Assignment 2

As discussed in the first two chapters, several factors in the global economy, including the rapid development of the Internet’s capabilities1 and globalization in general have made it increasingly difficult for firms to find ways to develop sustainable competitive advantages.2 Increasingly, innovation appears to be a vital path to efforts to develop such advantages.3 Subway’s introductions of a full breakfast menu and a line of pizza offerings are examples of product innovations this firm introduced recently as part of its efforts to develop a competitive advantage. Of course, Subway’s competitors remain committed to innovation as well. McDonald’s frozen strawberry-lemonade is an example of a recent product innovation from this firm.4

As is the case for Subway and McDonald’s, among many firms, Campbell Soup Co. is emphasizing innovation to increase its competitiveness relative to rivals such as General Mills Inc. and those producing lower-priced store brands. The contents of Campbell’s well-known condensed soups have been changed to enhance their flavor and the soups are now being offered in microwavable containers as well as in cans. Overall, Campbell’s CEO is committed to the firm pursuing innovations in terms of its core categories—simple meals, healthy beverages, and baked snacks—as the source of its success.5 At General Motors, efforts are underway to reduce the “drag” the firm’s bureaucracy creates on innovation. According to a company official, “GM still wastes millions of dollars developing engines and vehicle variants that interest few customers.” To remedy this problem, GM is making changes with the intention of having the “right people and the right engineers on the right priorities and products, not just do the most vehicles possible.” 6

People are an especially critical resource for helping organizations learn how to con- tinuously innovate as a means of achieving successful growth.7 This is the case at 3M, where the director of global compensation says that harnessing the innovative powers of the firm’s employees is the means for rekindling growth.8 At 3M and other companies, people who are able to facilitate their firm’s efforts to innovate are themselves a valuable resource with the potential to be a competitive advantage.9 A sign of the times is the fact that a global labor market now exists as firms seek talented individuals to add to their fold. As Richard Florida argues, “[W]herever talent goes, innovation, creativity, and eco- nomic growth are sure to follow.”10

To identify and successfully use resources over time, those leading firms need to think constantly about how to manage resources for the purpose of increasing the value their goods or services create for customers as compared to the value rivals’ products create. As this chapter shows, firms achieve strategic competitiveness and earn above- average returns by acquiring, bundling, and leveraging their resources for the purpose of taking advantage of opportunities in the external environment in ways that create value for customers.11

Even if the firm develops and manages resources in ways that create core competen- cies and competitive advantages, competitors will eventually learn how to duplicate the benefits of any firm’s value-creating strategy; thus all competitive advantages have a lim- ited life.12 Because of this, the question of duplication of a competitive advantage is not if it will happen, but when. In general, a competitive advantage’s sustainability is a function of three factors: (1) the rate of core competence obsolescence because of environmental changes, (2) the availability of substitutes for the core competence, and (3) the imitability of the core competence. 13 For all firms, the challenge is to effectively manage current core competencies while simultaneously developing new ones.14 Only when firms are able to do this can they expect to achieve strategic competitiveness, earn above-average returns, and remain ahead of competitors (see Chapter 5).

We studied the general, industry, and competitor environments in Chapter 2. Armed with knowledge about the realities and conditions of their external environment, firms have a better understanding of marketplace opportunities and the characteristics of the competitive environment in which those opportunities exist. In this chapter, we focus on the firm itself. By analyzing its internal organization, a firm determines what it can do. Matching what a firm can do (a function of its resources, capabilities, and core competen- cies in the internal organization) with what it might do (a function of opportunities and threats in the external environment) is a process that yields insights the firm requires to select its strategies.

We begin this chapter by briefly describing conditions associated with analyzing the firm’s internal organization. We then discuss the roles of resources and capabili- ties in developing core competencies, which are the sources of the firm’s competitive advantages. Included in this discussion are the techniques firms use to identify and evaluate resources and capabilities and the criteria for identifying core competencies from among them. Resources by themselves typically are not competitive advantages; in fact, resources create value when the firm uses them to form capabilities, some of which become core competencies, and hopefully competitive advantages. Because of the relationship among resources, capabilities, and core competencies, we also discuss the value chain and examine four criteria firms use to determine if their capabilities are core competencies and as such, sources of competitive advantage.15 The chapter closes with cautionary comments about outsourcing and the need for firms to prevent their core competencies from becoming core rigidities. The existence of core rigidities indicates that the firm is too anchored to its past, which prevents it from continuously developing new capabilities and core competencies.

Analyzing the Internal Organization

The Context of Internal Analysis

One of the conditions associated with analyzing a firm’s internal organization is the real- ity that in today’s global economy, some of the resources that were traditionally critical to firms’ efforts to produce, sell, and distribute their goods or services such as labor costs, access to financial resources and raw materials, and protected or regulated markets are still important; but, it is now less likely that these resources will become core compe- tencies and possibly competitive advantages.16 An important reason for this is that an increasing number of firms are using their resources to form core competencies through which they successfully implement an international strategy (discussed in Chapter 8) as a means of overcoming the advantages created by these more traditional resources.

