W-5.5

Strategic Management

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Frank T. Rothaermel Georgia Institute of Technology

FIFTH EDITION

Strategic Management

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STRATEGIC MANAGEMENT, FIFTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2021 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2019, 2017, and 2015. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 LWI 24 23 22 21 20

ISBN 978-1-260-26128-8 (bound edition) MHID 1-260-26128-X (bound edition) ISBN 978-1-264-10379-9 (loose-leaf edition) MHID 1-264-10379-4 (loose-leaf edition) ISBN 978-1-264-10370-6 (instructor’s edition) MHID 1-264-10370-0 (instructor’s edition)

Portfolio Director: Michael Ablassmeir Product Developers: Anne Ehrenworth, Lai Moy Executive Marketing Manager: Debbie Clare Content Project Managers: Mary E. Powers (core), Keri Johnson (assessment) Buyer: Susan K. Culbertson Design: Matt Diamond Content Licensing Specialist: Brianna Kirschbaum Cover Image: (Earth): skegbydave/Getty Images; (Spheres): Ilin Sergey/Shutterstock Compositor: Aptara®, Inc.

All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Names: Rothaermel, Frank T., author. Title: Strategic management / Frank T. Rothaermel. Description: Fifth edition. | New York, NY : McGraw-Hill Education, 2021. |  Includes bibliographical references and index. Identifiers: LCCN 2019046436 (print) | LCCN 2019046437 (ebook) | ISBN  9781264103799 (spiral bound) | ISBN 9781260261288 (hardback) | ISBN  9781264103782 (ebook) | ISBN 9781264103713 (ebook other) Subjects: LCSH: Strategic planning. | Management. Classification: LCC HD30.28 .R6646 2021 (print) | LCC HD30.28 (ebook) |  DDC 658.4/012—dc23 LC record available at https://lccn.loc.gov/2019046436 LC ebook record available at https://lccn.loc.gov/2019046437

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

mheducation.com/highered

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DEDICATION 

To my eternal family for their love, support, and sacrifice: Kelleyn, Harris, Winston, Roman, Adelaide, Avery, and Ivy.

—Frank T. Rothaermel

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PART ONE / ANALYSIS 2

CHAPTER 1 What Is Strategy? 4

CHAPTER 2 Strategic Leadership: Managing the Strategy Process 32

CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 72

CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 116

CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 154

PART TWO / FORMULATION 190

CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 192

CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 230

CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 276

CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions 320

CHAPTER 10 Global Strategy: Competing Around the World 350

PART THREE / IMPLEMENTATION 388

CHAPTER 11 Organizational Design: Structure, Culture, and Control 390

CHAPTER 12 Corporate Governance and Business Ethics 432

PART FOUR / MINICASES 459

HOW TO CONDUCT A CASE ANALYSIS 460

PART FIVE / FULL-LENGTH CASES Twelve full-length cases are included in Connect. A total of 22 full-length cases are available through McGraw-Hill Create: www.mcgrawhillcreate.com/rothaermel

CONTENTS IN BRIEF

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MINICASES & FULL-LENGTH CASES

MINICASES /

1 Apple: What’s Next? 471 2 Starbucks CEO Kevin Johnson: “I’m not Howard Schultz” 475 3 BlackBerry’s Rise and Fall 480 4 Nike’s Core Competency: The Risky Business of Creating Heroes 482 5 Business Model Innovation: How Dollar Shave Club Disrupted Gillette 487 6 How JCPenney Sailed into a Red Ocean 489 7 Platform Strategy: How PayPal Solved the Chicken-or-Egg Problem 492 8 GE: Corporate Strategy Gone Wrong 495 9 Disney: Building Billion-Dollar Franchises 499 10 Hollywood Goes Global 503 11 Yahoo: From Internet Darling to Fire Sale 508 12 Uber: Ethically Most Challenged Tech Company? 511

FULL-LENGTH CASES /

The twelve cases included in Connect are noted below. All cases are available through McGraw-Hill Create: www.mcgrawhillcreate.com/rothaermel

1 Airbnb, Inc. * ®

2 Kickstarter >> + 3 Facebook, Inc. >> ®

4 SpaceX >> + 5 Delta Air Lines, Inc. 6 The Movie Exhibition Industry >> + 7 Starbucks Corporation ®

8 The Vanguard Group * ®

9 Better World Books and the Triple Bottom Line 10 McDonald’s Corporation >> ®

11 Best Buy Co., Inc. >> ®

12 Walmart, Inc. 13 Tesla, Inc. >> ®

14 Netflix, Inc. ®

15 Amazon.com, Inc. >> ®

16 Apple, Inc. >> ®

17 The Walt Disney Company >> ®

18 UPS in India 19 Alphabet’s Google 20 Merck & Co., Inc. 21 Nike, Inc. * ®

22 Uber Technologies

* NEW TO FIFTH EDITION, >> REVISED AND UPDATED FOR THE FIFTH EDITION, + THIRD-PARTY CASE

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CHAPTERCASES /

1 Tesla’s Secret Strategy 5 2 Leadership Crisis at Facebook? 33 3 Airbnb: Disrupting the Hotel Industry 73 4 Five Guys’ Core Competency: “Make the Best

Burger, Don’t Worry about Cost” 117 5 The Quest for Competitive Advantage: Apple vs.

Microsoft 155 6 JetBlue Airways: En Route to a New Blue

Ocean? 193 7 Netflix: Disrupting the TV Industry 231 8 Amazon’s Corporate Strategy 277 9 Little Lyft Gets Big Alliance Partners and Beats

Uber in Going Public 321 10 IKEA: The World’s Most Profitable Retailer 351 11 “A” Is for Alphabet and “G” Is for Google 391 12 Theranos: Bad Blood 433

STRATEGYHIGHLIGHTS /

1.1 Does Twitter Have a Strategy? 9 1.2 Merck’s Stakeholder Strategy 20 2.1 Teach for America: How Wendy Kopp Inspires

Future Leaders 41 2.2 Starbucks CEO: “It’s Not What We Do” 54 3.1 Blockbuster’s Bust 79 3.2 From League of Legends to Fortnite: The Rise of

e-Sports 103 4.1 Dr. Dre’s Core Competency: Coolness

Factor 122 4.2 Applying VRIO: The Rise and Fall of

Groupon 133 5.1 PepsiCo’s Indra Nooyi: Performance with

Purpose 175 5.2 Threadless: Leveraging Crowdsourcing to

Design Cool T-Shirts 178 6.1 Dr. Shetty: “The Henry Ford of Heart

Surgery” 210 6.2 Cirque du Soleil: Finding a New Blue

Ocean? 219 7.1 Standards Battle: Which Automotive Technology

Will Win? 244 7.2 Wikipedia: Disrupting the Encyclopedia

Business 261 8.1 The Equity Alliance between Coca-Cola and

Monster: A Troubled Engagement? 288 8.2 P&G’s Diversification Strategy: Turning the

Tide? 306 9.1 How Tesla Used Alliances Strategically 327 9.2 Kraft Heinz: From Hostile Takeovers as Specialty

to Eating Humble Pie 338 10.1 Does GM’s Future Lie in China? 360 10.2 Walmart Retreats from Germany, and Lidl

Invades the United States 363 11.1 Zappos: Of Happiness and Holacracy 407 11.2 Sony vs. Apple: Whatever Happened to

Sony? 414 12.1 HP’s Boardroom Drama and Divorce 444 12.2 VW’s Dieselgate: School of Hard NOx 449

CHAPTERCASES & STRATEGY HIGHLIGHTS 

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ix

PART ONE / ANALYSIS 2

CHAPTER 1 WHAT IS STRATEGY? 4

CHAPTERCASE 1 / Part I Tesla’s Secret Strategy 5

1.1 What Strategy Is: Gaining and Sustaining Competitive Advantage 6

Crafting a Good Strategy at Tesla 7 What Is Competitive Advantage? 10

1.2 Stakeholder Strategy and Competitive Advantage 13

Value Creation 13 Stakeholder Strategy 14 Stakeholder Impact Analysis 15

1.3 The Analysis, Formulation, Implementation (AFI) Strategy Framework 21

Key Topics and Questions of the AFI Strategy Framework 22

1.4 Implications for Strategic Leaders 23

CHAPTERCASE 1 / Part II 24

CHAPTER 2 STRATEGIC LEADERSHIP: MANAGING THE STRATEGY PROCESS 32

CHAPTERCASE 2 / Part I Leadership Crisis at Facebook? 33

2.1 Strategic Leadership 34 What Do Strategic Leaders Do? 35 How Do You Become a Strategic Leader? 35 The Strategy Process across Levels: Corporate, Business, and Functional Managers 37

2.2 Vision, Mission, and Values 40 Vision 40 Mission 45 Values 46

2.3 The Strategic Management Process 47 Top-Down Strategic Planning 47 Scenario Planning 48 Strategy as Planned Emergence: Top-Down and Bottom-Up 51

2.4 Strategic Decision Making 57 Two Distinct Modes of Decision Making 58 Cognitive Biases and Decision Making 58 How to Improve Strategic Decision Making 62

2.5 Implications for Strategic Leaders 63

CHAPTERCASE 2 / Part II 64

CHAPTER 3 EXTERNAL ANALYSIS: INDUSTRY STRUCTURE, COMPETITIVE FORCES, AND STRATEGIC GROUPS 72

CHAPTERCASE 3 / Part I Airbnb: Disrupting the Hotel Industry 73

3.1 The PESTEL Framework 74 Political Factors 75 Economic Factors 76 Sociocultural Factors 78 Technological Factors 78 Ecological Factors 80 Legal Factors 80

3.2 Industry Structure and Firm Strategy: The Five Forces Model 81

Industry vs. Firm Effects in Determining Firm Performance 81 Competition in the Five Forces Model 82 The Threat of Entry 84 The Power of Suppliers 87 The Power of Buyers 88 The Threat of Substitutes 89 Rivalry among Existing Competitors 90 Applying the Five Forces Model to the U.S. Airline Industry 96 A Sixth Force: The Strategic Role of Complements 98

3.3 Changes over Time: Entry Choices and Industry Dynamics 99

Entry Choices 99 Industry Dynamics 102

3.4 Performance Differences within the Same Industry: Strategic Groups 105

The Strategic Group Model 106 Mobility Barriers 107

3.5 Implications for Strategic Leaders 108

CHAPTERCASE 3 / Part II 109

CONTENTS

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CHAPTER 4 INTERNAL ANALYSIS: RESOURCES, CAPABILITIES, AND CORE COMPETENCIES 116

CHAPTERCASE 4 / Part I Five Guys’ Core Competency: “Make the Best Burger, Don’t Worry about Cost” 117

4.1 From External to Internal Analysis 119 4.2 Core Competencies 120

Resources and Capabilities 124

4.3 The Resource-Based View 126 Resource Heterogeneity and Resource Immobility 127 The VRIO Framework 128 Isolating Mechanisms: How to Sustain a Competitive Advantage 132

4.4 The Dynamic Capabilities Perspective 137 Core Rigidities 137 Dynamic Capabilities 138 Resource Stocks and Resource Flows 139

4.5 The Value Chain and Strategic Activity Systems 140

The Value Chain 140 Strategic Activity Systems 143

4.6 Implications for Strategic Leaders 146 Using SWOT Analysis to Generate Insights from External and Internal Analysis 146

CHAPTERCASE 4 / Part II 148

CHAPTER 5 COMPETITIVE ADVANTAGE, FIRM PERFORMANCE, AND BUSINESS MODELS 154

CHAPTERCASE 5 / Part I The Quest for Competitive Advantage: Apple vs. Microsoft 155

5.1 Competitive Advantage and Firm Performance 156

Accounting Profitability 156 Shareholder Value Creation 163 Economic Value Creation 165 The Balanced Scorecard 171 The Triple Bottom Line 174

5.2 Business Models: Putting Strategy into Action 177

The Why, What, Who, and How of Business Models Framework 177 Popular Business Models 180 Dynamic Nature of Business Models 182

5.3 Implications for Strategic Leaders 183

CHAPTERCASE 5 / Part II 184

PART TWO / FORMULATION 190

CHAPTER 6 BUSINESS STRATEGY: DIFFERENTIATION, COST LEADERSHIP, AND BLUE OCEANS 192

CHAPTERCASE 6 / Part I JetBlue Airways: En Route to a New Blue Ocean? 193

6.1 Business-Level Strategy: How to Compete for Advantage 195

Strategic Position 196 Generic Business Strategies 196

6.2 Differentiation Strategy: Understanding Value Drivers 198

Product Features 201 Customer Service 201 Complements 201

6.3 Cost-Leadership Strategy: Understanding Cost Drivers 202

Cost of Input Factors 204 Economies of Scale 204 Learning Curve 207 Experience Curve 211

6.4 Business-Level Strategy and the Five Forces: Benefits and Risks 212

Differentiation Strategy: Benefits and Risks 212 Cost-Leadership Strategy: Benefits and Risks 214

6.5 Blue Ocean Strategy: Combining Differentiation and Cost Leadership 215

Value Innovation 216 Blue Ocean Strategy Gone Bad: “Stuck in the Middle” 218

6.6 Implications for Strategic Leaders 222

CHAPTERCASE 6 / Part II 222

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CONTENTS xi

CHAPTER 7 BUSINESS STRATEGY: INNOVATION, ENTREPRENEURSHIP, AND PLATFORMS 230

CHAPTERCASE 7 / Part I Netflix: Disrupting the TV Industry 231

7.1 Competition Driven by Innovation 232 Netflix’s Continued Innovation 233 The Speed of Innovation 233 The Innovation Process 234

7.2 Strategic and Social Entrepreneurship 237 7.3 Innovation and the Industry Life Cycle 240

Introduction Stage 241 Growth Stage 243 Shakeout Stage 247 Maturity Stage 247 Decline Stage 248 Crossing the Chasm 249

7.4 Types of Innovation 255 Incremental vs. Radical Innovation 256 Architectural vs. Disruptive Innovation 258

7.5 Platform Strategy 263 The Platform vs. Pipeline Business Models 263 The Platform Ecosystem 264

7.6 Implications for Strategic Leaders 268

CHAPTERCASE 7 / Part II 269

CHAPTER 8 CORPORATE STRATEGY: VERTICAL INTEGRATION AND DIVERSIFICATION 276

CHAPTERCASE 8 / Part I Amazon’s Corporate Strategy 277

8.1 What Is Corporate Strategy? 280 Why Firms Need to Grow 280 Three Dimensions of Corporate Strategy 281

8.2 The Boundaries of the Firm 283 Firms vs. Markets: Make or Buy? 284 Alternatives on the Make-or-Buy Continuum 287

8.3 Vertical Integration along the Industry Value Chain 291

Types of Vertical Integration 292 Benefits and Risks of Vertical Integration 294 When Does Vertical Integration Make Sense? 297 Alternatives to Vertical Integration 297

8.4 Corporate Diversification: Expanding Beyond a Single Market 299

Types of Corporate Diversification 301 Leveraging Core Competencies for Corporate Diversification 303 Corporate Diversification and Firm Performance 308

8.5 Implications for Strategic Leaders 311

CHAPTERCASE 8 / Part II 312

CHAPTER 9 CORPORATE STRATEGY: STRATEGIC ALLIANCES, MERGERS AND ACQUISITIONS 320

CHAPTERCASE 9 / Part I Little Lyft Gets Big Alliance Partners and Beats Uber in Going Public 321

9.1 How Firms Achieve Growth 323 The Build-Borrow-or-Buy Framework 323

9.2 Strategic Alliances 326 Why Do Firms Enter Strategic Alliances? 326 Governing Strategic Alliances 330 Alliance Management Capability 332

9.3 Mergers and Acquisitions 335 Why Do Firms Merge with Competitors? 335 Why Do Firms Acquire Other Firms? 337 M&A and Competitive Advantage 340

9.4 Implications for Strategic Leaders 341

CHAPTERCASE 9 / Part II 342

CHAPTER 10 GLOBAL STRATEGY: COMPETING AROUND THE WORLD 350

CHAPTERCASE 10 / Part I IKEA: The World’s Most Profitable Retailer 351

10.1 What Is Globalization? 353 Stages of Globalization 355 State of Globalization 357

10.2 Going Global: Why? 358 Advantages of Going Global 358 Disadvantages of Going Global 362

10.3 Going Global: Where and How? 365 Where in the World to Compete? The CAGE Distance Framework 365 How Do MNEs Enter Foreign Markets? 369

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10.4 Cost Reductions vs. Local Responsiveness: The Integration-Responsiveness Framework 370

International Strategy 371 Multidomestic Strategy 372 Global-Standardization Strategy 372 Transnational Strategy 373

10.5 National Competitive Advantage: World Leadership in Specific Industries 375

Porter’s Diamond Framework 376

10.6 Implications for Strategic Leaders 379

CHAPTERCASE 10 / Part II 380

PART THREE / IMPLEMENTATION 388

CHAPTER 11 ORGANIZATIONAL DESIGN: STRUCTURE, CULTURE, AND CONTROL 390

CHAPTERCASE 11 / Part I “A” Is for Alphabet and “G” Is for Google 391

11.1 Organizational Design and Competitive Advantage 393

Organizational Inertia: The Failure of Established Firms 395 Organizational Structure 397 Mechanistic vs. Organic Organizations 398

11.2 Strategy and Structure 400 Simple Structure 401 Functional Structure 401 Multidivisional Structure 404 Matrix Structure 408

11.3 Organizing for Innovation 412 11.4 Organizational Culture: Values, Norms, and Artifacts 416

Where Do Organizational Cultures Come From? 419 How Does Organizational Culture Change? 419 Organizational Culture and Competitive Advantage 420

11.5 Strategic Control-and-Reward Systems 422 Input Controls 423 Output Controls 423

11.6 Implications for Strategic Leaders 424

CHAPTERCASE 11 / Part II 425

CHAPTER 12 CORPORATE GOVERNANCE AND BUSINESS ETHICS 432

CHAPTERCASE 12 / Part I Theranos: Bad Blood 433

12.1 The Shared Value Creation Framework 435 Public Stock Companies and Shareholder Capitalism 435 Creating Shared Value 437

12.2 Corporate Governance 438 Agency Theory 440 The Board of Directors 441 Other Governance Mechanisms 443

12.3 Strategy and Business Ethics 448 Bad Apples vs. Bad Barrels 450

12.4 Implications for Strategic Leaders 451

CHAPTERCASE 12 / Part II 452

PART FOUR / MINICASES 459 HOW TO CONDUCT A CASE ANALYSIS 460

PART FIVE / FULL-LENGTH CASES Twelve full-length cases are included in Connect. A total of 22 full-length cases are available through McGraw-Hill Create: www.mcgrawhillcreate.com/ rothaermel

Company Index 517 Name Index 523 Subject Index 531

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Frank T. Rothaermel Georgia Institute of Technology

Frank T. Rothaermel, PhD, a Professor of Strategy & Innovation, holds the Russell and Nancy McDonough Chair in the Scheller College of Business at the Georgia Institute of Technology (GT) and is an Alfred P. Sloan Industry Studies Fellow. He received a National Science Foundation (NSF) CAREER award, which “offers the National Science Foundation’s most prestigious awards in support of … those teacher-scholars who most effectively integrate research and education” (NSF CAREER Award description).

Frank’s research interests lie in the areas of strategy, innovation, and entrepreneurship. Frank has published over 35 articles in leading aca- demic journals such as the Strategic Management Journal, Organization Science, Academy of Management Journal, Academy of Management Review, and elsewhere. Based on having published papers in the top 1 percent based on citations, Thomson Reuters identified Frank as one of the “world’s most influential scientific minds.” He is listed among the top-100 scholars based on impact over more than a decade in both eco- nomics and business. Bloomberg Businessweek named Frank one of Georgia Tech’s Prominent Faculty in its national survey of business schools. The Kauffman Foundation views Frank as one of the world’s 75 thought leaders in entrepreneurship and innovation.

Frank has received several recognitions for his research, including the Sloan Industry Studies Best Paper Award, the Academy of Management Newman Award, the Strategic Management Society Conference Best Paper Prize, the DRUID Conference Best Paper Award, the Israel Strategy Conference Best Paper Prize, and he is the inaugural recipient of the Byars Faculty Excellence Award. Frank currently serves or has served on the editorial boards of the Strategic Management Journal, Organization Science, Academy of Management Journal, Academy of Management Review, and Strategic Organization.

Frank regularly translates his research findings for wider audiences in articles in the MIT Sloan Management Review, The Wall Street Journal, Forbes, and elsewhere. To inform his research Frank has conducted extensive fieldwork and execu- tive training with leading corporations such as Amgen, Daimler, Eli Lilly, Equifax, GE Energy, GE Healthcare, Hyundai Heavy Industries (South Korea), Kimberly-Clark, Microsoft, McKesson, NCR, Turner (TBS), UPS, among others.

Frank has a wide range of executive education experience, including teaching in programs at GE Management Development Institute (Crotonville, New York), Georgia Institute of Technology, Georgetown University, ICN Business School (France), Politecnico di Milano (Italy), St. Gallen University (Switzerland), and the University of Washington. He received numerous teaching awards for excellence in the classroom including the GT-wide Georgia Power Professor of Excellence award.

When launched in 2012, Frank’s Strategic Management text received the McGraw-Hill 1st Edition of the Year Award in Business & Economics. In 2018, the 4th edition of the text received McGraw-Hill’s Product of the Year Award in Business & Economics. Frank’s Strategic Management text has been translated into Greek, Korean, Mandarin, and Spanish. Sixteen of his case studies are Most Popular among the cases distributed by Harvard Business Publishing.

Frank held visiting professorships at EBS University of Business and Law (Germany), Singapore Management University (Tommie Goh Professorship), and the University of St. Gallen (Switzerland). He is a member of the American Economic Association, Academy of Management, and the Strategic Management Society.

Frank holds a PhD degree in strategic management from the University of Washington; an MBA from the Marriott School of Management at Brigham Young University; and is Diplom-Volkswirt (M.Sc. equivalent) in economics from the University of Duisburg-Essen, Germany. Frank completed training in the case teaching method at the Harvard Business School.

ABOUT THE AUTHOR

©Kelleyn Rothaermel

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The market for strategy texts can be broadly separated into two overarching categories: tra- ditional application-based and research-based. Traditional application-based strategy books represent the first-generation texts with first editions published in the 1980s. The research- based strategy books represent the second-generation texts with first editions published in the 1990s. I wrote this text to address a needed new category—a third generation of strategy content that combines into one the student-accessible, application-oriented frameworks of the first-generation texts with the research-based frameworks of the second-generation texts. The market response to this unique approach to teaching and studying strategy continues to be overwhelmingly enthusiastic.

To facilitate an enjoyable and refreshing reading experience that enhances student learn- ing and retention, I synthesize and integrate strategy frameworks, empirical research, and practical applications with current real-world examples. This approach and emphasis on real-world examples offers students a learning experience that uniquely combines rigor and relevance. As John Media of the University of Washington’s School of Medicine and life- long researcher on how the mind organizes information explains:

How does one communicate meaning in such a fashion that learning is improved? A simple trick involves the liberal use of relevant real-world examples, thus peppering main learning points with meaningful experiences. . . . Numerous studies show this works. . . . The greater the number of examples . . . the more likely the students were to remember the information. It’s best to use real-world situations familiar to the learner. . . . Examples work because they take advantage of the brain’s natural predilection for pattern matching. Information is more readily processed if it can be immediately associated with information already present in the brain. We compare the two inputs, looking for similarities and differences as we encode the new informa- tion. Providing examples is the cognitive equivalent of adding more handles to the door. [The more handles one creates at the moment of learning, the more likely the information can be accessed at a later date.] Providing examples makes the information more elaborative, more complex, better encoded, and therefore better learned.*

Strategic Management brings conceptual frameworks to life via examples that cover products and services from companies with which students are familiar, such as Facebook, Amazon, Google, Tesla, Starbucks, Apple, McDonald’s, Nike, Disney, Airbnb, and Uber. Liberal use of such examples aids in making strategy relevant to students’ lives and helps them internal- ize strategy concepts and frameworks. Integrating current examples with modern strategy thinking, I prepare students with the foundation they need to understand how companies gain and sustain competitive advantage. I also develop students’ skills to become successful leaders capable of making well-reasoned strategic decisions in a turbulent 21st century.

I’m pleased to introduce the new 5th edition of Strategic Management. My distinctive approach to teaching strategy not only offers students a unique learning experience that com- bines theory and practice, but also provides tight linkages between concepts and cases. In this new 5th edition, I build upon the unique strengths of this product, and continue to add improvements based upon hundreds of insightful reviews and important feedback from pro- fessors, students, and working professionals. The hallmark features of this text continue to be:

■ Student engagement via practical and relevant application of strategy concepts using a holistic Analysis, Formulation, and Implementation (AFI) Strategy Framework.

■ Synthesis and integration of empirical research and practical applications combined with relevant strategy material to focus on “What is important?” for the student and “Why is it important?”

*Medina, J. (2014), Brain Rules: 12 Principles for Surviving and Thriving at Work, Home, and School. (Seattle: Pear Press), 139–140.

PREFACE

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PREFACE xv

■ Strong emphasis on diversity and inclusion by featuring a wide range of strategic leaders from different backgrounds and fields, not just in business, but also in entertainment, professional sports, and so forth.

■ Coverage of a wide array of organizations, including for-profit public (Fortune 100) com- panies, private firms (including startups), as well as nonprofit organizations. All of them need a good strategy!

■ Global perspective, with a focus on competing around the world, featuring many leading companies from Asia, Europe, and Latin America, as well as North America. I was for- tunate to study, live, and work across the globe, and I attempt to bring this cosmopoli- tan perspective to bear in this text.

■ Direct personal applications of strategy concepts to careers and lives to help internalize the content (including the popular myStrategy modules at the end of each chapter).

■ Industry-leading digital delivery option (Create), adaptive learning system (SmartBook), and online assignment and assessment system (Connect).

■ Standalone module on How to Conduct a Case Analysis. ■ High-quality Cases, well integrated with text chapters and standardized, high-quality

and detailed teaching notes; there are three types of cases that come with this text: ■ 12 ChapterCases begin and end each chapter, framing the chapter topic and content. ■ 12 MiniCases in Part 4 of the book, with one MiniCase tailored specifically to each

chapter with accompanying discussion questions. All of the cases are based on original research, provide dynamic opportunities for students to apply strategy concepts by assigning them in conjunction with specific chapters, and can be used in a variety of ways (as individual assignments, group work, and in class).

■ 22 full-length Cases, authored or co-authored by Frank T. Rothaermel specifi- cally to accompany this text; 12 of these cases are included complimentary in 5e Connect.

I have taken great pride in authoring all the case materials that accompany this text. This additional touch is a differentiating feature from other offerings on the market and allows for strict quality control and seamless integration with chapter content. All case materials come with sets of questions to stimulate class discussion and provide guidance for written assignments. High-quality case teaching notes that more fully integrate content and cases are available to instructors in the Connect Library.

In addition to these in-text cases, McGraw-Hill’s custom-publishing Create program offers all of the cases and teaching notes accompanying the current as well as prior editions (www.mcgrawhillcreate.com/rothaermel).

What’s New in the Fifth Edition? I have revised and updated the new edition in the following ways, many of which were inspired by conversations and feedback from the many users and reviewers of the prior editions.

OVERVIEW OF MAJOR CHANGES IN 5E ■ Section “Stakeholder Strategy and Competitive Advantage” now in Chapter 1. ■ Section “Vision, Mission, and Values” now in Chapter 2. ■ New section “Strategic Decision Making” in Chapter 2. ■ New section “From External to Internal Analysis” in Chapter 4.

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xvi PREFACE

■ Three new ChapterCases: Five Guys (Chapter 4), Alphabet and Google (Chapter 11), and Theranos (Chapter 12); all other ChapterCases revised and updated.

■ All new or updated and revised Strategy Highlights (two per chapter). ■ Revised and updated module on How to Conduct a Case Analysis. ■ Five new MiniCases (Uber, PayPal, JCPenney, GE, and BlackBerry), featuring not

only success stories but also failures; all other MiniCases revised and updated. One MiniCase per chapter, tightly integrated with learning objectives. Detailed and high-quality teaching notes are available in the Connect Library.

■ Three new full-length Cases (Airbnb, Nike, and The Vanguard Group); all other cases including most popular ones such as Amazon, Apple, Best Buy, Facebook, McDonald’s, and Tesla, among others, are revised and updated. Detailed and updated case teaching notes, as well as financial data for these cases, are available in the Connect Library.

IN DETAIL CHAPTER 1 ■ Revised and updated ChapterCase: “Tesla’s Secret Strategy” ■ New Strategy Highlight: “Does Twitter have a Strategy?” ■ New Strategy Highlight: “Merck’s Stakeholder Strategy” ■ Improved chapter flow through moving the updated section “Stakeholder Strategy and

Competitive Advantage” into Chapter 1 (from Chapter 2)

CHAPTER 2 ■ Revised and updated ChapterCase: “Leadership Crisis at Facebook?” ■ New section: “Strategic Decision Making” ■ New exhibit: “Two Distinct Modes of Decision Making” ■ New exhibit: “How to Use a Devil’s Advocate to Improve Strategic Decision

Making” ■ New Strategy Highlight: “Teach for America: How Wendy Kopp Inspires Future

Leaders” ■ Improved chapter flow through moving the updated section “Vision, Mission, and

Values” into Chapter 2 (from Chapter 1)

CHAPTER 3 ■ Revised and updated ChapterCase: “Airbnb: Disrupting the Hotel Industry” ■ New Strategy Highlight: “Blockbuster’s Bust” ■ New Strategy Highlight: “From League of Legends to Fortnite: The Rise of e-Sports”

CHAPTER 4 ■ New ChapterCase: “Five Guys’ Core Competency: ‘Make the Best Burger, Don’t

Worry about Cost’” ■ New section: “From External to Internal Analysis” ■ New Strategy Highlight: “Dr. Dre’s Core Competency: Coolness Factor”

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PREFACE xvii

CHAPTER 5 ■ Revised and updated ChapterCase: “The Quest for Competitive Advantage: Apple vs.

Microsoft” ■ New Strategy Highlight: “PepsiCo’s Indra Nooyi: Performance with a Purpose”

CHAPTER 6 ■ Revised and updated ChapterCase: “JetBlue Airways: En Route to a New Blue

Ocean?” ■ New Strategy Highlight: “Cirque du Soleil: Finding a New Blue Ocean?”

CHAPTER 7 ■ Revised and updated ChapterCase: “Netflix: Disrupting the TV Industry” ■ New Strategy Highlight: “Wikipedia: Disrupting the Encyclopedia Business”

CHAPTER 8 ■ Revised and updated ChapterCase: “Amazon's Corporate Strategy” ■ New Strategy Highlight: “P&G Diversification Strategy: Turning the Tide?”

CHAPTER 9 ■ Revised and updated ChapterCase: “Little Lyft Gets Big Alliance Partners and Beats

Uber in Going Public”

CHAPTER 10 ■ Revised and updated ChapterCase: “IKEA: The World’s Most Profitable Retailer” ■ New Strategy Highlight “Does GM’s future lie in China?”

CHAPTER 11 ■ New ChapterCase: “‘A’ is for Alphabet and ‘G’ is for Google” ■ New exhibit: “Formal and Informal Building Blocks of Organizational Design” ■ New Strategy Highlight: “Zappos: Of Happiness and Holacracy”

CHAPTER 12 ■ New ChapterCase: “Theranos: Bad Blood” ■ New Strategy Highlight: “HP’s Board Room Drama and Divorce” ■ New Strategy Highlight: “VW’s Dieselgate: School of Hard NOx”

MINICASES ■ 12 MiniCases, one for each chapter; each MiniCase is closely tied to the chapter’s

learning objectives and includes discussion questions and detailed teaching notes. ■ Five new MiniCases: Uber, PayPal, JCPenney, GE, and BlackBerry ■ The most popular MiniCases from the prior editions have been updated and revised.

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xviii PREFACE

FULL-LENGTH CASES ■ Three new full-length cases (Airbnb, Nike, and The Vanguard Group); all other cases,

including most popular ones such as Amazon, Apple, Best Buy, Facebook, McDonald’s, and Tesla, are updated and revised.

■ Detailed and updated case teaching notes as well as financial data for these cases are available for instructors in the Connect Library.

CONNECT ■ 12 full-length Cases are now included—complimentary—for students in 5e Connect.

Detailed case teaching notes are available in the Connect Library. All full-length cases included in 5e Connect were authored by Frank T. Rothaermel.

Connect, McGraw-Hill’s online assignment and assessment system, offers a wealth of con- tent for both students and instructors. Assignable activities include the following:

■ SmartBook, one of the first fully adaptive and individualized study tools, provides stu- dents with a personalized learning experience, giving them the opportunity to practice and challenge their understanding of core strategy concepts. It allows the instructor to set up all assignments prior to the semester, to have them auto-released on preset dates, and to receive auto-graded progress reports for each student and the entire class. Stu- dents love SmartBook because they learn at their own pace, and it helps them to study more efficiently by delivering an interactive reading experience through adaptive high- lighting and review.

■ Application Exercises (such as Whiteboard Animation video cases, MiniCase case analyses, click-and-drag activities, and new case exercises for all 12 full-length cases that are available in Connect) require students to apply key concepts, thereby closing the knowing and doing gap, while providing instant feedback for the student and progress tracking for the instructor.

INSTRUCTOR RESOURCES The Instructor Resources located in Connect provide the following teaching tools, all of which have been tested and updated with this edition:

■ The Teacher’s Resource Manual (TRM) includes thorough coverage of each chapter, as well as guidance for integrating Connect—all in a single resource. Included in this newly combined TRM, which retains favorite features of the previous edition’s Instructor’s Manual, is the appropriate level of theory, framework, recent applica- tion, additional company examples not found in the textbook, teaching tips, Power- Point references, critical discussion topics, and answers to end-of-chapter exercises.

■ The PowerPoint (PPT) slide decks, available in an accessible version for individuals with visual impairment, provide comprehensive lecture notes, video links, and addi- tional company examples not found in the textbook. Options include instructor media- enhanced slides as well as notes with outside application examples. All slides can be edited by individual instructors to suit their needs.

■ The Test Bank includes 100 to 150 questions per chapter, in a range of formats and with a greater-than-usual number of comprehension, critical-thinking, and application or scenario-based questions. Each question is tagged to learning objectives, Bloom’s Taxonomy levels, and AACSB compliance requirements. Many questions are new and written especially for this new edition.

rot6128x_fm_i-xxviii_1.indd 18 11/26/19 7:34 PM

PREFACE xix

■ The Video Guide includes video links that relate to concepts from chapters. The video links include sources such as Big Think, Stanford University’s Entrepreneurship Cor- ner, The McKinsey Quarterly, ABC, BBC, CBS, CNN, ITN/Reuters, MSNBC, NBC, PBS, and YouTube.

CREATE ■ Create, McGraw-Hill’s custom-publishing tool, is where you access additional full-

length cases (and Teaching Notes) beyond those included complimentary in Connect that accompany Strategic Management (http://www.mcgrawhillcreate.com/Rothaermel). You can create customized course packages in print and/or digital form at a competi- tive price point.

