Conduct a SWOT Analysis

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Chapter 5

Assessing the Company Itself

Robert Harding Picture Library/SuperStock

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Learning Objectives

By the time you have completed this chapter, you should be able to do the following:

Understand what is involved in a thorough �inancial analysis of a company and how to make sense of the data. Perform an analysis of a company's strengths, weaknesses, opportunities, and threats (SWOT analysis). Determine whether a company has a core competence and a competitive advantage. Understand a company's internal and external value chains. Determine the customer-value proposition and how strong it is. Understand the signi�icance of brand reputation, how strong it is, and how to manage it.

Analyzing and assessing the internal environment of the company is a key part of the strategic-planning process. The recent �inancial performance and current �inancial condition is an obvious place to start using quantitative data with which to reach an objective conclusion. There are also more subjective measures including an examination of a company's competitive strengths and weaknesses, its capabilities, and determining which, if any of them, might be core competencies that would give the company a competitive advantage. The value of a company's brand and the effectiveness of its management are also taken into consideration.

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5.1 Analysis of Financial Performance and Condition

Any analysis of an organization usually begins with careful evaluation of its �inancial position. To assess the recent �inancial performance and current �inancial condition of the company, you need three to �ive years of historical �inancial data—income statements and balance sheets (see box on �inancial statements for generic templates)—including the most recent year for which complete data are available.

Financial statements: Generic templates

Income-statement Balance sheet Total revenues (sales) Assets Cost of goods sold (COGS) Cash & cash equivalents Operating income (gross pro�it) Accounts receivable (A/R) Selling expenses Inventory General & administrative (G&A) Other current assets Earnings before interest & taxes & depreciation & amortization (EBITDA)

Total current assets Total �ixed assets

Depreciation & amortization Total assets Earnings before interest & taxes (EBIT) Total liabilities and stockholders' equity Net interest expense Accounts payable Other expense (income) Accrued liabilities Net income before taxes (NIBT) Other current liabilities Income tax expense Total current liabilities Net income after taxes (NIAT) Long-term debt

Total liabilities Common stock Retained earnings Paid-in capital Other equity Total stockholders' equity Total liabilities and stockholders' equity

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To properly assess the �inancial state of a company, you need three to �ive years of historical �inancial data in the form of income statements and balance sheets.

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Each subtotal in bold is equal to the previous bold subtotal minus the items in between. For example, NIAT = NIBT – income tax expense.

Each subtotal is the sum of elements above it Total assets = current assets + �ixed assets Total liabilities = current liabilities + L-T debt Total assets = total liabilities + stockholders' equity

An annual income statement presents a �inancial picture of a company's operations over the previous 12 months. A balance sheet is a "snapshot" at a point in time (usually at the close of a company's �iscal year) that presents a �inancial picture of its assets and the proportion in which those assets are �inanced through debt and equity. In a balance sheet, the total assets equal the total liabilities (debt) and stockholders' equity—the two sides must "balance."

A convenient way of analyzing several years' worth of �inancial data is to create a spreadsheet and enter the data for each year in a different column (Tables 5.1 and 5.2). Doing so enables annual changes in line items and ratios to be computed. More speci�ically, a thorough analysis of multiyear �inancial statements consists of the following elements (Bangs & Pellecchia, 1999):

Computing all liquidity, activity, leverage, and pro�itability ratios for all years. Computing year-to-year changes for all line items (in both the income statement and balance sheet) and all ratios for all years. Computing average annual changes over all years for line items and �inancial ratios. Computing common-size income statements for all years (everything on the income statement expressed as a percent of revenues). Computing a Z- or Z2-score for each year (Calandro, 2007). This computation involves �inancial ratios (see box on Z- and Z2-scores). Forming a conclusion about how the company has been performing �inancially (from the income statements—revenue and NIAT performance) and about its current �inancial condition (from the balance sheets—�inancial structure, cash �low, degree of debt, liquidity), and its overall �inancial health (Z- or Z2-scores).

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Table 5.1: Multiyear income statements for Net�lix

In $ Thousands 2000 2001 2002 2003 2004

Subscriptions 35,894 74,255 150,818 270,410 500,611

Sales - 1,657 1,988 1,833 5,617

Total Revenues or Sales 35,894 75,912 152,806 272,243 506,228

Cost of Goods Sold 24,861 49,907 78,136 148,360 276,458

Operating Income 11,033 26,005 74,670 123,883 229,770

Operating Expenses 62,511 59,138 78,606 109,826 194,129

General & Administrative 6,990 4,658 6,737 9,585 16,287

Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA)

(58,468) (37,791) (10,673) 4,472 19,354

Depreciation and Amortization - - - - -

Earnings Before Interest & Taxes (EBIT) (58,468) (37,791) (10,673) 4,472 19,354

Interest and other income (1,645) (461) (1,697) (2,457) (2,592)

Interest and other expense 1,451 1,852 11,972 417 170

Net Income Before Taxes (NIBT) (58,274) (39,182) (20,948) 6,512 21,776

Provision for income taxes - - - - -

Net Income After Taxes (NIAT) (58,274) (39,182) (20,948) 6,512 21,595

Source: Maddox, B., & Thompson, A. A., Jr. (2007). Net�lix versus Blockbuster versus Video-on-Demand. A case in Thompson, A. A., Jr., Strickland III, A. J., & Gamble, J. E. (Eds.), Crafting and Executing Strategy: Concepts and Cases (15th ed.; pp. C-148 to C-161). New York, NY: McGraw-Hill.

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Table 5.2: Multiyear balance sheets for Net�lix

2000 2001 2002 2003 2004

Assets

Cash & cash equivalents 14,895 16,131 59,814 89,894 174,461

Short-term investments - - 43,796 45,297 -

Other current assets - 3,421 3,465 3,755 12,885

Total Current Assets 14,895 19,552 107,075 138,946 187,346

Net investment in DVD library - 3,633 9,972 22,238 42,158

Other �ixed assets 37,593 18,445 13,483 14,828 22,289

Total Fixed Assets 37,593 22,078 23,455 37,066 64,447

Total Assets 52,488 41,630 130,530 176,012 251,793

Liabilities & Stockholders' Equity

Liabilities

Current liabilities 16,550 26,208 40,426 63,019 94,910

Total Current Liabilities 16,550 26,208 40,426 63,019 94,910

Notes & sub notes payable 1,843 2,799 - - -

Other LT debt 107,362 103,127 748 285 600

Total Liabilities 125,755 132,134 41,174 63,304 95,510

Stockholders' Equity

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Red. conv. preferred stock 101,830 101,830 - - -

Other equity (175,097) (192,334) 89,356 112,708 156,283

Total Stockholders' Equity (73,267) (90,504) 89,356 112,708 156,283

Total Liabilities & Stockholders' Equity 52,488 41,630 130,530 176,012 251,793

Source: Maddox, B., & Thompson, A. A., Jr. (2007). Net�lix versus Blockbuster versus Video-on-Demand. A case in Thompson, A. A., Jr., Strickland III, A. J., & Gamble, J. E. (Eds.), Crafting and Executing Strategy: Concepts and Cases (15th ed.; pp. C-148 to C-161). New York, NY: McGraw-Hill.