The Volkswagen Group has established “Strategy 2018” as its international strategy. The firm, which sells its products in over 150 countries, employs 400,000 people to operate its 62 production plants located in 15 European countries. By using its resources to form techno- logical and innovation capabilities, Volkswagen intends to create superior customer service and product quality as core competencies on which it will rely to implement its international strategy.17

Increasingly, those analyzing their firm’s inter- nal organization should use a global mind-set to do so. A global mind-set is the ability to analyze, understand, and manage an internal organization in ways that are not dependent on the assump- tions of a single country, culture, or context.18 Because they are able to span artificial boundaries, those with a global mind-set recognize that their firms must possess resources and capabilities that allow understanding of and appropriate responses to competitive situations that are influenced by country-specific factors and unique cultures. Using a global mind-set to analyze the internal organiza-

tion has the potential to significantly help the firm in its efforts to outperform rivals.19 A global mind-set was used to develop Volkswagen Group’s “Strategy 2018.”

Finally, analyzing the firm’s internal organization requires that evaluators examine the firm’s entire portfolio of resources and capabilities. This perspective suggests that individual firms possess at least some resources and capabilities that other companies do not—at least not in the same combination. Resources are the source of capabilities, some of which lead to the development of core competencies; in turn, some core competencies may lead to a competitive advantage for the firm. 20 Understanding how to leverage the firm’s unique bundle of resources and capabilities is a key outcome decision makers seek when analyzing the internal organization.21 Figure 3.1 illustrates the relationships among resources, capabilities, core competencies, and competitive advantages and shows how their integrated use can lead to strategic competitiveness. As we discuss next, firms use the assets in their internal organization to create value for customers.

Creating Value

Firms use their resources as the foundation for producing goods or services that will create value for customers.22 Value is measured by a product’s performance character- istics and by its attributes for which customers are willing to pay. Firms create value by innovatively bundling and leveraging their resources to form capabilities and core com- petencies.23 Firms with a competitive advantage create more value for customers than do competitors.24 Walmart uses its “every day low price” approach to doing business (an approach that is grounded in the firm’s core competencies, such as information technology and distribution channels) to create value for those seeking to buy products at a low price compared to competitors’ prices for those products.25 Mattress manu- facturer E. S. Kluft & Company creates value for customers interested in buying what the firm says is the “best mattress in the world.” Each of the firm’s products is made by hand by skilled craftsmen. Thus, human capital is a core competence and likely the source of a competitive advantage for E. S. Kluft. (The firm’s upper-end mattress sells for $50,000 per unit.)26 The stronger these firms’ core competencies, the greater the amount of value they’re able to create for their customers.27

Ultimately, creating value for customers is the source of above-average returns for a firm. What the firm intends regarding value creation affects its choice of business-level strategy (see Chapter 4) and its organizational structure (see Chapter 11).28 In Chapter 4’s discussion of business-level strategies, we note that value is created by a product’s low cost, by its highly differentiated features, or by a combination of low cost and high differentiation, compared with competitors’ offerings. A business-level strategy is effec- tive only when it is grounded in exploiting the firm’s capabilities and core competencies. Thus, the successful firm continuously examines the effectiveness of current capabilities and core competencies while thinking about the capabilities and competencies it will require for future success.29

At one time, the firm’s efforts to create value were largely oriented to understand- ing the characteristics of the industry in which it competed and, in light of those characteristics, determining how it should be positioned relative to competitors. This emphasis on industry characteristics and competitive strategy underestimated the role of the firm’s resources and capabilities in developing core competencies as the source of competitive advantages. In fact, core competencies, in combination with product-market positions, are the firm’s most important sources of competi- tive advantage.30 A firm’s core competencies, integrated with an understanding of the results of studying the conditions in the external environment, should drive the selection of strategies.31 As Clayton Christensen noted, “Successful strategists need to cultivate a deep understanding of the processes of competition and progress and of the factors that undergird each advantage. Only thus will they be able to see when old advantages are poised to disappear and how new advantages can be built in their stead.”32 By emphasizing core competencies when selecting and implementing strate- gies, companies learn to compete primarily on the basis of firm-specific differences. However, while doing so they must be simultaneously aware of how things are chang- ing in the external environment.33

The Challenge of Analyzing the Internal Organization

The strategic decisions managers make about their firm’s internal organization are non- routine,34 have ethical implications,35 and significantly influence the firm’s ability to earn above-average returns.36 These decisions involve choices about the resources the firm needs to collect and how to best manage them.