■ Through Create, you will be able to select from all author-written cases as well instruc- tor-written cases that match specifically with the new 5th edition. Create also contains cases from Harvard, Ivey Darden, NACRA, and much more! You can assemble your own course, selecting the chapters, cases (multiple formats), and readings that will work best for you, or choose from several ready-to-go, author-recommended complete course solutions, which include chapters, cases, and readings, preloaded in Create. Among the preloaded solutions, you’ll find options for undergraduate, MBA, accelerated, and other strategy courses.

rot6128x_fm_i-xxviii_1.indd 19 11/26/19 7:34 PM

xx

ACKNOWLEDGMENTS Any list of acknowledgments will always be incomplete, but I would like to thank some spe- cial people without whom this product would not have been possible. First and foremost, my wife, Kelleyn, and our children: Harris, Winston, Roman, Adelaide, Avery, and Ivy. Over the last few years, I have worked longer hours than when I was a graduate student to con- duct the research and writing necessary for this text and accompanying case studies and other materials. I sincerely appreciate the sacrifice this has meant for my family.

The Georgia Institute of Technology provides a conducive, intellectual environment and superb institutional support to make this project possible. I thank Russell and Nancy McDonough for generously funding the endowed chair that I am honored to hold. I’m grate- ful for Dean Maryam Alavi and Senior Associate Deans Saby Mitra and Peter Thompson for providing the exceptional leadership that allows faculty to focus on research, teaching, and service. I like to thank my colleagues at Georgia Tech—all of whom are not only great scholars but also fine individuals whom I’m fortunate to have as friends: Marco Ceccagnoli, Annamaria Conti, Anne Fuller, Jonathan Giuliano, Stuart Graham, Matt Higgins, David Ku, John McIntyre, Alex Oettl, Pian Shu, Eunhee Sohn, and Laurina Zhang.

I’m also fortunate to work with a great team at McGraw-Hill: Michael Ablassmeir (direc- tor), Terri Schiesl (managing director), Anne Ehrenworth (senior product developer), Haley Burmeister (product developer), Debbie Clare (executive marketing manager), Mary Powers and Keri Johnson (content project managers), and Matt Diamond (senior designer). Lai T. Moy contributed as a superb content development editor on the fifth edition manu- script; and I’m grateful for excellent research assistance provided by Laura Zhang.

I’m more than grateful for the contributions of great colleagues on various resources that accompany this new edition of Strategic Management:

■ John Burr (Purdue University) on the Video Guide. ■ Carla Flores (Ball State University) on the revision of Connect, including the Interac-

tive Exercises, MiniCase Exercises, and Case Exercises. ■ Melissa Francisco (University of Central Florida) on the accessible PowerPoint slide

decks. ■ Anne Fuller (Georgia Institute of Technology) on Teacher Resource Manual, Discussion

Questions, and myStrategy boxes. ■ Gita Mathur (San Jose State University) on MiniCase Teaching Notes. ■ Chandran Mylvaganam (Northwood University) on selected Case Abstracts and Case

Teaching Notes.

Last, but certainly not least, I wish to thank the reviewers and focus group attendees who shared their expertise with us, from the very beginning when we developed the prospectus to the new teaching and learning package that you hold in your hands. The reviewers have given us the greatest gift of all—the gift of time! These very special people are listed starting on page xxi.

Frank T. Rothaermel Georgia Institute of Technology

Web: ftrStrategy.com Email: [email protected]

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xxi

This book has gone through McGraw-Hill Education’s thorough development process. Over the course of several years, the project has benefited from numerous developmental focus groups, hundreds of reviews from instructors across the country, and beta-testing of the first- edition manuscript as well as market reviews of subsequent editions on a variety of cam- puses. The author and McGraw-Hill wish to thank the following people who shared their insights, constructive criticisms, and valuable suggestions throughout the development of this project. Your contributions have greatly improved this product:

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Analysis

PART

CHAPTER 1 What Is Strategy? 4

CHAPTER 2 Strategic Leadership: Managing the Strategy Process 32

CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 72

CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 116

CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 154

1

rot6128x_ch01_002-031.indd 2 12/5/19 7:53 AM

4

1 CHAPTER

Chapter Outline

1.1 What Strategy Is: Gaining and Sustaining Competitive Advantage Crafting a Good Strategy at Tesla What Is Competitive Advantage?

1.2 Stakeholder Strategy and Competitive Advantage Value Creation Stakeholder Strategy Stakeholder Impact Analysis

1.3 The Analysis, Formulation, Implementation (AFI) Strategy Framework Key Topics and Questions of the AFI Strategy Framework 

1.4 Implications for Strategic Leaders

Learning Objectives

After studying this chapter, you should be able to:

LO 1-1 Explain the role of strategy in a firm’s quest for competitive advantage.

LO 1-2 Define competitive advantage, sustainable competitive advantage, competitive disadvantage, and competitive parity.

LO 1-3 Assess the relationship between stakeholder strategy and sustainable competitive advantage.

LO 1-4 Conduct a stakeholder impact analysis.

LO 1-5 Explain the Analysis, Formulation, Implementation (AFI) Strategy Framework.

What Is Strategy?

rot6128x_ch01_002-031.indd 4 01/11/19 11:23 AM

5

Tesla’s Secret Strategy

TESLA INC., an American manufacturer of all-electric cars—boasted a market capitalization1 of some $60 billion (in early 2019), an appreciation of more than 1,400 per- cent over its initial public offering price in 2010. How can a California startup achieve a market valuation that ex- ceeds that of GM, one of the largest car manufacturers in the world, making some 10 million vehicles a year? The answer: Tesla’s secret strategy. In a summer 2006 blog en- try on Tesla’s website, Elon Musk, Tesla’s co-founder and CEO, explained the startup’s master plan:2

1. Build sports car.

2. Use that money to build an affordable car.

3. Use that money to build an even more affordable car.

4. While doing above, also provide zero-emission electric power genera- tion options.

5. Don’t tell anyone.2

Let’s see if Tesla stuck to its strategy. In 2008, Tesla in- troduced its first car: the Roadster, a $110,000 sports coupe with faster acceleration than a Porsche or a Ferrari. Tesla’s first vehicle served as a prototype to demonstrate that electric vehicles can be more than mere golf carts. Tesla thus successfully completed Step 1 of the master plan.

In Step 2, after selling some 2,500 Roadsters, Tesla discontinued its production in 2012 to focus on its next car: the Model S, a four-door family sedan, with an initial base price of $73,500. The line appeals to a somewhat larger market and thus allows for larger production runs to drive down unit costs. The Model S received an outstand- ing market reception. It was awarded not only the 2013 Motor Trend Car of the Year, but also received the highest score of any car ever tested by Consumer Reports (99/100). Tesla manufactures the Model S in the Fremont, California, factory that it purchased from Toyota. By the

end of 2018, it had sold more than 250,000 of the Model S worldwide.

Hoping for an even broader customer appeal, Tesla also introduced the Model X, a crossover between an SUV and a family van with futuristic falcon-wing doors for convenient access to second- and third-row seating. The $100,000 start- ing sticker price of the Model X is quite steep, thus limiting its mass-market appeal. Technical difficulties with its innova- tive doors delayed its launch until the fall of 2015. By the end of 2018, however, Tesla had sold more than 100,000 of the Model X globally.

Tesla also completed Step 3 of its master plan. In 2016, the electric car maker un- veiled the Model 3, an all- electric compact luxur y sedan, with a starting price of $35,000. Many want-to-be Tesla owners stood in line overnight, eagerly waiting for Tesla stores to open so they could put down their $1,000 deposits to secure a spot on the waiting list for the Model 3—a car they had not even seen, let alone taken for a test drive. As a result of this con- sumer enthusiasm, Tesla re- ceived more than 500,000 preorders before the first de- livery, and thus $500 million in interest-free loans. Despite

initial difficulties in scaling up production, deliveries of the Model 3 began in the fall of 2017. By the end of 2018, Tesla had delivered more than 100,000 of the Model 3 globally. To meet the strong demand for the lower priced Model 3, Tesla hopes to increase its annual production to 1 million vehicles by 2020.

In the spring of 2019, Tesla launched the Model Y, a compact SUV that is a smaller and much lower priced ver- sion of the Model X. Elon Musk plans to start deliveries of the new Model Y between the fall of 2020 and spring 2021, with the entry version starting at $39,000 (and 230 miles range) and the high-end performance version starting at $60,000 (and 280 miles range).

Step 4 of Musk’s master plan for Tesla aims to provide zero-emission electric power generation options. To achieve

CHAPTERCASE 1 Part I

The Tesla Roadster 2 set new records for a vehicle to be driven on public roads: It goes from 0–60 mph in 1.9 seconds and from 0–100 mph in 4.2 seconds, with top speeds of well above 250 mph. The base price of this newest Tesla, scheduled to launch in 2020, is $200,000.

KYDPL KYODO/AP Images

rot6128x_ch01_002-031.indd 5 01/11/19 11:23 AM

6

this goal, Tesla acquired SolarCity, a solar energy company, for more than $2 billion in the fall of 2016. This successful in- tegration of Tesla and SolarCity, which resulted in the first fully integrated clean-tech energy company that combines so- lar power, power storage, and transportation, marks the com- pletion of Step 4 in Tesla’s master plan.

Step 5: “Don’t tell anyone”—a humorous statement added by Elon Musk—thus the ChapterCase title “Tesla’s Secret Strategy.”3

NOTE: By summer 2019, Tesla’s market cap stood at about $45 billion.

Part II of this ChapterCase appears in Section 1.4.

WHY IS TESLA SO SUCCESSFUL? In contrast to Tesla’s success, the big-three U.S. automakers—Ford, GM, and Chrysler—struggled during the first decade of the 21st century, with both GM and Chrysler filing for bankruptcy protection.

If once-great firms can fail, why is any company successful? What enables some firms to gain and then sustain their competitive advantage over time? How can you as a strategic leader influence firm performance? These are the big questions that define strategic man- agement. Answering these questions requires integrating the knowledge you’ve obtained in your studies of various business disciplines to understand what leads to superior perfor- mance, and how you can help your organization achieve it.

Strategic management is the integrative management field that combines analysis, formu- lation, and implementation in the quest for competitive advantage. Mastery of strategic man- agement enables you to view an organization such as a firm or a nonprofit outfit in its entirety. It also enables you to think like a general manager to help position your organiza- tion for superior performance. The AFI Strategy Framework embodies this view of strategic management. It will guide our exploration of strategic management through the course of your study.

In this chapter, we lay the groundwork for the study of strategic management. We’ll intro- duce foundational ideas about strategy and competitive advantage. We also move beyond an understanding of competitive advantage solely as superior financial performance, and intro- duce the concept of stakeholder strategy. This allows us to appreciate the role of business in society more broadly. Next, we take a closer look at the components of the AFI framework and provide an overview of the entire strategic management process. We conclude this intro- ductory chapter, as we do with all others in this text, with a section titled Implications for Strategic Leaders. Here we provide practical applications and considerations of the material developed in the chapter. Let’s begin the exciting journey to understand strategic manage- ment and competitive advantage.

1.1 What Strategy Is: Gaining and Sustaining Competitive Advantage Strategy is a set of goal-directed actions a firm takes to gain and sustain superior perfor- mance relative to competitors.4 To achieve superior performance, companies compete for resources: New ventures compete for financial and human capital, existing companies com- pete for profitable growth, charities compete for donations, universities compete for the best students and professors, sports teams compete for championships, while celebrities com- pete for endorsements.

As highlighted in the ChapterCase, Tesla, a new entrant in the automotive industry, is competing for customers with established U.S. companies such as GM, Ford, and Chrysler and also with foreign automakers Toyota, Honda, Nissan, Hyundai, VW, Audi, Porsche,

strategic management An integrative manage- ment field that combines analysis, formulation, and implementation in the quest for competitive advantage.

strategy The set of goal-directed actions a firm takes to gain and sustain superior perfor- mance relative to com- petitors.

LO 1-1 Explain the role of strategy in a firm’s quest for competitive advantage.

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CHAPTER 1 What Is Strategy? 7

Mercedes, and BMW, among others. In any competitive situation, a good strategy enables a firm to achieve superior performance and sustainable competitive advantage relative to its competitors. A good strategy is based on a strategic management process that consists of three key elements:

1. A diagnosis of the competitive challenge. This element is accomplished through analysis of the firm’s external and internal environments (Part 1 of the AFI framework).

2. A guiding policy to address the competitive challenge. This element is accomplished through strategy formulation, resulting in the firm’s corporate, business, and functional strategies (Part 2 of the AFI framework).

3. A set of coherent actions to implement the firm’s guiding policy. This element is accom- plished through strategy implementation (Part 3 of the AFI framework).

CRAFTING A GOOD STRATEGY AT TESLA Let’s revisit ChapterCase 1 to see whether Tesla is pursuing a good strategy. Tesla appears to be performing quite well when considering indicators such as stock appreciation, where it outperforms its competitors. The appreciation of Tesla stock since its initial public offering (IPO) points to investors’ expectations of future growth. By other measures, such as generat- ing profits, Tesla underperforms compared to established car companies. Losses are common for startups early on, especially if the business requires large upfront investments such as build- ing new and retooling existing factories, which Tesla was required to do. What we can say at this point is that Tesla seems to be starting with a promising strategy and is in the process of achieving superior performance relative to its competitors. But can Tesla sustain this superior performance over time? Let’s use the three elements of good strategy to explore this question.

THE COMPETITIVE CHALLENGE. A good strategy needs to start with a clear and critical diagnosis of the competitive challenge. Musk, Tesla’s co-founder and CEO, describes himself as an “engineer and entrepreneur who builds and operates companies to solve environmental, social, and economic challenges.”5 Tesla was founded with the vision to “accelerate the world’s transition to sustainable transport.”6

To accomplish this mission, Tesla must build zero-emission electric vehicles that are attractive and affordable. Beyond achieving a competitive advantage for Tesla, Musk is work- ing to set a new standard in automotive technology. He hopes that zero-emission electric vehicles will one day replace gasoline-powered cars.

Tesla’s competitive challenge is sizable: To succeed it must manufacture attractive and affordable vehicles using its new technology, which will compete with traditional cars run- ning on gasoline. It also needs the required infrastructure for electric vehicles, including a network of charging stations to overcome “range anxiety”7 by consumers; many mass-market electric vehicles cannot drive as far on one charge as gasoline-powered cars can with a full tank of gas. Gas stations can be found pretty much on any corner in cities and every couple of miles on highways.8

A GUIDING POLICY. After the diagnosis of the competitive challenge, the firm needs to formulate an effective guiding policy in response. The formulated strategy needs to be con- sistent, often backed up with strategic commitments such as sizable investments or changes to an organization’s incentive and reward system—big changes that cannot be easily reversed. Without consistency in a firm’s guiding policy, employees become confused and cannot make effective day-to-day decisions that support the overall strategy. Moreover, without consistency in strategy, other stakeholders, including investors, also become frustrated.

good strategy Enables a firm to achieve supe- rior performance and sustainable competitive advantage relative to its competitors. It is based on a strategic manage- ment process that con- sists of three elements: (1) a diagnosis of the competitive challenge; (2) a guiding policy to address the competitive challenge; and (3) a set of coherent actions to implement a firm’s guid- ing policy.

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8 CHAPTER 1 What Is Strategy?

To address the competitive challenge, Tesla’s current guiding policy is to build a cost- competitive mass-market vehicle such as the Model 3 (this is also Step 3 in Tesla’s “Secret Strategy,” as discussed in the ChapterCase). Tesla’s formulated strategy is consistent with its mission and the competitive challenge identified. It also requires significant strategic com- mitments, as demonstrated by Tesla’s $5 billion investment in a new lithium-ion battery plant in Nevada, the so-called Gigafactory. Batteries are the most critical component for electric vehicles, so to accomplish this major undertaking, Tesla partnered with Panasonic of Japan, a world leader in battery technology. To achieve its massive scale-up in Model 3 production, Tesla invested over $2 billion in a new manufacturing facility.

In 2019, Tesla followed up with another multibillion investment by breaking ground for a factory in Shanghai, China. This factory is huge, combining the size of the Tesla car manu- facturing facility in Fremont, California, with its Gigafactory in Nevada. The goal is to pro- duce batteries and cars not only at large scale, but also in the same location. This will help lower the price of the Model 3 further to service the Chinese market, which is already the largest electric vehicle market globally by a wide margin. Although such large, up-front investments frequently lead to early-year losses, they also represent strong and credible com- mitments to becoming a viable competitor in the mass automobile market.

COHERENT ACTIONS. A clear guiding policy needs to be implemented with a set of coher- ent actions. Tesla appears to implement its formulated strategy with actions consistent with its diagnosis of the competitive challenge. To accomplish building a cost-competitive mass- market vehicle, Tesla must benefit from economies of scale, which are decreases in cost per vehicle as output increases. To reap these critical cost reductions, Tesla must ramp up its production volume. This is a huge challenge: Tesla aims to increase its production output by some 20 times, from 50,000 cars built in 2015 to 1 million cars by 2020. Tesla’s retooling of its manufacturing facility in Fremont, California, to rely more heavily on cutting-edge robot- ics as well as its multibillion-dollar investment to secure an uninterrupted supply of lithium- ion batteries exemplify actions coherent with Tesla’s formulated strategy.

After production of the Model 3 began in mid-2017, major problems in operations lim- ited the number of Model 3s produced to a mere 2,500 for the year. However, by the end of 2018, Tesla’s huge investments in both its highly automated car manufacturing facility and in its battery plant started to pay off—production of the Model 3 increased to 1,000 units a day. Thus, Tesla plans to produce more than 350,000 Model 3s (by end of 2019), a num- ber it needs to achieve if it is to sustain its cash flow and meet pent-up product demand. At the same time, Tesla is expanding its network of charging stations across North America, Europe, and China. To fund this initiative and to avoid bottlenecks, it announced it will no longer provide new Tesla owners free use of the company’s charging network.

To accomplish the lofty goal of making zero-emission electric motors the new standard in automotive technology rather than internal combustion engines, Tesla decided to make some of its proprietary technology available to the public. Musk’s hope is that sharing Tesla’s patents will expand the overall market size for electric vehicles as other manufactur- ers can employ Tesla’s technology.

In review, to craft a good strategy, three steps are crucial in the strategic management process: First, a good strategy defines the competitive challenges facing an organization through a critical and honest assessment of the status quo. Second, a good strategy provides an overarching approach on how to deal with the competitive challenges identified. The approach needs to be communicated in policies that provide clear guidance for employees. Last, a good strategy requires effective implementation through a coherent set of actions. Strategy Highlight 1.1 takes a closer look at Twitter, and asks whether the social media news service has a strategy.

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CHAPTER 1 What Is Strategy? 9

Does Twitter Have a Strategy? Twitter is not flying high! Shortly after its successful initial public offering in 2014, its market capitalization9 has fallen by 50 percent—from $40 billion to $20 billion in late 2018. Twitter’s user growth has stagnated, while core Tweeters are tweeting less and less. In 2015, co-founder Jack Dorsey returned as CEO but could not reverse Twitter’s de- cline. In comparison, during the same time period, Facebook’s market cap quadrupled from some $100 billion to $400 billion. The question thus arises: Does Twitter have a strategy?

Launched in 2006, Twitter is an online news and social networking site that allows its Tweeters to send short messages (“tweets”) of up to 280 characters or less (and can include images or videos) to all followers. People who follow each other on Twitter can see each others’ status updates in their feeds.  Users with the most followers in- clude Katy Perry, American singer-songwriter and actress, with more than 107 million; Justin Bieber, Canadian singer- songwriter, with 105 million; and former President Barack Obama with 104 million. 

While popular for its scannable content, Twitter’s so- cial significance resulted from its pivotal role during the Arab Spring (2010–2012), in the Black Lives Matter move- ment (founded in 2013), and for its real-time coverage of such breaking news as the raid on Osama bin Laden’s compound in Pakistan (2011). Many of the most powerful politicians in the world such as President Donald Trump and India Prime Minister Narendra Modi use Twitter to communicate directly with the public, allowing them to by- pass traditional media outlets.

To answer the question of whether Twitter has a strat- egy, let’s apply the three critical elements of a good strat- egy and the three critical tasks of a good strategic management process:  diagnose the competitive chal- lenge, derive a guiding policy, and implement a coherent set of actions.

THE COMPETITIVE CHALLENGE Twitter’s business model is to grow its user base and then charge advertisers for promoting goods and services to that user base. While individual users pay nothing, their tweets give Twitter free user-generated content to drive more traffic to its site. Com- panies pay for “promoted tweets” that are directly inserted

into a user’s news stream. But compare Twitter’s 330 million monthly users to Facebook’s over 2 billion users—this tells us that Facebook’s user base is almost seven times the size of Twitter’s. Given its much smaller user base, advertisers view Twitter as a niche application and thus will direct the bulk of their digital ad dollars to larger sites such as Facebook, Google, and Amazon. 

Compared to Facebook, Twitter suffers in ways other than sheer scale. For instance, it has allowed competitors such as Snapchat, WhatsApp, and Instagram (all owned by Facebook) to move into the space it originally created. In addition, Facebook allows advertisers to target their on- line ads more precisely by using the demographic data Facebook collects, including birth year, university affilia- tion, network of friends, interests, and so forth. (This data collection has created a whole different set of problems for Facebook, which is discussed further in ChapterCase 2). Clearly, Twitter needs a larger user base to attract more online advertisers and better monetize its social media service.

A G U I D I N G P O L I CY Here is where Twitter’s prob- lems begin. While its leaders have accurately identified and diagnosed Twitter’s competitive challenge (to grow its user base), they still lack a clear guiding policy for how to address this challenge. One way would be to simplify the sign-up process. Another would be to better explain the sometimes idiosyncratic conventions of Twitter use to a broader audience. Yet another would be to root out offen- sive content, fake accounts, and misinformation, and to be more aggressive about blocking cyber trolls. Perhaps even more important, Twitter needs to find a way to take

Strategy Highlight 1.1

Twitter is not flying high! Between 2014 and 2018, it lost $20 billion in market capitalization. x9626/Shutterstock

(Continued)

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10 CHAPTER 1 What Is Strategy?

back the social media space that’s now being dominated by Snapchat, WhatsApp, and Instagram.

COHERENT ACTIONS Changing the goalpost of which users (core, noncore, or passive viewers that see tweets on other media) to target not only confused management, but it also limited functional guidance for em- ployees in day-to-day operations. Consequences of confus- ing directions for strategy implementation followed, including increased frustration among managers and engi- neers, which led to the turnover of key personnel. As Twitter attempts to be more attractive to different types of users, it encounters trade-offs that are hard if not impossible to rec- oncile. Consider the search or mobile functionality of an ap- plication, for example: The needs of core users are very different from that of casual visitors or passive viewers.

Internal turmoil was further stoked by several management demotions as well as promotions of close personal friends of the CEO. From its inception, Twitter’s culture has been ham- pered by infighting and public intrigues among co-founders and other early leaders.

To reduce the gap with Facebook’s enormous scale and global reach, Twitter has attempted to be everything to everybody, without considering the strategic trade- offs. This has resulted in not only low employee morale, but also inferior performance. Declaring that Twitter’s “ a m b i t i o n i s t o h a v e t h e l a r g e s t a u d i e n c e i n t h e world”10  is not a good strategy; it is no strategy at all. Rather it is a mere statement of desire. With Twitter’s continuing decline in its market cap, it is likely to end up a takeover target.11

LO 1-2 Define competitive advantage, sustainable competitive advantage, competitive disadvantage, and competitive parity.

WHAT IS COMPETITIVE ADVANTAGE? A firm that achieves superior performance relative to other competitors in the same indus- try or the industry average has a competitive advantage.12 Competitive advantage is always relative, not absolute. To assess competitive advantage, we compare firm performance to a benchmark—that is, either the performance of other firms in the same industry or an indus- try average. In terms of stock market valuation, Tesla has appreciated much more in recent years than GM, Ford, or Chrysler, and thus appears to have a competitive advantage, at least on this dimension.

A firm that is able to outperform its competitors or the industry average over a prolonged period has a sustainable competitive advantage. Apple, for example, has enjoyed a sustain- able competitive advantage over Samsung in the smartphone industry for over a decade since its introduction of the iPhone in 2007. Other phone makers such as Microsoft (which purchased Nokia) and BlackBerry have all but exited the smartphone market, while new entrants such as Huawei and Xiaomi of China are trying to gain traction.

If a firm underperforms its rivals or the industry average, it has a competitive disadvan- tage. For example, a 15 percent return on invested capital may sound like superior firm performance. In the consulting industry, though, where the average return on invested capi- tal is often above 20 percent, such a return puts a firm at a competitive disadvantage. In contrast, if a firm’s return on invested capital is 2 percent in a declining industry, like news- paper publishing, where the industry average has been negative (–5 percent) for the past few years, then the firm has a competitive advantage. Should two or more firms perform at the same level, they have competitive parity. In Chapter 5, we’ll discuss in greater depth how to evaluate and assess competitive advantage and firm performance.

To gain a competitive advantage, a firm needs to provide either goods or services consumers value more highly than those of its competitors, or goods or services simi- lar to the competitors’ at lower cost. The rewards of superior value creation and cap- ture are profitability and market share. Elon Musk is particularly motivated to address

competitive advantage Superior performance relative to other competi- tors in the same industry or the industry average.

sustainable competi- tive advantage Out- performing competitors or the industry average over a prolonged period of time.

competitive disadvantage Under- performance relative to other competitors in the same industry or the industry average.

competitive parity Performance of two or more firms at the same level.

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CHAPTER 1 What Is Strategy? 11

Spanx founder and CEO Sara Blakely, a graduate of Florida State University and former salesperson of fax machines, was America’s richest self- made woman in 2018, according to Forbes. Marla Aufmuth/Getty Images

global warming, and thus formed Tesla to build electric vehicles with zero emissions. Sara Blakely, the founder and CEO of Spanx, the global leader in the shapewear industry, is motivated to change women’s lives. Sam Walton was driven by offering acceptable value at lower cost than his competitors when creating Walmart, the world’s largest (brick-and-mortar) retailer. For Musk, Blakely, Walton, and numerous other entrepreneurs and businesspeople, creating shareholder value and making money is the consequence of filling a need and providing a product, service, or experience consumers wanted, at a price they could afford while still making a profit.

The important point here is that strategy is about delivering superior value, while containing the cost to create it, or by offering similar value at lower cost. Managers achieve these combinations of value and cost through strategic positioning. That is, they stake out a unique position within an industry that allows the firm to provide value to customers, while controlling costs. The greater the difference between value creation and cost, the greater the firm’s economic contribution and the more likely it will gain competitive advantage.

Strategic positioning requires trade-offs, however. As a low-cost retailer, Walmart has a clear strategic profile and serves a specific market segment. Upscale retailer Nordstrom has also built a clear strategic profile by providing superior customer service to a higher end, luxury market segment. Although these companies are in the same industry, their customer segments overlap very little, and they are not direct competitors. Walmart and Nordstrom have each chosen a distinct but different strategic position. The managers make conscious trade-offs that enable each company to strive for competitive advantage in the retail industry, using different competitive strategies: cost leadership versus differ- entiation. In regard to the customer service dimension, Walmart provides acceptable ser- vice by low-skill employees in a big-box retail outlet offering “everyday low prices,” while Nordstrom provides a superior customer experience by professional salespeople in a luxury setting.

A clear strategic profile—in terms of product differentiation, cost, and customer service— allows each retailer to meet specific customer needs. Competition focuses on creating value for customers (through lower prices or better service and selection, in this example) rather than destroying rivals. Even though Walmart and Nordstrom compete in the same industry, both can win if they achieve a clear strategic position through a well-executed competitive strategy. Strategy, therefore, is not a zero-sum game.

The key to successful strategy is to combine a set of activities to stake out a unique strategic position within an industry. Competitive advantage has to come from perform- ing different activities or performing the same activities differently than rivals are doing. Ideally, these activities reinforce one another rather than create trade-offs. For instance, Walmart’s strategic activities strengthen its position as cost leader: Big retail stores in rural locations, extremely high purchasing power, sophisticated IT systems, regional distribution centers, low corporate overhead, and low base wages and salaries combined with employee profit sharing reinforce each other, to maintain the company’s cost leadership.

Since clear strategic positioning requires trade-offs, strategy is as much about deciding what not to do, as it is about deciding what to do.13 Because resources are limited, managers

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12 CHAPTER 1 What Is Strategy?

must carefully consider their strategic choices in the quest for competitive advantage. Trying to be everything to everybody will likely result in inferior performance.

As a striking example, the department store chain Sears was founded in 1886 and long hailed as an innovator. Sears pioneered its iconic mail-order catalog shortly after its founding, which allowed customers in rural and remote areas of the United States to shop like city dwellers (a similar service to what Amazon provides today, albeit relying on a much smaller selection and slower deliveries). Yet, as time progressed and Sears failed to adapt to new competitive challenges, it lost its competitive advantage. More recently, Sears did not have a clear strategic position but tried to be too many things for too many types of customers. As a consequence, after more than 130 years in business, Sears filed for bankruptcy in 2018.

It is also important to note that operational effectiveness, marketing skills, and other functional expertise all strengthen a unique strategic position. Those capabilities, though, do not substitute for competitive strategy. Competing to be similar but just a bit better than your competitor is likely to be a recipe for cut-throat competition and low profit potential. Let’s take this idea to its extreme in a quick thought experiment: If all firms in the same industry pursued a low-cost position through application of competi- tive benchmarking, all firms would have identical cost structures. None could gain a competitive advantage. Everyone would be running faster, but nothing would change in terms of relative strategic positions. There would be little if any value creation for cus- tomers because companies would have no resources to invest in product and process improvements. Moreover, the least-efficient firms would be driven out, further reducing customer choice.

To gain a deeper understanding of what strategy is, it may be helpful to think about what strategy is not.14 Be on the lookout for the following major hallmarks of what strategy is not:

GRANDIOSE STATEMENTS ARE NOT STRATEGY. You may have heard firms say things like, “Our strategy is to win” or “We will be No. 1.” Twitter, for example, declared its “ambi- tion is to have the largest audience in the world.”15 Such statements of desire, on their own, are not strategy. They provide little managerial guidance and often lead to goal conflict and confusion. Moreover, such wishful thinking frequently fails to address economic fundamen- tals. As we will discuss in the next section, an effective vision and mission can lay the foun- dation upon which to craft a good strategy. This foundation must be backed up, however, by strategic actions that allow the firm to address a competitive challenge with clear consider- ation of economic fundamentals, in particular, value creation and costs.

A FAILURE TO FACE A COMPETITIVE CHALLENGE IS NOT STRATEGY. If a firm does not define a clear competitive challenge, employees have no way of assessing whether they are making progress in addressing it. Strategic leaders at the now-defunct video rental chain Blockbuster, for example, failed to address the competitive challenges posed by new players Netflix, Redbox, Amazon Prime, and Hulu.

OPERATIONAL EFFECTIVENESS, COMPETITIVE BENCHMARKING, OR OTHER TACTICAL TOOLS ARE NOT STRATEGY. People casually refer to a host of different policies and initiatives as some sort of strategy: pricing strategy, internet strategy, alliance strategy, operations strategy, IT strategy, brand strategy, marketing strategy, HR strategy, China strat- egy, and so on. All these elements may be a necessary part of a firm’s functional and global initiatives to support its competitive strategy, but these elements are not sufficient to achieve competitive advantage. In this text, we will reserve the term strategy for describing the firm’s overall efforts to gain and sustain competitive advantage.

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CHAPTER 1 What Is Strategy? 13

1.2 Stakeholder Strategy and Competitive Advantage

VALUE CREATION Companies with a good strategy generate value for society. When firms compete in their own self-interest while obeying the law and acting ethically, they ultimately create value. Value creation occurs because companies with a good strategy are able to provide products or services to consumers at a price point that they can afford while keeping their costs in check, thus making a profit at the same time. Both parties benefit from this trade as each captures a part of the value created. In so doing, they leave society better off.16

Value creation in turn lays the foundation for the benefits that successful economies can provide: education, infrastructure, public safety, health care, clean water and air, among others. Superior performance allows a firm to reinvest some of its profits and to grow, which in turn provides more opportunities for employment and fulfilling careers. Although Google (a division of Alphabet) started as a research project in graduate school by Larry Page and Sergey Brin in the late 1990s, some 20 years later it had become one of the most valuable companies in the world with over $800 billion in mar- ket capitalization and 100,000 employees, not to mention the billions of people across the world who rely on it for information gathering and decision making, which is free for the end user.17

Strategic failure, in contrast, can be expensive. Once a leading technology company, Hewlett-Packard was known for innovation, resulting in superior products. The “HP way of management” included lifetime employment, generous benefits, work/life balance, and free- dom to explore ideas, among other perks.18 However, HP has not been able to address the competitive challenges of mobile computing or business IT services effectively. As a result, HP’s stakeholders suffered. Shareholder value was destroyed. The company also had to lay off tens of thousands of employees. Its customers no longer received the innovative products and services that made HP famous.

The contrasting examples of Alphabet and HP illustrate the relationship between indi- vidual firms, competitive advantage, and society at large. Successful firms ultimately create value for society. In the first decade of the new millennium, this relationship received more critical scrutiny due to major shocks to free market capitalism.19 In particular, the implicit trust relationship between the corporate world and society at large has deteriorated because of several notable crises. One of the first crises of the 21st century occurred when the accounting scandals at Enron, Arthur Andersen, WorldCom, Tyco, Adelphia, and others, came to light. Those events led to bankruptcies, large-scale job loss, and the destruction of billions of dollars in shareholder value. As a result, the public’s trust in business and free market capitalism began to erode.

Another major event occurred in the fall of 2008 with the global financial crisis, which shook the entire free market system to its core.20 A real estate bubble had developed in the United States, fueled by cheap credit and the availability of subprime mortgages. When that bubble burst, many entities faced financial duress or bankruptcy—those who had unsustain- able mortgages, investors holding securities based on those mortgages, and the financial institutions that had sold the securities. Some went under, and others were sold at fire-sale prices. Home foreclosures skyrocketed as a large number of borrowers defaulted on their mortgages. House prices in the United States plummeted by roughly 30 percent. The United States plunged into a deep recession. In the process, the Dow Jones Industrial Average (DJIA) lost about half its market value.

LO 1-3 Assess the relationship between stakeholder strategy and sustainable competitive advantage.

value creation Occurs when companies with a good strategy are able to provide products or services to consumers at a price point that they can afford while keeping their costs in check, thus making a profit at the same time. Both parties benefit from this trade as each captures a part of the value created.

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14 CHAPTER 1 What Is Strategy?

The impact was worldwide. The freezing of capital markets during the global financial crisis triggered a debt crisis in Europe. Some European governments (notably Greece) defaulted on government debt; other countries were able to repay their debts only through the assistance of other, more solvent European countries. This severe financial crisis not only put Europe’s common currency, the euro, at risk, but also led to a prolonged and deep recession in Europe. Disenchanted with the European Union, the United Kingdom voted in 2016 to leave the alliance in wake of the Brexit movement (short for British exit). In the United States, the Occupy Wall Street protest movement was born out of dissatisfaction with the capitalist system. Issues of income disparity, corporate ethics, corporate influence on governments, and ecological sustainability were key drivers.

Although these major events in the business world differed in their specifics, two com- mon features are pertinent to our study of strategic management.21 First, these events dem- onstrate that managerial actions can affect the economic well-being of large numbers of people around the globe. Most of the events resulted from executive actions within a few organizations, or compounded across a specific industry or government. The second perti- nent feature relates to stakeholders—organizations, groups, and individuals that can affect or be affected by a firm’s actions.22 This leads us to stakeholder strategy, which we discuss next.

STAKEHOLDER STRATEGY Stakeholders have a vested claim or interest in the performance and continued survival of the firm. Stakeholders can be grouped by whether they are internal or external to a firm. As shown in Exhibit 1.1, internal stakeholders include employees (executives, managers, and workers), stockholders, and board members. External stakeholders include customers, sup- pliers, alliance partners, creditors, unions, communities, governments at various levels, and the media.