Financial Ratios

Liquidity Ratios

Current ratio (CR) = Current assets / current liabilities

(When this ratio > 1.0, working capital (current assets – current liabilities) is positive, which is desirable.)

Quick ratio (QR) = (Current assets – inventory) / current liabilities

Inventory-to-net-working-capital ratio (INV/NWC) = Inventory / (current assets – current liabilities)

Activity Ratios

Inventory turnover (INV Turns) = Revenues / inventory

Total-asset turnover (TAT) = Revenues / total assets

Average collection period (ACP) (days) = Accounts receivable (A/R) / average daily sales or revenues/365

Leverage Ratios

Debt-to-equity ratio (D/E) = Total liabilities / total equity

(When this ratio > 2.0, debt is too high and needs to be reduced; when it is negative, debt is so high as to exceed the assets of the �irm and cause stockholders' equity to go negative, a serious problem.)

Debt-to-assets ratio (D/A) = Total liabilities / total assets

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(When this ratio > 0.67, debt is too high and needs to be reduced; when > 1.0, debt is so high as to exceed the assets of the �irm and cause stockholders' equity to go negative indicating a serious problem. Either D/E or D/A ratio is used, not both.)

Times interest earned (TIE) or coverage ratio = EBIT / interest expense

(When this ratio < 1.0, the company doesn't have enough money to pay the interest on the debt, a serious condition only experienced with very high debt.)

Pro�itability Ratios

Net pro�it margin (NPM) or Net return on sales (NROS) = Net income after taxes (NIAT) / revenues

Return on equity (ROE) = NIAT / total stockholders' equity

Return on assets (ROA) = NIAT / total assets

Two ratios reveal how productive assets are—TAT and ROA; when these are declining, increasing one's assets is problematical. Cash �low is made up of operational, �inancial, and investing cash �lows; when overall cash is increasing from year to year, cash �low is positive, otherwise it is negative.

Z- and Z2-Scores

Z- and Z2-scores are bankruptcy predictors, or indicators, developed by Edward I. Altman, a professor of �inance at New York University. The

Z-Score is based on data from manufacturing companies, while the Z2-score is based on data for nonmanufacturing companies. Each is a very

important indicator of a company's �inancial health or imminent bankruptcy.

Both indicators take the form of a regression equation:

Z-Score = 1.21X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Z2-Score = 6.5X1 + 3.26X2 + 6.72X3 + 1.05X4

Where X1 = Net Working Capital / Total Assets

X2 = Retained Earnings / Total Assets X3 = Earnings Before Interest & Taxes (EBIT) / Total Assets

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X4 = Total Stockholders' Equity / Total Liabilities X5 = Sales / Total Assets

Note that four of the �inancial ratios have total assets in the denominator and the other has total debt in the denominator. Thus, increasing assets through borrowing is not a good idea �inancially (unless performance improves), while one of the �irst things to do when a company is in �inancial trouble is to sell off some assets and use the proceeds to pay down debt. The �inal scores are compared to the following cutoffs to assess their signi�icance:

Criteria Safe Region Gray Region Bankrupt Region

(Financially healthy) (In serious trouble)

Z-Score > 2.99 1.81 – 2.99 < 1.81

Z2-Score > 2.59 1.11 – 2.59 < 1.11

The last step in the analysis is the most important. What sense can be made of the numbers? What picture do they paint of the company's performance over the past several years and current condition? You could draw any one of the following conclusions:

1. The company is very well managed, has been performing extremely well, and is in strong �inancial condition and overall �inancial health (all key indicators are good and none is bad).

2. The company is very well managed, has been performing extremely well, and is in strong �inancial condition and overall �inancial health except for one major bad thing, for example, having very high debt or declining total-asset turnover (a predominance of good indicators with one or possibly two bad ones).

3. The company turned in a mixed performance over this period and is neither performing well nor in serious trouble. The results are, in fact, inconclusive (an equal or roughly equal number of good and bad indicators).

4. The company's performance and �inancial condition is poor and key result indicators were declining steadily (or precipitously) over time; the company is or should be in serious �inancial trouble except for one major good thing, such as increasing revenues (a predominance of bad indicators with one or possibly two good ones).

5. The company's performance is poor, and key result indicators were declining steadily (or precipitously) over time; the company has not been managed well and is in serious �inancial trouble (all indicators of performance and condition are bad and none is good).

After completing the �inancial analysis, only one of the preceding �ive conclusions is possible. Whichever one is selected, it must be supported with selected statistics that summarize the current �inancial performance, condition, and health of the company, or the conclusion isn't valid. Because the principal ways for a company to �inance any strategic initiative are through cash or debt (or in the case of a public company,

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stock), the �inancial analysis provides essential information to top management as to the company's ability to fund a proposed strategy. As an example, an analysis of the �inancial data for Net�lix presented in the multiyear income statement (Table 5.1) and multiyear balance sheets (Table 5.2) produces the conclusion summarized in the following section.

Example of a Financial-Analysis Conclusion

Based on the income statements and balance sheets to 2004, Net�lix has performed very well �inancially, is in strong �inancial condition, and �inancially healthy.

In 2004:

Revenues increased 86% (for the fourth straight year) NIAT increased 231.6% (also for the fourth straight year) Current ratio is 1.97 (good working capital) D/E ratio is 0.61 (low debt, excellent �inancial leverage) Cash �low is positive, and increased 94.1% to $174.46 million.

This conclusion is #1, where all the indicators are good and none are bad. When the conclusion is supported by data—particularly from the most recent year—it becomes hard to refute.

Discussion Questions

1. What can you tell about a company's operations from looking at the past few years of income statements? 2. How much pro�it a company makes after all its expenses are deducted (NIAT) is shown on the income statement. Yet, a company cannot "spend" the pro�its it makes—it can spend only cash, which is a balance-sheet item. How do you explain this?

3. In a balance sheet, total assets must equal or balance total liabilities + total stockholders' equity. In what other ways is this principle of "balancing" useful?

4. In the newspapers, one often reads about companies that are "not managed well �inancially." Given what you have learned in this section (and perhaps in a previous course on �inance), what do you think this means?

5. The Z- and Z2-scores contain similar �inancial ratios as terms in their regression equations. From this, the two scores would go up with increasing working capital, retained earnings, EBIT, equity, and sales, and with decreasing assets and debt. However, all but EBIT and sales are balance-sheet items. Why do you think such bankruptcy indicators focus on balance-sheet items so heavily?

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Evaluating an organization's strengths based on its competitors can provide a more accurate assessment of the organization.

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5.2 Conducting a SWOT Analysis

Once a company has a �irm understanding of where it stands �inancially, the next part of the internal assessment is conducting a SWOT analysis, which stands for a company's strengths, weaknesses, opportunities, and threats. To be sure, opportunities and threats are more appropriately part of an external analysis, but doing a SWOT analysis is so widespread as part of a strategic analysis that they are discussed together here for convenience. As was discussed in Section 3.2, the search for opportunities is an integral part of strategic thinking.