Making decisions involving the firm’s assets—identifying, developing, deploying, and protecting resources, capabilities, and core competencies—may appear to be relatively easy. However, this task is as challenging and difficult as any other with which manag- ers are involved; moreover, the task is increasingly internationalized.37 Some believe that the pressure on managers to pursue only decisions that help the firm meet the quarterly earnings expected by market analysts makes it difficult to accurately examine the firm’s internal organization.38

The challenge and difficulty of making effective decisions are implied by prelimi- nary evidence suggesting that one-half of organizational decisions fail.39 Sometimes, mistakes are made as the firm analyzes conditions in its internal organization.40 Managers might, for example, think a capability is a core competence when it is not. This may have been the case at Polaroid Corporation as decision makers continued to believe that the capabilities it used to build its instant film cameras were highly relevant at the time its competitors were developing and using the capabilities required to intro- duce digital cameras. In this instance, Polaroid’s decision makers may have concluded that superior manufacturing was a core competence as was the firm’s ability to innovate in terms of creating value-adding features for its instant cameras. If a mistake is made when analyzing and manage a firm’s resources, such as appears to have been the case some years ago at Polaroid, decision makers must have the confidence to admit it and take corrective actions.41

A firm can improve by studying its mistakes; in fact, the learning generated by mak- ing and correcting mistakes can be important to efforts to create new capabilities and core competencies.42 Today, a substantially slimmed-down Polaroid is introducing a number of new products, including GL20 Camera Glasses. These glasses include a built- in camera and dual LCDs that appear to cover individuals’ eyes when wearing the over- sized glasses.43 These products are based on ideas advanced by Lady Gaga, who is now Polaroid’s creative director. Thus, Polaroid may be developing marketing and product design as capabilities and hopefully core competencies as the source of hoped-for com- petitive success.

Managers face uncertainty because of a number of issues, including those of new proprietary technologies, rapidly changing economic and political trends, transforma- tions in societal values, and shifts in customers’ demands.45 Environmental uncertainty increases the complexity and range of issues to examine when studying the internal environment.46 Consider how uncertainty affects how to use resources at Peabody Energy Corp.

Peabody is the world’s largest private-sector coal company. The firm’s coal prod- ucts fuel approximately 11 percent of all U.S. electricity generation and 2 percent of worldwide electricity. But the firm faces a great deal of uncertainty with respect to how it might best use its resources today to prepare for its future. One reason for this is that at least for some, coal is thought of as a “dirty fuel.” Partly to reduce the uncertainty the firm faces because of this, Peabody is using some of its resources to build a “clean” coal-fired plant and has signed two agreements to develop clean coal in China. As a proponent of strong emissions standards, Peabody’s leaders argue for more use of “clean coal.” One of these agreements calls for Peabody and its partners to develop a green coal energy campus, including a 1200-MW power plant that will capture CO2 and convert it into green building materials.47 Obviously, the complexity of the decisions Peabody is making to reduce uncertainty (such as working with part- ners in China) is quite significant. Biases about how to cope with uncertainty affect decisions made about how to manage the firm’s resources and capabilities to form core competencies.48 For example, Peabody’s CEO strongly believes in coal’s future, suggesting that automobiles capable of burning coal could be built. Finally, intraorga- nizational conflict may surface when decisions are made about the core competencies a firm should develop and nurture. Conflict might surface in Peabody about the degree to which resources and capabilities should be used to form core competencies to sup- port current coal technologies relative to the building of core competencies to support newer “clean technologies.”

In making decisions affected by these three conditions, judgment is required. Judgment is the capability of making successful decisions when no obviously correct model or rule is available or when relevant data are unreliable or incomplete. In such situations, decision makers must be aware of possible cognitive biases, such as over- confidence. Individuals who are too confident in the decisions they make about how to use the firm’s resources may fail to fully evaluate contingencies that could affect those decisions.49

When exercising judgment, decision makers often take intelligent risks. In the cur- rent competitive landscape, executive judgment can become a valuable capability. One reason is that, over time, effective judgment that decision makers demonstrate allows a firm to build a strong reputation and retain the loyalty of stakeholders whose support is linked to above-average returns.50

As we discuss in the Strategic Focus, finding individuals who can make the most successful decisions about using the organization’s resources is challenging. Being able to do this is important because the quality of leaders’ decisions regarding resources and their management affect a firm’s ability to achieve strategic competitiveness. Individuals holding these key decision-making positions are called strategic leaders. Discussed fully in Chapter 12, for our purposes in this chapter we can think of strategic leaders as individuals with an ability to make effective decisions when examining the firm’s resources, capabilities, and core competencies for the purpose of making choices about their use.

Next, we consider the relationships among a firm’s resources, capabilities, and core competencies. While reading these sections of materials, keep in mind that organizations have more resources than capabilities and more capabilities than core competencies.

Resources, Capabilities, and Core Competencies

Resources, capabilities, and core competencies are the foundation of competitive advan- tage. Resources are bundled to create organizational capabilities. In turn, capabilities are the source of a firm’s core competencies, which are the basis of establishing competitive advantages.51 We show these relationships in Figure 3.1. Here, we define and provide examples of these building blocks of competitive advantage.