All stakeholders make specific contributions to a firm, which in turn provides different types of benefits to different stakeholders. Employees contribute their time and talents to the firm, receiving wages and salaries in exchange. Shareholders contribute capital with the expectation that the stock will rise and the firm will pay dividends. Communities provide real estate, infrastructure, and public safety. In return, they expect that companies will pay

stakeholders Organi- zations, groups, and in- dividuals that can affect or are affected by a firm’s actions.

External Stakeholders • Customers • Suppliers • Alliance Partners • Creditors • Unions • Communities • Governments • Media

Internal Stakeholders

Be ne

fit s

Be ne

fit s

Be ne

fit s

Be ne

fit s

C on

tr ib

ut io

ns

C on

tr ib

ut io

ns

• Employees • Stockholders • Board Members

EXHIBIT 1.1 Internal and External Stakeholders in an Exchange Relationship with the Firm

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CHAPTER 1 What Is Strategy? 15

taxes, provide employment, and not pollute the environment. The firm, therefore, is embed- ded in a multifaceted exchange relationship with a number of diverse internal and external stakeholders. If any stakeholder withholds participation in the firm’s exchange relation- ships, it can negatively affect firm performance. The aerospace company Boeing, for exam- ple, has a long history of acrimonious labor relations, leading to walk-outs and strikes. This in turn has not only delayed production of airplanes but also raised costs.

Stakeholder strategy is an integrative approach to managing a diverse set of stakeholders effectively in order to gain and sustain competitive advantage.23 The unit of analysis is the web of exchange relationships a firm has with its stakeholders (see Exhibit 1.1). Stake- holder strategy allows firms to analyze and manage how various external and internal stakeholders interact to jointly create and trade value.24 A core tenet of stakeholder strat- egy is that a single-minded focus on shareholders alone exposes a firm to undue risks. Simply putting shareholder interest above all else can undermine economic performance and even threaten the very survival of the enterprise. A strategic leader, therefore, must understand the complex web of exchange relationships among different stakeholders. With that understanding, the firm can proactively shape the various relationships to maximize the joint value created and manage the distribution of this larger pie in a fair and transpar- ent manner. Effective stakeholder management exemplifies how strategic leaders can act to improve firm performance, thereby enhancing the firm’s competitive advantage and the likelihood of its continued survival.25

Taken together, strategy scholars have provided several arguments as to why effective stakeholder management can benefit firm performance:26

■ Satisfied stakeholders are more cooperative and thus more likely to reveal information that can further increase the firm’s value creation or lower its costs.

■ Increased trust lowers the costs for firms’ business transactions. ■ Effective management of the complex web of stakeholders can lead to greater organiza-

tional adaptability and flexibility. ■ The likelihood of negative outcomes can be reduced, creating more predictable and sta-

ble returns. ■ Firms can build strong reputations that are rewarded in the marketplace by business

partners, employees, and customers. Most managers do care about public perception of the firm and frequently celebrate and publicize high-profile rankings such as the “World’s Most Admired Companies” published annually by Fortune.27 In 2018, the top five companies in this ranking were Apple, Amazon, Alphabet, Berkshire Hathaway (the conglomerate led by Warren Buffett), and Starbucks. Because of its continued innova- tion in products, services, and delivery, Apple has been ranked as the world’s most admired company for the past several years by Fortune.

STAKEHOLDER IMPACT ANALYSIS The key challenge of stakeholder strategy is to effectively balance the needs of various stake- holders. The firm needs to ensure that its primary stakeholders—the firm’s shareholders and other investors—achieve their objectives. At the same time, the firm needs to recognize and address the concerns of other stakeholders—employees, suppliers, and customers—in an ethical and fair manner, so that they too are satisfied. This all sounds good in theory, but how can strategic leaders go about this in practice?

Stakeholder impact analysis provides a decision tool with which strategic leaders can recognize, prioritize, and address the needs of different stakeholders. This tool helps the firm achieve a competitive advantage while acting as a good corporate citizen. Stakeholder

LO 1-4 Conduct a stakeholder impact analysis.

stakeholder strategy An integrative approach to managing a diverse set of stakeholders effectively in order to gain and sustain competitive advantage.

stakeholder impact analysis A decision tool with which manag- ers can recognize, pri- oritize, and address the needs of different stakeholders, enabling the firm to achieve competitive advantage while acting as a good corporate citizen.

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16 CHAPTER 1 What Is Strategy?

impact analysis takes strategic leaders through a five-step process of recognizing stakehold- ers’ claims. In each step, they must pay particular attention to three important stakeholder attributes: power, legitimacy, and urgency.28

■ A stakeholder has power over a company when it can get the company to do something that it would not otherwise do.

■ A stakeholder has a legitimate claim when it is perceived to be legally valid or otherwise appropriate.

■ A stakeholder has an urgent claim when it requires a company’s immediate attention and response.

Exhibit 1.2 depicts the five steps in stakeholder impact analysis and the key questions to be asked. Let’s look at each step in detail.

STEP 1: IDENTIFY STAKEHOLDERS. In Step 1, strategic leaders ask, “Who are our stake- holders?” In this step, the strategic leaders focus on stakeholders that currently have, or potentially can have, a material effect on a company. This prioritization identifies the most powerful internal and external stakeholders as well as their needs. For public-stock compa- nies, key stakeholders are the shareholders and other providers of capital. If shareholders are not satisfied with returns to investment, they will sell the company’s stock, leading to a fall in the firm’s market value. If this process continues, it can make the company a take- over target, or launch a vicious cycle of continued decline.

A second group of stakeholders includes customers, suppliers, and unions. Local com- munities and the media are also powerful stakeholders that can affect the smooth operation of the firm. Any of these groups, if their needs are not met, can materially affect the com- pany’s operations.

For example, Boeing opened an airplane factory in South Carolina to move production away from its traditional plant near Seattle, Washington. South Carolina is one of 28 states in the United States that operates under a right-to-work law in which employees in unionized workplaces are allowed to work without being required to join the union. In contrast to its work force in Washington state, the South Carolina plant is nonunionized, which should

STEP 2

STEP 1 Who are our stakeholders?

What are our stakeholders’ interests and claims?

What opportunities and threats do our stakeholders present?

What economic, legal, ethical, and philanthropic responsibilities do we have to our stakeholders?

What should we do to effectively address the stakeholder concerns?

STEP 3

STEP 4

STEP 5

EXHIBIT 1.2 Stakeholder Impact Analysis

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CHAPTER 1 What Is Strategy? 17

lead to fewer work interruptions due to strikes and Boeing hopes to higher productivity and improvements along other performance dimensions (like on-time delivery of new airplanes). Boeing decided to build its new 787 Dreamliner jet exclusively in its nonunionized South Carolina factory.29

STEP 2: IDENTIFY STAKEHOLDERS’ INTERESTS. In Step 2, strategic leaders ask, “What are our stakeholders’ interests and claims?” They need to specify and assess the interests and claims of the pertinent stakeholders using the power, legitimacy, and urgency criteria introduced earlier. As the legal owners, shareholders have the most legitimate claim on a company’s profits. However, the wall separating the claims of ownership (by shareholders) and of management (by employees) has been eroding. Many companies incentivize top executives by paying part of their overall compensation with stock options. They also turn employees into shareholders through employee stock ownership plans (ESOPs). These plans allow employees to purchase stock at a discounted rate or use company stock as an invest- ment vehicle for retirement savings. For example, Alphabet, Coca-Cola, Facebook, Microsoft, Southwest Airlines, Starbucks, and Walmart all offer ESOPs. Clearly, the claims and interests of stakeholders who are employed by the company, and who depend on the company for salary and other benefits, will be somewhat different from those of stakehold- ers who merely own stock. The latter are investors who are primarily interested in the increased value of their stock holdings through appreciation and dividend payments. Executives, managers, and workers tend to be more interested in career opportunities, job security, employer-provided health care, paid vacation time, and other perks.

Even within stakeholder groups there can be significant variation in the power a stake- holder may exert on the firm. For example, public companies pay much more attention to large investors than to the millions of smaller, individual investors. Shareholder activists, such as Bill Ackman, Carl Icahn, or Daniel Loeb, tend to buy equity stakes in a corporation that they believe is underperforming to put public pressure on a company to change its strat- egy. Examples include the takeover battle at Dell Computer (which founder Michael Dell subsequently took private, before going public again a few years later), the pressure on Pep- siCo to spin off its Frito-Lay brand, or on Yahoo to sell itself to Verizon, which it did. Even top-performing companies are not immune to pressure by shareholder activists.30 As a result of a sustained competitive advantage over the last decade, Apple had not only become the first company to be valued above $1 trillion but also amassed some $200 billion in cash in the process. Apple CEO Tim Cook faced significant pressure from Carl Icahn, who held roughly $4 billion worth of Apple stock, to buy back more of its shares and thus to further raise Apple’s share price. Cook obliged, and Apple bought back a significant amount of stock, using its cash to buttress its share price.

Although both individual and activist investors may claim the same legitimacy as stock- holders, shareholder activists have much more power over a firm. They can buy and sell a large number of shares at once or exercise block-voting rights in the corporate governance process (which we’ll discuss in detail in Chapter 12). Shareholder activists frequently also demand seats on the company’s board to more directly influence its corporate governance, and with it exert more pressure to change a company’s strategy. These abilities make activist investors powerful stakeholders, with urgent and legitimate claims.

STEP 3: IDENTIFY OPPORTUNITIES AND THREATS. In Step 3, strategic leaders ask, “What opportunities and threats do our stakeholders present?” Since stakeholders have a claim on the company, opportunities and threats are two sides of the same coin. Consumer boycotts, for example, can be a credible threat to a company’s behavior. Some consumers boycotted BP for its role in the 2010 Gulf of Mexico oil spill and resulting environmental

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18 CHAPTER 1 What Is Strategy?

damages; Nestlé products were boycotted when the firm promoted infant formula over breast milk in developing countries. PETA31 called for a boycott of McDonald’s due to alleged animal-rights abuses.

In the best-case scenario, managers transform such threats into opportunities. Sony Corp. of Japan, for example, was able to do just that.32 During one holiday season, the Dutch government blocked Sony’s entire holiday season shipment of PlayStation game sys- tems, valued at roughly $500 million, into the European Union because of a small but legally unacceptable amount of toxic cadmium discovered in one of the system’s cables. This inci- dent led to an 18-month investigation in which Sony inspected over 6,000 supplier factories around the world to track down the source of the problem. The findings allowed Sony to redesign and develop a cutting-edge supplier management system that now adheres to a stringent extended value chain responsibility.

STEP 4: IDENTIFY SOCIAL RESPONSIBILITIES. In Step 4, strategic leaders ask, “What economic, legal, ethical, and philanthropic responsibilities do we have to our stakeholders?” To identify these responsibilities more effectively, scholars have advanced the notion of corporate social responsibility (CSR). This framework helps firms recognize and address the economic, legal, ethical, and philanthropic expectations that society has of the business enterprise at a given point in time.33 According to the CSR perspective, strategic leaders need to realize that society grants shareholders the right and privilege to create a publicly traded stock company. Therefore, the firm owes something to society.34 CSR provides stra- tegic leaders with a conceptual model that more completely describes a society’s expecta- tions and can guide strategic decision making more effectively. In particular, CSR has four components:

■ Economic responsibilities ■ Legal responsibilities ■ Ethical responsibilities ■ Philanthropic responsibilities35

Economic Responsibilities. The business enterprise is first and foremost an economic institution. Investors expect an adequate return for their risk capital. Creditors expect the firm to repay its debts. Consumers expect safe products and services at appropriate prices and quality. Suppliers expect to be paid in full and on time. Governments expect the firm to pay taxes and to manage natural resources such as air and water under a decent stewardship. To accomplish all this, firms must obey the law and act ethically in their quest to gain and sustain competitive advantage.

Nobel laureate Milton Friedman views the economic responsibility of the firm as its primary objective, as captured in his famous quote: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”36

Legal Responsibilities. Laws and regulations are a society’s codified ethics, embodying notions of right and wrong. They also establish the rules of the game. For example, business as an institution can function because property rights exist and contracts can be enforced in courts of law. Strategic leaders must ensure that their firms obey all the laws and regula- tions, including but not limited to labor, consumer protection, and environmental laws.

One far-reaching piece of U.S. legislation in terms of business impact, for example, is the Patient Protection and Affordable Care Act (PPACA), more commonly known as the

corporate social responsibility (CSR) A framework that helps firms recognize and ad- dress the economic, le- gal, social, and philanthropic expecta- tions that society has of the business enterprise at a given point in time.

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CHAPTER 1 What Is Strategy? 19

Affordable Care Act (ACA) or Obamacare. Key provisions of this federal law include, among others, that firms with 50 or more full-time employees must offer affordable health insurance to their employees and dependents, or pay a fine for each worker. This makes it harder for entrepreneurs to grow their ventures above this threshold. One reaction of many small businesses has been to reduce the number of full-time workers to 49 employees and add part-time employees only, which do not fall under this provision. Another reaction of employers is to offer lower wages to compensate for higher health care costs. Moreover, health insurance providers are no longer allowed to deny coverage based on preexisting medical conditions. As a consequence, health care premiums have been rising as the overall risk pool of insurers is less healthy.37

Ethical Responsibilities. Legal responsibilities, however, often define only the minimum acceptable standards of firm behavior. Frequently, strategic leaders are called upon to go beyond what is required by law. The letter of the law cannot address or anticipate all possi- ble business situations and newly emerging concerns such as internet privacy or advances in artificial intelligence, DNA testing, genetic engineering, and stem-cell research. A firm’s ethical responsibilities, therefore, go beyond its legal responsibilities. They embody the full scope of expectations, norms, and values of its stakeholders. Strategic leaders are called upon to do what society deems just and fair.

In the spring of 2018, Starbucks received harsh criticism from multiple stakehold- ers.38 Calls to #BoycottStarbucks went viral on social media. What caused the firestorm? Two African-American men were arrested at one of its Philadelphia locations. Reports indi- cated that the two men had entered the Starbucks store and asked one of the employees to use the restroom. The employee refused permission because the men had not (yet) pur- chased anything. They proceeded to sit down, stating they were meeting an associate for a business meeting and that they would order upon his arrival. Shortly thereafter the two men were asked to leave the store. The store manager eventually called the police who arrested them for alleged trespassing. A patron videotaped the entire scene and then posted it to Twitter; it has since been viewed more than 11 million times and retweeted more than 150,000 times. In the video, we see police officers handcuffing the two men while a per- plexed and upset bystander repeatedly asks the police, “But what did they do? What did they do? Someone tell me what they did.”39

In response to the public outcry over the store’s actions and the grave concerns expressed by stakeholders, Starbucks CEO Kevin Johnson issued a formal apology in which he expressed regret over the situation’s “reprehensible outcome” and stated that the actions of the employees were “not representative of … Starbucks’ mission and values.”40 A few weeks after the incident, Starbucks, at a significant cost, closed its more than 8,000 stores across the United States for a full day and dedicated the day to racial bias and diversity training for all employees. This was not an action the firm was legally required to do, but one it felt ethically obligated to do to avoid a repeat of such incidents.41

Philanthropic Responsibilities. Philanthropic responsibilities are often subsumed under the idea of corporate citizenship, reflecting the notion of voluntarily giving back to society. Over the years, Microsoft’s corporate philanthropy program has donated more than $3 bil- lion in cash and software to people who can’t afford computer technology.42

The pyramid in Exhibit 1.3 summarizes the four components of corporate social respon- sibility.43 Economic responsibilities are the foundational building block, followed by legal, ethical, and philanthropic responsibilities. Note that society and shareholders require economic and legal responsibilities. Ethical and philanthropic responsibilities result from a society’s expectations toward business. The pyramid symbolizes the need for firms to

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20 CHAPTER 1 What Is Strategy?

carefully balance their social responsibilities. Doing so ensures not only effective strategy implementation, but also long-term viability.

STEP 5: ADDRESS STAKEHOLDER CONCERNS. Finally, in Step 5, the firm asks, “What should we do to effectively address any stakeholder concerns?” In the last step in stake- holder impact analysis, strategic leaders need to decide the appropriate course of action for the firm, given all of the preceding factors. Thinking about the attributes of power, legitimacy, and urgency helps to prioritize the legitimate claims and to address them accordingly.

Strategy Highlight 1.2 describes Merck’s stakeholder strategy anchored in ethical core values. It showcases how Merck considered and addressed various claims from a wide variety of stakeholders, among them the most disadvantaged patients that can’t afford to pay for medications.

EXHIBIT 1.3 The Pyramid of Corporate Social Responsibility Adapted from A. B. (Carroll, 1991, July– August), “The pyramid of corporate social responsibility: Toward the moral management of organizational stakeholders,” Business Horizons: 42.

Philanthropic Responsibilities

Ethical Responsibilities

Legal Responsibilities

Economic Responsibilities

Corporate citizenship

Do what is right, just, and fair

Laws and regulations are society’s codified ethics

Define minimum acceptable standard

Gain and sustain competitive advantage

Merck’s Stakeholder Strategy Merck’s vision is to preserve and improve human life. The words of founder George W. Merck still form the basis of the company’s values today: We try to never forget that medicine is for the people. It is not for profits. The profits follow, and if we have remembered that, they have never failed to appear.44

ENDING RIVER BLINDNESS Ray Vagelos, a former Merck scientist turned CEO, announced (in 1987) that the company would donate its recently discovered drug Mecti- zan, without charge, to treat river blindness. For centuries,

river blindness—a parasitic disease that leads to loss of eye- sight—plagued remote communities in Africa and other parts of the world. Merck’s executives formed a novel private- public partnership, the Mectizan Donation Program (MDP), to distribute the drug in remote areas, where health services are often not available.

After more than 25 years, more than 1 billion treat- ments, and some 120,000 communities served, the dis- ease had effectively been eradicated. Merck’s current CEO, Kenneth Frazier, announced himself “humbled” by the result of the company’s value-driven actions.45

Strategy Highlight 1.2

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CHAPTER 1 What Is Strategy? 21

1.3 The Analysis, Formulation, Implementation (AFI) Strategy Framework

How do leaders craft and execute a strategy that enhances their chances of achieving superior performance? A successful strategy details a set of actions that managers take to gain and sustain competitive advantage. Effectively managing the strategy process is the result of

1. Analysis (A) 2. Formulation (F) 3. Implementation (I)

These three tasks are the pillars of research and knowledge of strategic management. Although we will study these tasks one at a time, they are highly interdependent and fre- quently occur simultaneously. Effective managers do not formulate strategy without think- ing about how to implement it, for instance. Likewise, while managers implement strategy, they also analyze the need to adjust to changing circumstances.

W I T H D R AW I N G V I OX X In the case of another drug, though, Merck’s stakeholder strategy was ques- tioned. Vioxx was a painkiller developed to produce fewer gastrointestinal side effects than aspirin or ibuprofen. Once the Food and Drug Administration (FDA) approved the new drug in 1999, Merck engaged in typical big pharma promotional practices:

• Heavy direct-to-consumer advertising via TV and other media.

• Luxury doctor inducements, including consulting contracts and free retreats at exotic resorts.

Merck’s new drug was a blockbuster, generating reve- nues of $2.5 billion a year by 2002 and growing fast.

Allegations began to appear, however, that Vioxx caused heart attacks and strokes. Critics alleged that Merck had suppressed evidence about Vioxx’s dangerous side effects from early clinical trials. In 2004, Merck vol- untarily recalled the drug. Merck’s CEO at the time, Raymond Gilmartin, framed the situation in terms of knowledge learned after the initial release. He said he received a phone call from the head of research. “He told me that our long-term safety study of Vioxx was showing an increased risk of cardiovascular events compared to placebo, and the trial was being discontinued…. After ana- lyzing the data further and consulting with outside ex- perts, the Merck scientists recommended that we voluntarily withdraw the drug.”46

Regardless of what Merck knew when, the voluntary withdrawal reconfirmed in a costly way its core value that patients come before profits. Merck’s reputation damaged, its stock fell almost 30 percent, eradicating $27 billion in market value almost overnight—an amount much greater than the estimated net present value of the profits that Merck would have obtained from contin- ued sales of Vioxx. Merck has been hit by lawsuits ever since; legal liabilities have cost the company up to $30 billion thus far.

Some corporate social responsibility experts argue that Merck should have never put Vioxx on the market in the first place, or that it should have at least provided up front, clear assessments of the risks associated with Vioxx.47

Kenneth Frazier, CEO of Merck. Stephanie Keith/Getty Images

LO 1-5 Explain the Analysis, Formulation, Implementation (AFI) Strategy Framework.

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22 CHAPTER 1 What Is Strategy?

We’ve captured these interdependent relationships in the Analysis, Formulation, Imple- mentation (AFI) Strategy Framework shown in Exhibit 1.4. This framework

1. Explains and predicts differences in firm performance. 2. Helps leaders formulate and implement a strategy that can result in superior perfor-

mance.

Each broad strategy task raises specific topics and questions that managers must address. These questions and topics are listed below. They are also addressed in the specific chapters listed in Exhibit 1.4: chapters 1 to 5 address questions related to analysis; chapters 6 to 10 cover formulation; and chapters 11 to 12 cover implementation.

KEY TOPICS AND QUESTIONS OF THE AFI STRATEGY FRAMEWORK Analysis (A) ■ Strategic Leadership and the Strategy Process. What roles do strategic leaders play, and

how do they help shape a firm’s vision, mission, and values? How does strategy come about, and what process for creating strategy should strategic leaders put in place? (Chapter 2)

■ External Analysis. What effects do forces in the external environment have on the firm’s potential to gain and sustain a competitive advantage? How should the firm deal with them? (Chapter 3)

Analysis, Formulation, Implementation (AFI) Strategy Framework A model that links three interdependent strategic management tasks—analyze, formu- late, and implement— that, together, help managers plan and im- plement a strategy that can improve perfor- mance and result in competitive advantage.

EXHIBIT 1.4 The Analysis, Formulation, Implementation (AFI) Strategy Framework

1. What Is Strategy?

3. External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 4. Internal Analysis: Resources, Capabilities, and Core Competencies 5. Competitive Advantage, Firm Performance, and Business Models

6. Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 7. Business Strategy: Innovation, Entrepreneurship, and Platforms

8. Corporate Strategy: Vertical Integration and Diversification 9. Corporate Strategy: Strategic Alliances, Mergers and Acquisitions

10. Global Strategy: Competing Around the World

11. Organizational Design: Structure, Culture, and Control

Getting Started

External and Internal Analysis

Formulation: Business Strategy

Formulation: Corporate Strategy

Implementation Gaining &

Sustaining Competitive Advantage

12. Corporate Governance and Business Ethics

2. Strategic Leadership: Managing the Strategy Process

Part 1: A nalysis

Part 1: A nalysis

Part 2: F ormulationPart 2: F ormulation

Part 3: Implementation

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CHAPTER 1 What Is Strategy? 23

■ Internal Analysis. What effects do internal resources, capabilities, and core competencies have on the firm’s potential to gain and sustain a competitive advantage? How should the firm leverage them for competitive advantage? (Chapter 4)

■ Competitive Advantage, Firm Performance, and Business Models. How does the firm make money? How can one assess and measure competitive advantage? What is the rela- tionship between competitive advantage and firm performance? (Chapter 5)

Formulation (F) ■ Business Strategy. How should the firm compete: cost leadership, differentiation, or value

innovation? (Chapters 6 and 7) ■ Corporate Strategy. Where should the firm compete: industry, markets, and geography?

(Chapters 8 and 9) ■ Global Strategy. How and where should the firm compete: local, regional, national, or inter-

national? (Chapter 10)

Implementation (I) ■ Organizational Design. How should the firm organize to turn the formulated strategy into

action? (Chapter 11) ■ Corporate Governance and Business Ethics. What type of corporate governance is most

effective? How does the firm anchor strategic decisions in business ethics? (Chapter 12)

The AFI Strategy Framework shown in Exhibit 1.4 is repeated at the beginning of each part of this text to help contextualize where we are in our study of the firm’s quest to gain and sustain competitive advantage. In addition, the AFI Strategic Management Process Map, presented at the end of Chapter 1, illustrates the steps in the AFI framework in more detail. This strategic management process map highlights the key strategy concepts and frame- works we’ll cover in each chapter. It also serves as a checklist for when you conduct a strate- gic management analysis.

We next turn to the Implications for Strategic Leaders section to provide practical applica- tions and considerations of the material discussed in this chapter.

1.4 Implications for Strategic Leaders Strategy is the art and science of success and failure. The difference between success and failure lies in an organization’s strategy. A good strategy is grounded in a strategic man- agement process that defines the competitive challenge, provides a guiding policy, and is implemented by coherent actions. A good strategy enhances the chances of achieving competitive advantage and superior performance. Moreover, strategic leaders appreci- ate the fact that competition is everywhere. Thus, you need a good strategy to deal with competition.

Strategic leaders are also mindful of the organization’s internal and external stake- holders, because they have a vested claim or interest in the performance and continued survival of the firm. Using a stakeholder strategy approach enables strategic leaders to manage a diverse set of stakeholders effectively in order to gain and sustain competitive advantage.

The strategic leader also realizes that the principles of strategic management can be applied universally to all organizations. Strategy determines performance whether in organi- zations large or small, multinational Fortune 100 companies, for-profit or nonprofit organi- zations; in the private or the public sector; and in developed as well as emerging economies.

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24 CHAPTER 1 What Is Strategy?

A good strategy is more likely to result when strategic leaders apply the three key tasks of the AFI Strategy Framework:

1. Analysis of the external and internal environments. 2. Formulation of an appropriate business and corporate strategy. 3. Implementation of the formulated strategy through structure, culture, and controls.

Keep in mind that strategic leaders are making decisions under conditions of uncertainty and complexity. They must carefully monitor and evaluate the progress toward key strategic objectives and make adjustments by fine-tuning any strategy as necessary. We discuss how this is done in the next chapter where we focus on strategic leaders and the strategic manage- ment process.

IN 2016, 10 years after Tesla’s initial “secret strategy,” Elon Musk unveiled the second part of his master plan for the company (“Master Plan, Part Deux”) to continue the pursuit of its vision “to accelerate the advent of sustainable energy.” Again, CEO Musk detailed a set of stretch goals:

1. Create stunning solar roofs with seamlessly integrated battery storage.

2. Expand the electric vehicle product line to address all major segments.

3. Develop a self-driving capability that is 10 times safer than manual via massive fleet learning.

4. Enable your car to make money for you when you aren’t using it.48

In the updated strategy, Step 1 leverages the integration of SolarCity. The new Tesla company is now a fully integrated sustainable energy company, combining energy generation with energy storage from SolarCity. It provides energy genera- tion via beautiful new solar roofs that look like regular shin- gles, but cost less, all things considered, and last longer. Tesla also offers its Powerwall to residential consumers, which al- lows customers to store the solar energy captured on their roofs for later use. Energy generation, therefore, becomes de- centralized. This implies that consumers are able to generate and use energy without being dependent on any utility, and are able to sell back excess energy to utilities. Indeed, consum- ers will generate not only energy for the use of their Tesla cars but also enough to cover the energy needs of the entire house.

In Step 2, Tesla is planning to expand the lineup of its electric vehicles to address all major segments. Elon Musk excels in product development, and Tesla has several new ve- hicles including a compact SUV, a pickup truck, a bus, and a

heavy-duty semi in development. In the spring of 2019, Tesla launched the Model Y, a compact SUV that is a smaller and much lower priced version of the Model X, starting at $39,000 (and a 230-mile range) with deliveries in spring 2021 and a higher-priced version starting at $47,000 to be available in the fall of 2020.

In Step 3, Tesla is aiming to further develop the self- driving capabilities of its vehicles. The goal is to make self-driving vehicles 10 times safer than manual driving, and thus being able to offer fully autonomous vehicles. Many in- dustry observers expect that commercial trucks will be some of the first vehicles to drive fully autonomous, especially on interstate highways. In this fashion, the large trucks can drive 24-7, and need to stop only to recharge their batteries.

Fully autonomous driving capabilities are required for Tesla to fulfill Step 4 of the new master plan: Turn your car into an income-generating asset. The idea is to offer an Uber- like service made up of Tesla vehicles, but without any drivers. On average, cars are used less than three hours during a day.

CHAPTERCASE 1 Part II

Tesla’s new solar roof, with a Tesla car and Powerwall in the garage.

Tesla/Newscom

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Who are your stakeholders?

H ow do you think about accomplishing your goals? One way to strategize your success is to use a ver-sion of the stakeholder impact analysis. On a per- sonal level, your internal stakeholders might be immediate family members and close personal friends. External stake- holders could be neighbors, peers, funding sources, and managers.

A key aspect presented in this chapter is to consider the point of view of a variety of stakeholders in meeting the goals of the firm. The same logic applies to many of your own personal or career goals as well. For instance, let’s say you are close to graduating from a university. How do your stakeholders view your job and career prospects? Do they

want you to stay close to home? Do they encourage you to start a new business?

As noted in the chapter, stakeholders will have different points of view and also different levels of impact upon your successes or failures.

1. List your personal goals. Which stakeholders are supportive of these goals? Which are likely to try to block these goals?

2. Develop a plan to address key stakeholder concerns from each perspective. Can you find a pathway in the stakeholder analysis to build support for your key goals?

3. What would it take to implement your ideas/plans to move forward with these goals?

mySTRATEGY

25

This chapter introduced the concept of strategy and the key role it plays in the success or failure of an organiza- tion. We learned that a good strategy results from a stra- tegic management process that defines the competitive challenge, provides a guiding policy, and is imple-

mented by coherent actions. A good strategy enhances the chances of achieving competitive advantage and superior performance. It also examines the relation- ship between stakeholder strategy and sustainable com- petitive advantage. Finally, this chapter set the stage for

TAKE-AWAY CONCEPTS

The idea is that your autonomous-driving Tesla will be part of a shared vehicle fleet when you are not using your car. This will drastically reduce the total cost of ownership of a Tesla vehicle, and it will also allow pretty much anyone to ride in a Tesla as a result of the sharing economy.49

Questions 1. Do you agree with the assessment that Elon Musk and

Tesla successfully fulfilled the first master plan pub- lished in 2006? Why or why not? To answer this ques- tion, apply the three-step process for crafting a good strategy explained in Section 1.1 (diagnose the competi- tive challenge, derive a guiding policy, and implement a set of coherent actions).

2. Does Tesla have a good strategy? Why or why not? How do you know? Consider: By summer 2019, Tesla’s

market cap had fallen by 30 percent to $45 billion, down from $65 billion a year earlier. Many wondered: Is Tesla in trouble?

3. Describe the rationale behind Tesla’s new master plan. How does this new strategy help Tesla fulfill its vision? To view Tesla’s “Master Plan, Part Deux” in its entirety, see Tesla’s blog: www.tesla.com/blog/master-plan-part- deux.

4. Apply again the three-step process for crafting a good strategy (see Section 1.1), this time to each element of the new master plan. On which steps of the new master plan has Tesla made the most progress? Explain. Also, what recommendations would you offer Elon Musk? Support your arguments and recommendations with examples and observations from the ChapterCase.

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26 CHAPTER 1 What Is Strategy?

further study of strategic management by introducing the AFI Strategy Framework.

LO 1-1 / Explain the role of strategy in a firm’s quest for competitive advantage. ■ Strategy is the set of goal-directed actions a firm

takes to gain and sustain superior performance relative to competitors.

■ A good strategy enables a firm to achieve superior performance. It consists of three elements: 1. A diagnosis of the competitive challenge. 2. A guiding policy to address the competitive

challenge. 3. A set of coherent actions to implement the

firm’s guiding policy. ■ A successful strategy requires three integrative

management tasks—analysis, formulation, and implementation.

LO 1-2 / Define competitive advantage, sustainable competitive advantage, competitive disadvantage, and competitive parity. ■ Competitive advantage is always judged relative to

other competitors or the industry average. ■ To obtain a competitive advantage, a firm must ei-

ther create more value for customers while keep- ing its cost comparable to competitors, or it must provide the value equivalent to competitors but at a lower cost.

■ A firm able to outperform competitors for pro- longed periods of time has a sustained competitive advantage.

■ A firm that continuously underperforms its rivals or the industry average has a competitive disadvantage.

■ Two or more firms that perform at the same level have competitive parity.

■ An effective strategy requires that strategic trade- offs be recognized and addressed—for example, between value creation and the costs to create the value.

LO 1-3 / Assess the relationship between stakeholder strategy and sustainable competitive advantage. ■ Stakeholders are individuals or groups that have

a claim or interest in the performance and con- tinued survival of the firm. They make specific

contributions for which they expect rewards in return.

■ Internal stakeholders include stockholders, em- ployees (for instance, executives, managers, and workers), and board members.

■ External stakeholders include customers, suppli- ers, alliance partners, creditors, unions, commu- nities, governments at various levels, and the media.

■ The effective management of stakeholders is nec- essary to ensure the continued survival of the firm and to sustain any competitive advantage. This is achieved through stakeholder strategy.

LO 1-4 / Conduct a stakeholder impact analysis. ■ Stakeholder impact analysis considers the needs

of different stakeholders, which enables the firm to perform optimally and to live up to the expecta- tions of good citizenship.

■ In a stakeholder impact analysis, managers pay particular attention to three important stake- holder attributes: power, legitimacy, and urgency.

■ Stakeholder impact analysis is a five-step pro- cess that answers the following questions for the firm: 1. Who are our stakeholders? 2. What are our stakeholders’ interests and claims? 3. What opportunities and threats do our stake-

holders present? 4. What economic, legal, ethical, and philan-

thropic responsibilities do we have to our stake- holders?

5. What should we do to effectively address the stakeholder concerns?

LO 1-5 / Explain the Analysis, Formulation, Implementation (AFI) Strategy Framework. ■ The Analysis, Formulation, Implementation

(AFI) Strategy Framework (1) explains and pre- dicts differences in firm performance, and (2) helps managers formulate and implement a strat- egy that can result in superior performance.

■ Effectively managing the strategy process is the result of 1. Analysis (A) 2. Formulation (F) 3. Implementation (I)

rot6128x_ch01_002-031.indd 26 01/11/19 11:23 AM

CHAPTER 1 What Is Strategy? 27

Stakeholders (p. 14) Strategic management (p. 6) Strategy (p. 6) Sustainable competitive

advantage (p. 10) Value creation (p. 13)

Analysis, Formulation, Implemen- tation (AFI) Strategy Frame- work (p. 22)

Competitive advantage (p. 10) Competitive disadvantage (p. 10) Competitive parity (p. 10)

Corporate social responsibility (CSR) (p. 18)

Good strategy (p. 7) Stakeholder impact

analysis (p. 15) Stakeholder strategy (p. 15)

KEY TERMS

DISCUSSION QUESTIONS 1. The text discusses strategic trade-offs that are dif-

ferent between Walmart and Nordstrom even though they are in the same industry. Think of an- other industry that you know fairly well and select two firms there that also have made very different choices for these trade-offs. Describe some of the differences between these firms. What type of trade-off decisions have these firms made?

2. Corporate social responsibility has four compo- nents. Do you agree that public firms should

address all four elements? Why or why not? If not, where should the firm “draw the line”? Please provide an example to explain your logic.

3. In the discussion about Merck (Strategy Highlight 1.2), the firm faces difficult situations about life-saving drugs. What is your assessment of Merck’s consideration of various stakeholders in the two situations described?