Strengths

Strengths and weaknesses are the "internal" aspects of the traditional SWOT analysis. Whenever something—or someone—is reviewed or assessed, it makes sense to point out the good points or what was done well, as well as the areas that need improvement. They are two sides of the same coin. This assessment is easy to do super�icially, which is often the case, but dif�icult to do candidly and realistically. It is nearly always subjective, but less so if done by a group with multiple perspectives, which is why companies sometimes hire outside consulting �irms to help them analyze their strengths and weaknesses. Regardless of who conducts it, the strength analysis should compare the �irm to itself at some previous point in its history, perhaps 2–4 years ago, and determine what it is doing better and what has not improved.

It might also be useful to think of strengths as special capabilities or expertise. These are things a company does well that have enabled it to be successful to this point, and how it has prepared itself to compete in the future. Comparing a company's strengths against those of its competitors and identifying the industry's critical success factors (Section 4.1) also provides a useful assessment.

Typical strengths that companies have might include the following:

Adequate �inancial resources to implement any likely strategy

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Strong cash �low Strong brand recognition Effective differentiation Effective advertising and promotion Consistent high quality in products/services Effective distribution Economies of scale Insulation from competition Proprietary technology and patents Low-cost leader Product-innovation skills Proven management Visionary CEO, strong leader Productive corporate culture that supports the strategy

The problem is that it can be easy to classify what a company does "well," but what exactly constitutes a "strength"? The answer is subjective; it depends on how high a company's internal standards are and how widely they are shared. For this reason, it should also compare strengths (and weaknesses) with its closest competitors. In assessing whether their company's brand is a strength or a weakness, executives at Wendy's must compare the brand to those of McDonald's and Burger King. Similarly, the athletic apparel offered by Adidas must be compared to the products offered by Nike. Because Wendy's and Adidas are established and successful companies, it is tempting to consider Wendy's and Adidas to possess strengths in terms of brand and apparel. These �irms' standing relative to their closest rivals, however, would suggest that these areas are in fact weaknesses.

Weaknesses

Much like the strengths that a company may possess, weaknesses are also internal. They include problems that need to be corrected, de�iciencies recognized through a comparison with competitors, or de�iciencies relative to proposed strategies such as lacking the resources to grow. Whether or not what is identi�ied is an actual weakness, it is the perception of a weakness that counts.

Some managers have no problem admitting to weaknesses when they are self-evident, while others �ind them hard to own up to in the belief that doing so casts them in a bad light as an ineffective manager. Sometimes, if a company is having problems and the top management team is meeting to discuss them, it is not unheard of for one department to �ind a way of blaming another department for the company's problems. The production manager might blame human resources for inadequate training resulting in low quality. Marketing might complain that engineering and R&D failed to act on its good market intelligence to create new products. Or R&D could complain about a cut in its budget for

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When the top management of struggling companies meets, it is quite common for one department to blame the other for the company's poor performance.

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When Ford Motor Company bought Jaguar, Ford's company executives found multiple weaknesses and wondered how Jaguar had survived.

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something far less important. In all these examples, grappling with weaknesses is not about �inding who is at fault or who is to blame. It is about gaining a realistic understanding of the company's weaknesses so that steps can be taken to alleviate or correct them.

Weaknesses can take many forms, including the following:

Obsolete facilities Key skills and competences missing or obsolete No core competence, hence no competitive advantage Internal operating problems and inef�iciencies Too narrow a product line Long cycle time to get product out Poor marketing skills A culture that hasn't changed

with the strategy Weak or eroding brand image Poor or negative cash �low from operations, including low or negative pro�its, resulting in an inability to service debt or fund needed programs

Weaknesses become real when compared to other companies in the industry. For example, you might think your company has low costs and believe that to be a strength only to discover that your costs are among the highest in the industry. Suddenly, that supposed strength becomes a weakness. A new CEO participating in a SWOT analysis with his or her new management for the �irst time will have a different frame of reference and a different set of standards from the managers, so the CEO might have dif�iculty agreeing with them on what strengths and weaknesses the company has. As noted previously, it is the perception that is important.

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These illustrations show that when making any assessment, even a seemingly casual one like identifying a strength or weakness, you are using an implicit standard or reference in making it. More experienced people will tend to be more critical because they may once have worked in organizations where they have observed things done better, thus raising their own standards. Again, the goal here is not to be "right" at the expense of someone else being "wrong." Rather, it is to reach consensus on what is real and problematic so that it can be attended to and the �irm's future prospects improved.

Opportunities

An analysis of strengths and weaknesses covers what is internal to the �irm, but that is only half the story as it pertains to assessing a company's potential success or failure. In order to stay competitive in an industry, one has to go looking for opportunities that would improve the company's situation.

An opportunity has a speci�ic technical de�inition; it is a product-market issue. It must include a product or service the �irm offers, including the existing ones, and a de�ined customer group at which that product or service is targeted, including the existing ones. The following are examples of real opportunities (and concentration strategies):

Staying with an existing product and existing market and penetrating the market further. Improving the product for an existing market; that is, implementing a product-development strategy. Examples include automobile companies producing new models annually, and software companies releasing upgraded versions of their software. Creating a new product for an existing market, which is also a product-development strategy. Examples include Nike offering athletic apparel in addition to athletic shoes for the same market, Microsoft creating application software for users of its Windows operating system, and Calvin Klein selling perfumes as well as clothes. Expanding the market for an existing product by implementing a market-development strategy, such as promoting the product to appeal to young adults in addition to teenagers or lowering the price so that more people can afford to buy the product. Facebook, for example, has gradually expanded its market from young people to people of all ages. Finding a new market for an existing product, which is another market-development strategy. Examples abound of companies going regional from being just local or a regional company going national or entering a new country, all without changing the product or service. For example, Indian automobile manufacturer Mahindra & Mahindra is planning to start selling pick-up trucks in the United States by 2016 (Hamprecht, 2011).

If a company goes to the trouble of identifying opportunities, it does so only when doing strategic planning, usually once a year. But why not institute and formalize an opportunity-�inding mechanism that would operate all the time, generating ideas and proposals on a continuous basis? This is what is truly meant by "being opportunistic."

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Many companies have instituted new-product-development committees that are responsible for evaluating new-product proposals. For promising proposals, the committee asks for more information or requests a prototype demonstration. Proposals that indicate potential for commercial success are provided with necessary support and development (Cooper, 1993). While such new products could form the basis for a future revenue stream, the probabilities for most companies are distressingly small.

By its very nature, the process can be likened to a funnel, where a large number of items are successively narrowed to a small number: only a few of the many ideas for new projects are researched further, even fewer are found to be feasible, fewer in turn are �inally adopted, and fewer still achieve success. Indeed, many �ields experience a similar, narrowing effect. Consider the example of the game of baseball. Each year more than 2 million youngsters worldwide play on Little League teams, many with dreams of one day making it to the "big leagues." Players who actually reach the minor league level number a few thousand while the active rosters in Major League Baseball include only 750 players.

Contrast such a system to another where the number of ideas vastly increases, and sifting through them becomes a fulltime job for several people. Avenues for involvement include asking customers for suggestions, reaching out beyond engineers to all company employees, and accepting ideas for improvement of all shapes and sizes—not just product innovation. In such an environment, a company can focus on opportunity-recognition, and rejuvenate its revenue model on an ongoing basis.