Resources

Broad in scope, resources cover a spectrum of individual, social, and organizational phe- nomena.52 By themselves, resources do not allow firms to create value for customers as the foundation for earning above-average returns. Indeed, resources are combined to form capabilities.53 Subway links its fresh ingredients with several other resources includ- ing the continuous training it provides to those running the firm’s units as the founda- tion for customer service as a capability; as explained in the Opening Case, customer service is also a core competence for Subway. As its sole distribution channel, the Internet is a resource for Amazon.com. The firm uses the Internet to sell goods at prices that typi- cally are lower than those offered by competitors selling the same goods through what are more costly brick-and-mortar storefronts. By combining other resources (such as access to a wide product inventory), Amazon has developed a reputation for excellent customer service. Amazon’s capability in terms of customer service is a core competence as well in that the firm creates unique value for customers through the services it provides to them. Amazon also uses its technological core competence to offer AWS (Amazon Web Services), services through which businesses can rent computing power from Amazon at a cost of pennies per hour. In the words of the leader of this effort, “AWS makes it pos- sible for anyone with an Internet connection and a credit card to access the same kind of world-class computing systems that Amazon uses to run its $34 billion-a-year retail operation.”54

Some of a firm’s resources (defined in Chapter 1 as inputs to the firm’s production process) are tangible while others are intangible. Tangible resources are assets that can be observed and quantified. Production equipment, manufacturing facilities, distribution centers, and formal reporting structures are examples of tangible resources. Subway’s food ingredients are a tangible resource. Intangible resources are assets that are rooted deeply in the firm’s history and have accumulated over time. Because they are embed- ded in unique patterns of routines, intangible resources are difficult for competitors to analyze and imitate. Knowledge, trust between managers and employees, managerial capabilities, organizational routines (the unique ways people work together), scientific capabilities, the capacity for innovation, brand name, the firm’s reputation for its goods or services and how it interacts with people (such as employees, customers, and suppli- ers), and organizational culture are intangible resources.55 The routines Subway uses to develop and use its training procedures are an example of an intangible resource.

The four primary categories of tangible resources are financial, organizational, physical, and technological (see Table 3.1). The three primary categories of intangible resources are human, innovation, and reputational (see Table 3.2).

Tangible Resources

As tangible resources, a firm’s borrowing capacity and the status of its physical facilities are visible. The value of many tangible resources can be established through financial statements, but these statements do not account for the value of all the firm’s assets, because they disregard some intangible resources.56 The value of tangible resources is also constrained because they are hard to leverage—it is difficult to derive additional busi- ness or value from a tangible resource. For example, an airplane is a tangible resource, but “You can’t use the same airplane on five different routes at the same time. You can’t put the same crew on five different routes at the same time. And the same goes for the financial investment you’ve made in the airplane.”57

Although production assets are tangible, many of the processes necessary to use these assets are intangible. Thus, the learning and potential proprietary processes associated with a tangible resource, such as manufacturing facilities, can have unique intangible attributes, such as quality control processes, unique manufacturing processes, and tech- nologies that develop over time.58

Intangible Resources

Compared to tangible resources, intangible resources are a superior source of capa- bilities and subsequently, core competencies. 59 In fact, in the global economy, “the success of a corporation lies more in its intellectual and systems capabilities than in its physical assets. [Moreover], the capacity to manage human intellect—and to convert it into useful products and services—is fast becoming the critical executive skill of the age.”60

Because intangible resources are less visible and more difficult for competitors to understand, purchase, imitate, or substitute for, firms prefer to rely on them rather than on tangible resources as the foundation for their capabilities. In fact, the more unobservable

(i.e., intangible) a resource is, the more valuable that resource is to create capabilities.61 Another benefit of intangible resources is that, unlike most tangible resources, their use can be lever- aged. For instance, sharing knowledge among employees does not diminish its value for any one person. To the contrary, two people sharing their individualized knowledge sets often can be leveraged to create additional knowledge that, although new to each individual, contributes to performance improvements for the firm.

Reputational resources (see Table 3.2) are important sources of a firm’s capabilities and core competencies. Indeed, some argue that a positive reputation can even be a source of competitive advantage.62 Earned through the firm’s actions as well as its words, a value-creating reputation is a product of years of superior marketplace compe- tence as perceived by stakeholders.63 A reputation indicates the level of awareness a firm has been able to develop among stakeholders and the degree to which they hold the firm in high esteem.64

A well-known and highly valued brand name is a specific reputational resource.65 A continuing commitment to innovation and aggressive advertising facilitates firms’ efforts to take advantage of the reputation associated with their brands.66 Harley- Davidson has a reputation for producing and servicing high-quality motorcycles with unique designs. Because of the desirability of its reputation, the company also produces a wide range of accessory items that it sells on the basis of its reputation for offering unique products with high quality. Sunglasses, jewelry, belts, wallets, shirts, slacks, belts, and hats are just a few of the large variety of accessories customers can purchase from a Harley-Davidson dealer or from its online store.67

Capabilities

The firm combines individual tangible and intangible resources to create capabilities. In turn, capabilities are used to complete the organizational tasks required to produce, distribute, and service the goods or services the firm provides to customers for the pur- pose of creating value for them.68 As a foundation for building core competencies and hopefully competitive advantages, capabilities are often based on developing, carrying, and exchanging information and knowledge through the firm’s human capital.69 Hence, the value of human capital in developing and using capabilities and, ultimately, core competencies cannot be overstated.70 At IBM, for example, human capital is critical to forming and using the firm’s capabilities for long-term customer relationships and deep scientific and research skills, and the breadth of the firm’s technical skills in hardware, software, and services.71

As illustrated in Table 3.3, capabilities are often developed in specific functional areas (such as manufacturing, R&D, and marketing) or in a part of a functional area (e.g., advertising). Table 3.3 shows a grouping of organizational functions and the capabilities that some companies are thought to possess in terms of all or parts of those functions.

