ongoing capacity of a com- pany to modify its existing resources and capabilities or create new ones.

A company requires a dynamically evolving portfolio of resources and capabilities to sustain its competitiveness and help drive improvements in its performance.

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also includes the capacity to add new resources and capabilities to the company’s com- petitive asset portfolio. One way to do this is through alliances and acquisitions. An example is General Motor’s partnership with Koren electronics firm LG Corporation, which enabled GM to develop a manufacturing and engineering platform for producing electric vehicles. This enabled GM to beat the likes of Tesla and Nissan to market with the first affordable all-electric car with good driving range—the Chevy Bolt EV.

• LO 4-4 Explain how value chain activities can affect a company’s cost structure and customer value proposition.

QUESTION 4: HOW DO VALUE CHAIN ACTIVITIES IMPACT A COMPANY’S COST STRUCTURE AND CUSTOMER VALUE PROPOSITION?

Company managers are often stunned when a competitor cuts its prices to “unbeliev- ably low” levels or when a new market entrant introduces a great new product at a sur- prisingly low price. While less common, new entrants can also storm the market with a product that ratchets the quality level up so high that customers will abandon com- peting sellers even if they have to pay more for the new product. This is what seems to have happened with Apple’s iPhone 7 and iMac computers.

Regardless of where on the quality spectrum a company competes, it must remain competitive in terms of its customer value proposition in order to stay in the game. Patagonia’s value proposition, for example, remains attractive to customers who value quality, wide selection, and corporate environmental responsibility over cheaper out- erwear alternatives. Since its inception in 1925, the New Yorker’s customer value prop-

osition has withstood the test of time by providing readers with an amalgam of well-crafted, rigorously fact-checked, and topical writing.

Recall from our discussion of the Customer Value Proposition in Chapter 1: The value (V) provided to the customer depends on how well a customer’s needs are met for the price paid (V-P). How well customer needs are met depends on the perceived quality of a product or service as well as on other, more tangible attributes. The greater the amount of customer value that the company can offer profitably compared to its rivals, the less vulnerable it will be to competitive attack. For managers, the key is to keep close track of how cost-effectively the company can deliver value to customers relative to its competitors. If it can deliver the same amount of value with lower expenditures (or more value at the same cost), it will maintain a competitive edge.

Two analytic tools are particularly useful in determining whether a company’s costs and customer value proposition are competitive: value chain analysis and benchmarking.

The Concept of a Company Value Chain Every company’s business consists of a collection of activities undertaken in the course of producing, marketing, delivering, and supporting its product or service. All the various activities that a company performs internally combine to form a value chain—so called because the underlying intent of a company’s activities is ulti- mately to create value for buyers.

As shown in Figure 4.3, a company’s value chain consists of two broad catego- ries of activities: the primary activities foremost in creating value for customers and the requisite support activities that facilitate and enhance the performance of the

The higher a company’s costs are above those of close rivals, the more com- petitively vulnerable the company becomes.

The greater the amount of customer value that a com- pany can offer profitably rel- ative to close rivals, the less competitively vulnerable the company becomes.

CORE CONCEPT A company’s value chain identifies the primary activi- ties and related support activities that create cus- tomer value.

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FIGURE 4.3 A Representative Company Value Chain

Operations Distribution Sales and Marketing

Service Profit

Margin

Supply Chain

Manage- ment

Primary Activities

and Costs

Support Activities

and Costs

Product R&D, Technology, and Systems Development

Human Resource Management

General Administration

PRIMARY ACTIVITIES

Supply Chain Management—Activities, costs, and assets associated with purchasing fuel, energy, raw materials, parts and components, merchandise, and consumable items from vendors; receiving, storing, and disseminating inputs from suppliers; inspection; and inventory management.

Operations—Activities, costs, and assets associated with converting inputs into final product form (production, assembly, packaging, equipment maintenance, facilities, operations, quality assurance, environmental protection).

Distribution—Activities, costs, and assets dealing with physically distributing the product to buyers (finished goods warehousing, order processing, order picking and packing, shipping, delivery vehicle operations, establishing and maintaining a network of dealers and distributors).

Sales and Marketing—Activities, costs, and assets related to sales force e�orts, advertising and promotion, market research and planning, and dealer/distributor support.

Service—Activities, costs, and assets associated with providing assistance to buyers, such as installation, spare parts delivery, maintenance and repair, technical assistance, buyer inquiries, and complaints.

SUPPORT ACTIVITIES

Product R&D, Technology, and Systems Development—Activities, costs, and assets relating to product R&D, process R&D, process design improvement, equipment design, computer software development, telecommuni- cations systems, computer-assisted design and engineering, database capabilities, and development of computerized support systems.