New technology, or more accurately newer technology brought to market faster, is a rich source of new opportunities. It is a risky business, however, especially when the pace of technological change is very fast. The key thing that separates the good opportunities from the bad ones is how well margins can be maintained over time or how well the resulting product can resist imitation or obsolescence over time. In a hypercompetitive industry, that is dif�icult to accomplish; companies should expect only temporary advantages at best (D'Aveni, 1995).

Change produces both threats and opportunities. Many companies, however, worry only about the threats and do not undertake systematic or frequent enough searches for opportunities. When an opportunity is found, it can take several years to take advantage of it, especially if it requires acquiring and adapting to new technology, understanding a new market, or changing the corporate culture to do it. The earlier it is found the better, thus the search for an opportunity should ideally be ongoing.

Threats

Threats are external to the company. Any "internal" threat is classi�ied as a weakness. Threats are external trends or forces that adversely affect the company. Left unaddressed or even ignored, some threats can wipe out a company. While threats derive from an external- environment scan and analysis, they are discussed here because they are typically included as part of a SWOT analysis. Threats can take many forms:

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Low-cost foreign competition Slower industry growth Costly regulatory requirements Adverse effects of a recession or business cycle Growing bargaining power of customers and suppliers Changing buyer tastes and needs Demographic changes that adversely affect the company Increasing interest rates Raw-material shortages

Implicit in recognizing a threat is the fact that it is a trend moving in a certain direction. Yet at what point—at what value of a trend—does a particular threat become real? For example, companies in the real-estate industry would consider interest rates slowly inching upward as a threat. Or when the price of a critical raw material rises, precisely when does it begin to threaten the company and prompt it to take offsetting action?

One way to deal with this problem is to classify threats on a two-dimensional grid (Figure 5.1). The purpose of doing so is to sort out which threats to pay attention to and do something about, and which to continue monitoring. To plot a threat on the grid you will have to decide on the severity of the likely impact of the threat on the company. Using the preceding interest-rate example, a just-rising interest rate would not have a high negative impact on the company; so it would go into the short-term, low-impact quadrant. However, a fast-rising, high-interest rate would represent a short-term, high-impact threat so would be placed in the upper-right quadrant. It is a judgment call; but again, if done by a group of people, the assessment will be more reliable.

Figure 5.1: Classifying threats grid

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Those threats in the top-left quadrant, that is, having a high negative impact in the short term, should receive priority attention by the company. Those in the top-right and bottom-left quadrants should both receive second priority, with individual threats being handled in appropriate priority order. The least pressing group is that in the bottom-right quadrant, which may need just steady monitoring but no action.

For high-priority threats, a company should begin at once to gather more data about them; assign a committee or task force to track, study, and report on them; and, most importantly, come up with contingency plans for dealing with them. These threats, along with selected threats from the top-right quadrant, should probably be treated as strategic issues.

Discussion Questions

1. Imagine you are part of a top-management team at a strategic-planning meeting. The discussion eventually gets round to listing the organization's strengths and weaknesses. People shout out what they believe are strengths and weaknesses to populate each list. Very seldom is there any discussion that challenges any of the items suggested. What would you suggest to delve a little deeper to ferret out real strengths and weaknesses from those on the list (or even not on the list)?

2. Which carries more weight as a source of strengths: a comparison with the company's own past, its current competitors, or its future strategies? Give reasons for your point of view.

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3. Admitting to shortcomings by people in positions of authority is considered by many to be a sign of weakness or inadequacy. How could such managers be persuaded that it is, in fact, a sign of strength?

4. Is the reluctance to admit mistakes or recognize weaknesses more of an individual failing or an aspect of the prevailing culture? How could this be determined? If the latter, is it easy to change?

5. A company identi�ied "lack of �inancial resources" as a weakness. If this were true only in the event of implementing a certain strategy, then shouldn't the strategy be determined �irst and then the weakness? Or would such a weakness preempt choosing a strategy that required greater �inancial resources? Discuss.

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A company's core competence and competitive advantage have become increasingly important concepts.

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5.3 Core Competence and Competitive Advantage

Core competence and competitive advantage are important concepts in the strategy literature, but the terms are often confused. The following should clarify their meaning:

Capability—the ability to do something (Capability, n.d.); capabilities may or may not be strengths. Core competence—a strategic capability that is simultaneously valuable, rare, costly to imitate, and nonsubstitutable, and one that underpins a company's strategy (Hitt, Ireland, & Hoskisson, 2005). Core competences are the assets and capabilities that can distinguish a company from its rivals. Competitive advantage—a signi�icant edge over competitors. This is often measured in developmental lead time, such as an 18-month lead over the nearest competitor in software. It may otherwise be something an organization can do that competitors can't (e.g., integrate systems ef�iciently) or that an organization has (e.g., patents, a core competence) that competitors lack. Sustainable competitive advantage—the ability to maintain or increase the edge that an organization has over its competitors over time. Given that a competitive advantage erodes over time, sustaining it takes focused effort and considerable resources (Grol, Schoch, & Roger, 1998). It involves "raising the bar" regularly; as soon as a competitor thinks it has caught up, the company in question must have developed something new that maintains the original lead. As Kevin P. Coyne (1986) writes, "The most important condition for sustainability is that existing and potential competitors either cannot or will not take the actions required to close the gap."

Addressing these competencies can allow a company to gain a competitive advantage, and this has been the case for successful companies in various industries. IKEA, a well-known seller of Swedish furniture worldwide, is a prime example of this. When it began operations in the United States in 1985, it used a business model that was unique in the industry. Customers were taken to the top �loor of a large three-story showroom and made to walk a prescribed route through dozens of �inished living room, of�ice, and bedroom, etc. sets, from the third �loor to the second and then to the �irst, where purchases were picked up before paying for them. No matter what the customer came into the store to buy in the �irst place, the idea was to expose the customer to other ideas for every room in the house, thereby selling more. The designs were simple, elegant, and modern, and the prices were low. Also, all furniture was sold unassembled, saving huge costs at the factory and store locations and passing the savings (and delivery and assembly) on to the

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customer. Clearly, the company has grown and is highly successful. Yet no one has been able to duplicate its business model or operations. Its competitive advantages have been sustained.

Case Study Sustainable Competitive Advantage: Southwest Airlines

Southwest Airlines began as a small intrastate operation serving the state of Texas in 1971 with three aircraft (Southwest.com, n.d.). From that limited beginning, Southwest has expanded into the largest airline in the United States (IATA, 2011), �lying to 72 cities in 37 states. While every other major U.S. airline has �iled for bankruptcy protection and consistently reported losses, Southwest has sustained a pro�it for nearly 40 consecutive years. What has made the difference? We have de�ined sustainable competitive advantage as "the ability to maintain or increase the edge that an organization has over its competitors over time." Clearly, Southwest has been able to create and sustain its competitive advantage. Let's take a look at one of the factors that has contributed to this.