Core Competencies

Defined in Chapter 1, core competencies are capabilities that serve as a source of com- petitive advantage for a firm over its rivals. Core competencies distinguish a company competitively and reflect its personality. Core competencies emerge over time through an organizational process of accumulating and learning how to deploy different resources and capabilities.72 As the capacity to take action, core competencies are “crown jewels of a company,” the activities the company performs especially well compared to competi- tors and through which the firm adds unique value to the goods or services it sells to customers.73

Innovation is thought to be a core competence at Apple. As a capability, R&D activi- ties are the source of this core competence. More specifically, the way Apple has combined some of its tangible (e.g., financial resources and research laboratories) and intangible (e.g., scientists and engineers and organizational routines) resources to complete research and development tasks creates a capability in R&D. By emphasizing its R&D capability, Apple is able to innovate in ways that create unique value for customers in the form of the products it sells, suggesting that innovation is a core competence for Apple.

Excellent customer service in its retail stores is another of Apple’s core competen- cies. In this instance, unique and contemporary store designs (a tangible resource) are combined with knowledgeable and skilled employees (an intangible resource) to provide superior service to customers. A number of carefully developed training and development procedures are capabilities on which Apple’s core competence of excellent customer ser- vice is based. The procedures that are capabilities include “. . . intensive control of how employees interact with customers, scripted training for on-site tech support and consid- eration of every store detail down to the pre-loaded photos and music on demo devices.”74

Consumer products giant Procter & Gamble (P&G) sells branded products that it believes are of superior quality and value to customers located in more than 180 coun- tries. Generating approximately $80 billion in annual sales revenue, P&G has numerous tangible and intangible resources that are used to form capabilities, some of which are core competencies. We examine the relationship between some of the firm’s capabilities and competencies in the Strategic Focus. Interestingly, even in light of its size and scale (in terms of the number of products sold and the firm’s encompassing geographic reach), P&G apparently has five core competencies (labeled core strengths by the firm).

Building Core Competencies

Two tools help firms identify their core competencies. The first consists of four specific criteria of sustainable competitive advantage that can be used to determine which capa- bilities are core competencies. Because the capabilities shown in Table 3.3 have satisfied these four criteria, they are core competencies. The second tool is the value chain analy- sis. Firms use this tool to select the value-creating competencies that should be main- tained, upgraded, or developed and those that should be outsourced.

The Four Criteria of Sustainable Competitive Advantage

Capabilities that are valuable, rare, costly to imitate, and nonsubstitutable are core competen- cies (see Table 3.4). In turn, core competencies can lead to competitive advantages for the firm over its rivals. Capabilities failing to satisfy the four criteria are not core competencies, meaning that although every core competence is a capability, not every capability is a core competence. In slightly different words, for a capability to be a core competence, it must be valuable and unique from a customer’s point of view. For a core competence to be a potential source of competitive advantage, it must be inimitable and nonsubstitutable by competitors.75

A sustainable competitive advantage exists only when competitors cannot duplicate the benefits of a firm’s strategy or when they lack the resources to attempt imitation. For some period of time, the firm may have a core competence by using capabilities that are valuable and rare, but imitable. For example, some firms are trying to develop a core competence and potentially a competitive advantage by out-greening their competitors.

(Interestingly, developing a “green” core competence can contribute to the firm’s efforts to earn above-average returns while benefitting the broader society.) Since 2005, Walmart has used its resources in ways that have allowed it to reduce its stores’ carbon footprint by more than 10 percent and the carbon footprint of its trucking fleet by several times this percentage. Additionally, progress is being made toward the firm’s goal of zero waste going to landfills from its operations. A reduction of its waste by 81 percent in California suggests that this goal may be attainable.76 Competitor Target is also using its resources and capabilities for the purpose of forming a “green” core competence. “Environmental sustainability is integrated throughout our businesses—from the way we build our stores to the products on our shelves,” the store says. Packaging its Archer Farms Balanced Potato Crisps in bags that are manufactured with 25 percent renewable plant-based plas- tic is one example of actions Target is taking to be environmentally sustainable.

The length of time a firm can expect to create value by using its core competencies is a function of how quickly competitors can successfully imitate a good, service, or process. Value-creating core competencies may last for a relatively long period of time only when all four of the criteria we discuss next are satisfied. Thus, either Walmart or Target would know that it has a core competence and possibly a competitive advantage in terms of green prac- tices if the way the firm uses its resources to complete these practices satisfies the four criteria.