Human Resource Management—Activities, costs, and assets associated with the recruitment, hiring, training, development, and compensation of all types of personnel; labor relations activities; and development of knowledge-based skills and core competencies.

General Administration—Activities, costs, and assets relating to general management, accounting and finance, legal and regulatory a�airs, safety and security, management information systems, forming strategic alliances and collaborating with strategic partners, and other “overhead” functions.

Source: Based on the discussion in Michael E. Porter, Competitive Advantage (New York: Free Press, 1985), pp. 37–43.

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primary activities.10 The kinds of primary and secondary activities that constitute a company’s value chain vary according to the specifics of a company’s business; hence, the listing of the primary and support activities in Figure 4.3 is illustrative rather than definitive. For example, the primary activities at a hotel operator like Starwood Hotels and Resorts mainly consist of site selection and construction, reservations, and hotel operations (check-in and check-out, maintenance and housekeeping, dining and room service, and conventions and meetings); principal support activities that drive costs and impact customer value include hiring and training hotel staff and handling general administration. Supply chain management is a crucial activity for Boeing and Amazon but is not a value chain component at Facebook, WhatsAPP, or Goldman Sachs. Sales and marketing are dominant activities at GAP and Match.com but have only minor roles at oil-drilling companies and natural gas pipeline companies. Customer delivery is a crucial activity at Domino’s Pizza and Blue Apron but insignificant at Starbucks and Dunkin Donuts.

With its focus on value-creating activities, the value chain is an ideal tool for examining the workings of a company’s customer value proposition and business model. It permits a deep look at the company’s cost structure and ability to offer low prices. It reveals the emphasis that a company places on activities that enhance dif- ferentiation and support higher prices, such as service and marketing. It also includes a profit margin component (P-C), since profits are necessary to compensate the com- pany’s owners and investors, who bear risks and provide capital. Tracking the profit margin along with the value-creating activities is critical because unless an enterprise succeeds in delivering customer value profitably (with a sufficient return on invested capital), it can’t survive for long. Attention to a company’s profit formula in addi- tion to its customer value proposition is the essence of a sound business model, as described in Chapter 1.

Illustration Capsule 4.1 shows representative costs for various value chain activities performed by Boll & Branch, a maker of luxury linens and bedding sold directly to consumers online.

Comparing the Value Chains of Rival Companies Value chain analysis facili- tates a comparison of how rivals, activity by activity, deliver value to customers. Even rivals in the same industry may differ significantly in terms of the activities they per- form. For instance, the “operations” component of the value chain for a manufacturer that makes all of its own parts and components and assembles them into a finished product differs from the “operations” of a rival producer that buys the needed parts and components from outside suppliers and performs only assembly operations. How each activity is performed may affect a company’s relative cost position as well as its capacity for differentiation. Thus, even a simple comparison of how the activities of rivals’ value chains differ can reveal competitive differences.

A Company’s Primary and Secondary Activities Identify the Major Components of Its Internal Cost Structure The combined costs of all the various primary and support activities constituting a company’s value chain define its internal cost struc- ture. Further, the cost of each activity contributes to whether the company’s overall cost position relative to rivals is favorable or unfavorable. The roles of value chain analy- sis and benchmarking are to develop the data for comparing a company’s costs activity by activity against the costs of key rivals and to learn which internal activities are a source of cost advantage or disadvantage.

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ILLUSTRATION CAPSULE 4.1 The Value Chain for Boll & Branch

©fizkes/Shutterstock

A king-size set of sheets from Boll & Branch is made from 6 meters of fabric, requiring 11 kilograms of raw cotton.

Raw Cotton $ 28.16

Spinning/Weaving/Dyeing 12.00

Cutting/Sewing/Finishing 9.50

Material Transportation 3.00

Factory Fee 15.80

Cost of Goods $ 68.46

Inspection Fees 5.48

Ocean Freight/Insurance 4.55

Import Duties 8.22

Warehouse/Packing 8.50

Packaging 15.15

Customer Shipping 14.00

Promotions/Donations* 30.00

Total Cost $154.38

Boll & Brand Markup About 60%

Boll & Brand Retail Price $250.00

Gross Margin** $ 95.62

Source: Adapted from Christina Brinkley, “What Goes into the Price of Luxury Sheets?” The Wall Street Journal, March 29, 2014, www.wsj.com/articles/SB10001424052702303725404579461953672838672 (accessed February 16, 2016).