Customer Service

By numerous metrics, Southwest Airline's strength appears to exist in its ability to consistently provide superior customer service. According to numerous customer-satisfaction surveys, Southwest ranks �irst among U.S. carriers on customer experience; the airline was ranked #1 by Consumer Reports in 2011 for customer service; and in 2011, MSN Money ranked Southwest in the top ten of all companies for its Customer Service Hall of Fame. In an era marked by high-pro�ile stories of passengers stuck on airport tarmacs in aircraft with no food, beverages, or working bathrooms for many hours and little sympathy from airline personnel (Katrandjian & Schabner, 2011), Southwest has continued to stand out as the airline "with a heart." From small gestures like the continued service of free snacks to the savings afforded passengers by free baggage handling (when all other U.S. carriers are now charging for checked bags), Southwest continues to illustrate that it is a customer- focused operation. Entire websites are dedicated to consumer complaints about major U.S. airlines that range from cancelled and oversold �lights; lost, vandalized, and stolen luggage; to ground holds that approach or exceed federal regulations. Although none of these problems is new to the airline industry (including Southwest), what appears to frustrate passengers the most is the apathetic attitude that airline personnel take toward customer frustration and inconvenience. In other words, the perceived rudeness of airline employees and the feeling

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that passenger problems are "just numbers," often processed by off-shore call centers, contribute to more customer negativity than the original problems themselves. Common customer-service problems that unfold to nightmares for passengers on most airlines are merely inconveniences for Southwest customers who typically leave the negative experiences feeling validated and "whole." When one �light in 2006 was stuck on the tarmac due to deicing delays and a federally mandated crew change, the pilot walked the aisles updating passengers on the delay and accommodations for connecting �lights. Within a few days, passengers received letters of apology and vouchers for the full price of a future trip on the airline (Customer service champs, 2007).

This type of response is standard operating procedure for Southwest—not an anomaly or the charity of one particularly sensitive employee or crewmember—and accounts for a large part of the airline's sustained competitive advantage over other carriers perceived as uncaring about their customers. Customers are even compensated for inconvenience associated with major storm delays—a condition for which no other major airline bears any responsibility. Customer service like this is not an accident; it's a coordinated effort that involves the entire company from top management to the front lines and that is rewarded and valued. Customer service is a way that Southwest Airlines distinguishes itself.

Questions for Critical Thinking and Engagement

1. Although customer service is a well-known and important contributor to Southwest Airline's competitive advantage, it is just one ingredient. Spend some time researching this classic example of a well-managed and well-led organization, and identify other elements that may contribute to its sustained competitive advantage.

2. What perceived barriers prevent other organizations from distinguishing themselves through the kind of service exempli�ied by Southwest?

3. Identify factors contributing to sustained competitive advantage for an organization you are familiar with. What speci�ic strategies does the organization use to continue upping its game and maintaining its edge over its competitors?

4. What role does strategic management play in developing and sustaining competitive advantage? Identify and explain.

McDonald's is another well-known company that has crafted a sustained competitive advantage over time. McDonald's success has been built around providing consistent products in a speedy fashion. Travelers have con�idence that when they enter a McDonald's in Seattle, the Big Mac and French fries that they purchase will taste the same as if they were purchased in Los Angeles or Dallas. Firms such as Burger King have tried to copy McDonald's formula, but no company has been able to duplicate McDonald's success. Importantly, McDonald's executives have been willing to change with the times in order to preserve the �irm's competitive advantage. Although McDonald's business emphasized

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hamburgers and other high-calorie foods for several decades, the company now offers an array of healthy options such as salads and fruit smoothies that appeal to today's customers.

The four criteria that distinguish capabilities from core competencies are related to competitive advantage and �irm performance. Valuable capabilities are those that add or create value for a �irm. Rare capabilities are those possessed by no known current or potential competitor. Costly-to-imitate capabilities are those that other �irms cannot develop easily, quickly, or inexpensively. Nonsubstitutable capabilities are those that do not have strategic equivalents. The owners of certain movie franchises have developed signi�icant competitive advantages by building �ilms around compelling characters that are valuable, rare, costly (and perhaps impossible) to imitate, and nonsubstitutable. The Harry Potter, James Bond, and Star Wars series have all earned more than $4 billion at the box of�ice. Toys, video games, and other complementary products built around these franchises have earned signi�icant revenue too.

The following is a list of typical capabilities:

Design and production skills yielding reliable products Product and design quality Technological capability Integrating different technologies to produce a desired system or product for the customer Swift conversion of technology into new goods and procedures Effective promotion of brand-name products Strong brand (well known, high value) Strong customer service Innovative merchandising Excellent training (Hitt, Ireland, & Hoskisson, 2005)

While these criteria appear straightforward, applying them is dif�icult. Take any of the capabilities in the preceding list, for example, and try to apply these criteria. It may take some research to evaluate them. For �irms without a core competence, or with capabilities that meet two or fewer criteria, the strategic-planning imperative is clear. A company must work to develop a core competence that meets all the criteria and that produces a sustainable competitive advantage. On the downside, a core competence can be outdated by environmental change, replaced by substitution, or eroded through imitation and competitive action. In 2011, American Airlines �iled for bankruptcy protection. Like most airlines, American has struggled to create a competitive advantage. It tried to do so by creating the world's �irst frequent-�lier program to reward repeat customers. Unfortunately, its rivals such as Delta quickly introduced their own frequent-�lier programs. Imitation had prevented American from carving out a competitive advantage in the airline industry.

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Discussion Questions

1. The phrase "competitive advantage" is often tossed around loosely in the business press. CEOs will label seemingly anything they do—whether the training they give their people to how they talk to customers to their prices—a competitive advantage. What might be the motivation for why they do this?

2. The concepts of core competence and sustainable competitive advantages are discussed as part of an internal analysis. Yet without an in-depth knowledge of a �irm's competitors, these concepts cannot be realized. Does this mean that an external analysis should always be done before an internal analysis? Discuss.

3. How many capabilities should be included in a search for a core competence? Explain the number you suggest as your answer.

4. Which of the four criteria for determining a core competence is the most dif�icult to answer? Why? 5. List the ways in which a core competence or competitive advantage can erode. 6. Is it more dif�icult to prevent erosion of an existing core competence or develop a new one?

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5.4 Competitive Strength

How competitive is your company? To �ind out, do an analysis very similar to the one done to assess industry attractiveness, except with different factors (see the illustration shown in Table 5.3). As with the industry-attractiveness matrix, assign a weight to each of these factors according to their perceived importance, then rate each factor from the point of view of the company doing the analysis on a scale of 0–1.0, 1.0 being highest, and �inally multiply the weight by the rating for each factor. Here, the factors should re�lect what it takes to be competitive in an industry. When you have �inished, you will have a resultant competitive-strength (C.S.) index at the bottom. The higher the percentage �igure, the more competitive your company is considered to be in the industry, assuming realistic ratings. (While this technique is also highly subjective, it becomes less so when done by a group of people with knowledge of the company.)

Table 5.3: Competitive-strength matrix

Factor Weight Rating Product

Brand reputation 24 0.9 21.6

Customer service 22 0.9 19.8

Cost control 18 0.9 16.2

Innovative capability 14 0.5 7.0

Financial strength 12 0.8 9.6

Management 10 0.8 8.0

Totals 100 C.S. Index 82.2

In Table 5.3, the competitive-strength (C.S.) index of 82.2 shows that the company being analyzed is a strong competitor, given that the factors meaningfully describe its competitive characteristics.