1. Market capitalization (or, market cap) = Share price × Number of outstanding shares.

2. Musk, E. (2006, Aug. 2), “The secret Tesla Motors Master Plan (just between you and me),” Tesla website, http://bit.ly/29Y1c3m.

3. This ChapterCase is based on: Hoang, H., and F. T. Rothaermel (2016), “How to manage alliances strategically,” MIT Sloan Management Review, Fall, 58(1): 69–76; Ramsey, M., Jacobides, M. G., J. P. MacDuffie, and C. J. Tae (2016), “Agency, structure, and the domi- nance of OEMs: Change and stability in the automotive sector,” Strategic Management Journal, 37(9): 1942– 1967; Perkins, G., and J. P. Murmann (2018), “What does the success of Tesla mean for the future dynamics in the global automobile sector?” Management and Organization Review (14) 3: 471–480; Ramsey, M., (2016, March 30), “A lot riding on Tesla’s Model 3 unveiling,” The Wall Street Journal; Ramsey, M., and C. Sweet (2016, Aug. 1), “Tesla and SolarCity agree to $2.6 billion deal,” The Wall Street Journal; Pulliam, S., M. Ramsey, and I. J. Dugan (2016, Aug. 15), “Elon Musk sets ambitious goals at Tesla—and often falls short,” The Wall Street Journal; “The

Falcon Heavy’s creator is trying to change more worlds than one,” The Economist, Feb. 10, 2018; and Tesla Inc. Annual Reports (various years).

4. This section draws on: McGrath, R.G. (2013), The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business (Boston: Harvard Business Review Press); Rumelt, R. (2011), Good Strategy, Bad Strategy: The Difference and Why It Matters (New York: Crown Business); Porter, M.E. (2008, January), “The five competitive forces that shape strategy,” Harvard Business Review: 78–93; Porter, M.E. (1996, November– December), “What is strategy?” Harvard Business Review: 61–78; and Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Competitors (New York: The Free Press).

5. As quoted in: Rothaermel, F. T. (2017), “Tesla, Inc.,” McGraw-Hill Education Case Study MHE-FTR-032.

6. Tesla’s mission statement. Tesla, Inc.

7. Range anxiety denotes the concern that an electric vehicle has insufficient range to reach

its destination on a single charge. Tesla’s cars can go some 250 miles per charge. The lower cost Nissan Leaf (~$30k) can go some 85 miles per charge, while GM’s Chevy Bolt can drive some 200 miles per charge, based on EPA estimates. The average American drives about 40 miles per day. http://www.fuelecon- omy.gov/

8. The discussion of Tesla throughout this chapter is based on Rothaermel, F.T., and D. King (2015), Tesla Motors, Inc., McGraw-Hill Education Case Study MHE-FTR-032; Hoang, H., and F. T. Rothaermel (2016, Fall), “How to manage alliances strategically,” MIT Sloan Management Review, 58(1): 69–76; Ramsey, M. (2016, March 30), “A lot riding on Tesla’s Model 3 unveiling,” The Wall Street Journal; Ramsey, M., and C. Sweet (2016, Aug. 1), “Tesla and SolarCity agree to $2.6 billion deal,” The Wall Street Journal; Pulliam, S., M. Ramsey, and I.J. Dugan (2016, Aug. 15), “Elon Musk sets ambitious goals at Tesla—and often falls short,” The Wall Street Journal; and Ramsey, M. (2014, June 12), “Tesla Motors offers open licenses to its patents,” The Wall Street Journal.

ENDNOTES

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28 CHAPTER 1 What Is Strategy?

9. Market capitalization (or, market cap) = Share price × Number of outstanding shares.

10. “Twitter’s future: How high can it fly?” The Economist (2014, Nov. 7), https://www. economist.com/business/2014/11/07/how-high- can-it-fly.

11. This Strategy Highlight is based on the fol- lowing sources: Bilton, N. (2013), Hatching Twitter: A True Story of Money, Power, Friendship, and Betrayal (London, UK: Sceptre); “Twitter in retweet,” The Economist (2016, Sept. 17); “New models for new media,” The Economist (2017, Feb. 16); Conger, K. (2018, Oct. 25), “Twitter posts another profit as user numbers drop,” The New York Times; and Twitter annual reports (various years).

12. This section draws on Porter, M.E. (2008, January) “The five competitive forces that shape strategy,” Harvard Business Review; Porter, M.E. (1996, November–December), “What is strategy?” Harvard Business Review; and Porter, M.E. (1989), Competitive Strategy (New York: Free Press).

13. Rumelt, R.P. (2011), Good Strategy, Bad Strategy: The Difference and Why It Matters (New York: Crown); and Porter, M.E. (1996, November–December), “What is strategy?” Harvard Business Review.

14. Rumelt, R.P. (2011), Good Strategy, Bad Strategy: The Difference and Why It Matters (New York: Crown); and Porter, M.E. (1996, November–December), “What is strategy?” Harvard Business Review.

15. Koh, Y., and K. Grind (2014, Nov. 6), “Twitter CEO Dick Costolo struggles to define vision,” The Wall Street Journal.

16. Smith, A. (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, 5th ed. (published 1904) (London: Methuen and Co.).

17. Levy, S. (2011), In the Plex: How Google Thinks, Works, and Shapes Our Lives (New York: Simon & Schuster); and www.wolframal- pha.com/input/?i=google.

18. “The HP Way,” see www.hpalumni.org/ hp_way.htm; and Packard, D. (1995), HP Way: How Bill Hewlett and I Built Our Company (New York: HarperCollins).

19. This discussion draws on: Carroll, A.B., and A.K. Buchholtz (2012), Business & Society: Ethics, Sustainability, and Stakeholder Management (Mason, OH: South-Western Cengage); Porter, M.E., and M.R. Kramer (2011, January–February), “Creating shared value: How to reinvent capitalism—and unleash innovation and growth,” Harvard Business Review; Parmar, B.L., R.E. Freeman, J.S. Harrison, A.C. Wicks, L. Purnell, and S. De Colle (2010), “Stakeholder theory: The state of the art,” Academy of Management Annals 4:

403–445; and Porter, M.E., and M.R. Kramer (2006, December), “Strategy and society: The link between competitive advantage and corpo- rate social responsibility,” Harvard Business Review: 80–92.

20. See the discussion by Lowenstein, R. (2010), The End of Wall Street (New York: Penguin Press); Paulson, H.M. (2010), On the Brink: Inside the Race to Stop the Collapse of the Global Financial System (New York: Business Plus); and Wessel, D. (2010), In FED We Trust: Ben Bernanke’s War on the Great Panic (New York: Crown Business).

21. Parmar, B.L., R.E. Freeman, J.S. Harrison, A.C. Wicks, L. Purnell, and S. De Colle (2010), “Stakeholder theory: The state of the art,” Academy of Management Annals 4: 403–445.

22. Phillips, R. (2003), Stakeholder Theory and Organizational Ethics (San Francisco: Berrett-Koehler); Freeman, E.R., and J. McVea (2001), “A stakeholder approach to strategic management,” in Hitt, M.A., E.R. Freeman, and J.S. Harrison (eds.), The Blackwell Handbook of Strategic Management (Oxford, UK: Blackwell), 189–207; and Freeman, E.R. (1984), Strategic Management: A Stakeholder Approach (Boston, MA: Pitman).

23. To acknowledge the increasing importance of stakeholder strategy, the Strategic Management Society (SMS)—the leading asso- ciation for academics, business executives, and consultants interested in strategic manage- ment—has recently created a stakeholder strategy division; see http://strategicmanage- ment.net/. Also see Anderson, R.C. (2009), Confessions of a Radical Industrialist: Profits, People, Purpose—Doing Business by Respecting the Earth (New York: St. Martin’s Press); Sisodia, R.S., D.B. Wolfe, and J.N. Sheth (2007), Firms of Endearment: How World-Class Companies Profit from Passion and Purpose (Upper Saddle River, NJ: Prentice-Hall Pearson); and Svendsen, A. (1998), The Stakeholder Strategy: Profiting from Collaborative Business Relationships (San Francisco: Berrett-Koehler).

24. Parmar, B.L., R.E. Freeman, J.S. Harrison, A.C. Wicks, L. Purnell, and S. De Colle (2010), “Stakeholder theory: The state of the art,” Academy of Management Annals 4: 406.

25. Parmar, B.L., R.E. Freeman, J.S. Harrison, A.C. Wicks, L. Purnell, and S. De Colle (2010), “Stakeholder theory: The state of the art,” Academy of Management Annals 4: 406.

26. Parmar, B.L., R.E. Freeman, J.S. Harrison, A.C. Wicks, L. Purnell, and S. De Colle (2010), “Stakeholder theory: The state of the art,” Academy of Management Annals 4: 406.

27. “The World’s Most Admired Companies,” Fortune (2018), http://fortune.com/ worlds-most-admired-companies.

28. Eesley, C., and M.J. Lenox (2006), “Firm responses to secondary stakeholder action,” Strategic Management Journal 27: 765–781; and Mitchell, R.K., B.R. Agle, and D.J. Wood (1997), “Toward a theory of stakeholder identi- fication and salience,” Academy of Management Review 22: 853–886.

29. Ostrower, J. (2014, July 30), “Boeing to build stretched 787–10 in South Carolina,” The Wall Street Journal.

30. Benoit, D. (2014, Feb. 10), “Icahn ends Apple push with hefty profit,” The Wall Street Journal.

31. People for the Ethical Treatment of Animals (PETA) is an animal-rights organization.

32. This example is drawn from: Esty, D.C., and A.S. Winston (2006), Green to Gold: How Smart Companies Use Environmental Strategy to Innovate, Create Value, and Build Competitive Advantage (Hoboken, NJ: Wiley).

33. This discussion draws on: Carroll, A.B., and A.K. Buchholtz (2012), Business & Society: Ethics, Sustainability, and Stakeholder Management (Mason, OH: South-Western Cengage); Carroll, A.B. (1991, July–August), “The pyramid of corporate social responsibility: Toward the moral management of organizational stakeholders,” Business Horizons: 39–48; and Carroll, A.B. (1979), “A three-dimensional, con- ceptual model of corporate social performance,” Academy of Management Review 4: 497–505.

34. For an insightful but critical treatment of this topic, see the 2003 Canadian documen- tary film The Corporation.

35. For recent empirical findings concerning the relationship between corporate social re- sponsibility and firm performance, see Barnett, M.L., and R.M. Salomon (2012), “Does it pay to be really good? Addressing the shape of the relationship between social and financial performance,” Strategic Management Journal 33: 1304–1320; Wang, T., and P. Bansal (2012), “Social responsibility in new ventures: Profiting from a long-term orienta- tion,”Strategic Management Journal 33: 1135– 1153; and Jayachandran, S., K. Kalaignanam, and M. Eilert (2013), “Product and environ- mental social performance: Varying effect on firm performance,”Strategic Management Journal 34: 1255–1264.

36. Friedman, M. (1970, Sept. 13), “The so- cial responsibility of business is to increase its profits,” The New York Times Magazine.

37. Armour, S. (2015, Oct. 25), “ACA premi- ums jump 25%; administration acknowledges extended enrollment,” The Wall Street Journal.

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CHAPTER 1 What Is Strategy? 29

38. Gasparro, A. and T. D. Hobbs (2018, April 15), “Starbucks faces backlash over ar- rest of black men,” The Wall Street Journal.

39. The video of the arrest can be viewed at https://bit.ly/2HzKhTH.

40. Stevens, M. (2018, April 17), “Starbucks CEO apologizes after arrests of 2 black men,” The New York Times.

41. Jargon, J., and L. Weber (2018, April 17), “Starbucks to shut stores for antibias training,” The Wall Street Journal; and Meyer, D. (2018, May 29), “Starbucks is closing today for its company-wide unconscious bias training: Here’s what you need to know,” Fortune.

42. Gates, B. (2008, Aug. 11), “How to help those left behind,” Time.

43. Carroll, A.B. (1991, July–August), “The pyramid of corporate social responsibility:

Toward the moral management of organiza- tional stakeholders,” Business Horizons: 39–48.

44. As quoted in: Collins, J. (2009), How the Mighty Fall. And Why Some Companies Never Give In (New York: HarperCollins), 53.

45. http://www.merck.com/about/featured-sto- ries/mectizan1.html.

46. Gilmartin, R.V. (2011, Oct. 6), “The Vioxx recall tested our leadership,” Harvard Business Review Blog Network.

47. The Merck river blindness case and the quote by CEO Kenneth Frazier draw from: http://www.merck.com/about/featured-sto- ries/mectizan1.html. The Vioxx example draws from “Jury finds Merck liable in Vioxx death and awards $253 million,” The New York Times, August 19, 2005; Heal, G.

(2008), When Principles Pay: Corporate Social Responsibility and the Bottom Line (New York: Columbia Business School); Collins, J. (2009), How the Mighty Fall. And Why Some Companies Never Give In (New York: HarperCollins); and Wang, T., and P. Bansal (2012), “Social responsibility in new ven- tures: profiting from a long-term orienta- tion,” Strategic Management Journal 33: 1135–1153.

48. Musk, E. (2016, Jul. 20), “Master Plan, Part Deux,” http://bit.ly/2aa5LHv.

49. Ramsey, M. (2016, Jul. 21), “Elon Musk unveils plans for new Tesla vehicle types,” The Wall Street Journal; Musk, E. (2019, Mar. 14), “Tesla Y Launch Event,” www.you- tube.com/watch?v=lIkm6xhror4&t=4s [33:53 min].

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32

2 CHAPTER

Chapter Outline

2.1 Strategic Leadership What Do Strategic Leaders Do? How Do You Become a Strategic Leader? The Strategy Process across Levels: Corporate, Business, and Functional Managers

2.2 Vision, Mission, and Values Vision Mission Values

2.3 The Strategic Management Process Top-Down Strategic Planning Scenario Planning Strategy as Planned Emergence: Top-Down and Bottom-Up

2.4 Strategic Decision Making Two Distinct Modes of Decision Making Cognitive Biases and Decision Making How to Improve Strategic Decision Making

2.5 Implications for Strategic Leaders

Learning Objectives

After studying this chapter, you should be able to:

LO 2-1 Explain the role of strategic leaders and what they do.

LO 2-2 Outline how you can become a strategic leader.

LO 2-3 Compare and contrast the roles of corporate, business, and functional managers in strategy formulation and implementation.

LO 2-4 Describe the roles of vision, mission, and values in a firm’s strategy.

LO 2-5 Evaluate the strategic implications of product-oriented and customer-oriented vision statements.

LO 2-6 Justify why anchoring a firm in ethical core values is essential for long-term success.

LO 2-7 Evaluate top-down strategic planning, scenario planning, and strategy as planned emergence.

LO 2-8 Describe and evaluate the two distinct modes of decision making.

LO 2-9 Compare and contrast devil’s advocacy and dialectic inquiry as frameworks to improve strategic decision making.

Strategic Leadership: Managing the Strategy Process

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33

Leadership Crisis at Facebook?

WITHIN A MERE SIX MONTHS, in the latter half of 2018, Facebook’s share price dropped by more than 30 percent, wip- ing out over $200 billion in shareholder value. Making matters worse was a seeming crisis of leadership swirling around Face- book’s two top executives: founder and Chief Executive Offi- cer Mark Zuckerberg and Chief Operating Officer Sheryl Sandberg. After a decade of exponential growth and unabated success, the global social network with its more than 2 billion monthly active users found itself in serious trouble.

FACEBOOK’S LEADERSHIP DUO As depicted in the Hollywood movie The Social Network (2010), Facebook began as a startup in 2004 in the Harvard dorm room of then 19-year-old Mark Zuckerberg with the sup- port of three college pals. At the time, Myspace was the lead- ing social networking site, and in 2005, it was acquired by News Corp. for close to $600 million. For several years, Facebook lagged be- hind Myspace in both in- vestments and users, but it stayed alive thanks to cash injections from Microsoft, Yahoo, and a Russian in- vestment group.

In 2008 Mark Zucker- berg made a genius move: He persuaded Sheryl Sand- berg, at the time the vice president of global online sales and operations at Google, to leave Google and join Facebook as the new sec- ond in command. Zuckerberg was a computer hacker at heart. He opted to spend his energy on fulfilling his vision of Facebook—to turn it into a tool that would “make a more open and connected world.”1 He preferred coding to busi- ness deals and freely admitted that he did not have the skills to run a business successfully. Sandberg did. She brought with her all the business skills that Zuckerberg lacked. She had demonstrated her superb leadership capabilities at Google and was recognized for her sales, business develop- ment, public policy, and communications prowess. Put sim- ply, and partially, Zuckerberg saw his role as bringing in the users; he saw Sandberg’s role as bringing in the money.

The Zuckerberg–Sandberg leadership duo would turn out to be pure dynamite. It led to exponential growth—from 100 million users in 2008 to 1 billion users in 2012—a feat that no other firm has ever accomplished. Just five years later, in 2017, Facebook crossed the 2 billion users mark. By the summer of 2018, Facebook’s market capitalization stood at more than $600 billion, up over 630 percent since its ini- tial public offering (IPO) in 2012—a mere six years earlier.

THE END OF THE ZUCKERBERG–SANDBERG ERA? By 2019, Facebook found itself caught in a perfect storm, and many were demanding that Zuckerberg and Sandberg step down. What had happened? Due to its lenient privacy controls, third parties were able to siphon off the personal data of tens of millions of Facebook users; lax data over- sight also led to other alleged misdeeds, including the en- abling of foreign interference during the 2016 U.S. presidential elections. Critics assert that because of its

single-minded pursuit of e x p o n e n t i a l g r ow t h , Facebook’s leadership failed to consider the po- tentiality and gravity of negative side effects on the firm, its stakeholders, and its reputation.

Facebook’s exclusive focus on user growth be- gan in 2012 shortly before its IPO. In a fateful meet- ing of top executives and lead product developers, Sandberg showed that Facebook’s revenues were flat and user growth was

slowing considerably. For a social media company to grow, she said, it must pursue a business model that provides free services to the end user but that charges advertisers for plac- ing online ads. Sandberg admonished the lead product de- velopers, saying “things had to change” and “we have to do something.”2 This meant, as one of the software engineers present at the meeting recalls, that “we needed to pull out all of the stops and to experiment way more aggressively with user engagement with the goal to make money.”3 The march- ing orders were clear: Drive exponential growth and user engagement, while keeping costs down. Very quickly, soft- ware engineers and product developers learned that four features could serve as the keys to increasing user

CHAPTERCASE 2 Part I

Facebook’s dynamite leadership duo: CEO Mark Zuckerberg and COO Sheryl Sandberg (left): David Ramos/Getty Images, (right): Justin Sullivan/Getty Images.

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34

engagement and driving future growth: News Feed, Likes, po- larizing news, and microtargeting.

Facebook’s News Feed is akin to a personalized news- paper and gossip page. A proprietary algorithm identifies the content that will be most interesting to each unique user and accordingly compiles a customized News Feed for that user. Meanwhile, the Like button, internally described as a “social lubricant and social flywheel by which users [feel] they [are] heard,”4 has helped Facebook to better understand its users. Product developers noticed that polarizing news and messages were often the most liked. Note that Facebook’s algorithm doesn’t know which content is good or bad, polarizing or non- polarizing, fake or real. It only knows to which content users most respond. About two-thirds of all Americans get their news from social media sites such as Facebook, and over time, hyped-up and outrageous content increasingly made its way into users’ personal News Feeds, creating a much more polar- ized and tribal user base. Further compounding this situation is the fact that Facebook does not engage in any editorial re- view of the content that surfaces on its site. Rather, it relies on its algorithm, fine-tuned to maximize user engagement, to

serve as its editor. On top of the data breaches and privacy is- sues, this polarization of Facebook’s users has only exacer- bated matters for the firm.

Facebook and Google have captured most of the astro- nomical growth in online advertising spending over the past few years, reaching $100 billion in 2018.5 A massive base of more than 2 billion users, combined with high user engage- ment, has enabled Facebook to place and sell ads with ex- treme accuracy—what is known as microtargeting. For microtargeting to work effectively, it relies on accurate user profiles. Now that Facebook owns the photo-sharing app Ins- tagram and the messaging service WhatsApp, it has additional data sources at its disposal to help it to create even more ac- curate user profiles. All these data are combined with a user’s “shadow profile,” which enables Facebook to not only track each of its user’s activities, but the activities of his or her friends as well, even as they move across the web visiting other non-Facebook sites. As a result, Facebook can offer the most detailed, accurate, and targeted data to advertisers.

Part II of this ChapterCase appears in Section 2.5.

HOW DO STRATEGIC LEADERS like Sheryl Sandberg guide their companies to gain and sustain a competitive advantage? How do they make strategic decisions? How do strategic leaders formulate and implement their companies’ strategies? How

do they lead and motivate employees? In Chapter 2, we move from thinking about why strategy is important to what role strate-

gic leaders play, specifically how strategic leaders select, guide, and manage the strategy process across different levels in the organization. One of the first things a strategic leader must do is to shape an organization’s vision, mission, and values, as each of these plays an important role in anchoring a winning strategy. We then explore some of the frameworks strategic leaders use to develop strategy and maintain an effective strategic management process. Next we delve deeper into strategic decision making, in particular how biases, even those that strategic leaders and groups may not be consciously aware of, can impact the abil- ity to make rational decisions. Lastly, we summarize some of the most important practical insights in our Implications for Strategic Leaders.

2.1 Strategic Leadership Executives whose vision and decisions enable their organizations to achieve competitive advan- tage demonstrate strategic leadership.6 Strategic leadership pertains to executives’ use of power and influence to direct the activities of others when pursuing an organization’s goals.7 Power is defined as the strategic leader’s ability to influence the behavior of other organizational mem- bers to do things, including things they would not do otherwise.8 Strategic leaders can draw on position power as vested in their authority, for example as chief executive officer (CEO), as well as informal power, such as persuasion to influence others when implementing strategy.

In leading Facebook to become the most successful social network and one of the most valuable companies worldwide, Sheryl Sandberg has clearly demonstrated effective strategic

LO 2.1 Explain the role of strategic leaders and what they do.

strategic leadership Executives’ use of power and influence to direct the activities of others when pursuing an organization’s goals.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 35

leadership. As chief operating officer (COO), Sandberg has tremen- dous position power because she is the second in command at Face- book and reports only to CEO Mark Zuckerberg. Sandberg’s business development skills are legendary: She transformed a money-losing out- fit into a titan of online advertising, with over $65 billion in annual revenues. She designed and implemented Facebook’s business model (how it makes money). In particular, Sandberg attracted high-profile advertisers by demonstrating how Facebook can place precisely tar- geted and timed ads when it matches what it knows about each user, based on that person’s social network, with the advertisers’ targets. Less quantifiable, but perhaps an even more valuable contribution, Sandberg provides “adult supervision and a professional face” for a firm populated by socially awkward computer geeks.9

While the effect of strategic leaders may vary, they clearly matter to firm performance.10 Think of great business founders and their impact on the compa- nies they built—Mark Zuckerberg at Facebook, Phil Knight at Nike, Elon Musk at Tesla and SpaceX, Jack Ma at Alibaba, Oprah Winfrey with her media empire, and Jeff Bezos at Amazon. Many strategic leaders also have shaped and revitalized existing businesses. In addition to Sheryl Sandberg at Facebook, we have Angela Ahrendts at Apple (left in 2019), Sundar Pichai at Google, Mary Barra at GM, Indra Nooyi at PepsiCo (left in 2018), How- ard Schultz at Starbucks, and Satya Nadella at Microsoft.11

At the other end of the spectrum, some CEOs have massively destroyed shareholder value: Ken Lay at Enron, John Sculley at Apple, Bernard Ebbers at WorldCom, Charles Prince at Citigroup, Richard Fuld at Lehman Brothers, Richard Wagoner at GM, Robert Nardelli at The Home Depot and later Chrysler, Martin Winterkorn at VW, and Ron Johnson at JCPenney, among many others.

Why do some leaders create great companies or manage them to greatness, while others lead them into decline and sometimes even demise? To answer that question, let’s first con- sider what strategic leaders actually do.

WHAT DO STRATEGIC LEADERS DO? What do strategic leaders do that makes some more effective than others? In a study of more than 350 CEOs, strategy scholars found that they spend, on average, roughly two-thirds of their time in meetings, 13 percent working alone, 7 percent on e-mail, 6 percent on phone calls, 5 percent on business meals, and 2 percent on public events such as ribbon-cutting for a new factory (see Exhibit 2.1).12 Other studies have also found that most managers prefer oral communication: CEOs spend most of their time “interacting—talking, cajoling, soothing, selling, listening, and nodding—with a wide array of parties inside and outside the organiza- tion.”13 Surprisingly given the advances in information technology, CEOs today spend most of their time in face-to-face meetings. They consider face-to-face meetings most effective in getting their message across and obtaining the information they need. Not only do meetings present data through presentations and verbal communications, but they also enable CEOs to pick up on rich nonverbal cues such as facial expressions, body language, and mood, that are not apparent to them if they use e-mail or even Skype, for example.14

HOW DO YOU BECOME A STRATEGIC LEADER? Is becoming an ethical and effective strategic leader innate? Can it be learned? According to the upper-echelons theory, organizational outcomes including strategic choices and perfor- mance levels reflect the values of the top management team.15 These are the individuals at

Indra Nooyi, PepsiCo CEO, 2006–2018. Nooyi is a transformational stra- tegic leader who guided PepsiCo with a powerful vision of “performance with purpose.” Under Nooyi’s leadership, PepsiCo transformed itself into a company offering more healthy snack and beverage choices, while its rev- enues grew by 80 per- cent. Moreover, Nooyi’s 12-year tenure as CEO is more than double the length of the average Fortune 500 CEO. Alex Goodlett/Getty Images

LO 2-2 Outline how you can become a strategic leader.

upper-echelons theory A conceptual framework that views organizational out- comes—strategic choices and perfor- mance levels—as re- flections of the values of the members of the top management team.

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36 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

the upper levels of an organization. The theory states that strategic leaders interpret situations through the lens of their unique perspectives, shaped by personal cir- cumstances, values, and experiences. Their leadership actions ref lect characteristics of age, education, and career experiences, filtered through personal interpreta- tions of the situations they face. The upper-echelons theory favors the idea that effective strategic leadership is the result of both innate abilities and learning.

In the bestseller Good to Great, Jim Collins explored over 1,000 good companies to find 11 great ones. He identified great companies as those that transitioned from average performance to sustained competitive advantage. He measured that transition as “cumulative stock returns of almost seven times the general market in the 15 years following their transition points.”16 A lot has happened since the book was published almost two decades ago. Today only a few of the original 11 stayed all that great, including Kimberly-Clark and Walgreens. Some fell back to mediocrity; a few no longer exist in their earlier form. Anyone remember Circuit City or Fannie Mae? Let’s agree that competitive advantage is hard to achieve and even harder to sustain. But his study remains valuable for its thought-provoking obser- vations. Studying these large corporations, Collins found consistent patterns of leadership among the top

companies, as pictured in the Level-5 leadership pyramid in Exhibit 2.2. The pyramid is a conceptual framework that shows leadership progression through five distinct, sequential levels. Collins found that all the companies he identified as great were led by Level-5 executives. So if you are interested in becoming an ethical and effective strategic leader, the leadership pyramid suggests the areas of growth required.

According to the Level-5 leadership pyramid, effective strategic leaders go through a natural progression of five levels. Each level builds upon the previous one; the individual can move on to the next level of leadership only when the current level has been mas- tered. On the left in Exhibit 2.2 are the capabilities associated with each level. But not all companies are Fortune 500 behemoths. On the right-hand side we suggest that the model is also valuable to the individual looking to develop the capacity for greater professional success.

At Level 1, we find the highly capable individual who makes productive contributions through her motivation, talent, knowledge, and skills. These traits are a necessary but not sufficient condition to move on to Level 2, where the individual attains the next level of strategic leadership by becoming an effective team player. As a contributing team mem- ber, she works effectively with others to achieve common objectives. In Level 3, the team player with a high individual skill set turns into an effective manager who is able to orga- nize the resources necessary to accomplish the organization’s goals. Once these three levels are mastered, in Level 4, the effective professional has learned to do the right things, meaning she does not only command a high individual skill set and is an effective team player and manager, but she also knows what actions are the right ones in any given situation to pursue an organization’s strategy. Combining all four prior levels, at Level 5, the strategic leader builds enduring greatness by combining willpower and humility. This

Source: Data from O. Bandiera, A. Prat, and R. Sadun (2012), “Management capital at the top: Evidence from the time use of CEOs,” London School of Economics and Harvard Business School Working Paper.

Working Alone 13%

E-mail 7%

Calls 6%

Business Meals 5%

Public Events 2%

Face-to-Face Meetings 67%

EXHIBIT 2.1 How CEOs Spend Their Days

Level-5 leadership pyramid A conceptual framework of leader- ship progression with five distinct, sequential levels.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 37

implies that a Level-5 executive works to help the organization succeed and others to reach their full potential.

As detailed in the ChapterCase, Facebook CEO Mark Zuckerberg highly values COO Sheryl Sandberg. Here he says why: “She could go be the CEO of any company that she wanted, but I think the fact that she really wants to get her hands dirty and work, and doesn’t need to be the front person all the time, is the amazing thing about her. It’s that low-ego element, where you can help the people around you and not need to be the face of all the stuff.”17 Clearly, Sandberg appears to be a Level-5 executive: She built enduring greatness at Facebook through a combination of skill, willpower, and humility. After a highly successful decade, however, by early 2019 many critics questioned Sandberg and Zuckerberg’s leadership skills (see the ChapterCase at the beginning of this chapter).

THE STRATEGY PROCESS ACROSS LEVELS: CORPORATE, BUSINESS, AND FUNCTIONAL MANAGERS According to the upper-echelons theory, strategic leaders primarily determine a firm’s abil- ity to gain and sustain a competitive advantage through the strategies they pursue. Given the importance of such strategies, we need to gain a deeper understanding of how they are cre- ated. The strategy process consists of two parts: strategy formulation (which results from strategy analysis) and strategy implementation.

Source: Adapted from J. Collins (2001), Good to Great: Why Some Companies Make the Leap . . . And Others Don’t (New York: HarperCollins), 20.

EXHIBIT 2.2 Strategic Leaders: The Level-5 Pyramid Adapted to compare corporations and entrepreneurs

Builds enduring greatness through a combination of willpower and humility.

Presents compelling vision and mission to guide groups toward superior performance. Does the right things.

Is efficient and effective in organizing resources to accomplish stated goals and objectives. Does things right.

Uses high level of individual capability to work effectively with others in order to achieve team objectives.

Makes productive contributions through motivation, talent, knowledge, and skills.

Level 5: Executive

Level 4: Effective Leader

Level 3: Competent Manager

Level 2: Contributing Team Member

Level 1: Highly Capable Individual

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LO 2-3 Compare and contrast the roles of corporate, business, and functional managers in strategy formulation and implementation.

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38 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

Strategy formulation concerns the choice of strategy in terms of where and how to com- pete. In contrast, strategy implementation concerns the organization, coordination, and integration of how work gets done. In short, it concerns the execution of strategy. It is helpful to break down strategy formulation and implementation into three distinct areas—corporate, business, and functional.

■ Corporate strategy concerns questions relating to where to compete as to industry, markets, and geography.

■ Business strategy concerns the question of how to compete. Three generic business strat- egies are available: cost leadership, differentiation, or value innovation.

■ Functional strategy concerns the question of how to implement a chosen business strat- egy. Different corporate and business strategies will require different activities across the various functions.

Exhibit 2.3 shows the three areas of strategy formulation and implementation. Although we generally speak of the firm in an abstract form, individual employees

make strategic decisions—whether at the corporate, business, or functional levels. Corpo- rate executives at headquarters formulate corporate strategy, such as Sheryl Sandberg (Facebook), Mukesh Ambani (Reliance Industries), Rosalind Brewer (Starbucks), Mary Barra (GM), Larry Page (Alphabet), or Marillyn Hewson (Lockheed Martin). Corpo- rate executives need to decide in which industries, markets, and geographies their com- panies should compete. They need to formulate a strategy that can create synergies across business units that may be quite different, and determine the boundaries of the firm by deciding whether to enter certain industries and markets and whether to sell certain divisions. They are responsible for setting overarching strategic objectives and allocating scarce resources among different business divisions, monitoring performance, and making adjustments to the overall portfolio of businesses as needed. The objective of

strategy formulation The part of the strate- gic management pro- cess that concerns the choice of strategy in terms of where and how to compete.

strategy implementa- tion The part of the strategic management process that concerns the organization, coor- dination, and integra- tion of how work gets done, or strategy execution.

EXHIBIT 2.3 Strategic Formulation and Implementation across Levels: Corporate, Business, and Functional Strategy

SBU 1 How to compete?

SBU 2 How to compete?

SBU 3 How to compete?

Headquarters Where to compete?

Business Function 1 How to implement business strategy?

Business Function 2 How to implement business strategy?

Business Function 3 How to implement business strategy?

Business Function 4 How to implement business strategy?

Corporate Strategy

Business Strategy

Functional Strategy

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 39

corporate-level strategy is to increase overall corporate value so that it is higher than the sum of the individual business units.

Business strategy occurs within strategic business units (SBUs), the standalone divisions of a larger conglomerate, each with its own profit-and-loss responsibility. General managers in SBUs must answer business strategy questions relating to how to compete in order to achieve superior performance. Within the guidelines received from corporate headquarters, they formulate an appropriate generic busi- ness strategy, including cost leadership, differentiation, or value inno- vation, in their quest for competitive advantage.

Rosalind Brewer, while president and CEO of Sam’s Club, pursued a somewhat different business strategy from that of parent company Walmart. By offering higher-quality products and brand names with bulk offerings and by prescreening customers via required Sam’s Club memberships to establish creditworthiness, Brewer achieved annual revenues of roughly $60 billion. This would place Sam’s Club in the top 50 in the Fortune 500 list. Although as CEO of Sam’s Club, Brewer was responsible for the performance of this strategic business unit, she reported to Walmart’s CEO, Doug McMillon, who as corporate executive oversees Walmart’s entire operations, with over $500 billion in annual revenues and 12,000 stores globally.18

In 2017, Brewer was appointed COO of Starbucks, the leading coffeehouse chain globally with $25 billion in annual revenues and some 300,000 employees. Brewer is in charge of all Starbucks operations in the Americas (Canada, the United States, and Latin America) as well as the company’s global supply chain, product innovation, and store development, which includes 15,000 stores globally. As second in command at Starbucks, Brewer reports directly (and only) to Kevin Johnson, Starbucks CEO. Many observers believe that Brewer is being groomed to become the next CEO of Starbucks.

Within each strategic business unit are various business functions: accounting, finance, human resources, product development, operations, manufacturing, marketing, and cus- tomer service. Each functional manager is responsible for decisions and actions within a single functional area. These decisions aid in the implementation of the business-level strat- egy, made at the level above (see Exhibit 2.3).

Returning to our ChapterCase, COO Sheryl Sandberg determines Facebook’s corporate strategy jointly with CEO Mark Zuckerberg. Facebook, with some 35,000 employees, is a far-flung internet firm—its various services are available in more than 100 languages and it has offices in more than 30 countries.19 Together, they are responsible for the performance of the entire organization, and decide

■ What types of products and services to offer. ■ Which industries to compete in. ■ Where in the world to compete.

One example of Sandberg’s effective strategic leadership is Facebook’s turnaround beginning in 2013 when it did not have much of a mobile presence. Part of the problem was the inferior quality of the mobile app; Zuckerberg had initially built Facebook for the desktop personal computer, not for mobile devices. Sandberg initiated a company- wide “mobile first” initiative focusing its engineers and marketers on mobile. The suc- cess of this turnaround strategy is stunning: Today Facebook is a mobile advertising powerhouse, generating over 80 percent of its revenues of more than $65 billion annually from mobile advertising.20

strategic business units (SBUs) Stand- alone divisions of a larger conglomerate, each with their own profit-and-loss responsibility.