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Evaluating a company’s cost-competitiveness involves using what accountants call activity-based costing to determine the costs of performing each value chain activ- ity.11 The degree to which a company’s total costs should be broken down into costs for specific activities depends on how valuable it is to know the costs of specific activ- ities versus broadly defined activities. At the very least, cost estimates are needed for each broad category of primary and support activities, but cost estimates for more specific activities within each broad category may be needed if a company discov- ers that it has a cost disadvantage vis-à-vis rivals and wants to pin down the exact source or activity causing the cost disadvantage. However, a company’s own internal costs may be insufficient to assess whether its product offering and customer value proposition are competitive with those of rivals. Cost and price differences among

competing companies can have their origins in activities performed by suppliers or by distribution allies involved in getting the product to the final customers or end users of the product, in which case the company’s entire value chain system becomes relevant.

The Value Chain System A company’s value chain is embedded in a larger system of activities that includes the value chains of its suppliers and the value chains of whatever wholesale distributors and retailers it utilizes in getting its product or service to end users. This value chain system (sometimes called a vertical chain) has implications that extend far beyond the company’s costs. It can affect attributes like product quality that enhance differentia- tion and have importance for the company’s customer value proposition, as well as its profitability.12 Suppliers’ value chains are relevant because suppliers perform activi- ties and incur costs in creating and delivering the purchased inputs utilized in a com- pany’s own value-creating activities. The costs, performance features, and quality of these inputs influence a company’s own costs and product differentiation capabilities. Anything a company can do to help its suppliers drive down the costs of their value chain activities or improve the quality and performance of the items being supplied can enhance its own competitiveness—a powerful reason for working collaboratively with suppliers in managing supply chain activities.13 For example, automakers have encouraged their automotive parts suppliers to build plants near the auto assembly plants to facilitate just-in-time deliveries, reduce warehousing and shipping costs, and promote close collaboration on parts design and production scheduling.

Similarly, the value chains of a company’s distribution-channel partners are rel- evant because (1) the costs and margins of a company’s distributors and retail dealers are part of the price the ultimate consumer pays and (2) the activities that distribu- tion allies perform affect sales volumes and customer satisfaction. For these reasons, companies normally work closely with their distribution allies (who are their direct customers) to perform value chain activities in mutually beneficial ways. For instance, motor vehicle manufacturers have a competitive interest in working closely with their automobile dealers to promote higher sales volumes and better customer satisfaction with dealers’ repair and maintenance services. Producers of kitchen cabinets are heav- ily dependent on the sales and promotional activities of their distributors and build- ing supply retailers and on whether distributors and retailers operate cost-effectively enough to be able to sell at prices that lead to attractive sales volumes.

As a consequence, accurately assessing a company’s competitiveness entails scrutinizing the nature and costs of value chain activities throughout the entire value chain system for delivering its products or services to end-use customers. A typical value chain system that incorporates the value chains of suppliers and forward-channel allies (if any) is shown in Figure 4.4. As was the case with company value chains, the specific activities constituting

A company’s cost-competitiveness depends not only on the costs of internally performed activities (its own value chain) but also on costs in the value chains of its suppliers and distribution-channel allies.

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value chain systems vary significantly from industry to industry. The primary value chain system activities in the pulp and paper industry (timber farming, logging, pulp mills, and papermaking) differ from the primary value chain system activities in the home appliance industry (parts and components manufacture, assembly, wholesale distribu- tion, retail sales) and yet again from the computer software industry (programming, disk loading, marketing, distribution).

Benchmarking: A Tool for Assessing the Costs and Effectiveness of Value Chain Activities Benchmarking entails comparing how different companies perform various value chain activities—how materials are purchased, how inventories are managed, how products are assembled, how fast the company can get new products to market, how customer orders are filled and shipped—and then making cross-company com- parisons of the costs and effectiveness of these activities.14 The comparison is often made between companies in the same industry, but benchmarking can also involve comparing how activities are done by companies in other industries. The objectives of benchmarking are simply to identify the best means of performing an activity and to emulate those best practices. It can be used to benchmark the activities of a company’s internal value chain or the activities within an entire value chain system.

A best practice is a method of performing an activity or business process that consistently delivers superior results compared to other approaches.15 To qualify as a legitimate best practice, the method must have been employed by at least one enterprise and shown to be consistently more effective in lowering costs, improving quality or performance, shortening time requirements, enhancing safety, or achiev- ing some other highly positive operating outcome. Best practices thus identify a path to operating excellence with respect to value chain activities.

Xerox pioneered the use of benchmarking to become more cost-competitive, quickly deciding not to restrict its benchmarking efforts to its office equipment rivals but to extend them to any company regarded as “world class” in performing any activity relevant to Xerox’s business. Other companies quickly picked up on Xerox’s approach. Toyota managers got their idea for just-in-time inventory deliveries by study- ing how U.S. supermarkets replenished their shelves. Southwest Airlines reduced the

FIGURE 4.4 A Representative Value Chain System

Supplier-Related Value Chains

Activities, costs, and margins of suppliers

Internally performed activities,

costs, and

margins

Activities, costs, and margins of

forward-channel allies and strategic partners

Buyer or end-user

value chains

Forward-Channel Value Chains

A Company’s Own Value Chain

Source: Based in part on the single-industry value chain displayed in Michael E. Porter, Competitive Advantage (New York: Free Press, 1985), p. 35.