Both indices are used to place the company on the G.E. Matrix, which plots industry attractiveness against competitive strength (Figure 5.2). Notice that the grid is divided into nine cells. If a company were to end up in any of the three cells in the top-right corner of the grid (pink

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squares), the strategy would be to "grow, invest, and build." If it were to end up in any of the three cells in the bottom-left comer of the grid (blue squares), the strategy would be to "harvest or exit" from the industry. (What else can a weak, uncompetitive company do in an unattractive industry?) The remaining three cells are more dif�icult to assess, and strategies should be developed in these situations on a case-by-case basis. The value of plotting a company on this grid is to get an early "take" on the strategy it should follow. Based on the indexes arrived at for the industry-attractiveness and competitive-strength matrices (Table 5.3), the example company would be plotted in a pink square as shown.

Figure 5.2: G.E. matrix

Is the Current Strategy Working?

First of all, what is the company's current strategy? Once it can be articulated (and there could be more than one—see Section 1.6), three questions should be asked to tell you whether it has been working: (1) Has the company made progress toward achieving, or has it achieved, its vision and strategic intent? (2) Have its stated objectives been attained? (3) Is its �inancial performance and condition good or at least meeting expectations? A public company's stock price depends heavily on this last question.

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In 2011, Net�lix faced a �irestorm of criticism about a new strategy. Net�lix executives announced a plan to split the company's video service into two services. Streaming video would continue to carry the Net�lix name. Customers wishing to rent DVDs, however, would have to subscribe to a new service called Qwikster. After thousands of customers abandoned Net�lix, the company quickly changed course and announced that the services would both remain under the Net�lix banner. But the damage had been done. Net�lix stocked lost 60% of its value between July and October of 2011 (Woo, 2011).

Table 5.4: Questions to challenge the current strategy

Questions about scope Questions about choices Questions about process

What assumptions about market trends, competitor behavior, new entrants, changes in technology and customer needs have you made? If those assumptions were wrong, how would the strategy be affected?

What strategic choices are you making, and what are you rejecting? What is the rationale? Are there circumstances or situations that would cause you to choose differently?

How many customers did you interview? How many noncustomers?

Are there trends that could force you to change the way you do business now?

Are you pursuing growth aggressively enough? Are you compromising growth by failing to provide adequate resources?

How did you involve different markets from around the world?

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If you had to triple your growth, what new business would you enter?

Can you reverse a basic assumption held in the industry? How, and what would be the bene�it?

What approaches did you use to develop creative or breakthrough strategies?

What is the de�inition of the market you are in, and what is the logic behind that de�inition?

How are your plans the same as or different from those of your competitors? How will you ensure that you have a different value proposition? What actions have your competitors taken in the last three years to upset global market dynamics? What are the most dangerous things they could do in the next three years?

Have you committed suf�icient resources to your strategic initiatives? Are they linked to your �inancial and HR plans?

What new uses for your products and technologies have you explored?

What have you done to affect global dynamics over that period, and what are the most effective things you could do in the next three years?

Source: From Sarah Kaplan and Eric D. Beinhocker, The real value of strategic planning. MIT Sloan Management Review, 44(2), 73. Reprinted by permission of MIT Press.

In other cases, whether or not a strategy is working is far less clear. Consider the questions shown in Table 5.4. If you �ind that objectives have not been met, resist jumping to the conclusion that the strategy has not been working. The strategy could be appropriate in the circumstances, but the execution of it may be poor; or the company may have underestimated how quickly the objectives could be achieved. However, if the execution was good, then it is likely that the strategy was not working and should be changed. Also, if the company has been making satisfactory progress toward achieving its vision and strategic intent but not achieving its objectives, it could be that the objectives were set too high or were otherwise unreasonable. And a �inancial review of the past three to �ive years' data could also surface some

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problems. Thus, such a review ought to be done carefully, because what you conclude could set the stage for what strategic alternatives you come up with later in the process.

Discussion Questions

1. The matrix that is used to determine a competitive-strength index, like the one that determines an industry-attractiveness index, is subjective. The �inal result depends on the kind and number of factors used in the analysis, how they are weighted, and how the company itself is rated on each of those factors. Discuss some ways of reducing the amount of subjectivity present.

2. Are there certain factors, independent of industry, that are perennially more important than others? Which ones and why? 3. Why do managers and executives �ind it dif�icult to tell an outsider what strategy a �irm is pursuing? Given that they are able to do so, why are their answers different from each other? How might you address this problem?

4. Should a company's strategies be con�idential? Why or why not? 5. Many strategies don't have core competence as an element; yet having a core competence is central to earning above- industry-average pro�its. How do you reconcile this seeming anomaly?

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5.5 Value-Chain Analysis

A value chain can be described in two ways: (1) within a company, the term encompasses the different value-added phases from buying materials to distributing, selling, and servicing the �inal product (Porter, 1985), and (2) outside of the company, it describes the value-added phases from raw material to end-user as a product is produced and distributed, with each phase representing an industry (Abraham, 2006). For simplicity, these two de�initions will be referred to as "internal" and "external" value chains.

The concept of the internal value chain is critical in the �ield of strategic management and has been well examined. While the concept of the external value chain is less explored, it is equally valuable as it entails elements such as upstream/supply and downstream/distribution processes. While such processes may occur outside the walls of a corporation, they hold many strategic opportunities. Consider the following:

Outsourcing—involves moving speci�ic primary or support functions from the internal value chain to the external value chain. Vertical integration—involves absorbing one or more stages of the external value chain and making them internal. Horizontal expansion—involves developing fresh product lines or broadening channels of distribution, including geographic growth. Strategic alliances with suppliers—involves monitoring external suppliers as if they were part of the internal value chain, while not actually owning them. For example, in Toyota's Kaizen system, key suppliers are based close to a factory and provided with signi�icant guidance and training from Toyota to ensure ef�icient production.

Wayne McPhee and David Wheeler (2006) have extended Porter’s concept of internal value-chain analysis in order to look at value-chain operations outside the realm of the company (Figure 5.3). The �igure shows both Porter's initial concept of an internal value chain and the "external" additions set forth by McPhee and Wheeler, in bold. The introduction of value-chain analysis has proven extremely bene�icial in three key areas: cost analysis and reduction, differentiation, and product development.

Walmart provides a good example of an internal and external value chain (Figures 5.4 and 5.5). Depicting these initial stages is relatively easy. Achieving a full and detailed understanding would be possible by speaking with Walmart executives and monitoring the company’s operations over time.

Figure 5.3: Porter's internal value chain extended

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Source: Wayne McPhee and David Wheeler, "Making the case for the value-added chain," Strategy and Leadership, Vol 24 No. 4 (2008) Exhibit 1.41. Copyright © Emerald Group Publishing Limited. Reprinted by

permission.

Figure 5.4: Walmart's internal value chain

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Tim Boyle/Bloomberg News via Getty Images

Source: David W. Crain and Stan Abraham, "Using value-chain analysis to discover customers' strategic needs," Strategy and Leadership, Vol 36, No. 4 (2008), Exhibit 3, 31. Copyright © Emerald Group Publishing Limited.