Rosalind Brewer is chief operating officer of Starbucks and thus sec- ond in command, report- ing directly to CEO Kevin Johnson. Previously, Brewer served as Sam’s Club president and CEO (2012–2017). Phelan M. Ebenhack/ AP Images

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40 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

2.2 Vision, Mission, and Values The first step in the strategic management process is to define an organization’s vision, mis- sion, and values by asking the following questions:

■ Vision. What do we want to accomplish ultimately? ■ Mission. How do we accomplish our goals? ■ Values. What commitments do we make, and what safe guards do we put in place, to act

both legally and ethically as we pursue our vision and mission?

The vision is the first principle that needs to be defined because it succinctly identifies the primary long-term objective of the organization. Strategic leaders need to begin with the end in mind.21 In other words, strategic success begins when a vision is formulated; that suc- cess continues when that vision is implemented. This process of creating and implementing a vision begins with the formulation of (both business and corporate) strategies that enhance the chances of gaining and sustaining competitive advantage. It ends with the cre- ation of a strategy that enables a firm to implement its vision. This is an iterative process that can be compared to designing and building a house. You need an approved blueprint in place before construction can even begin. The same holds for strategic success; it is first created through strategy formulation based on careful analysis before any actions are taken. Let’s look at this process in more detail.

VISION A vision captures an organization’s aspiration and spells out what it ultimately wants to accomplish. An effective vision pervades the organization with a sense of winning and moti- vates employees at all levels to aim for the same target, while leaving room for individual and team contributions.

Tesla’s vision is to accelerate the world’s transition to sustainable transport. The goal is to provide affordable zero-emission mass-market cars that are the best in class. SpaceX is a spacecraft manufacturer and space transport services company, also founded by Elon Musk, whose inspirational vision is to make human life multi planetary. To achieve this goal, SpaceX aims to make human travel to Mars not only possible but also affordable. Moreover, SpaceX also sees a role in helping establish a self-sustainable human colony on Mars.22

Employees in visionary companies tend to feel part of something bigger than them- selves. An inspiring vision helps employees find meaning in their work and value beyond monetary rewards. It gives them a greater sense of purpose. People have an intrinsic motivation to make the world a better place through their work activities.23 In turn, this motivation, which inspires individual purpose, can lead to higher organi- zational performance.24 Using the vision as its foundation, a firm will build the neces- sary resources and capabilities to translate a stretch goal or strategic intent into a reality, usually through continuous organizational learning, including learning from failure.25

A firm’s vision is expressed as a statement, and this statement should be forward- looking and inspiring to ensure it provides meaning for employees in pursuit of the organization’s ultimate goals. Strategy Highlight 2.1 shows how at the heart of Teach for America’s (TFA) vision statement is an inspiring vision. This statement effectively and clearly communicates TFA’s stretch goal, as well as what it ultimately seeks to accomplish.

LO 2-4 Describe the roles of vision, mission, and values in a firm’s strategy.

vision A statement about what an organi- zation ultimately wants to accomplish; it cap- tures the company’s aspiration.

strategic intent A stretch goal that per- vades the organization with a sense of win- ning, which it aims to achieve by building the necessary resources and capabilities through continuous learning.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 41

Teach for America: How Wendy Kopp Inspires Future Leaders Teach for America (TFA) is a nonprofit organization of fu- ture leaders that works to ensure that underprivileged youth get an excellent education. TFA corp members spend two years teaching in economically disadvantaged communities across the United States. Although TFA ini- tially targeted college seniors, today it recruits both grad- uates and professionals to help achieve the following TFA vision: One day, all children in this nation will have the opportunity to attain an excellent education.

TFA began as a college senior thesis written in 1989 by a then-21-year-old Wendy Kopp. Kopp was convinced that young people generally sought for meaning in their lives, and that they could create meaning by making a positive contribution to society. Kopp’s genius was that she flipped on its head the social perception of teaching—she turned a seemingly unattractive, low-status job into a high- prestige, professional opportunity.

In the first four months after creating TFA, Kopp re- ceived more than 2,500 applicants. She marketed the idea by passing out and posting flyers in college dorms. During its first academic year (1990–91), TFA served five states and changed the lives of 36,000 students. By 2018, TFA had some 60,000 corps members and alumni, more than 2,500 school partnerships, and impacted millions of students.

To be chosen for TFA is considered an honor. Of the total number of applicants that TFA receives annually, ap- proximately 15 percent are accepted; this is roughly equiv- alent to the admission rate of highly selective universities such as Northwestern, Cornell, and University of Califor- nia, Berkeley. Compared to the national average of people of color in teaching positions (20 percent), 50 percent of TFA corps members are people of color—a more accurate reflection of the population they teach. TFA corps mem- bers receive the same pay as other first-year teachers in their respective local school districts.

In an effort to eliminate educational inequity, Kopp de- liberately enlists the nation’s most promising future lead- ers; this conscious decision to recruit only the best has

had a hugely positive impact on students. Approximately 95 percent of all school principals working with TFA mem- bers say they have made significant strides with their stu- dents. Furthermore, a study commissioned by the U.S. Department of Education found that students being taught by TFA corps members showed significantly higher achievement, especially in math and science.

TFA CEO Elisa Villanueva Beard was inspired to sign up for TFA when she was a college student at DePauw University. She recalls that what inspired her most was Wendy Kopp’s “audacity to believe young people could make a profound difference in the face of intractable problems standing between the ideals of a nation I loved and a starkly disappointing reality; who were bound by a fierce belief that all children, from American Indian reser- vations in South Dakota to Oakland to the Rio Grande Valley to the Bronx, should have the opportunity to write their own stories and fulfill their true potential.”26

Yet, despite all its remarkable success, TFA finds itself wrestling with several challenges. For instance, applica- tions in the last few years have dropped (an estimated 35 percent over three years), causing TFA to fail to meet its recruiting target. Second, the short but intensive five- week summer boot camp intended to ready new recruits for teaching in some of the toughest schools in United States is increasingly criticized as insufficient.27

Strategy Highlight 2.1

Wendy Kopp, Teach for America founder. Astrid Stawiarz/Getty Images

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42 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

That vision statements can inspire and motivate employees in the nonprofit sector comes as no surprise. Who wouldn’t find wanting to help children attain an excellent education, the vision of TFA, meaningful? Likewise, who wouldn’t be moved by the promise to always be there in times of need, the vision of the American Red Cross? But can for-profit firms inspire and motivate just as well? The answer is yes; a truly meaningful and inspiring vision—no matter if of a nonprofit or for-profit firm—makes employees feel they are part of something bigger, which can be highly motivating. When employees are highly motivated, firm finan- cial performance can also improve. For example, visionary for-profit companies such as 3M and Walmart provide aspirational ideas that are not exclusively financial; as such, they tend to outperform their competitors over the long run. Tracking the stock market performance of companies over several decades, strategy scholars found that visionary companies outper- formed their peers by a wide margin.28

However, as the ChapterCase on Facebook warns, single-mindedly pursuing a vision can also be detrimental, even if that vision inspires and motivates. When followed too strictly, it can generate unexpected challenges that can be difficult to overcome. Critics assert that Facebook’s leadership failed to consider the potential for serious negative side-effects, such as the mass-manipulation of users by nefarious actors, or the large-scale breach of user pri- vacy that resulted in the siphoning off of personal data by mal-intent third parties.

VISION STATEMENTS AND COMPETITIVE ADVANTAGE. Do vision statements help firms gain and sustain competitive advantage? It depends. The effectiveness of vision statements differs by type. Customer-oriented vision statements allow companies to adapt to changing environments. Product-oriented vision statements often constrain this ability. This is because customer-oriented vision statements focus employees to think about how best to solve a problem for a consumer.29

Clayton Christensen shares how a customer focus let him help a fast food chain increase sales of milkshakes. The company approached Christensen after it had made several changes to its milkshake offerings based on extensive customer feedback but sales failed to improve. Rather than asking customers what kind of milkshake they wanted, he thought of the prob- lem in a different way. He observed customer behavior and then asked customers, “What job were you trying to do that caused you to hire that milkshake?”30 He wanted to know what problem the customers were trying to solve. Surprisingly he found that roughly half of the shakes were purchased in the mornings, because customers wanted an easy breakfast to eat in the car and a diversion on long commutes. Based on the insights gained from this problem-solving perspective, the company expanded its shake offerings to include healthier options with fruit chunks and provided a prepaid dispensing machine to speed up the drive- through, and thus improve customers’ morning commute. A customer focus made finding a solution much easier.

You could say that the restaurant company had a product orientation that prevented its executives from seeing unmet customer needs. Product-oriented vision statements focus employees on improving existing products and services without consideration of underlying customer problems to be solved. Our environments are ever-changing and sometimes seem chaotic. The increased strategic flexibility afforded by customer-oriented vision statements can provide a basis on which companies can build competitive advantage.31 Let’s look at both types of vision statements in more detail.

PRODUCT-ORIENTED VISION STATEMENTS. A product-oriented vision defines a business in terms of a good or service provided. Product-oriented visions tend to force managers to take a more myopic view of the competitive landscape. Consider the strategic decisions of U.S. railroad companies. Railroads are in the business of moving goods and people from

LO 2-5 Evaluate the strategic implications of product- oriented and customer- oriented vision statements.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 43

point A to point B by rail. When they started in the 1850s, their short-distance competition was the horse or horse-drawn carriage. There was little long-distance competition (e.g., ship canals or good roads) to cover the United States from coast to coast. Because of their monopoly, especially in long-distance travel, these companies were initially extremely profit- able. Not surprisingly, the early U.S. railroad companies saw their vision as being in the railroad business, clearly a product-based definition.

However, the railroad companies’ monopoly did not last. Technological innovations changed the transportation industry dramatically. After the introduction of the automobile in the early 1900s and the commercial jet in the 1950s, consumers had a wider range of choices to meet their long-distance transportation needs. Rail companies were slow to respond; they failed to redefine their business in terms of services provided to the consumer. Had they envisioned themselves as serving the full range of transportation and logistics needs of people and businesses across America (a customer-oriented vision), they might have become successful forerunners of modern logistics companies such as FedEx or UPS.

Recently, the railroad companies seem to be learning some lessons: CSX Railroad is now redefining itself as a green-transportation alternative. It claims it can move one ton of freight 423 miles on one gallon of fuel. However, its vision remains product-oriented: to be the safest, most progressive North American railroad.

CUSTOMER-ORIENTED VISION STATEMENTS. A customer-oriented vision defines a busi- ness in terms of providing solutions to customer needs. For example, “We provide solutions to professional communication needs.” Companies with customer-oriented visions can more easily adapt to changing environments. Exhibit 2.4 provides additional examples of companies with customer-oriented vision statements. In contrast, companies that define themselves based on product-oriented statements (e.g., “We are in the typewriter business”) tend to be less flexible and thus more likely to fail. The lack of an inspiring needs-based vision can cause the long-range problem of failing to adapt to a changing environment.

Customer-oriented visions identify a critical need but leave open the means of how to meet that need. Customer needs may change, and the means of meeting those needs may change with it. The future is unknowable, and innovation is likely to provide new ways to meet needs that we cannot fathom today.32 For example, consider the need to transmit infor- mation over long distances. Communication needs have persisted throughout the millennia,

Alibaba: To make it easy to do business anywhere.

Amazon: To be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online.

Better World Books: To harness the power of capitalism to bring literacy and opportunity to people around the world.

Facebook: To make the world more open and connected.

GE: To move, cure, build, and power the world.

Google: To organize the world’s information and make it universally accessible and useful.

Nike: To bring inspiration and innovation to every athlete in the world.

SpaceX: To make human life multi planetary.

Tesla: To accelerate the world’s transition to sustainable energy.

Walmart: To be the best retailer in the hearts and minds of consumers and employees.

Warby Parker: To offer designer eyewear at a revolutionary price, while leading the way for socially conscious businesses.

EXHIBIT 2.4 Companies with Customer-Oriented Vision Statements

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44 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

but the technology to solve this problem has changed drastically over time.33 During the reign of Julius Caesar, moving information over long distances required papyrus, ink, a chariot, a horse, and a driver. During Abraham Lincoln’s time, the telegraph was used for short messages while railroads handled larger documents, and an airplane transported let- ters when Franklin Delano Roosevelt was president. Today, we use connected mobile devices to move information over long distances at the speed of light. The problem to be solved—moving information over long distance—has remained the same, but the technology employed to do this job has changed quite drastically. Christensen recommends that strate- gic leaders think hard about how the means of getting a job done have changed over time and ask themselves, “Is there an even better way to get this job done?”

It is critical that an organization’s vision should be flexible to allow for change and adap- tation. Consider how Ford Motor Co. has addressed the problem of personal mobility over the past 100 years. Before Ford entered the market in the early 1900s, people traveled long distances by horse-drawn buggy, horseback, boat, or train. But Henry Ford had a different idea. In fact, he famously said, “If I had listened to my customers, I would have built a better horse and buggy.”34 Instead, Henry Ford’s original vision was to make the automobile acces- sible to every American. He succeeded, and the automobile dramatically changed how mobil- ity was achieved.

Fast-forward to today: Ford Motor Co.’s vision is to provide personal mobility for people around the world. Note that it does not even mention the automobile. By focusing on the consumer need for personal mobility, Ford is leaving the door open for exactly how it will fulfill that need. Today, it’s mostly with traditional cars and trucks propelled by gas-powered internal combustion engines, with some hybrid electric vehicles in its lineup. In the near future, Ford is likely to provide vehicles powered by alternative energy sources such as elec- tric power or hydrogen. Moreover, vehicles will be driven autonomously, and thus a human driver is no longer needed. With this expected shift to arrive in the near future, automobiles will unlikely be owned personally but rather rides will be provided on demand by ride hail- ing services such as Uber or Lyft. In the far-reaching future, perhaps Ford will get into the business of individual flying devices. Throughout all of this, its vision would still be relevant and compel its managers to engage in future markets. In contrast, a product-oriented vision would greatly constrain Ford’s degree of strategic flexibility.

MOVING FROM PRODUCT-ORIENTED TO CUSTOMER-ORIENTED VISION STATEMENTS.  In some cases, product-oriented vision statements do not interfere with the firm’s success in achieving superior performance and competitive advantage. Consider Intel Corp., one of the world’s leading silicon innovators. Intel’s early vision was to be the preeminent building- block supplier of the PC industry. Intel designed the first commercial microprocessor chip in 1971 and set the standard for microprocessors in 1978. During the personal computer (PC) revolution in the 1980s, microprocessors became Intel’s main line of business. Intel’s cus- tomers were original equipment manufacturers that produced consumer end-products, such as computer manufacturers HP, IBM, Dell, and Compaq.

In the internet age, though, the standalone PC as the end-product has become less impor- tant. Customers want to stream video and share selfies and other pictures online. These activities consume a tremendous amount of computing power. To reflect this shift, Intel in 1999 changed its vision to focus on being the preeminent building-block supplier to the internet economy. Although its product-oriented vision statements did not impede performance or competitive advantage, in 2008 Intel fully made the shift to a customer-oriented vision: to delight our customers, employees, and shareholders by relentlessly delivering the platform and technology advancements that become essential to the way we work and live. Part of this shift was reflected by the hugely successful “Intel Inside” advertising campaign in the 1990s that

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 45

made Intel a household name worldwide. Yet, even more than a decade later, this is still Intel’s vision statement.

Intel accomplished superior firm performance over decades through continuous adapta- tions to changing market realities. Its formal vision statement lagged behind the firm’s stra- tegic transformations. Intel regularly changed its vision statement after it had accomplished each successful transformation.35 In such a case, vision statements and firm performance are clearly not related to one another.

It is also interesting to note that customer-oriented visions also frequently change over time. When Tesla was founded in 2003, its vision was to accelerate the world’s transition to sustainable transport. Over the last decade or so, Tesla completed several steps of its initial master plan (as detailed in ChapterCase 1), including providing zero-emission electric power generation options (Step 4), through the acquisition of the SolarCity. Tesla, there- fore, no longer views itself as a car company but as a fully integrated clean-tech company. To capture this ambition more accurately Tesla changed its vision: to accelerate the world’s tran- sition to sustainable energy. To reposition Tesla as an integrated clean-tech energy company, in 2017 Tesla changed its official name from Tesla Motors to simply Tesla, Inc.

Taken together, empirical research shows that sometimes vision statements and firm performance are associated with one another. A positive relationship between vision state- ments and firm performance is more likely to exist under certain circumstances:

■ The visions are customer-oriented. ■ Internal stakeholders are invested in defining the vision. ■ Organizational structures such as compensation systems align with the firm’s vision

statement.36

The upshot is that an effective vision statement can lay the foundation upon which to craft a strategy that creates competitive advantage.

MISSION Building on the vision, organizations establish a mission, which describes what an organiza- tion actually does—that is, the products and services it plans to provide, and the markets in which it will compete. People sometimes use the terms vision and mission interchangeably, but in the strategy process they differ.

■ A vision defines what an organization wants to be, and what it wants to accomplish ulti- mately. A vision begins with the infinitive form of a verb (starting with to). As discussed in Strategy Highlight 2.1, TFA’s vision is to attain an excellent education for all children.

■ A mission describes what an organization does and how it proposes to accomplish its vision. The mission is often introduced with the preposition by. Thus, we can cast a mis- sion statement for TFA that reads: To attain an excellent education for all children by enlisting, developing, and mobilizing as many as possible of our nation’s most promising future leaders to grow and strengthen the movement for educational equity and excellence.

To be effective, firms need to back up their visions and missions with strategic commit- ments, in which the enterprise undertakes credible actions. Such commitments are costly, long-term oriented, and difficult to reverse.37 However noble the mission statement, to achieve competitive advantage companies need to make strategic commitments informed by economic fundamentals of value creation.

As mentioned in ChapterCase 1, Tesla is investing billions of dollars to equip its car fac- tory in California with cutting-edge robotics and to build the Gigafactory producing lithium- ion batteries in Nevada. These investments by Tesla are examples of strategic commitments

mission Description of what an organization actually does—the products and services it plans to provide, and the markets in which it will compete.

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46 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

because they are costly, long-term, and difficult to reverse. They are clearly supporting Tesla’s vision to accelerate the world’s transition to sustainable transport. Tesla hopes to trans- late this vision into reality by providing affordable zero-emission mass-market cars that are the best in class, which captures Tesla’s mission.

VALUES While many companies have powerful vision and mission statements, they are not enough. An organization’s values also need to be clearly articulated in the strategy process. A core values statement matters because it provides touchstones for employees to understand the company culture. It offers bedrock principles that employees at all levels can use to manage complexity and to resolve conflict. Such statements can help provide the organization’s employees with a moral compass.

Consider that much of unethical behavior, while repugnant, may not be illegal. Often we read the defensive comment from a company under investigation or fighting a civil suit that “we have broken no laws.” However, any firm that fails to establish extra-legal, ethical stan- dards will be more prone to behaviors that can threaten its very existence. A company whose culture is silent on moral lapses breeds further moral lapses. Over time such a culture could result in a preponderance of behaviors that cause the company to ruin its reputation, at the least, or slide into outright legal violations with resultant penalties and punishment, at the worst.

Organizational core values are the ethical standards and norms that govern the behavior of individuals within a firm or organization. Strong ethical values have two important func- tions. First, ethical standards and norms underlay the vision statement and provide stability to the strategy, thus laying the groundwork for long-term success. Second, once the com- pany is pursuing its vision and mission in its quest for competitive advantage, they serve as guardrails to keep the company on track.

The values espoused by a company provide answers to the question, how do we accom- plish our goals? They help individuals make choices that are both ethical and effective in advancing the company’s goals. For instance, Teach for America (TFA) has a set of core values that focus on transformational change through team-based leadership, diversity, respect, and humility. These values guide TFA corp members in their day-to-day decision making. It aids each corp member in making ethical and value-based decisions in teaching environments that can often be quite stressful.

One last point about organizational values: Without commitment and involvement from top managers, any statement of values remains merely a public relations exercise. Employ- ees tend to follow values practiced by strategic leaders. They observe the day-to-day deci- sions of top managers and quickly decide whether managers are merely paying lip service to the company’s stated values. Organizational core values must be lived with integrity, espe- cially by the top management team. Unethical behavior by top managers is like a virus that spreads quickly throughout an entire organization.

Take, for example, Volkswagen (VW), the largest carmaker by volume worldwide. Although one of its long-time marketing slogans was Truth in Engineering, this did not pre- vent the forced resignation of VW CEO Martin Winterkorn in the fall of 2015—a conse- quence of an emissions cheating scandal dubbed Dieselgate. Moreover, in 2018, Winterkorn was indicted on fraud and conspiracy charges. What had happened? VW had illegally installed so-called “defeat devices” in some 11 million vehicles. When programmed and installed, the software for these devices enabled emissions controls when the vehicle was on a test stand. However, the device disabled emissions controls when the vehicle was in daily driving mode on public roads. These defeat devices helped VW diesel cars pass stringent

LO 2-6 Justify why anchoring a firm in ethical core values is essential for long-term success.

core values statement Statement of principles to guide an organization as it works to achieve its vision and fulfill its mis- sion, for both internal conduct and external interactions; it often includes explicit ethical considerations.

organizational core values Ethical stan- dards and norms that govern the behavior of individuals within a firm or organization.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 47

emissions tests, even though in reality they were emitting up to 40 times the allowed level of pollutants. In the end, Volkswagen paid more than $22 billion in fines and damaged its stel- lar reputation. Ironically, the fines alone were much higher than the cost of equipping the diesel engines with the appropriate pollution controls.38

As the VW example demonstrates, it is imperative that strategic leaders set the example of ethical behavior by living their firm’s core values. Strategic leaders have a strong influ- ence in setting their organization’s vision, mission, and values—the first step of the strategic management process, which we turn to next.

2.3 The Strategic Management Process An effective strategic management process lays the foundation for sustainable competitive advantage. Strategic leaders design a process to formulate and implement strategy. In the Strategic Leadership section, we gained insight into the corporate, business, and functional levels of strategy. Here we turn to the process or method by which strategic leaders formu- late and implement strategy. When setting the strategy process, strategic leaders rely on three approaches:

1. Strategic planning. 2. Scenario planning. 3. Strategy as planned emergence.

This order also reflects the sequence of development of these approaches: We begin with strategic planning, followed by scenario planning, and then strategy as planned emergence. The first two are relatively formal, top-down planning approaches. The third begins with a strategic plan but offers a less formal and less stylized approach. Each approach has its strengths and weaknesses, depending on the circumstances under which it is employed.

TOP-DOWN STRATEGIC PLANNING The prosperous decades after World War II resulted in tremendous growth of corporations. As company executives needed a way to man- age ever more complex firms more effectively, they began to use strategic planning.39 Top-down strategic planning, derived from military strat- egy, is a rational process through which execu- tives attempt to program future success.40 In this approach, all strategic intelligence and decision-making responsibilities are concen- trated in the office of the CEO. The CEO, much like a military general, leads the com- pany strategically through competitive battles.

Exhibit 2.5 shows the three steps of strate- gic management: analysis, formulation, and implementation in a traditional top-down stra- tegic planning process. Strategic planners pro- vide detailed analyses of internal and external data and apply them to all quantifiable areas: prices, costs, margins, market demand, head count, and production runs. Five-year plans,

LO 2-7 Evaluate top-down strategic planning, scenario planning, and strategy as planned emergence.

strategic management process Method put in place by strategic lead- ers to formulate and implement a strategy, which can lay the foun- dation for a sustainable competitive advantage.

top-down strategic planning A rational, data-driven strategy process through which top management attempts to program future success.

• Structure, Culture, & Control • Corporate Governance & Business Ethics

• Corporate Strategy • Business Strategy • Functional Strategy

Analysis

Formulation

Implementation

• Vision, Mission, and Values • External Analysis • Internal Analysis

EXHIBIT 2.5 Top-Down Strategic Planning in the AFI Strategy Framework

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48 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

revisited regularly, predict future sales based on anticipated growth. Top executives tie the allocation of the annual corporate budget to the strategic plan and monitor ongoing perfor- mance accordingly. Based on a careful analysis of these data, top managers reconfirm or adjust the company’s vision, mission, and values before formulating corporate, business, and functional strategies. Appropriate organizational structures and controls as well as gov- ernance mechanisms aid in effective implementation.

Top-down strategic planning more often rests on the assumption that we can predict the future from the past. The approach works reasonably well when the environment does not change much. One major shortcoming of the top-down strategic planning approach is that the formulation of strategy is separate from implementation, and thinking about strategy is separate from doing it. Information flows one way only: from the top down. Another short- coming of the strategic planning approach is that we simply cannot know the future. There are no data. Unforeseen events can make even the most scientifically developed and formal- ized plans obsolete. Moreover, strategic leaders’ visions of the future can be downright wrong, save for a few notable exceptions.

At times, strategic leaders impose their visions onto a company’s strategy, structure, and culture from the top down to create and enact a desired future state. Under its co-founder and long-time CEO Steve Jobs, Apple was one of the few successful tech companies using a top-down strategic planning process.41 Jobs felt that he knew best what the next big thing should be. Under his top-down, autocratic leadership, Apple did not engage in market research because Jobs firmly believed that “people don’t know what they want until you show it to them.”42 In his well-researched, 700-page biography on Steve Jobs, Walter Isaac- son presents to readers Jobs’ lessons in strategic leadership in 14 memorable aphorisms, including push for perfection, tolerate only “A” players, and bend reality, among others.43

The traditional top-down strategy process served Apple well in its journey to becoming the world’s first company to be valued above $1 trillion. Under Tim Cook, Jobs’ successor as CEO, Apple’s strategy process has become more flexible. The company is now trying to incorporate the possibilities of different future scenarios and bottom-up strategic initiatives.44

SCENARIO PLANNING Given that the only constant is change, should managers even try to strategically plan for the future? The answer is yes—but they also need to expect that unpredictable events will happen. Strategic planning in a fast-changing environment happens in a fashion similar to the way a fire department plans for a fire.45 There is no way to know in advance where and when the next emergency will arise; neither we can know in advance its magnitude. None- theless, fire chiefs always consider the “what-if” scenarios; they put contingency plans in place that address a wide range of emergencies and their different dimensions.

When scenario planning, managers also ask those what-if questions. Similar to top- down strategic planning, scenario planning also starts with a top-down approach to the strategy process. In addition, in scenario planning, top management envisions different scenarios, to anticipate plausible futures in order to derive strategic responses. For exam- ple, new laws might restrict carbon emissions or expand employee health care. Demo- graphic shifts may alter the ethnic diversity of a nation; changing tastes or economic conditions will affect consumer behavior. Technological advances may provide completely new products, processes, and services. How would any of these changes affect a firm, and how should it respond? Scenario planning takes place at both the corporate and business levels of strategy.

Typical scenario planning addresses both optimistic and pessimistic futures. For instance, strategy executives at UPS identified a number of issues as critical to shaping its future

scenario planning Strategy planning activity in which top management envisions different what-if scenarios to anticipate plausible futures in order to derive strategic responses.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 49

competitive scenarios: (1) big data analytics; (2) being the target of a terrorist attack, or having a security breach or IT system disruption; (3) large swings in energy prices, including gasoline, diesel and jet fuel, and interruptions in supplies of these commodities; (4) fluctua- tions in exchange rates or interest rates; and (5) climate change.46 Managers then formulate strategic plans they could activate and implement should the envisioned optimistic or pes- simistic scenarios begin to appear.

To model the scenario-planning approach, place the elements in the Analysis, Formula- tion, Implementation (AFI) strategy framework in a continuous feedback loop, where analy- sis leads to formulation to implementation and back to analysis. Exhibit 2.6 elaborates on this simple feedback loop to show the dynamic and iterative method of scenario planning.

The goal is to create a number of detailed and executable strategic plans. This allows the strategic management process to be more flexible and more effective than the more static strategic planning approach with one master plan. In the analysis stage, managers brain- storm to identify possible future scenarios. Input from several levels within the organiza- tion and from different functional areas such as R&D, manufacturing, and marketing and sales is critical. UPS executives considered, for example, how they would compete if the price of a barrel of oil was $35, or $100, or even $200. Strategic leaders may also attach probabilities (highly likely versus unlikely, or 85 percent likely versus 2 percent likely) to different future states.

Although strategic leaders often tend to overlook pessimistic future scenarios, it is imper- ative to consider negative scenarios carefully. Exporters such as Boeing, Harley-Davidson, or John Deere would want to analyze the impact of shifts in exchange rates on profit

Feedback Loop

Monitoring Perform ance

Analysis

F ormulation

I mplementation

Develop Strategic Plans to Address Future Scenarios

Execute Dominant Strategic Plan

Dis car

d D om

ina nt

Pla n i

f N ece

ssa ry

Create Strategic Options

Through Developing Alternative Plan(s)

Identify Multiple Future Scenarios

Activate and Execute

N ew Plan if Necessary

EXHIBIT 2.6 Scenario Planning within the AFI Strategy Framework

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50 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

margins. They might go through an exercise to derive different strategic plans based on large exchange rate fluctuations of the U.S. dollar against major foreign currencies such as the euro, Japanese yen, or Chinese yuan. What if the euro depreciated to below $1 per euro, or the Chinese yuan depreciated rather than appreciated? How would Disney compete if the dollar were to appreciate so much as to make visits by foreign tourists to its California and Florida theme parks prohibitively expensive? Or, they might consider the implications of tariffs being levied in the trade war between the U.S. and China.

The metaphor of a black swan, therefore, describes the high impact of a highly improbable event. In the past, most people assumed that all swans are white, so when they first encoun- tered swans that were black, they were surprised.47 Strategic leaders need also consider how black swan events might affect

their strategic planning. In the UPS scenario planning exercise, a terrorist attack or a complete security breach of its IT system are examples of possible black swan events. Looking at highly improbable but high-impact events allows UPS executives to be less surprised and more prepared should they indeed occur. Other examples of black swan events include the 9/11 terrorist attacks, the British exit from the European Union (Brexit), and the European refugee and migrant crisis. Such black swan events are consid- ered to be highly improbable and thus unexpected, but when they do occur, each has a profound impact.

For instance, the BP oil spill was a black swan for many businesses on the Gulf Coast, including the tourism, fishing, and energy industries. In 2010, an explosion occurred on BP’s Deepwater Horizon oil drilling rig off the Louisiana coastline, killing 11 workers. The subsequent oil spill continued unabated for over three months. It released an estimated 5 million barrels of crude oil into the Gulf of Mexico, causing the largest environmental disaster in U.S. history. Two BP employees even faced manslaughter charges. The cleanup alone cost BP $14 billion. Because of the company’s haphazard handling of the crisis, Tony Hayward, BP’s CEO at the time, was fired.

In the aftermath of the oil spill, BP faced thousands of claims by many small-business owners in the tourism and seafood industries. These business owners were not powerful individually, and pursuing valid legal claims meant facing protracted and expensive court proceedings. As a collective organized in a class-action lawsuit, however, they were power- ful. Moreover, their claims were backed by the U.S. government, which has the power to withdraw BP’s business license or cancel current permits and withhold future ones. Collec- tively, the small-business owners along the Gulf Coast became powerful BP stakeholders, with a legitimate and urgent claim that needed to be addressed. In response, BP agreed to pay over $25 billion to settle their claims and cover other litigation costs.

Even so, this was not the end of the story for BP. The oil company was found to have committed “gross negligence” (reckless and extreme behavior) by a federal court. Addi- tional fines and other environmental costs added another $8.5 billion. BP’s total tab for the Gulf of Mexico disaster was $56 billion! BP CEO Bob Dudley sold about $40 billion in assets, turning BP into a smaller company that aims to become more profitable.

What should strategy leaders do about possible future black swan and other unexpected circumstances? In the formulation stage in scenario planning, management teams develop different strategic plans to address possible future scenarios. This kind of what-if exercise forces managers to develop detailed contingency plans before events occur. Each plan relies on an entire set of analytical tools, which we will introduce in upcoming chapters.

Bernd Wolter/ Shutterstock

black swan events Incidents that describe highly improbable but high-impact events.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 51

They capture the firm’s internal and external environments when answering several key questions:

■ What resources and capabilities do we need to compete successfully in each future scenario?

■ What strategic initiatives should we put in place to respond to each respective scenario? ■ How can we shape our expected future environment?

By formulating responses to the varying scenarios, managers build a portfolio of future options. They then continue to integrate additional information over time, which in turn influences future decisions. Finally, managers transform the most viable options into full- fledged, detailed strategic plans that can be activated and executed as needed. The scenarios and planned responses promote strategic flexibility for the organization. If a new scenario should emerge, the company won’t lose any time coming up with a new strategic plan. It can activate a better suited plan quickly based on careful scenario analysis done earlier.

In the implementation stage, managers execute the dominant strategic plan, the option that top managers decide most closely matches the current reality. If the situation changes, managers can quickly retrieve and implement any of the alternate plans developed in the formulation stage. The firm’s subsequent performance in the marketplace gives managers real-time feedback about the effectiveness of the dominant strategic plan. If performance feedback is positive, managers continue to pursue the dominant strategic plan, fine-tuning it in the process. If performance feedback is negative, or if reality changes, managers consider whether to modify further the dominant strategic plan in order to enhance firm perfor- mance or to activate an alternative strategic plan.

The circular nature of the scenario-planning model in Exhibit 2.6 highlights the continu- ous interaction among analysis, formulation, and implementation. Through this interactive process, managers can adjust and modify their actions as new realities emerge. The interde- pendence among analysis, formulation, and implementation also enhances organizational learning and flexibility.

STRATEGY AS PLANNED EMERGENCE: TOP-DOWN AND BOTTOM-UP Critics of top-down and scenario planning argue that strategic planning is not the same as strategic thinking.48

In fact, they argue that strategic planning processes are often too regimented and confin- ing. As such, they lack the flexibility needed for quick and effective response. Managers engaged in a more formalized approach to the strategy process may also fall prey to an illu- sion of control, which describes an inclination by managers to overestimate their ability to control events.49 Hard numbers in a strategic plan can convey a false sense of security. According to critics of strategic planning, to be successful, a strategy should be based on an inspiring vision and not on hard data alone. They advise that strategic leaders should focus on all types of information sources, including soft sources that can generate new insights, such as personal experience, deep domain expertise, or the insights of front-line employees. The important work, according to this viewpoint, is to synthesize all available input from different internal and external sources into an overall strategic vision. An inspiring vision in turn should then guide the firm’s strategy (as discussed in the previous section).

In today’s complex and uncertain world, the future cannot be predicted from the past with any degree of certainty. Black swan events can profoundly disrupt businesses and soci- ety. Moreover, the other two approaches to planning just discussed do not account suffi- ciently for the role employees at all levels of the organization may play. This is because

dominant strategic plan The strategic option that top managers decide most closely matches the current reality and which is then executed.

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52 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

lower-level employees not only implement the given strategy, but they also frequently come up with initiatives on their own that may alter a firm’s strategy. In many instances, front-line employees have unique insights based on constant and unfiltered customer feedback that may elude the more removed executives. Moreover, hugely successful strategic initiatives are occasionally the result of serendipity, or unexpected but pleasant surprises.