Valuable

Valuable capabilities allow the firm to exploit opportunities or neutralize threats in its external environment. By effectively using capabilities to exploit opportunities or neutral- ize threats, a firm creates value for customers. For publishers, e-books are both an oppor- tunity (to sell books through a different distribution channels) and a threat (a reduction in publishers’ ability to sell books through traditional channels such as physical store- fronts). To neutralize the possibility/threat of lower sales revenue from traditional chan- nels, publishers such as Penguin Group are trying to determine how to take advantage of the opportunities digital technologies create to transform their businesses. In partnership with other companies, Penguin sees using the Internet to sell directly to customers as an opportunity to create value for customers. “Penguin is one of three major publishers back- ing a new Web venture . . . that will highlight new titles and authors, and sell books directly to consumers. The site, Bookish.com is expected to launch” in the summer of 2011.77

Rare

Rare capabilities are capabilities that few, if any, competitors possess. A key question to be answered when evaluating this criterion is, “How many rival firms possess these valuable capabilities?” Capabilities possessed by many rivals are unlikely to become core competencies for any of the involved firms. Instead, valuable but common (i.e., not rare) capabilities are sources of competitive parity.78 Competitive advantage results only when firms develop and exploit valuable capabilities that become core competencies and that differ from those shared with competitors. It is possible that Walmart and Target might reach competitive parity with their sustainability/green initiatives given that the capabili- ties used to complete green-oriented tasks are valuable but may not be rare.

Costly to Imitate

Costly-to-imitate capabilities are capabilities that other firms cannot easily develop. Capabilities that are costly to imitate are created because of one reason or a combination of three reasons (see Table 3.4). First, a firm sometimes is able to develop capabilities because of unique historical conditions. As firms evolve, they often acquire or develop capabilities that are unique to them.79

A firm with a unique and valuable organizational culture that emerged in the early stages of the company’s history “may have an imperfectly imitable advantage over firms founded in another historical period;” 80 one in which less valuable or less competitively useful val- ues and beliefs strongly influenced the development of the firm’s culture. Briefly discussed in Chapter 1, organizational culture is a set of values that are shared by members in the organization. We explain this in greater detail in Chapter 12. An organizational culture is a source of advantage when employees are held together tightly by their belief in it.81 With its emphasis on cleanliness, consistency, and service and the training that reinforces the value of these characteristics, McDonald’s culture is thought by some to be a core competence and a competitive advantage. The same appears to be the case for Mustang Engineering (an engineering and project management firm based in Houston, Texas). Established as a place where people are expected to take care of people, Mustang offers “a company culture that we believe is unique in the industry. Mustang is a work place with a family feel. A client once described Mustang as a world-class company with a mom-and-pop culture.”82

A second condition of being costly to imitate occurs when the link between the firm’s core competencies and its competitive advantage is causally ambiguous.83 In these instances, competitors can’t clearly understand how a firm uses its capabilities that are core compe- tencies as the foundation for competitive advantage. As a result, firms are uncertain about the capabilities they should develop to duplicate the benefits of a competitor’s value-creating strategy. For years, firms tried to imitate Southwest Airlines’ low-cost strategy but most have been unable to do so, primarily because they can’t duplicate this firm’s unique culture.

Costly to Imitate

Costly-to-imitate capabilities are capabilities that other firms cannot easily develop. Capabilities that are costly to imitate are created because of one reason or a combination of three reasons (see Table 3.4). First, a firm sometimes is able to develop capabilities because of unique historical conditions. As firms evolve, they often acquire or develop capabilities that are unique to them.79

A firm with a unique and valuable organizational culture that emerged in the early stages of the company’s history “may have an imperfectly imitable advantage over firms founded in another historical period;” 80 one in which less valuable or less competitively useful val- ues and beliefs strongly influenced the development of the firm’s culture. Briefly discussed in Chapter 1, organizational culture is a set of values that are shared by members in the organization. We explain this in greater detail in Chapter 12. An organizational culture is a source of advantage when employees are held together tightly by their belief in it.81 With its emphasis on cleanliness, consistency, and service and the training that reinforces the value of these characteristics, McDonald’s culture is thought by some to be a core competence and a competitive advantage. The same appears to be the case for Mustang Engineering (an engineering and project management firm based in Houston, Texas). Established as a place where people are expected to take care of people, Mustang offers “a company culture that we believe is unique in the industry. Mustang is a work place with a family feel. A client once described Mustang as a world-class company with a mom-and-pop culture.”82

A second condition of being costly to imitate occurs when the link between the firm’s core competencies and its competitive advantage is causally ambiguous.83 In these instances, competitors can’t clearly understand how a firm uses its capabilities that are core compe- tencies as the foundation for competitive advantage. As a result, firms are uncertain about the capabilities they should develop to duplicate the benefits of a competitor’s value-creating strategy. For years, firms tried to imitate Southwest Airlines’ low-cost strategy but most have been unable to do so, primarily because they can’t duplicate this firm’s unique culture.