Reprinted by permission.

Figure 5.5: Walmart's external value chain

Source: David W. Crain and Stan Abraham, "Using value-chain analysis to discover customers' strategic needs," Strategy and Leadership, Vol 36, No. 4 (2008), Exhibit 3, 31. Copyright © Emerald Group Publishing Limited.

Reprinted by permission.

A more detailed examination of Walmart's internal value chain might illuminate the company's aggressive strategy where technology is concerned (one of the support activities). Walmart was not only the �irst retailer to use bar codes, but it also uses satellite communication between stores. It has integrated its POS, RFID, inventory-control, and additional technologies that serve to decrease delivery time, bolster security (including merchandise shrinkage), and lower costs. It has created regional procurement centers to supplement its well-known center in Bentonville, Arkansas (known as "Vendorville"), including a center near Shenzhen, China. Suppliers base their satellite of�ices near well-placed procurement centers—such as Walmart's

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Walmart's internal value chain includes the latest in technological logistics and regional distribution centers worldwide. Suppliers establish satellite of�ices near these centers to reduce costs.

largest supplier Procter & Gamble, which has 300 fulltime employees in Bentonville. Finally, Walmart's hallmark involves focusing on the complete "customer experience," such as personally welcoming customers as they enter the store, helping to locate items, process returns, and transport purchases to the customer's car (Crain & Abraham, 2008).

Since Walmart is just a retailer and not a manufacturer, its external value chain is quite simple. It works with numerous vendors and sells to customers. But despite this outward simplicity, Walmart's secrets of success lie in analyzing its internal value chain.

Discussion Questions

1. Should value chains be a part of a company's external or internal analysis, or both? Discuss. 2. Porter's Five-Forces Model includes the immediate portion of the company's external value chain (the three horizontal boxes—suppliers, rivals, and buyers). Isn't this enough? Why might doing a more detailed value-chain analysis be more bene�icial?

3. The external value chain has two main aspects: "upstream" of the company (its supply chain) and "downstream" (its distribution system). Of course, if the company is a retailer, there is no downstream part because it sells directly to its customers. Can you think of any situation where the supply chain affects distribution or vice-versa?

4. Can you think of any reason why it might be worth a company's time to analyze any of its suppliers' or customers' value chains?

5. To what extent might pursuing a strategy of low-cost leadership involve a company's internal or external value chain?

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Company brands involve a name, term, design, symbol, or any other feature that identi�ies the product as distinct from other products.

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5.6 Brand Reputation, Equity, and Loyalty

The American Marketing Association de�ines a brand as a "name, term, design, symbol, or any other feature that identi�ies one seller's good or service as distinct from those of other sellers" (Brand, n.d.). A brand is also a reputational asset, the result of pursuing a differentiation strategy for a considerable number of years (see Section 3.2) that creates very loyal customers. Unfortunately, as an intangible resource, it remains largely invisible in a company's balance sheet. A major reason why companies' stock-market valuations are higher than their balance-sheet valuations (book value) is the value of their brand (Grant, 2008).

Companies can choose to develop a separate brand for each of their products as in the case of Proctor & Gamble, with its 52 brands of beauty and grooming products and 46 brands of household-care products or, if the same promise covers all products, for the entire company like Sony, Amazon.com, or Apple. Promoting individual brands under brand managers, a system of managing them developed by P&G, is like running separate businesses, each having a budget, target customers, and speci�ic competitors. Promoting the whole company as a brand bene�its its whole product line and means that whatever product a customer buys from that company will be "protected" by the same brand promise.

Brand equity is a measure of the value of a brand and can be computed by taking the price premium attributable to the brand, multiplying it by the brand's annual sales volume over a number of years, and calculating the net present value of this revenue stream (Grant, 2008). Given this formula, it is easy to see how brand equity or strength can erode over time. Either the price

premium or total sales of the brand declines as a result of competition, or because the discount rate used in the net present value computation increases as a re�lection of a more dif�icult business climate in the future.

Not only is there a tangible �inancial reason to have a strong brand but also the effect on its target customers is real. Brand loyalty is customers' repeated preference for either particular branded products or for any product of a branded company (Jones & George, 2007). If rivals in an industry are all branded and enjoy considerable brand loyalty, then new entrants will �ind it a major barrier to entry, requiring huge advertising costs and considerable time to build customer awareness and, �inally, loyalty. Trader Joe's, discussed in Section 3.2, has a

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brand trusted by consumers who have become loyal customers; anything it sells under its own private label is immediately trusted and tried by its customers.

Customer-Value Proposition

A customer-value proposition is a succinct statement summarizing why customers you are targeting should buy from you and not your competitors. The unique value offered includes a mix of elements that could be quantitative (like price or speed of service) or qualitative (like design or customer experience). The stronger or more persuasive the company's customer-value proposition is, the stronger will be its brand and the more loyal its customers.

The following are some possible ways in which a company could create value for its customers (Osterwalder & Pigneur, 2010):

Newness—for example, new technology such as a product that is the �irst of its kind, like the iPad. Performance—in products such as cars, computers, or smartphones. These kinds of customer-value propositions quickly erode because competitors catch up. Customization—including recent trends like mass-customization or tailoring offerings to match customers' needs and time available (Ott, 2010). Reliability—like Rolls-Royce jet engines where the probability of failure has to be zero. Design—hard to measure, products nevertheless succeed because their design appeals to customers. Examples include the iPod and the Aeron chair. Brand/status—from wearing a Rolex watch or driving a Porsche or BMW to wearing a logo T-shirt from your university. Price—although this aspect of a transaction is what the customer sees, it is low costs that companies have to worry about. Anyone can lower prices, but making a pro�it at the same time is more dif�icult. This element of customer value works only with price-sensitive customers (like no-frills Southwest Airlines and Ryanair airfares). Cost-reduction—customers, particularly business customers, will buy products that can help them lower their costs; for instance, if they can realize signi�icant savings for bulk purchases or via a hosted CRM application like salesforce.com. Risk-reduction—the role played by warranties, service guarantees, and return policies. These often make the difference in a purchase decision, contributing to the success of companies like Nordstrom and Costco. Accessibility—being able to access a product or service hitherto inaccessible, like NetJets, enabling customers who could never otherwise afford it rent private jets. Convenience—making it easy to buy and use, like iTunes, or Enterprise rent-a-car, which will pick you up and drop you off when you rent a car.

In conclusion, some major outcomes of a successful differentiation strategy are to enhance a company's brand image, increase its brand equity, create strong brand loyalty, and help the company achieve above-industry-average pro�its. The challenge in assessing brand

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reputation, equity, and loyalty is to get customers' input as well as top management's, and to have in place a system for tracking brand equity and brand loyalty so that they don't erode. It is also impossible to have a strong brand without a compelling customer-value proposition.

Discussion Questions

1. Some companies believe they will retain their "brand leadership" for many years, a dangerous assumption. Increasingly, consumers are �inding it dif�icult to distinguish among competing products. What type of resources are brands? Could a brand ever be the ultimate competitive weapon for a company?