In 1990, for example, online retailing was nonexistent. Today, almost all internet users have purchased goods and services online. As a total of all sales, online retailing was about 15 percent in 2018 and is expected to double by 2030.50 Given the success of Amazon as the world’s leading online retailer, brick-and-mortar companies such as Best Buy, The Home Depot, JCPenney, and even Walmart have all been forced to respond and adjust their strate- gies. Others such as Kmart, Radio Shack, and even the venerable Sears filed for Chapter 11 bankruptcy (a provision of the U.S. bankruptcy code, which allows reorganization and restructuring of debts owed), while Circuit City, Borders, and others went out of business altogether (liquidation bankruptcy). Given the more or less instant global presence of online retailers,51 Alibaba is emerging as the leading internet-based wholesaler connecting manu- facturers in China to retailers in the West, as well as a direct online retailer. In a similar fashion, the ride-hailing services Uber, Lyft, Didi Chuxing, and Grab are disrupting the existing taxi and limousine businesses in many metropolitan areas around the world. Having been protected by decades of regulations, existing taxi and limo services scramble to deal with the unforeseen competition. Many try through the courts or legislative system to block the new entrants, alleging the ride-sharing services violate safety and other regulations. Another new sharing economy venture, Airbnb, is facing a similar situation. Airbnb is an online platform that allows users to list or rent lodging of residential properties.

The critics of more formalized approaches to strategic planning, most notably Henry Mintzberg, propose a third approach to the strategic management process. In contrast to the two top-down strategy processes discussed above, this one is a less formal and less styl- ized approach to the development of strategy. To reflect the reality that strategy can be planned or emerge from the bottom up, Exhibit 2.7 shows a more integrative approach to

Realized Strategy

Unrealized Strategy • Unpredictable Events

Intended Strategy • Top-Down Strategic Plan

Bottom-Up Emergent Strategy

• Autonomous Actions • Serendipity • Resource Allocation Process

Analysis

Formulation

Implementation

EXHIBIT 2.7 Realized Strategy Is a Combination of Top-Down Intended Strategy and Bottom-Up Emergent Strategy

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 53

managing the strategy process. Please note that even in strategy as planned emer- gence, the overall strategy process still unfolds along the AFI framework of anal- ysis, formulation, and implementation.

According to this more holistic model, the strategy process also begins with a top-down strategic plan based on analysis of external and internal environments. Top-level executives then design an intended strategy—the outcome of a rational and structured, top-down strategic plan. Exhibit 2.7 illustrates how parts of a firm’s intended strategy are likely to fall by the wayside because of unpredictable events and turn into unrealized strategy.

A firm’s realized strategy is generally formulated through a combination of its top-down strategic intentions and bottom-up emergent strategy. An emergent strategy describes any unplanned strategic initiative bubbling up from deep within the organization. If successful, emergent strategies have the potential to influence and shape a firm’s overall strategy.

The strategic initiative is a key feature in the strategy as a planned emergence model. A strategic initiative is any activity a firm pursues to explore and develop new products and processes, new markets, or new ventures. Strategic initiatives can come from anywhere. They could emerge as a response to external trends or come from internal sources. As such, strategic initiatives can be the result of top-down planning by executives, or they can also emerge through a bottom-up process. Many high-tech companies employ the planned emer- gence approach to formulate strategy. For example, the delivery-by-drone project at Amazon was conceived of and invented by a lower-level engineer. Even relatively junior employees can come up with strategic initiatives that can make major contributions if the strategy pro- cess is sufficiently open and flexible.52

The arrows in Exhibit 2.7 represent different strategic initiatives. In particular, strategic initiatives can bubble up from deep within a firm through

■ Autonomous actions. ■ Serendipity. ■ Resource-allocation process (RAP).53

AUTONOMOUS ACTIONS. Autonomous actions are strategic initiatives undertaken by lower-level employees on their own volition and often in response to unexpected situations. Strategy Highlight 2.2 illustrates that successful emergent strategies are sometimes the result of autonomous actions by lower-level employees.

Functional managers such as Diana, the Starbucks store manager featured in Strategy Highlight 2.2 , are much closer to the final products, services, and customers than are the more removed corporate- or business-level managers. They also receive much more direct customer feedback. As a result, functional managers may start strategic initiatives based on autonomous actions that can influence the direction of the company. To be successful, how- ever, top-level executives need to support emergent strategies that they believe fit with the firm’s vision and mission. Diana’s autonomous actions might not have succeeded or might have got her in trouble if she did not garner the support of a senior Starbucks executive. This

intended strategy The outcome of a rational and structured top- down strategic plan.

Amazon Prime Air is a future service that will deliver packages up to five pounds in 30 minutes or less using small drones. This strategic initiative was conceived of and invented by a lower-level engineer. Johannes Schmitt-Tegge/ dpa/Alamy Stock Photo

realized strategy Combina- tion of intended and emergent strategy.

emergent strategy Any unplanned strategic initiative bubbling up from the bottom of the organization.

strategic initiative Any activ- ity a firm pursues to explore and develop new products and processes, new markets, or new ventures.

autonomous actions Strategic initiatives undertaken by lower- level employees on their own volition and often in response to unexpected situations.

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54 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

Starbucks CEO: “It’s Not What We Do” Diana, a Starbucks store manager in Southern California, received several requests a day for an iced beverage offered by a local competitor. After receiving more than 30 requests one day, she tried the beverage herself. Thinking it might be a good idea for Starbucks to of- fer a similar iced beverage, she re- quested that headquarters consider adding it to the product lineup. Diana had an internal champion in Howard Behar, then a top Starbucks executive. Behar presented this strategic initia- tive to the Starbucks executive commit- tee. The committee voted down the idea in a 7:1 vote. Starbucks CEO How- ard Schultz commented, “We do coffee; we don’t do iced drinks.”

Diana, however, was undeterred. She experimented until she created the iced drink, and then she began to of- fer it in her store. When Behar visited Diana’s store, he was shocked to see this new drink on the menu—all

Starbucks stores were supposed to offer only company-approved drinks. But Diana told him the new drink was

selling well. Behar flew Diana’s team to Starbucks

headquarters in Seattle to serve the iced-coffee drink to the executive committee. They liked its taste, but

still said no. Then Behar pulled out the sales numbers that Diana had carefully

kept. The drink was selling like crazy: 40 drinks a day the first week, 50 drinks

a day the next week, and then 70 drinks a day in the third week after introduction.

They had never seen such growth num- bers. These results persuaded the execu- tive team to give reluctant approval to

introduce the drink in all Starbucks stores. You’ve probably guessed by now that

we’re talking about Starbucks Frappuccino. Frappuccino is now a multibillion-dollar busi-

ness for Starbucks. At one point, this iced drink brought in more than 20 percent of Starbucks’s total

revenues, which were over $26 billion in 2019.54

Strategy Highlight 2.2

M. Unal Ozmen/Shutterstock

executive championed her initiative and helped persuade other top executives. Internal champions, therefore, are often needed for autonomous actions to be successful.

Although emergent strategies can arise in the most unusual circumstances, it is impor- tant to emphasize the role that top management teams play in this type of strategy process. In the strategy-as-planned-emergence approach, executives need to decide which of the bottom-up initiatives to pursue and which to shut down. This critical decision is made on the basis of whether the strategic initiative fits with the company’s vision and mission, and whether it provides an opportunity worth exploiting. Executives, therefore, continue to play a critical role in the potential success or failure of emergent strategies because they determine how limited resources are allocated. After initial resistance, as detailed in Strat- egy Highlight 2.2, the Starbucks executive team around CEO Howard Schultz fully sup- ported the Frappuccino strategic initiative, providing the resources and personnel to help it succeed.

SERENDIPITY. Serendipity describes random events, pleasant surprises, and accidental happenstances that can have a profound impact on a firm’s strategic initiatives.

There are dozens of examples where serendipity had a crucial influence on the course of business and entire industries. The discovery of 3M’s Post-it Notes or Pfizer’s Viagra, first

serendipity Any ran- dom events, pleasant surprises, and acciden- tal happenstances that can have a profound impact on a firm’s stra- tegic initiatives.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 55

intended as a drug to treat hypertension, are well known. Less well known is the discovery of potato chips.55 The story goes that in the summer of 1853, George Crum was working as a cook at the Moon Lake Lodge resort in Saratoga Springs, New York. A grumpy patron ordered Moon resort’s signature fried potatoes. These potatoes were served in thick slices and eaten with a fork as was in the French tradition. When the patron received the fries, he immediately returned them to the kitchen, asking for them to be cut thinner. Crum prepared a second plate in order to please the patron, but this attempt was returned as well. The third plate was prepared by an annoyed Crum who, trying to mock the patron, sliced the potatoes sidewise as thin as he could and fried them. Instead of being offended, the patron was ecstatic with the new fries and suddenly other patrons wanted to try them as well. Crum later opened his own restaurant and offered the famous “Saratoga Chips,” which he set up in a box and some customers simply took home as a snack to be eaten later. Today, PepsiCo’s line of Frito-Lay’s chips are a multibillion-dollar business.

How do strategic leaders create a work environment in which autonomous actions and seren- dipity can flourish? One approach is to provide time and resources for employees to pursue other interests. Google, the online search and advertising subsidiary of Alphabet, for exam- ple, organizes the work of its engineers according to a 70-20-10 rule. The majority of the engineers’ work time (70 percent) is focused on its main business (search and ads).56 Google also allows its engineers to spend one day a week (20 percent) on ideas of their own choosing, and the remainder (10 percent) on total wild cards such as Project Loon, which places high-altitude balloons into the stratosphere to create a high-speed wireless network with global coverage. Google reports that half of its new products and services came from the 20 percent rule, including Gmail, Google Maps, Google News, and Orkut.57 With the restructuring of Google into a corporation with multiple strategic business units, engineers spending their 10 percent time on total wild cards do so within Google X, its research and development unit.58

RESOURCE-ALLOCATION PROCESS. A firm’s resource-allocation process (RAP) deter- mines the way it allocates its resources and can be critical in shaping its realized strategy.59 Emergent strategies can result from a firm’s resource-allocation process (RAP).60 Intel Corp. illustrates this concept.61 Intel was created to produce DRAM (dynamic random- access memory) chips. From the start, producing these chips was the firm’s top-down stra- tegic plan, and initially it worked well. In the 1980s, Japanese competitors brought better-quality chips to the market at lower cost, threatening Intel’s position and obsoleting its top-down strategic plan. However, Intel was able to pursue a strategic transformation because of the way it set up its resource-allocation process. In a sense, Intel was using functional-level managers to drive business and corporate strategy in a bottom-up fashion. In particular, during this time Intel had only a few fabrication plants (called “fabs”) to pro- duce silicon-based products. It would have taken several years and billions of dollars to build additional capacity by bringing new fabs online.

With constrained capacity, Intel had implemented the production-decision rule to maxi- mize margin-per-wafer-start. Each time functional managers initiated a new production run, they were to consider the profit margins for DRAM chips and for microprocessors, the “brains” of personal computers. The operations managers then could produce whichever product delivered the higher margin. By following this simple rule, front-line managers shifted Intel’s production capacity away from the lower-margin DRAM business to the higher-margin microprocessors business. The firm’s focus on microprocessors emerged from the bottom up, based on resource allocation. Indeed, by the time top management finally approved the de facto strategic switch, the company’s market share in DRAM had dwindled to less than 3 percent.62

resource-allocation process (RAP) The way a firm allocates its resources based on predetermined policies, which can be critical in shaping its realized strategy.

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56 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

Taken together, a firm’s realized strategy is frequently a combination of top-down strate- gic intent and bottom-up emergent strategies, as Exhibit 2.7 shows. This type of strategy process is called planned emergence. In that process, organizational structure and systems allow bottom-up strategic initiatives to emerge and be evaluated and coordinated by top management.63 These bottom-up strategic initiatives can be the result of autonomous actions, serendipity, or the resource allocation process.

Exhibit 2.8 compares and contrasts the three different approaches to the strategic man- agement process: top-down strategic planning, scenario planning, and strategy as planned emergence.

planned emergence Strategy process in which organizational structure and systems allow bottom-up strategic initiatives to emerge and be evalu- ated and coordinated by top management.

EXHIBIT 2.8 Comparing and Contrasting Top-Down Strategic Planning, Scenario Planning, and Strategy as Planned Emergence

Strategy Process Description Pros Cons Where Best Used

Top-Down Strategic Planning

A rational strategy process through which top management attempts to program future success; typically concentrates strategic intelligence and decision-making responsibilities in the office of the CEO.

• Provides a clear strategy process and lines of communication.

• Affords coordination and control of various business activities.

• Readily accepted and understood as process is well established and widely used.

• Works relatively well in stable environments.

• Fairly rigid and inhibits flexibility.

• Top-down, one-way communication limits feedback.

• Assumes that the future can usually be predicted based on past data.

• Separates elements of AFI framework so that top management (analysis & formulation) are removed from line employees (implementation).

• Highly regulated and stable industries such as utilities, e.g., Georgia Power in Southeast United States or Framatome, state-owned nuclear operator in France.

• Government

• Military

Scenario Planning

Strategy-planning activity in which top management envisions different what-if scenarios to anticipate plausible futures in order to plan optimal strategic responses.

• Provides a clear strategy process and lines of communication.

• Affords coordination and control of various business activities.

• Readily accepted and understood as process is well established and widely used.

• Provides some strategic flexibility.

• Top-down, one-way communication limits feedback.

• Separates elements of AFI framework so that top management (analysis & formulation) are removed from line employees (implementation).

• As the future is unknown, responses to all possible events cannot be planned.

• Leaders tend to avoid planning for pessimistic scenarios.

• Fairly stable industries, often characterized by some degree of regulation such as airlines, logistics, or medical devices, e.g., American Airlines, Delta Air Lines, and United Airlines; FedEx and UPS; Medtronic.

• Larger firms in industries with a small number of other large competitors (oligopoly).

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 57

2.4 Strategic Decision Making Although we like to believe that we make rational decisions, especially in business, informed by data and facts, the truth is that as fallible human beings, our decision making is fraught with cognitive limitations and biases. Herbert Simon, a Nobel Laureate in economics, devel- oped the theory of bounded rationality, the core tenet of which posits that rather than to optimize when faced with decisions, we tend to “satisfice”— a portmanteau of the two words satisfy and suffice.64

Cognitive limitations tend to lead us to choose the “good enough option” that satisfies our immediate needs, rather than to search for an optimal solution. One argument that sup- ports this tendency suggests that we do not have all the information we need to arrive at an optimal decision. However, another argument suggests that online search engines, such as Google, and AI assistants, such as Apple’s Siri and Amazon’s Alexa, now give us access to a wealth of information—perhaps too much. Simon asserts that cognitive limitations are what prevent us from appropriately processing and evaluating each piece of information that we encounter (a concept known as information overload), especially when faced with constraints such as time.

Today, managers are generally faced with an issue of not too little, but rather that of too much information. The lack of available time and attention also hinder their ability to make optimal decisions. This combination of conditions results in a wealth of information, but scarcity of attention. Indeed, one of the strengths of strategy frameworks is that they allow managers to cut through a lot of the “noise” and to focus on the “signal,” that is, the most important pieces of information.

Strategic decisions are frequently made using simple heuristics and rules of thumb rather than entirely based on rational thinking, in other words, using tacit (or implicit)

Strategy Process Description Pros Cons Where Best Used

Strategy as Planned Emergence

Blended strategy process in which organizational structure and systems allow both top-down vision and bottom-up strategic initiatives to emerge for evaluation and coordination by top management.

• Combines all elements of the AFI framework in a holistic and flexible fashion.

• Provides provisional direction through intended strategy.

• Accounts for unrealized strategy (not all strategic initiatives can be implemented).

• Accounts for emergent strategy (good ideas for strategic initiatives can bubble up from lower levels of hierarchy through autonomous actions, serendipity, and RAP).

• The firm’s realized strategy is a combination of intended and emergent strategy.

• Highest degree of strategic flexibility and buy-in by employees.

• Unclear strategy process and lines of communication can lead to employee confusion and lack of focus.

• Many ideas that bubble up from the bottom may not be worth pursuing.

• Firms may lack a clear process of how to evaluate emergent strategy, increasing the chances of missing mega opportunities or pursuing dead ends; may also contribute to employee frustration and lower morale.

• New ventures and smaller firms.

• High-velocity industries such as technology ventures.

• Internet companies; e.g., Airbnb, Alibaba, Alphabet (parent company of Google), Amazon, Facebook, Twitter, and Uber.

• Biotech companies; e.g., Amgen, Biogen, Gilead Sciences, Genentech, and Genzyme.

LO 2-8 Describe and evaluate the two distinct modes of decision making.

theory of bounded rationality When indi- viduals face decisions, their rationality is con- fined by cognitive limi- tations and the time available to make a de- cision. Thus, individu- als tend to “satisfice” rather than to optimize.

cognitive limitations Constraints such as time or the brain’s in- ability to process large amounts of data that prevent us from appro- priately processing and evaluating each piece of information we en- counter.

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58 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

knowledge rather than on explicit knowledge. Thus, through professional experience and by viewing the complex and uncertain information world through the lens of theory and frameworks, managers can become better equipped and faster at making sound strategic decision making.

TWO DISTINCT MODES OF DECISION MAKING In his popular book, Thinking, Fast and Slow, Daniel Kahneman, a Nobel Laureate in economics, describes the research in behavioral economics that he and his collaborator Amos Tversky spent decades conducting.65 They posit that our decision making is gov- erned by two different systems. System 1 is the brain’s default mode. It is the gut reaction we experience when we see something beautiful, for instance. It is that confidence we feel while driving down a stretch of highway that we’ve driven along a thousand times before. So familiar it is, we feel as though we can drive it on autopilot. We like System 1 and use it most of the time because it is fast (giving way to “snap judgments”66), efficient, and automatic, and therefore requires little, if any, attentional energy. In contrast, System 2 is logical, analytical, and deliberate. Because logical and analytical thinking consume much more of our brain’s energy, this system of decision making tends to be slower. This is a challenge when the brain is already energy hungry. While it comprises only 2 percent of our body weight, it consumes over 20 percent of our energy. Exhibit 2.9 offers a compara- tive view of some of the key characteristics of System 1 and System 2.

We tend to rely on System 1 when we are tired or aggravated. For example, let’s assume your goal is to lose 15 pounds. It is the end of a long day and you are exhausted and hungry. You stop off at the market to pick up a few healthy items for dinner. Instead, you find

yourself wandering to the frozen food aisle and reaching for a pint of Haagen-Dazs ice cream. In this situation, you are activating System 1 precisely because you’re exhausted. The brain energy required to keep System 1 in check, and to activate System 2, has already been spent as you moved throughout the course of your day working, studying, or both. Had System 2 been in charge, you would have opted for a salad, perhaps, instead of a pint of ice cream.

COGNITIVE BIASES AND DECISION MAKING Along with cognitive limitations, human beings are also prone to cognitive biases, which lead to systematic errors in our decision making and interfere with our

EXHIBIT 2.9 Two Distinct Modes of Decision Making

System 1 System 2

Fast Slow

Unconscious Conscious

Automatic Effortful

Everyday, Snap Decisions Complex, Analytical Decisions

Error Prone, Higher Likelihood of Biases

Reliable, Lower Likelihood of Biases

Source: Author’s creation based on D. Kahneman (2011), Thinking, Fast and Slow (New York: Farrar, Straus and Giroux).

behavioral economics A field of study that blends re- search findings from psychol- ogy with economics to provide valuable insights showing when and why individuals do not act like rational decision makers, as assumed in neo- classical economics.

System 1 One of two distinct modes of thinking used in deci- sion making. It is our default mode because it is automatic, fast, and efficient, requiring lit- tle energy or attention. System 1 is prone to cognitive biases that can lead to systematic er- rors in our decision making.

System 2 One of two distinct modes of thinking used in deci- sion making that applies ratio- nality and relies on analytical and logical reasoning. Thus, it is an effortful, slow, and delib- erate way of thinking.

cognitive biases Obstacles in thinking that lead to systematic errors in our decision making and interfere with our rational thinking.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 59

rational thinking. Many of our cognitive biases result from System 1–governed thinking. Research in behavioral economics has identified a host of cognitive biases that can lead to systematic errors in decision making.67 We highlight the most common ones that can affect managers in the sections that follow. Creating awareness of the sources behind the systematic errors that can negatively impact strategic decision making allows managers to put some safeguards in place for overcoming them and, thus, make better, more rational decisions.

ILLUSION OF CONTROL. One of the more common biases (mentioned briefly in the sec- tion covering strategy as planned emergence) is the illusion of control, which describes the tendency to overestimate our ability to control events.68 Put simply, the illusion of control describes the belief that you control things that you do not. Successful individuals such as CEOs and other top-level executives are highly prone to the illusion of control because they tend to attribute their success to their own abilities, including the mistaken belief that they can fully control their circumstances.

An example of the illusion of control may be seen in the relationship between air traffic controllers and pilots.69 Some air traffic controllers observed that after complimenting pilots with phrases such as “nice landing,” the next time these same pilots landed an aircraft in the same airport, the landings were not as good. Conversely, when air traffic controllers expressed that the landings were not good (e.g., “you really missed the mark on that one”), the next set of landings would be better. From this, the air traffic controllers formed the mistaken belief that their comments influenced the quality of the landings. They hypothe- sized that complimenting pilots for good landings would result in pilot complacency and therefore lead to subsequent poor landings. They also hypothesized that criticizing seem- ingly complacent pilots for sloppy landings would result in pilot improvement and therefore lead to subsequent better landings.

Although this reasoning made perfect sense to the air traffic controllers and resulted in mostly negative feedback, a more likely explanation is simply that a regression to the mean is taking place. If we assume a normal (bell-shaped) distribution and the landing under consid- eration was perfect (thus in the far-right tail of the distribution), then the probability that the pilots’ next landing will not be as perfect is nearly 100 percent. Conversely, if the pilot team put down a sloppy landing (far left tail of distribution), then the likelihood that the next landing will be better is close to 100 percent also. In sum, the air traffic controllers were under the illusion that they could directly influence from their towers the quality of the landings the pilots put down. In truth, what they were really observing was the regression of the mean phenomenon.

In “The Strategic Management Process” section, we highlighted that managers that implement a formalized, top-down strategy process frequently fall prey to the illusion of control; this is because such strategic leaders tend to rely on hard data from the past to forecast the future success of their organization. Such thinking is often f lawed, however, because we all know that the past often does not predict the future. The only constant is change.

ESCALATING COMMITMENT. An escalating commitment is another common cognitive bias. It occurs when decision makers continue to support and invest in a project despite hav- ing received feedback that it is likely not going to succeed; typically, a significant amount of time and financial resources have already been committed to the project.70 Rather than ignoring the prior resources already spent, which are the sunk costs, and shut the project down, which would be the rational decision, the strategic decision makers commit more and

illusion of control A cognitive bias that highlights people’s tendency to overesti- mate their ability to control events.

escalating commitment A cognitive bias in which an individual or a group faces increas- ingly negative feed- back regarding the likely outcome from a decision, but neverthe- less continues to invest resources and time in that decision, often ex- ceeding the earlier commitments.

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60 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

more resources to a failing course of action (“doubling down”). In other words, past invest- ments, like spilled milk or money spent on salaries, are sunk costs because you can’t recover them. Thus, the most rational approach would be to ignore the past sunk costs and consider any future decisions with a clean-slate approach. Although this seems a bit counterintuitive, it is the most rational approach when making strategic decisions. Yet, such rational deci- sions are hard to implement because of loss aversion; strategic leaders feel that they need to “recover” the investments already made. An escalating commitment to a failing course of action is often observed in R&D projects.

For example, Motorola spent billions of dollars and many years engineering its Iridium project in the hopes that it would eventually be successful.71 Iridium was an ill-fated, satellite-based telephone system that Motorola attempted to commercialize in the 1990s. Despite clear evidence that an earth-based cellular telephone network was going to be much more successful because it was less expensive to deploy and thus more affordable for the end consumer, Motorola continued investing billions of dollars in its Iridium project for more than a decade. For the project to work, several dozen satellites needed to be launched into space—an exorbitant expense. And even though executives at Motorola knew early on that satellite-based telephone systems would not work in either buildings or cars, something that most businesspeople need to rely on, Motorola kept on spending. Clearly, Motorola’s strategic decision makers fell prey to escalating commitment; although appar- ent that the project was failing commercially, executives persisted in “throwing good money after bad,” meaning, they wasted money that could have been put to use much more effec- tively elsewhere.

CONFIRMATION BIAS. Confirmation bias, also called prior hypothesis bias, is the tendency of individuals to search for information that confirms their existing beliefs. When con- fronted with evidence that contradicts these beliefs, they either ignore the evidence or inter- pret it such that it supports their beliefs. People tend to cling, in particular, to their prior beliefs about a relationship between two variables (e.g., market share is the key to profitabil- ity) or how the world works in general.

Confirmation bias often occurs when earlier experience appears to support a prior hypothesis. For example, strategic decision makers at Intel might believe that the key to continued success is to develop yet another faster chip for personal computers (PCs) using the same x86 architecture as in the past. This prior hypothesis is based on the observation that this incremental innovation strategy was successful for 30 years (e.g., starting with the 8086 chip in 1978 to the Intel Atom chip in 2008). In the meantime, while the strategic managers at Intel clung to their prior hypothesis of how to sustain a competitive advantage, the external environment shifted away from personal computing to mobile computing—a change for which Intel was ill-prepared. Consequently, it lost out to ARM, Nvidia, and other mobile chip makers and is now playing catch-up.

REASON BY ANALOGY. Reason by analogy is the tendency to use simple analogies to make sense out of complex problems. Analogies allow us to examine and compare a complex problem to something familiar, even though the two objects or ideas might actually be very different from each other. In essence, this is the primary drawback of reason by analogy: What appears to be similar on the surface may actually be very different on a deeper level. For example, Walmart executives might have fallen prey to reason by analogy when they first entered the Canadian market in 1994. The firm attempted to use the same cost- leadership strategy that garnered it success in the United States (opening large supercenters in rural areas, implementing sophisticated IT systems, and hiring minimum-wage employ- ees, for instance). Walmart looked at Canada and saw opportunity in the country’s rural

confirmation bias A cognitive bias in which individuals tend to search for and inter- pret information in a way that supports their prior beliefs. Regard- less of facts and data presented, individuals will stick with their prior hypothesis.

reason by analogy A cognitive bias in which individuals use simple analogies to make sense out of complex problems.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 61

areas, believing the regions strongly resembled the rural areas in the United States. More- over, they saw English being spoken in both countries and Canada being one of the closest U.S. trading partners as advantages. Yet, despite these similarities and advantages, Walmart struggled in the Canadian market and lost money. What Walmart executives discovered the hard way is that the Canadian market is quite different from the U.S. market in such key areas as customers, preferences, and culture.

REPRESENTATIVENESS. Representativeness refers to the cognitive bias of drawing conclu- sions based on small samples, or even from one memorable case or anecdote. Relying on this simple heuristic violates the law of large numbers, which states that a large enough sample is needed so that a calculated value is close enough to the expected value that would be observed across all possible observations.

In the 1990s, many internet entrepreneurs and venture capitalists fell prey to represen- tativeness bias. They saw the early success of Amazon, eBay, and Yahoo and decided that they, too, could build a successful online business. Most of these entrepreneurial ventures failed in the dot-com crash of 2001, taking with it billions in venture capital investments. A similar phenomenon is being observed today in the app economy, where most young entrepreneurs are currently directing their energies. Their reasoning based on representa- tiveness bias goes as follows: “We will be the Uber of X, where X is any other category than ride hailing” or “We will be the Airbnb of Y, where Y is any other category than hospitality services.”

GROUPTHINK. While the cognitive limitations discussed so far tend to aff lict individu- als, one important cognitive bias that can affect entire teams is called groupthink, a situa- tion in which opinions coalesce around a leader without individuals critically evaluating and challenging that leader’s opinions and assumptions.72 We have seen this occur in military history. For instance, in 1812, Napoleon Bonaparte’s commanders endorsed his idea to invade Russia, convinced that his strategy was a well-thought-out one. The com- manders’ unquestioned conformity around Napoleon’s beliefs led to disastrous conse- quences. Their groupthink, combined with Napoleon’s hubris, led to one of the most devastating military defeats in history.73 Napoleon began his campaign with almost 700,000 soldiers (the largest army ever amassed at that point in history), but only about 20,000 lived to return home.

In business, strong leaders tend to set the culture of their organizations. This process is reinforced by leaders’ strong preference to recruit, retain, and promote employees that sub- scribe to the same values, which, in turn, attracts more people with similar values to that organization.74 Although this process strengthens an organization’s culture and makes it more distinct, it also creates a more homogeneous organization, leaving its employees vul- nerable to groupthink.

Groupthink frequently comes into play when executives consider major strategic deci- sions such as takeovers. In 2015, for example, General Electric (GE) paid close to $20 bil- lion to acquire Alstom, a French industrial conglomerate.75 Then CEO Jeffrey Immelt and this team of hand-selected lieutenants were certain that acquiring Alstom was needed to transform the flagging U.S. conglomerate. They further convinced themselves that they could integrate Alstom into GE and manage the combined entity successfully. Their think- ing went along these lines: Since GE produced the best business leaders in the world that could manage any situation, who other than GE could pull this off?

Despite many red f lags, such as the apparent overpayment for the target and massive regulatory pushback, as well as subsequent deep concessions by GE, Immelt pushed the acquisition through. Just three years later, GE had to write off more than $20 billion in

representativeness A cognitive bias in which conclusions are based on small sam- ples, or even from one memorable case or an- ecdote.

groupthink A situation in which opinions coalesce around a leader without individ- uals critically evaluat- ing and challenging that leader’s opinions and assumptions.

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62 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

assets from its Power Division, most of it caused by the failed Alstom acquisition. After a 16-year tenure as CEO, Jeffrey Immelt was replaced. His successor, John Flannery (another GE insider), lasted 14 months on the job, before he too was fired. GE, once the most valuable company in the United States with some $600 billion in market capi- talization in mid-2000, had lost 90 percent of its market value or $540 billion by the end of 2018.76

In sum, cohesive, nondiverse groups are highly susceptible to groupthink, which in turn can lead to flawed decision making with potentially disastrous consequences.

HOW TO IMPROVE STRATEGIC DECISION MAKING What can strategic leaders do to ensure that they base their decisions on relevant and criti- cal information, while overcoming groupthink and the cognitive biases that can affect all of us? Two techniques have proven effective at improving strategic decision making: devil’s advocacy and dialectic inquiry.77

Devil’s Advocacy. The devil’s advocacy decision framework begins with one team generat- ing a detailed course of action. Next, a second team plays devil’s advocate and challenges the proposal generated by Team 1. Team 2 questions the underlying assumptions made in the proposal and highlights anything that might go wrong in the proposed course of action, thus illuminating potential downsides. In a third step, Team 1 then revises its initial proposal based on input and suggestions received from the devil’s advocate (that is, Team 2). This process is then repeated one more time. In a final step, both teams agree upon a course of action. The entire process frequently takes place under the supervision of a higher-level executive or executive team.

Amazon, for example, uses the devil’s advocacy approach when making strategic deci- sions. Founder and CEO Jeff Bezos banned all PowerPoint presentations and requires each manager to write a “narrative memo” no longer than six pages to which others are expected to respond as devil’s advocates. These written exchanges become the documents referenced when Amazon’s management teams meet to make decisions.78 Exhibit 2.10 shows the devil’s advocacy framework to enhance strategic decision making.

LO 2-9 Compare and contrast devil’s advocacy and dialectic inquiry as frameworks to improve strategic decision making.

devil’s advocacy Technique that can help to improve strate- gic decision making; a key element is that of a separate team or indi- vidual carefully scruti- nizing a proposed course of action by questioning and critiquing underlying assumptions and high- lighting potential downsides.

Team 1 generates a detailed course of action.

Team 2 plays devil’s advocate and questions assumptions of and criticizes proposed course of action.

Team 1 revises proposed course of action based on input received from Team 2.

Team 2 questions assumptions of and criticizes revised course of action. Team 1 further revises the proposed course of action.

Both teams agree upon a course of action. The entire process frequently takes place under the supervision of a higher-level executive or executive team.

EXHIBIT 2.10 How to Use a Devil’s Advocate to Improve Strategic Decision Making Source: Author’s own creation.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 63

Dialectic Inquiry. In contrast to the dev- il’s advocacy decision framework, which begins with a team generating one detailed course of action, in the dialectic inquiry framework, two teams each gener- ate a detailed course of action. In Step 1, Team 1 generates a detailed course of action (thesis) and Team 2 responds to Team 1 by generating a second, but alter- nate detailed course of action (antithesis). In Step 2, a debate in front of higher-level executives takes place where both thesis and antithesis are presented and dis- cussed. In the final step, the executive team synthesizes both proposals into a compromise plan of action and decides whether to adopt either proposal or nei- ther of them. Exhibit 2.11 shows the dia- lectic inquiry framework as another option to enhance strategic decision making.

2.5 Implications for Strategic Leaders Executives whose vision and decisions enable their organizations to achieve competitive advantage demonstrate strategic leadership. Effective strategic leaders use position as well as informal power and influence to direct the activities of others when implementing the orga- nization’s strategy. To gain and sustain a competitive advantage, strategic leaders need to put an effective strategic management process in place. An important first step in crafting an effective strategic management process is to articulate an inspiring vision and mission backed up by ethical core values. Customer-oriented or problem-defining vision statements are often correlated with firm success over long periods of time. This is because they allow firms strategic flexibility to change in order to meet changing customer needs and exploit external opportunities.

Another important implication of our discussion is that all employees should feel invested in and inspired by the firm’s vision and mission. Companies use different tactics to achieve such commitment; some firms annually invite all employees to review and revise the statement of firm values; others ask employees to rank themselves, their departments, and management on success relative to the vision and mission. Belief in a company’s vision and mission motivates its employees.

Strategic leaders, moreover, need to design a process that supports strategy formulation and implementation. In particular, strategic leaders have three options in their strategic toolkit: top-down strategic planning, scenario planning, and strategy as planned emergence. Each of the three strategy processes has its strengths and weaknesses (see Exhibit 2.8). Strategic leaders also need to consider the rate of change and firm size, two factors that affect the effectiveness of a chosen strategy process. The rate of change, internally and exter- nally, can suggest the more useful planning approach. In a slow-moving and stable environ- ment, top-down strategic planning might be the most effective. In a fast-moving and changeable environment, strategy as planned emergence might be the most effective. As to firm size, larger firms tend to use either a top-down strategic planning process or scenario

dialectic inquiry Technique that can help to improve strate- gic decision making; key element is that two teams each generate a detailed but alternate plan of action (thesis and anti-thesis). The goal, if feasible, is to achieve a synthesis between the two plans.

Step 3: Synthesis

Higher-level executive team takes one of three courses of action: adopts neither Team 1’s nor Team 2’s proposal, adopts either proposal, or adopts

a synthesis (some combination of both proposals) 

Step 2: Debate

Team 1 presents proposal to higher-level executive team 

Team 2 presents alternative proposal to higher-level executive team

Step 1: Thesis and Antithesis

Team 1 generates a detailed course of action (Thesis)  

Team 2 generates a detailed but alternative course of action (Antithesis)

EXHIBIT 2.11 How to Use Dialectic Inquiry to Improve Strategic Decision Making

Source: Author’s own creation.

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64 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

planning. Smaller firms may find it easier to implement strategy as planned emergence when feedback loops are short and the ability to respond quickly is keen.