Social complexity is the third reason that capabilities can be costly to imitate. Social complexity means that at least some, and frequently many, of the firm’s capabilities are the product of complex social phenomena. Interpersonal relationships, trust, friendships among managers and between managers and employees, and a firm’s reputation with suppliers and customers are examples of socially complex capabilities. Southwest Airlines is careful to hire people who fit with its culture. This complex interrelationship between the culture and human capital adds value in ways that other airlines cannot, such as jokes on flights by the flight attendants or the cooperation between gate personnel and pilots.

Nonsubstitutable

Nonsubstitutable capabilities are capabilities that do not have strategic equivalents. This final criterion “is that there must be no strategically equivalent valuable resources that are themselves either not rare or imitable. Two valuable firm resources (or two bundles of firm resources) are strategically equivalent when they each can be separately exploited to implement the same strategies.” 84 In general, the strategic value of capabili- ties increases as they become more difficult to substitute. The more intangible and hence invisible capabilities are, the more difficult it is for firms to find substitutes and the greater the challenge is to competitors trying to imitate a firm’s value-creating strategy. Firm-specific knowledge and trust-based working relationships between managers and nonmanagerial personnel, such as existed for years at Southwest Airlines, are examples of capabilities that are difficult to identify and for which finding a substitute is challenging. However, causal ambiguity may make it difficult for the firm to learn as well and may stifle progress, because the firm may not know how to improve processes that are not easily codified and thus are ambiguous.85

In summary, only using valuable, rare, costly-to-imitate, and nonsubstitutable capa- bilities has the potential for the firm to create sustainable competitive advantages. Table 3.5 shows the competitive consequences and performance implications resulting from combinations of the four criteria of sustainability. The analysis suggested by the table helps managers determine the strategic value of a firm’s capabilities. The firm should not empha- size capabilities that fit the criteria described in the first row in the table (i.e., resources and capabilities that are neither valuable nor rare and that are imitable and for which strategic substitutes exist). Capabilities yielding competitive parity and either temporary or sustain- able competitive advantage, however, will be supported. Some competitors such as Coca- Cola and PepsiCo and Boeing and Airbus may have capabilities that result in competitive parity. In such cases, the firms will nurture these capabilities while simultaneously trying to develop capabilities that can yield either a temporary or sustainable competitive advantage.

Value Chain Analysis

Value chain analysis allows the firm to understand the parts of its operations that cre- ate value and those that do not.86 Understanding these issues is important because the firm earns above-average returns only when the value it creates is greater than the costs incurred to create that value.87

The value chain is a template that firms use to analyze their cost position and to identify the multiple means that can be used to facilitate implementation of a chosen strategy.88 Today’s competitive landscape demands that firms examine their value chains in a global rather than a domestic-only context.89 In particular, activities associated with supply chains should be studied within a global context.90

We show a model of the value chain in Figure 3.3. As depicted in the model, a firm’s value chain is segmented into value chain activities and support functions. Value chain activities are activities or tasks the firm completes in order to produce products and then sell, distribute, and service those products in ways that create value for customers. Support functions include the activities or tasks the firm completes in order to support the work being done to produce, sell, distribute, and service the products the firm is producing. A firm can develop a capability and/or a core competence in any of the value chain activities and in any of the support functions. When it does so, it has established an ability to create value for customers. In fact, as shown in Figure 3.3, customers are the ones firms seek to serve when using value chain analysis to identify their capabilities and core competencies. When using their unique core competencies to create unique value for customers that competitors cannot duplicate, firms have established one or more competitive advantages. This appears to be the case for P&G as it relies on the five core competencies described earlier in a Strategic Focus to produce unique, high-quality branded products that are sold to customers throughout the world.

The activities associated with each part of the value chain are shown in Figure 3.4 while the activities that are part of the tasks firms complete when dealing with support functions appear in Figure 3.5. All items in both figures should be evaluated relative to competitors’ capabilities and core competencies. To become a core competence and a source of com- petitive advantage, a capability must allow the firm (1) to perform an activity in a manner that provides value superior to that provided by competitors, or (2) to perform a value- creating activity that competitors cannot perform. Only under these conditions does a firm create value for customers and have opportunities to capture that value.

Creating value for customers by completing activities that are part of the value chain often requires building effective alliances with suppliers (and sometimes others to which the firm outsources activities, as discussed in the next section) and developing strong positive relationships with customers. When firms have such strong positive relation- ships with suppliers and customers, they are said to have “social capital.”91 The rela- tionships themselves have value because they produce knowledge transfer and access to resources that a firm may not hold internally.92 To build social capital whereby resources such as knowledge are transferred across organizations requires trust between the parties. The partners must trust each other in order to allow their resources to be used in such a way that both parties will benefit over time and neither party will take advantage of the other.93 Trust and social capital usually evolve over time with repeated interactions but firms can also establish special means to jointly manage alliances that promote greater trust with the outcome of enhanced benefits for both partners.94

Evaluating a firm’s capability to execute its value chain activities and support func- tions is challenging. Earlier in the chapter, we noted that identifying and assessing the value of a firm’s resources and capabilities requires judgment. Judgment is equally nec- essary when using value chain analysis, because no obviously correct model or rule is universally available to help in the process.