2. Could a brand ever be a company weakness? 3. Customer loyalty is more than just repeat purchases. Do you agree? Why? 4. Enterprise Rent-A-Car asks customers two questions: What is the customer's rental experience, and how likely is the customer to rent from the company again? Are these questions enough, or could you think of others in order to determine the extent of customers' loyalty?

5. What organizational capabilities are needed to develop customer loyalty? 6. To what extent does customer loyalty materially add to the value of a company's brand? 7. Brand identity is how a company wants its customers to perceive the product or company, while brand image is the customer's mental image of the brand. If they are different, how can the company reconcile them?

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Strategic decisions cannot be made without a conclusive assessment of the company's resources and capabilities.

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5.7 Assessing Management and Leadership

The �inal aspect of a company analysis is an assessment of its management and leadership capability. Section 2.2 discussed the differences between leaders and managers.

One of the most dif�icult imperatives for a company is to develop the next wave of leaders. This is particularly important for companies that are committed to promoting from within. First, they have to have a good talent pool, which means hiring carefully people with leadership potential. Then, there has to be a conscious developmental program of putting these people into challenging situations and cross-functional teams and obtaining feedback about them and their performance from those that see them in action (Fulmer, Stumpf, & Bleak, 2009). Finally, it may be possible to groom certain individuals for speci�ic higher-management positions to ensure smooth succession when the time is right, particularly to C-level and vice-president positions.

Evaluating managers and leaders is never done as part of a strategic-planning process, for obvious reasons. C-level and vice-president executives, middle managers, and supervisors are evaluated individually every year by their immediate superior, direct reports, and any groups they have worked with. The CEO and president are evaluated by the board of directors, usually with input from their direct reports.

The following are some key areas that should be included in any evaluation of a company's leadership:

In what regard do their peers and direct reports hold them? Do they command respect? Are they easy to approach and communicate with? How open are they to new ideas and new ways of doing things? Do they learn from past mistakes or tend to repeat them (Pfeffer, 2008)? What ethical standards and values do they espouse? Are they good role models, leading by example? Do they put a high priority on developing the people they supervise? Are they good motivators? Do the people they develop often get promoted?

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Are they critical and demanding—that is, do they have high standards and espouse ambitious goals? Do they put the organization's goals ahead of their own? Are they empathetic and compassionate?

Discussion Questions

1. Is it possible for a top-management team to do a good job of assessing the state of its own management and leadership? Why or why not?

2. Aside from its value as part of an internal assessment of the company, what other bene�its might accrue from a detailed assessment of the state of management and leadership in the company?

3. Given that the assessment just described is quite detailed, do you believe it should be done annually in every strategic- planning meeting? Biannually? Once every three years? Give reasons for your answers.

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Summary

An internal analysis of a company entails arriving at a shared understanding among the strategic-planning team. An essential �irst step is assessing a company's �inancial performance and condition to see whether the company has any �inancial problems that might impact its ability to fund its strategic initiatives in the near future. This requires an examination of its recent history by way of multiyear income statements and multiyear balance sheets.

Conducting a SWOT analysis takes into account the company's strengths, weaknesses, opportunities, and threats. It's bene�icial to determine strengths and weaknesses compared to the previous year and also with current competitors.

The internal analysis must also include an assessment of the company's breadth of capabilities in an effort to see whether any of them give the company a strategic advantage. Each has to be tested against criteria of being valuable, rare, costly to imitate, and nonsubstitutable (having no strategic equivalent) to be considered a core competence and hence give the company a sustainable competitive advantage. To be a strong competitor in its industry, a core competence is highly desirable. If companies don't have a core competence, they should try to acquire one. If they do have one, they should make great efforts to make sure it doesn't erode.

A value-chain analysis provides knowledge of a �irm's internal primary and support activities. Primary activities depict the process of creating a product or service from raw materials or ideas to �inished product. Value-chain analysis informs decisions whether to outsource any primary activities as well as whether to bring into the company any part of the external value chain (the chain of activities that covers a company's upstream supply chain and its downstream distribution channels).

Brand reputation is the customer's perception of what the company is promising. Dimensions of that are its brand equity, which should be preserved or increased, and how loyal its customers are. This should be assessed for each individual brand or for the brand for the company as a whole. The customer-value proposition is a statement of why customers should buy products or services from the company instead of from its competitors.

The �inal consideration is of the �irm's management and leadership: Is this team experienced and suf�iciently knowledgeable to implement any strategy that might be chosen? Are they properly evaluated every year?

Concept Check

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Key Terms

average collection period (ACP) The average number of days it takes a company to collect money owed to it, calculated by dividing accounts receivable (A/R) by the company's average daily sales (revenues/365).

balance sheet A "snapshot" at a point in time (usually midnight on December 31 or whenever a company's �iscal year ends) that presents a �inancial picture of its assets and the proportion in which those assets are �inanced through debt and equity (prepared according to GAAP).

brand loyalty Customers' repeated preference for either particular branded products or for any product of a branded company.

capability The ability to perform actions; requires both expertise and the capacity to deploy resources.

common-size income statement A computation where every line on the income statement is expressed as a percent of revenues.

coverage ratio See TIE ratio.

current ratio (CR) Current assets divided by current liabilities; a value < 1.0 signi�ies negative working capital.

customer-value proposition A succinct statement summarizing why customers you are targeting should buy from you and not your competitors.

debt-to-assets ratio (D/A) Total liabilities divided by total assets.

debt-to-equity ratio (D/E) Total liabilities divided by total stockholders' equity.

�inancial statements Required of public companies both quarterly and annually, and consist of an income statement, balance sheet, and cash-�low statement, along with notes to the �inancial statements.

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G.E. (General Electric) matrix A two-dimensional diagram of industry attractiveness against competitive strength that forms a guide as to whether to invest and build or harvest and exit an industry.

income statement A �inancial summary of a company's operations over the previous 12 months, prepared according to GAAP.

inventory-to-net-working-capital ratio (INV/NWC) Inventory divided by working capital.

inventory turnover (INV Turns) Total revenues divided by inventory; the larger this ratio is, the better.

outsourcing involves moving speci�ic primary or support functions from the internal value chain to the external value chain.

quick ratio (QR) Current assets minus inventory divided by current liabilities.

return on assets (ROA) NIAT divided by total assets.

strengths Strengths are special capabilities or expertise, things a company does well that has enabled it to be successful to this point, and how it has prepared itself to compete in the future. Comparing a company's strengths against competitors' provides a more realistic assessment of them.

sustainable competitive advantage The key condition for sustainability is a state in which current and potential competitors either cannot or will not take steps to close the (advantage) gap.

times interest earned (TIE) ratio Earnings before interest and taxes (EBIT) divided by interest expense; if this value < 1.0, it means that the company doesn't have enough money even to pay the interest owed on the debt it has.

total asset turnover (TAT) Total revenues divided by total assets.

vertical integration involves absorbing one or more stages of the external value chain and making them internal.

weaknesses Weaknesses are internal. They include problems that need to be corrected, de�iciencies recognized through a comparison with competitors, or de�iciencies relative to proposed strategies (e.g., not enough resources to grow).

Z-Score A bankruptcy indicator for manufacturing companies.

Z2-Score A bankruptcy indicator for nonmanufacturing companies.

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