For instance, a nuclear power provider such as Framatome in France, providing over 75 percent of the country’s energy and with the long-term backing of the state, might do well using a top-down strategy approach. Take the issue of disaster planning. Nuclear accidents, while rare, have tremendous impact as witnessed in Chernobyl, Russia, and Fukushima, Japan, so power providers need to be prepared. Nuclear accidents are considered black swans, low-probability events with high impact. Framatome might use scenario planning to prepare for such a black swan event. Contrast this with fast-moving environments. Internet- based companies, such as Airbnb, Alibaba, Alphabet, Amazon, Facebook, or Uber, tend to use strategy as planned emergence. In this process, every employee plays a strategic role. When a firm is using top-down planning or scenario planning, lower-level employees focus mainly on strategy implementation. As the examples in this chapter have shown, however, any employee, even at the entry level, can have great ideas that might become strategic initia- tives with the potential to transform companies.

Even the most well-designed strategic management process will fail if strategic leaders are unable to use the information at their disposal; our rationality is bounded—that is, while many of us attempt to be rational, we are unable to process a vast amount of information in real time. Individuals are not (yet) cyborgs, after all. Furthermore, every individual, including the most astute strategic leaders, are susceptible to a host of cognitive biases that lead to system- atic errors in our decision making. Thus, it is imperative that strategic leaders put in place safeguards, such as devil’s advocacy and dialectic inquiry, to improve strategic decision making.

The conclusion of our discussion of the strategic management process marks the end of the “getting started” portion of the Analysis, Formulation, Implementation (AFI) strategy framework (see Exhibit 1.4). The next three chapters cover the analysis part of the frame- work, where we begin by studying external and internal analyses before taking a closer look at competitive advantage, firm performance, and business models.

DURING THE PAST DECADE, the Zuckerberg-Sandberg lead- ership duo has created the most successful social network ever. When Sheryl Sandberg joined Facebook in 2008, her main priority was to develop a sustainable business model from which Facebook could make money. In short, her task was to build a big advertising business. Sandberg used the same playbook that she had used so successfully at Google: first, build a large user base—in this area, Mark Zuckerberg and his team of developers excelled.

Second, gather as much personal data as possible from Facebook’s users, their friends, and all their activities on the open web. Not only did Facebook excel in this area as well, it also purchased additional personal data from data brokers (such as Acxiom and Epsilon) and consumer credit reporting companies (such as Experian, Equifax, and TransUnion) about each American. From these data, Facebook gathered a

wide range of personal information: what each American buys, where each lives, where each works, how much money each makes, each person’s traffic patterns, family activities, likes and dislikes, movies watched, restaurants dined at, and much more. Most consumers are unaware that so much per- sonal data are being collected, which has led some critics to accuse Facebook of being a “surveillance machine.”

Third, place micro-targeted ads using a proprietary algo- rithm. Facebook managed to collect a breadth of fine-grained and high-quality consumer data, the best in the industry, which it then used to develop unique profiles for each user. Advertisers then relied on these profiles to place their micro- targeted ads. It was precisely for this capability of accurate individual profiling that advertisers (ranging from consumer product companies to presidential campaigns) were willing to pay a premium. Facebook’s business model—offering free

CHAPTERCASE 2 Part II

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65

services to end users while allowing advertisers to place finely targeted ads for a premium price—turned out to be highly prof- itable. It would serve as the foundation for Facebook’s decade- long competitive advantage.

Now, however, Facebook appears to be in a deep crisis and is struggling to maintain its reputation. It has lost users’ trust as well as legitimacy among many other stakeholders includ- ing the media, politicians, and regulators both in the United States and Europe. The demands to regulate its platform more closely are gathering steam. User engagement has fallen, and the company’s valuation had dropped by $200 billion during the last six months of 2018 alone.

What led to this crisis? First and foremost, user privacy became a growing concern. Facebook has long been criticized for alleged lax handling of user information and an opaque privacy policy that changed frequently. In the spring of 2018, however, things came to a head when it was revealed that Cambridge Analytica, a political consulting firm, used Facebook data from millions of users (and their friends) with- out their consent to create micro-targeted political advertising campaigns during the 2016 presidential election in the United States. This privacy scandal compelled Zuckerberg to testify before Senate committees, where he declared that Facebook users “have complete control” over which data they share. This turned out not to be true. As was reported in the fall of 2018, Facebook had allowed a number of tech companies, in- cluding Netf lix, Microsoft, Yahoo, Amazon, Pandora, and Spotify, access to user data and private messages.

Second, Facebook has been criticized for becoming a news organization rather than a social network, which has become a serious issue in the era of fake news. Roughly two-thirds of Americans of all ages (and a higher percentage of youth) get their political news from social media sites. Critics, therefore, want Facebook to demonstrate a higher degree of editorial

oversight, similar to the oversight demonstrated by traditional publishers. Facebook maintains that it is agnostic on news con- tent and points to existing U.S. law (Section 230 of the Com- munications Decency Act), which states that internet firms are not liable for the content that is published on their platform.

Third, critics and even early investors of Facebook allege that Zuckerberg and Sandberg responded too slowly to the vari- ous crises they were facing: Russian meddling in U.S. elections, abuse of personal data by third parties such as Cambridge Analytica, and Facebook’s abdication of any responsibilities for the content posted on its website.

Lastly, Facebook’s leaders have been criticized for priori- tizing exponential growth above anything else and that it failed to consider the potential downsides of creating an infor- mation platform for more than 2 billion people. Many have equated the network to “a digital nation-state.”79

Questions 1. What challenges (as detailed in this ChapterCase) is

Facebook facing? How should Mark Zuckerberg and Sheryl Sandberg deal with each of them? List each of the challenges, and make specific recommendations on how to address them.

2. Compare and contrast the strategic leadership of Mark Zuckerberg and Sheryl Sandberg. Which qualities for each strategic leader stand out to you, and why? Where would you place each individual on the Level-5 pyramid for strategic leaders (see Exhibit 2.2), and why? Is either of them an effective strategic leader? Explain your answers.

3. Given the apparent leadership crisis at Facebook should Mark Zuckerberg and/or Sheryl Sandberg be replaced? Why, or why not? Explain your answers.

Given the ongoing crises at Facebook around alleged violation of user privacy, foreign meddling in U.S. elections, and the company’s continued abdication of taking responsibility for the content published on its site, Facebook CEO Mark Zucker- berg and COO Sheryl Sandberg were both compelled to testify on several occasions in front of Congress in 2018.

(left): Andrew Harnik/AP Images, (right): Ron Sachs/CNP/AdMedia/Newscom

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66 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

How Much Are Your Values Worth to You?

H ow much are you willing to pay for the job you want? This may sound like a strange question, since your employer will pay you to work, but think again. Con- sider how much you value a specific type of work, or how much you would want to work for a specific organization be- cause of its values.

A study shows scientists who want to continue engaging in research will accept some $14,000 less in annual salary to work at an organization that permits them to publish their findings in academic journals, implying that some scientists will “pay to be scientists.” This finding appears to hold in the general business world too. In a survey, 97 percent of Stanford MBA students indicated they would forgo some 14 percent of their expected salary, or about $11,480 a year, to work for a company that matches their own values with concern for stakeholders and sustainability. According to Monster.com, an online career service, about 92 percent of all undergraduates want to work for a “green” company. These diverse examples

demonstrate that people put a real dollar amount on pursuing careers in sync with their values.

On the other hand, certain high-powered jobs such as management consulting or investment banking pay very well, but their high salaries come with strings attached. Pro- fessionals in these jobs work very long hours, including weekends, and often take little or no vacation time. These workers “pay for pay” in that they are often unable to form stable relationships, have little or no leisure time, and some- times even sacrifice their health. People “pay for”—make certain sacrifices for—what they value, because strategic de- cisions require important trade-offs.80

1. Identify your personal values. How do you expect these values to affect your work life or your career choice?

2. How much less salary would (did) you accept to find employment with a company that is aligned with your values?

3. How much are you willing to “pay for pay” if your dream job is in management consulting or investment banking?

mySTRATEGY

This chapter examined the role strategic leaders play, delineated different processes to create strategy, and outlined the different cognitive biases that can nega- tively impact strategic decision making and what man- agers can do to improve decision making. We summarize the discussion in the following learning ob- jectives and related take-away concepts.

LO 2-1 / Explain the role of strategic leaders and what they do. ■ Executives whose vision and decisions enable their

organizations to achieve competitive advantage demonstrate strategic leadership.

■ Strategic leaders use formal and informal power to influence the behavior of other organizational members to do things, including things they would not do otherwise.

■ Strategic leaders can have a strong (positive or negative) performance impact on the organiza- tions they lead.

LO 2-2 / Outline how you can become a strategic leader. ■ To become an effective strategic leader, you

need to develop skills to move sequentially through five leadership levels: highly capable individual, contributing team member, compe- tent manager, effective leader, and executive (see Exhibit 2.2).

■ The Level-5 strategic leadership pyramid applies to both distinct corporate positions and personal growth.

TAKE-AWAY CONCEPTS

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 67

LO 2-3 / Compare and contrast the roles of corporate, business, and functional managers in strategy formulation and implementation. ■ Corporate executives must provide answers to the

question of where to compete, whether in indus- tries, markets, or geographies, and how to create synergies among different business units.

■ General managers in strategic business units must answer the strategic question of how to compete in order to achieve superior performance. They must manage and align the firm’s different functional areas for competitive advantage.

■ Functional managers are responsible for implementing business strategy within a single functional area.

LO 2-4 / Describe the roles of vision, mission, and values in a firm’s strategy. ■ A vision captures an organization’s aspirations.

An effective vision inspires and motivates mem- bers of the organization.

■ A mission statement describes what an organiza- tion actually does—what its business is—and why and how it does it.

■ Core values define the ethical standards and norms that should govern the behavior of individu- als within the firm.

LO 2-5 / Evaluate the strategic implications of product-oriented and customer-oriented vision statements. ■ Product-oriented vision statements define a busi-

ness in terms of a good or service provided. ■ Customer-oriented vision statements define busi-

ness in terms of providing solutions to customer needs.

■ Customer-oriented vision statements provide managers with more strategic flexibility than product-oriented missions.

■ To be effective, visions and missions need to be backed up by hard-to-reverse strategic commit- ments and tied to economic fundamentals.

LO 2-6 / Justify why anchoring a firm in ethical core values is essential for long-term success. ■ Ethical core values underlay the vision statement

to ensure the stability of the strategy, and thus lay the groundwork for long-term success.

■ Ethical core values are the guardrails that help keep the company on track when pursuing its mis- sion and its quest for competitive advantage.

LO 2-7 / Evaluate top-down strategic planning, scenario planning, and strategy as planned emergence. ■ Top-down strategic planning is a sequential, linear

process that works reasonably well when the envi- ronment does not change much.

■ In scenario planning, managers envision what-if scenarios and prepare contingency plans that can be called upon when necessary.

■ Strategic initiatives can be the result of top-down planning or can emerge through a bottom-up pro- cess from deep within the organization. They have the potential to shape a firm’s strategy.

■ A firm’s realized strategy is generally a combina- tion of its top-down intended strategy and bottom- up emergent strategy, resulting in planned emergence.

LO 2-8 / Describe and evaluate the two distinct modes of decision making. ■ When faced with decisions, individuals tend to sat-

isfice rather than to optimize due to cognitive limi- tations.

■ Our decision making is governed by two distinct ways of thinking: System 1 and System 2.

■ System 1 is our default mode of thinking because it is automatic, fast, and efficient, requiring little energy or attention. System 1 is prone to cognitive biases that can lead to systematic errors in deci- sion making.

■ System 2 is based on attempting to apply rational- ity to our decision making by relying on analytical and logical reasoning. It is an effortful, slow, and deliberate way of thinking.

■ Along with cognitive limitations, as humans we are prone to a host of cognitive biases, which leads to systematic errors in our decision making when compared to a more rational decision.

LO 2-9 / Compare and contrast devil’s advocacy and dialectic inquiry as frameworks to improve strategic decision making. ■ Devil’s advocacy and dialectic inquiry are two

techniques to improve strategic decision making.

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68 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

■ Devil’s advocacy is a technique that can help to improve strategic decision making; a key element is that of a separate team or individual carefully scrutinizing a proposed course of action by ques- tioning and critiquing underlying assumptions and highlighting potential downsides.

■ Dialectic inquiry is a technique that can help to improve strategic decision making; the key ele- ment is that two teams generate detailed but alter- nate plans of action (thesis and antithesis). The goal, if feasible, is to achieve a synthesis between the two plans.

Strategic leadership (p. 34) Strategic management

process (p. 47) Strategy formulation (p. 38) Strategy implementation (p. 38) System 1 (p. 58) System 2 (p. 58) Theory of bounded rationality 

(p. 57)

Top-down strategic planning  (p. 47)

Upper-echelons theory (p. 35) Vision (p. 40)

Autonomous actions (p. 53) Behavioral economics (p. 58) Black swan events (p. 50) Cognitive biases (p. 58) Cognitive limitations (p. 57) Confirmation bias (p. 60) Core values statement (p. 46) Devil’s advocacy (p. 62) Dialectic inquiry (p. 63) Dominant strategic plan (p. 51) Emergent strategy (p. 53) Escalating commitment (p. 59) Groupthink (p. 61) Illusion of control (p. 59) Intended strategy (p. 53)

Level-5 leadership pyramid (p. 36) Mission (p. 45) Organizational core values (p. 46) Planned emergence (p. 56) Realized strategy (p. 53) Reason by analogy (p. 60) Representativeness (p. 61) Resource-allocation process

(RAP) (p. 55) Scenario planning (p. 48) Serendipity (p. 54) Strategic business unit (SBU) 

(p. 39)

Strategic initiative (p. 53) Strategic intent (p. 40)

KEY TERMS

DISCUSSION QUESTIONS 1. The chapter discusses several strategic leadership

issues at Facebook. Several other firms are also noted in the chapter with some positive and some negative leadership results. Choose a firm men- tioned in the chapter and discuss current contro- versial issues it faces. How should strategic leaders address the major issues you identified? In what situations is top-down planning likely to be supe- rior to bottom-up emergent strategy development?

2. This chapter introduces three levels appropriate for strategic considerations (see Exhibit 2.3). In what situations would some of these levels be more important than others? For example, what issues might be considered by the corporate level? How should the organization ensure the proper attention to each level of strategy as needed?

3. The “job to do” approach discussed with the Clayton Christensen milkshake example can be useful in a variety of settings. Even when we are

the customers ourselves, sometimes we don’t look for better solutions because we get into routines and habits. Think about a situation you sometimes find frustrating in your own life or one you hear others complaining about frequently. Instead of focusing on the annoyance, can you take a step back and look for the real job that needed doing when the frustration occurred? What other options can be developed to “do the job” that may lead to less irritation in these situations?

4. In what situations is top-down planning likely to be superior to bottom-up emergent strategy devel- opment? Please provide an example.

5. Several elements of strategic decision making are highlighted in this chapter. Think of an important decision a firm has recently faced and choose either devil’s advocacy or dialectic inquiry to lay out some of the key factors the firm likely consid- ered in making its decisions.

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 69

1. Frontline (2018, Oct. 29 and Oct. 30), “The Facebook dilemma,” PBS, www.pbs.org/wgbh/ frontline/film/facebook-dilemma/.

2. Frontline (2018, Oct. 29 and Oct. 30), “The Facebook dilemma,” www.pbs.org/wgbh/ frontline/film/facebook-dilemma.

3. Quotes from Frontline (2018, Oct. 29 and Oct. 30), “The Facebook dilemma,” www.pbs. org/wgbh/frontline/film/facebook-dilemma/.

4. The Facebook Dilemma (Part One and Two),” Frontline PBS Documentary, aired on October 29 and 30, 2018, https://www.pbs.org/ wgbh/frontline/film/facebook-dilemma

5. This ChapterCase is based on: Sandberg, S. (2010), “Why we have too few women leaders,” TED talk, http://bit.ly/1czSD6n; Auletta, K. (2011, Jul. 11), “A woman’s place,” The New Yorker; Holms, A. (2013, Mar. 4), “Maybe you should read the book: The Sheryl Sandberg backlash,” The New Yorker; Sandberg, S. (2013), Lean In: Women, Work, and the Will to Lead (New York: Knopf); Parker, G.G., M.W. Van Alstyne, and S.P. Choudary (2016), Platform Revolution: How Networked Markets Are Transforming the Economy—And How to Make Them Work for You (New York: Norton); “The Facebook scandal could change politics as well as the internet,” The Economist (2018, March 22); “Facebook faces a reputational meltdown,” The Economist (2018, March 22); Frenkel, S., N. Confessore, C. Kang, M. Rosenberg, and J. Nicas (2018, Nov. 14), “Delay, deny and de- flect: How Facebook’s leaders fought through crisis,” The New York Times; Halpern, S. (2018, Dec. 5), “Facebook’s very bad month just got worse,” The New Yorker; and Facebook, Inc. (various annual reports).

6. Finkelstein, S., D.C. Hambrick, and A.A. Cannella (2008), Strategic Leadership: Theory and Research on Executives, Top Management Teams, and Boards (Oxford, UK: Oxford University Press), 4.

7. Finkelstein, S., D.C. Hambrick, and A.A. Cannella (2008), Strategic Leadership: Theory and Research on Executives, Top Management Teams, and Boards (Oxford, UK: Oxford University Press); and Yulk, G. (1998), Leadership in Organizations, 4th ed. (Englewood Cliffs, NJ: Prentice Hall).

8. Pfeffer, J. (1994), Managing with Power: Politics and Influence in Organizations (Boston: Harvard Business School Press).

9. “The acceptable face of Facebook,” The Economist (2011, Jul. 21).

10. Hambrick, D.C., and E. Abrahamson (1995), “Assessing managerial discretion across industries: A multimethod approach,”

Academy of Management Journal 38: 1427–1441.

11. “The 100 best performing CEOs in the World,” Harvard Business Review (2016, November).

12. Bandiera, O., A. Prat, and R. Sadun (2012), “Managerial capital at the top: Evidence from the time use of CEOs,” London School of Economics and Harvard Business School Working Paper; and “In defense of the CEO,” The Wall Street Journal (2013, Jan. 15). The patterns of how CEOs spend their time have held in a number of different studies across the world.

13. Finkelstein, S., D.C. Hambrick, and A.A. Cannella (2008), Strategic Leadership: Theory and Research on Executives, Top Management Teams, and Boards (Oxford, UK: Oxford University Press), 17.

14. Bandiera, O., A. Prat, and R. Sadun (2012), “Managerial capital at the top: Evidence from the time use of CEOs,” London School of Economics and Harvard Business School Working Paper; and “In defense of the CEO,” The Wall Street Journal (2013, Jan. 15).

15. Hambrick, D.C. (2007), “Upper echelons theory: An update,” Academy of Management Review 32: 334–343; and Hambrick, D.C., and P.A. Mason (1984), “Upper echelons: The or- ganization as a reflection of its top managers,” Academy of Management Review 9: 193–206.

16. Collins, J.C. (2001), Good to Great: Why Some Companies Make the Leap . . . And Others Don’t (New York: HarperBusiness).

17. As quoted in Auletta, K. (2011, July 11), “A woman’s place,” The New Yorker.

18. 2016 Walmart Annual Report at http://bit. ly/1r2LXuV; see also Bowman, J. (2015, May 12), “The largest retailer in history: How Walmart sales reached $500 billion,” Motley Fool.

19. 2018 Facebook Annual Report.

20. 2018 Facebook Annual Report; and Seetharaman, D. (2016, Apr. 28), “Facebook revenue soars on ad growth,” The Wall Street Journal.

21. Covey, S.R. (1989), The 7 Habits of Highly Effective People: Powerful Lessons in Personal Change (New York: Simon & Schuster).

22. Musk, E. (2011, Sept. 29), “SpaceX vision and mission statement,” presentation to The National Press Club, Washington, DC, http:// bit.ly/2frJx4f.

23. Frankl, V.E. (1984), Man’s Search for Meaning (New York: Simon & Schuster).

24. Pink, D.H. (2011), The Surprising Truth about What Motivates Us (New York: Riverhead Books).

25. Hamel, G., and C.K. Prahalad (1989, May–June), “Strategic intent,” Harvard Business Review: 64–65; Hamel, G., and C.K. Prahalad (1994), Competing for the Future (Boston: Harvard Business School Press); and Collins, J.C., and J.I. Porras (1994), Built to Last: Successful Habits of Visionary Companies (New York: HarperCollins).

26. Villanueva Beard, Elisa. 2016. Teach for America annual report, Teach For America, Inc.

27. Teach for America press kit (www.teachfo- ramerica.org/press ); Simon, S. (2013, Sept. 10), “New study finds Teach for America re- cruits boost student achievement in math,” Politico; Kopp, W. (2011), A Chance to Make History: What Works and What Doesn’t in Providing an Excellent Education for All (Philadelphia, PA: Public Affairs); Xu, Z., J. Hannaway, and C. Taylor (2008, Mar. 27), “Making a difference? The effect of Teach for America on student performance in high school,” Urban Institute; “Wendy Kopp Explains Teach for America,” http://bit. ly/2gy1iTy (video 4.05 min); and Kopp, W. (2001), One Day, All Children. . .: The Unlikely Triumph of Teach for America and What I Learned Along the Way (Cambridge, MA: Perseus Book Group); Strauss, V. (2016, Mar. 22), “Big trouble at Teach For America?” The Washington Post; and Brown, E. (2016, Apr. 12), “Teach for America applications fall again, diving 35 percent in three years,” The Washington Post.

28. Collins, J.C., and J.I. Porras (1994), Built to Last: Successful Habits of Visionary Companies (New York: HarperCollins); Collins, J.C. (2001), Good to Great: Why Some Companies Make the Leap . . . And Others Don’t (New York: HarperBusiness).

29. For academic work on using a problem- solving perspective as the basis for understand- ing the firm, see Nickerson, J., and T. Zenger (2004), “A knowledge-based theory of the firm—the problem-solving perspective,” Organization Science 15: 617–632.

30. This example is drawn from Clayton Christensen’s work as described in Kane, Y.I. (2014), Haunted Empire: Apple after Steve Jobs (New York: HarperCollins), 191.

31. Germain, R., and M.B. Cooper (1990), “How a customer mission statement affects company performance,” Industrial Marketing Management 19(2): 47–54; Bart, C.K. (1997),

ENDNOTES

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70 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

“Industrial firms and the power of mission,” Industrial Marketing Management 26(4): 371–383; and Bart, C.K. (2001), “Measuring the mission effect in human intellectual capi- tal,” Journal of Intellectual Capital 2(3): 320–330.

32. Christensen, C. (1997), The Innovator’s Dilemma (New York: HarperCollins).

33. Kane, Y.I. (2014), Haunted Empire: Apple After Steve Jobs (New York: HarperCollins), 191.

34. “The three habits . . . of highly irritating management gurus,” The Economist (2009, Oct. 22).

35. Burgelman, R.A., and A.S. Grove (1996), “Strategic dissonance,” California Management Review 38: 8–28; and Grove, A.S. (1996), Only the Paranoid Survive: How to Exploit the Crisis Points that Challenge Every Company (New York: Currency Doubleday).

36. Bart, C.K., and M.C. Baetz (1998), “The relationship between mission statements and firm performance: An exploratory study,” Journal of Management Studies 35: 823–853.

37. Dixit, A., and B. Nalebuff (1991), Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: Norton); and Brandenburger, A.M., and B.J. Nalebuff (1996), Co-opetition (New York: Currency Doubleday).

38. Ewing, J. (2017, May 6), “Inside VW’s campaign of trickery,” The New York Times.

39. For a superb treatise of the history of strategy, see: Freedman, L. (2013), Strategy: A History (New York: Oxford University Press).

40. This discussion is based on: Mintzberg, H. (1993), The Rise and Fall of Strategic Planning: Reconceiving Roles for Planning, Plans, and Planners (New York: Simon & Schuster); and Mintzberg, H. (1994, January–February), “The fall and rise of strategic planning,” Harvard Business Review: 107–114.

41. Isaacson, W. (2011), Steve Jobs (New York: Simon & Schuster). See also: Isaacson, W. (2012, April), “The real leadership lessons of Steve Jobs,” Harvard Business Review.

42. Jobs, S. (1998, May 25) “There is sanity returning,” BusinessWeek.

43. Isaacson, W. (2011), Steve Jobs (New York: Simon & Schuster). See also: Isaacson, W. (2012, April), “The real leadership lessons of Steve Jobs,”Harvard Business Review.

44. “CEO Tim Cook pushes employee-friendly benefits long shunned by Steve Jobs,” The Wall Street Journal (2012, Nov. 12).

45. Grove, A.S. (1996), Only the Paranoid Survive: How to Exploit the Crisis Points that Challenge Every Company (New York: Currency Doubleday).

46. UPS 2014 Investor Conference Presentations (2014, Nov. 13); and UPS 2013 Annual Report.

47. Talib, N.N. (2007), The Black Swan: The Impact of the Highly Improbable (New York: Random House).

48. Mintzberg, H. (1993), The Rise and Fall of Strategic Planning: Reconceiving Roles for Planning, Plans, and Planners (New York: Simon & Schuster); and Mintzberg, H. (1994, January– February), “The fall and rise of strategic plan- ning,” Harvard Business Review: 107–114.

49. Thompson, S.C. (1999), “Illusions of con- trol: How we overestimate our personal influ- ence,” Current Directions in Psychological Science 8: 187–190.

50. “FTI Consulting projects U.S. online retail sales to reach $525 billion in 2018,” Global Newswire (2018, Sept. 11), https://bit. ly/2EvFO5I.

51. Kotha, S., V. Rindova, and F.T. Rothaermel (2001), “Assets and actions: Firm- specific factors in the internationalization of U.S. internet firms,”Journal of International Business Studies 32(4): 769–791; and Rothaermel, F.T., S. Kotha, and H.K. Steensma (2006), “International market entry by U.S. internet firms: An empirical analysis of country risk, national culture, and market size,” Journal of Management 32(1): 56–82.

52. Kantor, J., and D. Streitfeld (2015, Aug. 15), “Inside Amazon: Wrestling big ideas in a bruising workplace,” The New York Times.

53. Arthur, B.W. (1989), “Competing technolo- gies, increasing returns, and lock-in by historical events,” Economic Journal 99: 116–131; and Brown, S.L., and K.M. Eisenhardt (1998), Competing on the Edge: Strategy as Structured Chaos (Boston, MA: Harvard Business School Press); Bower, J.L. (1970), Managing the Resource Allocation Process (Boston: Harvard Business School Press); Bower, J.L., and C.G. Gilbert (2005), From Resource Allocation to Strategy (Oxford, UK: Oxford University Press); Burgelman, R.A. (1983), “A model of the inter- action of strategic behavior, corporate context, and the concept of strategy,” Academy of Management Review 8: 61–71; and Burgelman, R.A. (1983), “A process model of internal cor- porate venturing in a major diversified firm,” Administrative Science Quarterly 28: 223–244.

54. Based on: Howard Behar, retired presi- dent, Starbucks North America and Starbucks International, (2009), Impact Speaker Series Presentation, College of Management, Georgia Institute of Technology, October 14. See also Behar, H. (2007), It’s Not About the Coffee: Leadership Principles from a Life at Starbucks (New York: Portfolio).

55. This example is drawn from: “Crispy ‘Saratoga chips’ potato chips invented in

Saratoga,” at www.saratoga.com/news/sara- toga-chips.cfm; and “George Crum,” at http:// lemelson.mit.edu/resources/george-crum.

56. Levy, S. (2011), In the Plex: How Google Thinks, Works, and Shapes Our Lives (New York: Simon & Schuster).

57. Mayer, M. (2006, May 11), “Nine lessons learned about creativity at Google,” presenta- tion at Stanford Technology Ventures Program.

58. Barr, A., and R. Winkler (2015, Aug. 10), “Google creates parent company called Alphabet in restructuring,” The Wall Street Journal.

59. Bower, J.L., and C.G. Gilbert (2005), From Resource Allocation to Strategy (Oxford, UK: Oxford University Press).

60. Bower, J.L. (1970), Managing the Resource Allocation Process (Boston: Harvard Business School Press); Bower, J.L., and C.G. Gilbert (2005), From Resource Allocation to Strategy (Oxford, UK: Oxford University Press); Burgelman, R.A. (1983), “A model of the inter- action of strategic behavior, corporate context, and the concept of strategy,” Academy of Management Review 8: 61–71; and Burgelman, R.A. (1983), “A process model of internal cor- porate venturing in a major diversified firm,” Administrative Science Quarterly 28: 223–244.

61. Burgelman, R.A. (1994), “Fading memo- ries: A process theory of strategic business exit in dynamic environments,” Administrative Science Quarterly 39: 24–56.

62. Burgelman, R.A., and A.S. Grove (1996), “Strategic dissonance,” California Management Review 38: 8–28.

63. Grant, R.M. (2003), “Strategic planning in a turbulent environment: Evidence from the oil majors,” Strategic Management Journal 24: 491–517; Brown, S.L., and K.M. Eisenhardt (1997), “The art of continuous change: Linking complexity theory and time-based evo- lution in relentlessly shifting organizations,” Administrative Science Quarterly 42: 1–34; Farjourn, M. (2002), “Towards an organic per- spective on strategy,” Strategic Management Journal 23: 561–594; Mahoney, J. (2005), Economic Foundation of Strategy (Thousand Oaks, CA: Sage); and Burgelman, R.A., and A.S. Grove (2007), “Let chaos reign, then rein in chaos—repeatedly: Managing strategic dy- namics for corporate longevity,” Strategic Management Journal 28(10): 965–979.

64. Simon, H.A. (1956). “Rational choice and the structure of the environment.” Psychological Review, 63(2): 129–138. Section 2.4 draws on Kahneman, D. (2011), Thinking, Fast and Slow (New York: Farrar, Straus and Giroux). See also: Thaler, R.H., and C.R. Sunstein (2008), Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press).

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 71

65. Kahneman, D. (2011), Thinking, Fast and Slow (New York: Farrar, Straus and Giroux). See also: Thaler, R.H., and C.R. Sunstein (2008), Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press).

66. The idea of snap judgments was popular- ized in: Gladwell, M. (2005), Blink: The Power of Thinking Without Thinking (New York: Hachette Group).

67. Kahneman, D. (2003). “Maps of bounded rationality: Psychology for behavioral econom- ics.” American Economic Review 93 (5): 1449–1475; Kahneman, D. (2011), Thinking, Fast and Slow (New York: Farrar, Straus and Giroux). See also: Thaler, R.H., and C.R. Sunstein (2008), Nudge: Improving Decisions About Health, Wealth, and Happiness (New Haven, CT: Yale University Press).

68. Thompson, S.C. (1999), “Illusions of con- trol: How we overestimate our personal influ- ence,” Current Directions in Psychological Science 8: 187–190.

69. I’m deeply indebted to Professor Joseph T. Mahoney, the Caterpillar Chair of Business at the University of Illinois at Urbana- Champaign, for not only encouraging me to include a section on strategic decision making in this text but also for sharing some excellent examples of cognitive biases with me that I’m gratefully including in this section.

70. Staw, B.M. (1981). “The escalation of commitment to a course of action.” Academy of Management Journal 6: 577–587.

71. The Iridium example is drawn from: Fin- kelstein, S. (2003), Why Smart Executives Fail: And What You Can Learn from Their Mistakes (New York: Portfolio). We discuss the Iridium case in much more detail in Chapter 7, “Business Strategy: Innovation, Entrepreneur- ship, and Platforms.”

72. Janis, I.L. (1972). Victims of Groupthink: A Psychological Study of Foreign-Policy Decisions and Fiascoes (Oxford, England: Houghton Mifflin).

73. Kioll, M.J., L.A. Toombs, and P. Wright (2000), “Napoleon’s tragic march home from Moscow: Lessons in hubris,” Academy of Management Executive 14(1): 117–128.

74. Schneider, B., H.W. Goldstein, and D.B. Smith (1995), “The ASA framework: An up- date,” Personnel Psychology 48: 747–773.

75. See a detailed and insightful description of GE’s decline over time in: Gryta, T., and T. Mann (2018, Dec. 14). “GE powered the American century—then it burned out,” The Wall Street Journal.

76. Gryta, T., and T. Mann (2018, Dec. 14). “GE powered the American century—then it burned out.” The Wall Street Journal.

77. Schweiger, D.M., W.R. Sandberg, and J.W. Ragan (1986). “Group approaches for improv- ing strategic decision making: A comparative analysis of dialectical inquiry, devil’s advocacy, and consensus.” Academy of Management Journal, 29(1): 51–71.

78. Gallo, C. (2018, April 25). “Jeff Bezos banned PowerPoint in meetings. His replace-

ment is brilliant.” Inc. Magazine, www.inc. com/carmine-gallo/jeff-bezos-bans-powerpoint- in-meetings-his-replacement-is-brilliant.html.

79. Sources: “The Facebook scandal could change politics as well as the internet,” The Economist (2018, Mar. 22); “Facebook faces a reputational meltdown,” The Economist (2018, Mar. 22); Frenkel, S., N. Confessore, C. Kang, M. Rosenberg, and J. Nicas (2018, Nov. 14), “Delay, deny and deflect: How Facebook’s leaders fought through crisis,” The New York Times; Dance, G.J.X., M. LaForgia, and N. Confessore (2018, Dec. 18), “As Facebook raised a privacy wall, it carved an opening for tech giants,” The New York Times; Lapowsky, I. (2018, Dec. 20), “The 21 (and counting) big- gest Facebook scandals of 2018,” Wired; Confessore, N., M. LaForgia, and G.J.X. Dance (2018, Dec. 18), “Facebook’s data shar- ing and privacy rules: 5 takeaways from our Investigation,” The New York Times; and LaForgia, M., N. Confessore, and G.J.X. Dance (2018, Dec. 19), “Facebook rebuked for failing to disclose data-sharing deals,” The New York Times.

80. Based on: Stern, S. (2004), “Do scientists pay to be scientists?” Management Science 50(6): 835–853; and Esty, D.C., and A.S. Winston (2009), Green to Gold: How Smart Companies Use Environmental Strategy to Innovate, Create Value, and Build Competitive Advantage, revised and updated (Hoboken, NJ: John Wiley).

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72

Chapter Outline

3.1 The PESTEL Framework Political Factors Economic Factors Sociocultural Factors Technological Factors Ecological Factors Legal Factors

3.2 Industry Structure and Firm Strategy: The Five Forces Model Industry vs. Firm Effects in Determining Firm Performance Competition in the Five Forces Model The Threat of Entry The Power of Suppliers The Power of Buyers The Threat of Substitutes Rivalry among Existing Competitors Applying the Five Forces Model to the U.S. Airline Industry A Sixth Force: The Strategic Role of Complements

3.3 Changes over Time: Entry Choices and Industry Dynamics Entry Choices Industry Dynamics

3.4 Performance Differences within the Same Industry: Strategic Groups The Strategic Group Model Mobility Barriers

3.5 Implications for Strategic Leaders

CHAPTER

3 Learning Objectives

After studying this chapter, you should be able to:

LO 3-1 Generate a PESTEL analysis to evaluate the impact of external factors on the firm.

LO 3-2 Differentiate the roles of firm effects and industry effects in determining firm performance.

LO 3-3 Apply Porter’s five competitive forces to explain the profit potential of different industries.

LO 3-4 Examine how competitive industry structure shapes rivalry among competitors.

LO 3-5 Describe the strategic role of complements in creating positive-sum co-opetition.

LO 3-6 Explain the five choices required for market entry.

LO 3-7 Appraise the role of industry dynamics and industry convergence in shaping the firm’s external environment.

LO 3-8 Generate a strategic group model to reveal performance differences between clusters of firms in the same industry.