What should a firm do about value chain activities and support functions in which its resources and capabilities are not a source of core competence? Outsourcing is one solution to consider.

Outsourcing

Concerned with how components, finished goods, or services will be obtained, outsourcing is the purchase of a value-creating activity or a support function activity from an external supplier.95 Not-for-profit agencies as well as for-profit organizations actively engage in out- sourcing.96 Firms engaging in effective outsourcing increase their flexibility, mitigate risks, and reduce their capital investments.97 In multiple global industries, the trend toward outsourcing continues at a rapid pace.98 Moreover, in some industries virtually all firms seek the value that can be captured through effective outsourcing. As with other strategic management process decisions, careful analysis is required before the firm decides to outsource.99 And if outsourc- ing is to be used, firms must recognize that only activities where they cannot create value or where they are at a substantial disadvantage compared to competitors should be outsourced.100

Outsourcing can be effective because few, if any, organizations possess the resources and capabilities required to achieve competitive superiority in all value chain activities and support functions. For example, research suggests that few companies can afford to develop internally all the technologies that might lead to competitive advan- tage.101 By nurturing a smaller number of capabili- ties, a firm increases the probability of developing core competencies and achieving a competitive advantage because it does not become overex- tended. In addition, by outsourcing activities in which it lacks competence, the firm can fully con-centrate on those areas in which it can create value.

The consequences of outsourcing cause addi- tional concerns.102 For the most part, these con- cerns revolve around the potential loss in firms’ innovative ability and the loss of jobs within com- panies that decide to outsource some of their work activities to others. Thus, innovation and tech- nological uncertainty are two important issues to consider when making outsourcing decisions. However, firms can also learn from outsource suppliers how to increase their own innovation capabilities.103 Companies must be aware of these issues and be prepared to fully consider the concerns about opportunities from outsourcing suggested by different stakeholders (e.g., employees). The opportunities and concerns may be especially significant when firms outsource activities or functions to a foreign supply source (often referred to as offshoring).104 Bangalore and Belfast are the new- est hotspots for technology outsourcing, competing with major operations in other nations such as China.105 Yet, IBM recently made the decision to keep outsourced activities in the United States instead of moving them to a foreign location.10

Competencies, Strengths, Weaknesses, and Strategic Decisions

By analyzing the internal organization, firms are able to identify their strengths and weak- nesses in resources, capabilities, and core competencies. For example, if a firm has weak capabilities or does not have core competencies in areas required to achieve a competitive advantage, it must acquire those resources and build the capabilities and competencies needed. Alternatively, the firm could decide to outsource a function or activity where it is weak in order to improve its ability to use its remaining resources to create value.107

In considering the results of examining the firm’s internal organization, managers should understand that having a significant quantity of resources is not the same as hav- ing the “right” resources. The “right” resources are those with the potential to be formed into core competencies as the foundation for creating value for customers and develop- ing competitive advantages as a result of doing so. Interestingly, decision makers some- times become more focused and productive when seeking to find the right resources when the firm’s total set of resources is constrained.108

Tools such as outsourcing help the firm focus on its core competencies as the source of its competitive advantages. However, evidence shows that the value-creating ability of core competencies should never be taken for granted. Moreover, the ability of a core competence to be a permanent competitive advantage can’t be assumed. The reason for these cautions is that all core competencies have the potential to become core rigidi- ties.109 Typically, events occurring in the firm’s external environment create conditions through which core competencies can become core rigidities, generate inertia, and stifle innovation. “Often the flip side, the dark side, of core capabilities is revealed due to external events when new competitors figure out a better way to serve the firm’s custom- ers, when new technologies emerge, or when political or social events shift the ground underneath.”1

Historically, Borders Group Inc. relied on its large storefronts that were conveniently located for customers to visit and browse through books and magazines in a pleasant atmosphere as sources of its competitive success. Over the past decade or so, though, digital technologies (part of the firm’s external environment) rapidly changed customers’ shopping patterns for reading materials. Discussed earlier in the chapter, Amazon.com’s use of the Internet significantly changed the competitive landscape for Borders and simi- lar competitors such as Barnes & Noble. It is possible that Borders’ core competencies of store locations and a desirable physical environment for customers became core rigidities for this firm, eventually leading to the filing of bankruptcy in early 2011 and subsequent liquidation.111 Managers studying the firm’s internal organization are responsible for making certain that core competencies do not become core rigidities.

After studying its external environment to determine what it might choose to do (as explained in Chapter 2) and its internal organization to understand what it can do (as explained in this chapter), the firm has the information required to select a business-level strategy that it will use to compete against rivals. We describe different business-level strategies in the next chapter.