CORE CONCEPT Benchmarking is a potent tool for improving a value chain activities that is based on learning how other companies perform them and borrowing their “best practices.”

CORE CONCEPT A best practice is a method of performing an activity that consistently delivers superior results compared to other approaches.

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turnaround time of its aircraft at each scheduled stop by studying pit crews on the auto racing circuit. More than 80 percent of Fortune 500 companies reportedly use benchmarking for comparing themselves against rivals on cost and other competitively important measures.

The tough part of benchmarking is not whether to do it but, rather, how to gain access to information about other companies’ practices and costs. Sometimes bench- marking can be accomplished by collecting information from published reports, trade groups, and industry research firms or by talking to knowledgeable industry ana- lysts, customers, and suppliers. Sometimes field trips to the facilities of competing or noncompeting companies can be arranged to observe how things are done, com- pare practices and processes, and perhaps exchange data on productivity and other cost components. However, such companies, even if they agree to host facilities tours and answer questions, are unlikely to share competitively sensitive cost information. Furthermore, comparing two companies’ costs may not involve comparing apples to apples if the two companies employ different cost accounting principles to calculate the costs of particular activities.

However, a third and fairly reliable source of benchmarking information has emerged. The explosive interest of companies in benchmarking costs and identify- ing best practices has prompted consulting organizations (e.g., Accenture, A. T. Kearney, Benchnet—The Benchmarking Exchange, and Best Practices, LLC) and several associations (e.g., the QualServe Benchmarking Clearinghouse, and the Strategic Planning Institute’s Council on Benchmarking) to gather benchmarking data, distribute information about best practices, and provide comparative cost

data without identifying the names of particular companies. Having an independent group gather the information and report it in a manner that disguises the names of individual companies protects competitively sensitive data and lessens the potential for unethical behavior on the part of company personnel in gathering their own data about competitors. Industry associations are another source of data that may be used for benchmarking purposes, as exemplified in the cement industry. Benchmarking data is also provided by some government agencies; data of this sort plays an important role in electricity pricing, for example. Illustration Capsule 4.2 describes benchmarking practices in the solar industry.

Strategic Options for Remedying a Cost or Value Disadvantage The results of value chain analysis and benchmarking may disclose cost or value disad- vantages relative to key rivals. Such information is vital in crafting strategic actions to eliminate any such disadvantages and improve profitability. Information of this nature can also help a company find new avenues for enhancing its competitiveness through lower costs or a more attractive customer value proposition. There are three main areas in a company’s total value chain system where company managers can try to improve its efficiency and effectiveness in delivering customer value: (1) a company’s own inter- nal activities, (2) suppliers’ part of the value chain system, and (3) the forward-channel portion of the value chain system.

Improving Internally Performed Value Chain Activities Managers can pursue any of several strategic approaches to reduce the costs of internally performed value chain activities and improve a company’s cost-competitiveness. They can implement best practices throughout the company, particularly for high-cost activities. They can

Benchmarking the costs of company activities against those of rivals provides hard evidence of whether a com- pany is cost-competitive.

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ILLUSTRATION CAPSULE 4.2

The cost of solar power production is dropping rapidly, leading to lower solar power prices for consumers and an expanding market for solar companies. According to the Solar Energy Industries Association, over 11 gigawatts (GW) of solar serving electric utilities were installed in 2016—enough to supply power for approxi- mately 1.8 million households. Simultaneously, the solar landscape is becoming more competitive. As of 2017, 46 firms had installed a cumulative total of over 45 GW of solar serving electric utilities in the United States.

As competition grows, benchmarking plays an increas- ingly critical role in assessing a solar company’s relative costs and price positioning compared to other firms. This is often measured using the all-in installation and production costs per kilowatt hour generated by a solar asset, called the “Levelized Cost of Energy” (LCOE). Kilowatt hours are the units of electricity that are sold to consumers.

In 2008, SunPower—one of the largest solar firms in the United States—used benchmarking to target a 50 percent decrease in its solar LCOE by 2012. This early benchmarking strategy helped the company to defend against new market entrants offering lower prices. But in the ensuing years, between 2009 and 2014, the overall industry solar LCOE fell by 78 percent, leading the com- pany to conclude that an even more aggressive approach was needed to manage downward pricing pressure. Over the course of 2017, SunPower’s quarterly earnings calls highlighted efforts to compete on benchmark prices by simplifying its company structure; divesting from non-core assets; and diversifying beyond the low-cost, large-scale utility solar market and into residential and commercial solar where it could compete more easily on price.