External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

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73

Airbnb: Disrupting the Hotel Industry

IN 2019, AIRBNB had 5 million listings in over 81,000 cities in some 190 countries, ranging from spare rooms to entire islands. With its “asset-light approach” based on its platform strategy, Airbnb is able to offer more accommodations than the three biggest hotel chains combined: Marriott, Hilton, and Intercontinen- tal. And just like global hotel chains, Airbnb uses sophisticated pricing and reservation systems for guests to find, reserve, and pay for rooms to meet their travel needs. In this sense, Airbnb is a new en- trant that competes in the global hotel industry.

Brian Chesky and Joe Gebbia, Airbnb founders, were roommates in San Francisco a little more than a decade earlier. Both were industrial designers, people who shape the form and function of everything from coffee cups to office furniture to airplane interiors. But since work opportunities were hit-and-miss, they found themselves struggling to make their rent payments. On a whim, they decided to e-mail everyone on the distribution list for an up- coming industrial design conference in their hometown: “If you’re heading out to the [industrial design conference] in San Francisco next week and have yet to make accommoda- tions, well, consider networking in your jam-jams. That’s right. For an affordable alternative to hotels in the city, imagine yourself in a fellow design industry person’s home, fresh awake from a snooze on the ol’ air mattress, chatting about the day’s upcoming events over Pop Tarts and OJ.”1

Three people took up the offer, and the two roommates made some money to subsidize their rent payments. But more importantly, Chesky and Gebbia felt that they had stumbled upon a new business idea: Help people rent out their spare rooms. They then brought on computer scientist Nathan Blecharczyk, one of Gebbia’s former roommates, to create a website where hosts and guests could meet and transact, naming their site AirBedandBreakfast.com (later

shortened to Airbnb). The three entrepreneurs tested their new site at the 2008 South by Southwest (SXSW), an annual music, film, and interactive media conference. SXSW also serves as an informal launch pad for new ventures; for exam- ple, Twitter was unveiled at SXSW just a year earlier to great fanfare. Airbnb’s launch at SXSW flopped, however, because the conference organizers had exclusive contracts with local hotels (which Airbnb founders learned about later), and so

conference organizers didn’t drive any traffic to Airbnb’s site.

Not to be discouraged, Airbnb decided to take ad- vantage of the anticipated shortage of hotel rooms in Denver, Colorado, the site of the Democratic Na- tional Convention (DNC) in the summer of 2008. After all hotels were booked, the founders pre- pared media releases with titles such as “Grassroots Housing for Grassroots Campaign,” which Obama supporters loved. As luck

would have it, Airbnb was covered in both The New York Times and The Wall Street Journal. And the newly designed Airbnb site worked! It facilitated about 100 rentals during the DNC. Soon after the event, however, website traffic to Airbnb’s site fell back to zero. To keep going, Chesky and Gebbia decided to become cereal entrepreneurs, creating “Obama-O’s: The breakfast of change” and “Cap’n McCains: A maverick in every bite,” with illustrated images of the 2008 presidential candidates on 1,000 cereal boxes. After sending samples to their press contacts and subsequent coverage in the media, the limited edition cereal sold out quickly, provid- ing enough cash to keep going with Airbnb a bit longer.

The f ledgling venture’s breakthrough came in 2009 when it was accepted into a program run by Y Combinator, a start-up accelerator that has spawned famous tech compa- nies such as Dropbox, Stripe, and Twitch.tv. In exchange for equity in the new venture, these start-up accelerators provide office space, mentoring, and networking opportunities, in- cluding with venture capitalists looking to fund the next “big thing.” In 2010, Airbnb received funding from Sequoia Capital, one of the most prestigious venture capital firms in

CHAPTERCASE 3 Part I

Nathan Blecharczyk, Joe Gebbia, and Brian Chesky founded Airbnb on a shoestring budget in 2008. Today, Airbnb is the largest hospitality platform globally.

Stefanie Keenan/Getty Images

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74

Silicon Valley, having provided early-stage capital to compa- nies such as Apple, Google, Oracle, PayPal, YouTube, and WhatsApp. Although not a first mover in the peer-to-peer rental space, Airbnb, with support of Y Combinator, was the first one to figure out that a sleek website design comprising professional photos of available rentals made all the differ- ence. In addition, Airbnb developed a seamless transaction experience between hosts and guests and was able to earn a little over 10 percent on each transaction conducted on its site. Timing was now much more fortuitous; with the global financial crisis in full swing, people were looking for low-cost

accommodations while hosts were trying to pay rent or mort- gages to keep their homes.

In 2019, Airbnb was valued at a whopping $31 billion. This makes Airbnb the fourth most valuable private startup on the planet, just after Didi Chuxing, China’s version of Uber ($56 billion), WeWork ($47 billion), and JUUL ($38 billion). Even more stunning, Airbnb’s valuation approaches that of Marriott ($39 billion in 2019), the world’s largest hotel chain with over $20 billion in annual revenues.2

Part II of this ChapterCase appears in Section 3.5.

HOW CAN AN INTERNET startup based on the idea of home sharing disrupt the global hotel industry, long dominated by corporate giants such as Marriott, Hilton, and Intercontinental? One reason is that Airbnb, now the world’s largest accommoda-

tion provider, owns no real estate. Instead, it uses a business model innovation to circum- vent traditional entry barriers into the hotel industry. Just like Uber, Facebook, or Amazon, Airbnb provides an online platform for sellers (hosts) and buyers (renters) to connect and transact (we’ll take a closer look at “Platform Strategy” in Chapter 7). While traditional hotel chains need years and millions of dollars in real estate investments to add additional capacity (finding properties, building hotels, staffing and running them, etc.), Airbnb’s inventory is basically unlimited as long as it can sign up users with spare rooms to rent. Even more importantly, Airbnb does not need to deploy millions of dollars in capital to acquire and manage physical assets or manage a large cadre of employees. For example, Marriott has almost 250,000 employees, while Airbnb’s headcount is approximately 2,500 employees (only 1 percent of Marriott’s). Thus, Airbnb can grow much faster and respond much more quickly to local circumstances affecting the demand and supply of accommodations. The competitive intensity in the hotel industry is likely to increase, especially in high-traffic met- ropolitan cities such as New York, Paris, Dubai, and Seoul.

In this chapter, we present a set of frameworks to analyze the firm’s external environment— that is, the industry in which the firm operates, and the competitive forces that surround the firm from the outside. We move from a more macro perspective to a more micro understand- ing of how the external environment affects a firm’s quest for competitive advantage. We begin with the PESTEL framework, which allows us to scan, monitor, and evaluate changes and trends in the firm’s macroenvironment. Next, we study Porter’s five forces model of competition, which helps us to determine an industry’s profit potential. Depending on the firm’s strategic position, these forces can affect its performance for good or ill. We also take a closer look at the choices firms must make when considering entry into an industry. We then move from a static analysis of a firm’s industry environment to a dynamic understand- ing of how industries and competition change over time. We also discuss how to think through entry choices once an attractive industry has been identified. Next we introduce the strategic group model for understanding performance differences among clusters of firms in the same industry. Finally, we offer practical Implications for Strategic Leaders.

3.1 The PESTEL Framework A firm’s external environment consists of all factors outside the firm that can affect its potential to gain and sustain a competitive advantage. By analyzing the factors in the firm’s external environment, strategic leaders can mitigate threats and leverage opportunities. One

LO 3-1 Generate a PESTEL analysis to evaluate the impact of external factors on the firm.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 75

common approach to understanding how external factors impinge upon a firm is to con- sider the source or proximity of these factors. For example, external factors in the firm’s general environment are ones that strategic leaders have little direct influence over, such as macroeconomic factors (e.g., interest or currency exchange rates). In contrast, external fac- tors in the firm’s task environment are ones that strategic leaders do have some influence over, such as the composition of their strategic groups (a set of close rivals) or the structure of the industry. We will now look at each of these environmental layers in detail, moving from a firm’s general environment to its task environment. Following along in Exhibit 3.1, we will be working from the outer ring to the inner ring.

The PESTEL model groups the factors in the firm’s general environment into six segments:

■ Political ■ Economic ■ Sociocultural ■ Technological ■ Ecological ■ Legal

Together these form the acronym PESTEL. The PESTEL model provides a relatively straightforward way to scan, monitor, and evaluate the important external factors and trends that might impinge upon a firm. Such factors create both opportunities and threats.

POLITICAL FACTORS Political factors result from the processes and actions of government bodies that can influ- ence the decisions and behavior of firms.3

Although political factors are located in the firm’s general environment, where firms traditionally wield little inf luence, companies nevertheless increasingly work to shape

Political Economic

Sociocultural

TechnologicalEcological

Firm

Industry

Legal

Strategic Group

External Environment

External Environment

EXHIBIT 3.1 The Firm within Its External Environment, Industry, and Strategic Group, Subject to PESTEL Factors

PESTEL model A framework that catego- rizes and analyzes an important set of exter- nal factors (political, economic, sociocul- tural, technological, ecological, and legal) that might impinge upon a firm. These fac- tors can create both opportunities and threats for the firm.

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76 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

and inf luence this realm. They do so by applying by pursuing a nonmarket strategy—that is, through lobbying, public relations, contributions, litigation, and so on—in ways that are favorable to the firm.4 For example, hotel chains and resort owners have challenged Airbnb in courts and lobbied local governments, some of which passed regulations to limit or prohibit short-term rentals. Local residents in New York, San Francisco, Berlin, Paris, and many other cities are also pressuring local governments to enact more aggres- sive rules banning short-term rentals because they argue that companies such as Airbnb contribute to a shortage of affordable housing by turning entire apartment complexes into hotels or transforming quiet family neighborhoods into all-night, every-night party hot spots.

Political and legal factors are closely related, as political pressure often results in changes in legislation and regulation (we discuss legal factors later in this chapter). For example, macro effects of the U.S.-China trade war (since 2016) have direct implications for a num- ber of businesses. U.S. exporters, such as soybean farmers, face higher tariffs in China, so their products are more expensive. Chinese electronics companies, such as Huawei, ZTE, and others, are considered a threat to U.S. national security, so are more or less banned from doing business in the United States.

ECONOMIC FACTORS Economic factors in a firm’s external environment are largely macroeconomic, affecting economy-wide phenomena. Strategic leaders need to consider how the following five macro- economic factors can affect firm strategy:

■ Growth rates. ■ Levels of employment. ■ Interest rates. ■ Price stability (inflation and deflation). ■ Currency exchange rates.

GROWTH RATES. The overall economic growth rate is a measure of the change in the amount of goods and services produced by a nation’s economy. Strategic leaders look to the real growth rate, which adjusts for inflation. This real growth rate indicates the current busi- ness cycle of the economy—that is, whether business activity is expanding or contracting. In periods of economic expansion, consumer and business demands are rising, and competi- tion among firms frequently decreases. During economic booms, businesses expand opera- tions to satisfy demand and are more likely to be profitable. The reverse is generally true for recessionary periods, although certain companies that focus on low-cost solutions may ben- efit from economic contractions because demand for their products or services rises in such times. For customers, expenditures on luxury products are often the first to be cut during recessionary periods. For instance, you might switch from a $5 venti latte at Starbucks to a $1 alternative from McDonald’s.

Occasionally, boom periods can overheat and lead to speculative asset bubbles. In the early 2000s, the United States experienced an asset bubble in real estate.5 Easy credit, made possible by the availability of subprime mortgages and other financial innovations, fueled an unprecedented demand in housing. Real estate, rather than stocks, became the investment vehicle of choice for many Americans, propelled by the common belief that house prices could only go up. When the housing bubble burst, the deep economic reces- sion of 2008–2009 began, impacting in some way nearly all businesses in the United States and worldwide.

nonmarket strategy Strategic leaders’ ac- tivities outside market exchanges where firms sell products or pro- vide services to influ- ence a firm’s general environment through, for example, lobbying, public relations, contri- butions, and litigation in ways that are favor- able to the firm.

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LEVELS OF EMPLOYMENT. Growth rates directly affect the level of employment. In boom times, unemployment tends to be low, and skilled human capital becomes a scarce and more expensive resource. As the price of labor rises, firms have an incentive to invest more into capital goods such as cutting-edge equipment or artificial intelligence (AI).6 In economic downturns, unemployment rises. As more people search for employment, skilled human capital is more abundant and wages usually fall.

INTEREST RATES. Another key macroeconomic variable for strategic leaders to track is real interest rates—the amount that creditors are paid for use of their money and the amount that debtors pay for that use, adjusted for inflation. The economic boom during the early years in the 21st century, for example, was fueled by cheap credit. Low real interest rates have a direct bearing on consumer demand. When credit is cheap because interest rates are low, consumers buy homes, condos, automobiles, computers, smartphones, and vacations on credit; in turn, all of this demand fuels economic growth. During periods of low real interest rates, firms can easily borrow money to finance growth. Borrowing at lower real rates reduces the cost of capital and enhances a firm’s competitiveness. These effects reverse, however, when real interest rates are rising. Consumer demand slows, credit is harder to come by, and firms find it more difficult to borrow money to support operations, possibly deferring investments.

PRICE STABILITY. Price stability—the lack of change in price levels of goods and services—is rare. Therefore, companies will often have to deal with changing price levels, which is a function of the amount of money in any economy. When there is too much money in an economy, we tend to see rising prices—inflation. Indeed, a popular economic definition of inflation is too much money chasing too few goods and services.7 Inflation tends to go with lower economic growth. Countries such as Argentina, Brazil, Mexico, Poland, and Venezu- ela experienced periods of hyperinflation in the recent past.

Deflation describes a decrease in the overall price level. A sudden and pronounced drop in demand generally causes def lation, which in turn forces sellers to lower prices to motivate buyers. Because many people automatically think of lower prices from the buyer’s point of view, a decreasing price level seems at first glance to be attractive. However, def lation is actually a serious threat to economic growth because it distorts expectations about the future.8 For example, once price levels start falling, companies will not invest in new production capacity or innovation because they expect a further decline in prices. In recent decades, the Japanese economy has been plagued with def lation.

CURRENCY EXCHANGE RATES. The currency exchange rate determines how many dollars one must pay for a unit of foreign currency. It is a critical variable for any company that buys or sells products and services across national borders. For example, if the U.S. dollar appre- ciates against the euro, and so increases in real value, firms need more euros to buy one dollar. This in turn makes U.S. exports such as Boeing aircraft, Intel chips, John Deere trac- tors, or American soybeans more expensive for European buyers and reduces demand for U.S. exports overall. This process reverses when the dollar depreciates (decreases in real value) against the euro. In this scenario it would take more dollars to buy one euro, and European imports such as LVMH luxury accessories or Porsche automobiles become more expensive for U.S. buyers.

In a similar fashion, if the Chinese yuan appreciates in value, Chinese goods imported into the United States become relatively more expensive. At the same time, Chinese pur- chasing power increases, which in turn allows their businesses to purchase more U.S. capital

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78 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

goods such as sophisticated machinery and other cutting-edge technologies. The reverse holds true if the Chinese yuan depreciates in value.

In summary, economic factors affecting businesses are ever-present and rarely static. Strategic leaders need to fully appreciate the power of these factors, in both domestic and global markets, to assess their effects on firm performance.

SOCIOCULTURAL FACTORS Sociocultural factors capture a society’s cultures, norms, and values. Because sociocultural factors not only are constantly in flux but also differ across groups, strategic leaders need to closely monitor such trends and consider the implications for firm strategy. In recent years, for example, a growing number of U.S. consumers have become more health-conscious about what they eat. This trend led to a boom for businesses such as Chipotle, Subway, and Whole Foods. At the same time, traditional fast food companies McDonald’s and Burger King, along with grocery chains such as Albertsons and Kroger, have all had to scramble to provide healthier choices in their product offerings.

Demographic trends are also important sociocultural factors. These trends capture popula- tion characteristics related to age, gender, family size, ethnicity, sexual orientation, religion, and socioeconomic class. Like other sociocultural factors, demographic trends present opportunities but can also pose threats. Recent U.S. census data reveals that 59 million Americans (18.1 percent of the total population) are Hispanic. It is now the largest minority group in the United States and growing fast. On average, Hispanics are also younger and their incomes are climbing quickly. This trend is not lost on companies trying to benefit from this opportunity. For example, MundoFox and ESPN Deportes (specializing in soccer) have joined Univision and NBC’s Telemundo in the Spanish-language television market. In the United States, Univision is now the fifth most popular network overall, just behind the four major English-language networks (ABC, NBC, CBS, and Fox). Likewise, advertisers are pouring dollars into the Spanish-language networks to promote their products and services.9

TECHNOLOGICAL FACTORS Technological factors capture the application of knowledge to create new processes and prod- ucts. Major innovations in process technology include lean manufacturing, Six Sigma qual- ity, and biotechnology. The nanotechnology revolution, which is just beginning, promises significant upheaval for a vast array of industries ranging from tiny medical devices to new- age materials for earthquake-resistant buildings.10 Recent product innovations include the smartphone, wearable devices such as smart watches, and high-performing electric cars such as the Tesla Model S.

Continued advances in artificial intelligence (AI) and machine learning promise to fun- damentally alter the way we work and live.11 While we are familiar with early AI applications such Amazon’s Alexa, Apple’s Siri, and Google’s Assistant, the future will bring much more significant changes, including autonomous driving as well as the internet of things. The transportation industry is seeing early signs of disruption with autonomous vehicles and trucks, which can drive themselves from coast to coast, 24/7, with no breaks for the driver needed (other than recharging or exchanging battery packs). Our cities will be filled with autonomous taxis, which are already on the road in some places in the United States. The internet of things will connect all sorts of devices such as vehicles, airplanes, home appli- ances, computers, manufacturing facilities, power grids, and so forth to exchange data and to manage systems in a more holistic and smarter fashion to reduce, for example, energy consumption or letting the user know when a system is in need of maintenance long before it breaks down.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 79

Blockbuster’s Bust Blockbuster was not only a pioneer in the video rental business, but it was also the undisputed industry leader from the mid-1980s to the early 2000s. At its peak, Block- buster opened a new store every 17 hours, for a total of 9,000 stores across the United States, and earned $6 bil- lion in annual revenue. As such, Blockbuster was a main- stay of American culture and an essential element of family movie night. But in 2010, the once mighty Block- buster filed for bankruptcy. What went wrong?

Blockbuster was unable to respond effectively to technological changes in the industry. A first wave of disruption hit the TV industry in the 1980s and 1990s when cable networks started offering hundreds of channels, challenging the cozy oligopoly of the three old- line broadcast networks ABC, CBS, and NBC. With the arrival of the cable networks, Blockbuster’s fortunes began to dim as reflected in a double-digit decline in its market valuation. Unable to address the technological challenge posed by cable network content as a substitute to video rentals, Blockbuster’s creator and owner, Wayne Huizenga, sold the company to the media conglomerate Viacom in 1994.

By the late 1990s and early 2000s, Blockbuster was also challenged more directly by low-cost substitutes such as Netflix’s mail-order DVD service and Redbox’s auto- mated DVD rental kiosks. In 1997, annoyed for having to pay more than $40 in late fees for a Blockbuster video, Reed Hastings decided to start Netflix—a subscription- based business model that offered consumers DVD rentals online. When the dot-com bubble burst in 2000, however, Netflix reached near bankruptcy. Hastings approached Blockbuster and proposed selling Netflix to it for a mere

$50 million and rebranding the chain Blockbuster.com. The idea was that Netflix would become Blockbuster’s on- line branch. Thinking that it would be a small niche busi- ness at best, Blockbuster turned Netflix down.

Netflix managed to stay afloat. Its low-cost option for at-home viewing via higher-quality DVD technology (compared to lower-quality VHS tapes) attracted more and more subscribers; this allowed the firm to weather the dot-com crash. To fund future growth, Netflix went public in 2002 at a valuation of $310 million. Just a year later, Netflix surpassed 1 million subscribers. After seeing Netflix’s success, Blockbuster began to mimic its online subscription model. Unlike Netflix, however, which did not charge late fees given Reed Hastings’ aversion to penalizing customers, Blockbuster continued to do so. The firm relied on late fees because fees were, unfortunately, one of the most profitable aspects of its business model.

Technological progress continued at a rapid clip. The next wave of technological disruption hit the home media industry in the mid-2000s. The ability to stream content directly onto a host of devices, such as laptops, tablets, smartphones, and newer internet-based TVs, turned basi- cally any screen into a personal media conduit. Preva- lence of high-speed internet connections combined with advances in mobile devices, changed the way people con- sumed entertainment. The days where people needed to go to a brick-and-mortar store to rent a videotape or DVD were gone. With on-demand video streaming, consumers could choose from a near unlimited inventory of movies while sitting on their couch in the living room. In the end, Blockbuster’s attempts to change were too little, too late. In 2010, the once mighty Blockbuster filed for bankruptcy. And in 2019, Netflix was valued at close to $160 billion.13

Strategy Highlight 3.1

As discussed in the ChapterCase, Airbnb launched a process innovation of offering and renting rooms based on a business model leveraging the sharing economy. If one thing seems certain, technological progress is relentless and seems to be picking up speed.12 Not surprisingly, changes in the technological environment bring both oppor- tunities and threats for companies. Given the importance of a firm’s innovation strategy to competitive advantage, we discuss the effect of technological factors in greater detail in Chapter 7.

Strategy Highlight 3.1 details how the once mighty video rental chain Blockbuster fell when it failed to pay sufficient attention to the PESTEL factors.

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80 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

ECOLOGICAL FACTORS Ecological factors involve broad environmental issues such as the natural environment, global warming, and sustainable economic growth. Organizations and the natural environ- ment coexist in an interdependent relationship. Managing these relationships in a responsi- ble and sustainable way directly influences the continued existence of human societies and the organizations we create. Strategic leaders can no longer separate the natural and the business worlds; they are inextricably linked.14

Unfortunately, many business organizations have contributed to the pollution of air, water, and land, as well as the depletion of the world’s natural resources. One infamous example that comes readily to mind is the 2010 BP oil spill in the Gulf of Mexico. The spill destroyed fauna and flora along the U.S. shoreline from Texas to Florida. It led to a drop in fish and wildlife populations, triggered a decline in the fishery and tourism industries, and threatened the livelihood of thousands of people. It also cost BP more than $50 billion and one-half of its market value.

The relationship between organizations and the natural environment need not be adver- sarial, however. Ecological factors can also provide business opportunities. As we saw in ChapterCase 1, Tesla is addressing environmental concerns regarding the carbon emissions of gasoline-powered cars by building zero-emission battery-powered vehicles. To generate the needed energy to charge the batteries in a sustainable way, Tesla acquired SolarCity to provide integrated, clean-tech energy services for its customers, including decentralized solar power generation and storage via its Powerwall.

LEGAL FACTORS Legal factors include the official outcomes of political processes as manifested in laws, man- dates, regulations, and court decisions—all of which can have a direct bearing on a firm’s profit potential. In fact, regulatory changes tend to affect entire industries at once. Many industries in the United States have been deregulated over the past few decades, including airlines, telecom, energy, and trucking, among others.

As noted earlier, legal factors often coexist with or result from political will. Govern- ments especially can directly affect firm performance by exerting both political pressure and legal sanctions, including court rulings and industry regulations. Consider how several European countries and the European Union (EU) apply political and legal pressure on U.S. tech companies. European targets include Apple, Amazon, Facebook, Google, and Microsoft—the five largest U.S. tech companies—but also startups such as Uber. Europe’s policy makers seek to retain control over important industries, including transportation and the internet, to ensure that profits earned in Europe by Silicon Valley firms are taxed locally. The European Parliament even proposed legislation to break up “digital monopolies” such as Google. This proposal would require Google to offer search services independently as a standalone company from its other online services, including Google Drive, a cloud-based file storage and synchronization service.

But the EU’s wariness extends beyond tax revenue: It has much stronger legal require- ments and cultural expectations concerning data privacy. In 2018, for instance, the EU implemented the General Data Protection Regulation (GDPR), which gives individuals wide-reaching control over their personal data as well as secured protection of these data. Personal data comprise any information related to a person such as a name, home address, e-mail address, phone number, location details, photos, videos, social media post- ings, computer IP addresses, and so forth. GDPR grants all EU residents far-reaching rights concerning their personal data, including the right to access, the right to be

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 81

forgotten, the right to data portability across providers, the right to be notified, and so forth. All U.S. companies such as Google and Facebook had to change their policies to comply with the GDPR and thus be permitted to continue doing busi- ness in Europe. The data protection and privacy regulations that internet companies face in the EU are currently much more stringent than those in the United States, an aspect that came to the fore during the Facebook crisis regarding alleged foreign interference in U.S. elections and the siphoning off of private data for an unauthorized use by third parties (see ChapterCase 2).

Taken together, political/legal factors, along with other PESTEL factors, can have a direct bearing on a firm’s performance—consider the implementation of autonomous vehicles for commercial and private use. Companies such as Uber, Waymo (a unit of Alphabet, the parent company of Google), and Tesla are ready to deploy autonomous vehicles, but political and legal factors are providing serious challenges and are delaying their widespread use.

3.2 Industry Structure and Firm Strategy: The Five Forces Model

INDUSTRY VS. FIRM EFFECTS IN DETERMINING FIRM PERFORMANCE Firm performance is determined primarily by two factors: industry and firm effects. Industry effects describe the underlying economic structure of the industry. They attribute firm performance to the industry in which the firm competes. The structure of an industry is determined by elements common to all industries, such as entry and exit barriers, number and size of companies, and types of products and services offered. Firm effects attribute firm performance directly to the actions strategic leaders take.

In a series of empirical studies, academic researchers show that industry effects explain roughly 20 percent of overall firm performance, while firm effects (i.e., specific managerial actions) explain about 55 percent. In Chapter 4, we look inside the firm to understand why firms within the same industry differ and how differences among firms can lead to competi- tive advantage. For now, the important point is that external and internal factors combined explain roughly 75 percent of overall firm performance. The remaining 25 percent relates partly to business cycles and other effects.15 Exhibit 3.2 shows these findings.

To better understand how external factors affect firm strategy and performance, and what strategic leaders can do about it, we take a closer look in this chapter at an industry’s underlying structure. As such, we now move one step closer to the firm (in the center of Exhibit 3.1) and come to the industry in which it competes.

An industry is a group of incumbent firms facing more or less the same set of suppliers and buyers. Firms competing in the same industry tend to offer similar products or services

The Waymo autonomous vehicle marks another step in an effort to revolu- tionize the way people get around. Instead of driving themselves, people will be chauffeured in self- driving cars if Waymo, Tesla, and ride-hailing ser- vices such as Uber realize their vision. Traditional automakers such as GM, Ford, and VW also invest tremendous amounts of money into autonomous vehicles. Taken together, the automobile industry is likely to be upended in the next few years, includ- ing who the key players will be and if individuals still want to own a car or prefer catching a ride in an autonomous vehicle available for a per-ride usage fee (“pay as you go”) rather than requiring fairly large upfront invest- ments when purchasing or leasing a vehicle. Sundry Photography/ Shutterstock

LO 3-2 Differentiate the roles of firm effects and industry effects in determining firm performance.

Industry effects Firm performance attrib- uted to the structure of the industry in which the firm competes.

Firm effects Firm performance attributed to the actions strategic leaders take.

industry A group of incumbent companies that face more or less the same set of sup- pliers and buyers.

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82 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

to meet specific customer needs. Although the PESTEL framework allows us to scan, monitor, and evaluate the external envi- ronment to identify opportunities and threats, industry analysis provides a more rigorous basis not only to identify an industry’s profit potential—the level of profitability that can be expected for the average firm—but also to derive implica- tions for one firm’s strategic position within an industry. A firm’s strategic posi- tion relates to its ability to create value for customers (V) while containing the cost to do so (C). Competitive advantage flows to the firm that is able to create as large a gap as possible between the value the firm’s product or service generates and the cost required to produce it (V – C).

COMPETITION IN THE FIVE FORCES MODEL Michael Porter developed the highly influential five forces model to help strategic leaders understand the profit potential of different industries and how they can position their respective firms to gain and sustain competitive advantage.16 By combining theory from industrial organization economics with detailed case studies, Porter derived two key insights that form the basis of his seminal five forces model:

1. Competition is viewed more broadly in the five forces model. Rather than defining competi- tion narrowly as the firm’s closest competitors to explain and predict a firm’s perfor- mance, competition must be viewed more broadly to also encompass the other forces in an industry: buyers, suppliers, potential new entry of other firms, and the threat of sub- stitutes.

2. Profit potential is a function of the five competitive forces. The profit potential of an indus- try is neither random nor entirely determined by industry-specific factors. Rather, it is a function of the five forces that shape competition: threat of entry, power of suppliers, power of buyers, threat of substitutes, and rivalry among existing firms.

COMPETITION BROADLY DEFINED. We start with the concept of competition, which, in Porter’s model, is more broadly defined to include other industry forces: buyers, suppliers, potential new entry of other firms, and the threat of substitutes. Strategy addresses the ques- tion of how to deal with competition. In the five forces model, any of those forces is viewed as a potential competitor attempting to extract value from the industry. In particular, com- petition describes the struggle among these forces to capture as much of the economic value created in an industry as possible. A firm’s strategic leaders, therefore, must be concerned not only with the intensity of rivalry among direct competitors (e.g., Nike versus Under

Up to 55%

~25%

~20%

Other Effects (Business Cycle Effects,

Unexplained Variance)

Firm Effects

Industry Effects

EXHIBIT 3.2 Industry, Firm, and Other Effects Explaining Firm Performance

LO 3-3 Apply Porter’s five competitive forces to explain the profit potential of different industries.

industry analysis A method to (1) identify an industry’s profit potential and (2) derive implications for a firm’s strategic position within an industry.

strategic position A firm’s strategic pro- file based on the difference between value creation and cost (V − C).

five forces model A framework that iden- tifies five forces that determine the profit potential of an industry and shape a firm’s competitive strategy.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 83

Armour, The Home Depot versus Lowe’s, Merck versus Pfizer, and so on), but also with the strength of the other competitive forces that are attempting to extract part or all of the eco- nomic value that the firm creates.

Recall that firms create economic value by expanding as much as possible the gap between the perceived value (V) the firm’s product or service generates and the cost (C) to produce it. Economic value thus equals (V – C). To succeed, creating value is not enough. Firms must also be able to capture a significant share of the value created to gain and sustain a competitive advantage. When faced with competition in this broader sense, strategy explains how a firm should position itself to enhance the chances of achieving superior performance.

PROFIT POTENTIAL. The five forces model enables strategic leaders to not only under- stand the firm’s industry environment but also to shape firm strategy. As a rule of thumb, the stronger the five forces, the lower the industry’s profit potential—making the industry less attractive for competitors. The reverse is also true: the weaker the five forces, the greater the industry’s profit potential—making the industry more attractive. Therefore, from the perspec- tive of a strategic leader of an existing firm competing for advantage in an established indus- try, the company should be positioned in a way that relaxes the constraints of strong forces and leverages weak forces. The goal of crafting a strategic position is of course to improve the firm’s ability to achieve and sustain a competitive advantage.

As Exhibit 3.3 shows, Porter’s model identifies five key competitive forces that strategic leaders need to consider when analyzing the industry environment and formulating com- petitive strategy:

1. Threat of entry. 2. Power of suppliers. 3. Power of buyers. 4. Threat of substitutes. 5. Rivalry among existing competitors.

Rivalry among

Existing Competitors

Bargaining Power of Suppliers

Bargaining Power of Buyers

Threat of New Entrants

Threat of Substitute Products or Services

EXHIBIT 3.3 Porter’s Five Forces Model Source: M. E. Porter (2008, January). “The five competitive forces that shape strategy,” Harvard Business Review.

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84 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

THE THREAT OF ENTRY The threat of entry describes the risk of potential competitors entering the industry. Poten- tial new entry depresses industry profit potential in two major ways:

1. Reduces the industry’s overall profit potential. With the threat of additional capacity com- ing into an industry, incumbent firms may lower prices to make the entry appear less attractive to the potential new competitors, which in turn would reduce the industry’s overall profit potential, especially in industries with slow or no overall growth in demand. Consider the market for new microwaves. Demand consists of the replacement rate for older models and the creation of new households. Since this market grows slowly, if at all, any additional entry would likely lead to excess capacity and lower prices overall.

2. Increases spending among incumbent firms. The threat of entry by additional competitors may force incumbent firms to spend more to satisfy their existing customers. This spend- ing reduces an industry’s profit potential, especially if firms can’t raise prices. Consider how Starbucks has chosen to constantly upgrade and refresh its stores and service offer- ings. Starbucks has over 14,000 U.S. stores and more than 28,000 global locations. By raising the value of its offering in the eyes of consumers, it slows others from entering the industry or from rapidly expanding. This allows Starbucks to keep at bay both smaller regional competitors, such as Peet’s Coffee & Tea with fewer than 200 stores mostly on the West Coast, and smaller national chains, such as Caribou Coffee, with 415 stores nationally. Starbucks is willing to accept a lower profit margin to maintain its market share.

Of course, the more profitable an industry, the more attractive it is for new competitors to enter. However, a number of important barriers exist that can reduce that threat. Entry barriers, which are advantageous for incumbent firms, are obstacles that determine how easily a firm can enter an industry. Incumbent firms can benefit from several important sources of entry barriers:

■ Economies of scale. ■ Network effects. ■ Customer switching costs. ■ Capital requirements. ■ Advantages independent of size. ■ Government policy. ■ Credible threat of retaliation.

ECONOMIES OF SCALE. Economies of scale are cost advantages that accrue to firms with larger output because they can spread fixed costs over more units, employ technology more efficiently, benefit from a more specialized division of labor, and demand better terms from their suppliers. These factors in turn drive down the cost per unit, allowing large incumbent firms to enjoy a cost advantage over new entrants that cannot muster such scale.

We saw the important relationship between scale and production cost with Tesla in ChapterCase 1. Usually entrants into the broad automobile industry need large-scale pro- duction to be efficient. Tesla leveraged new technology to circumvent this entry barrier. Yet, reaching sufficient manufacturing scale to be cost-competitive is critical for Tesla as it moves more into the mass market.

To benefit from economies of scale, Tesla gradually introduced new vehicles to appeal more to the mass market. Its first vehicle, the Roadster (priced at over $110,000) was more

threat of entry The risk that potential com- petitors will enter an industry.

entry barriers Obsta- cles that determine how easily a firm can enter an industry and often significantly predict industry profit potential.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 85

or less a prototype to prove the viability of an all-electric car that can outperform high- performance traditional sports cars. For consumers, it created a new mind-set of what electric cars can do. Tesla ended production of the Roadster to focus more fully on its next model: the family sedan Model S (with a baseline price of $70,000). With this model, Tesla’s manu- facturing scale increased more than 50-fold, from 2,500 Roadsters to 125,000 Model S’s. Tesla is now hoping for an even broader customer appeal with its Model 3, a smaller and lower-priced vehicle (starting at $35,000) that will allow the company to break into the mass market and manufacture many more cars. Tesla’s product introductions over time are moti- vated by an attempt to capture benefits that accrue to economies of scale. To capture benefits from economies of scale, including lower unit cost, Elon Musk hopes Tesla can increase its production volume to 1 million vehicles a year by 2020 (an increase by a factor of 20, from the 50,000 vehicles Tesla produced in 2015).

NETWORK EFFECTS. Network effects describe the positive effect that one user of a product or service has on the value of that product or service for other users. When network effects are present, the value of the product or service increases with the number of users. This is an example of a positive externality. The threat of potential entry is reduced when network effects are present.

For example, Facebook, with over 2 billion active users worldwide, enjoys tremen- dous network effects, making it difficult for such other social media entrants such as Twitter or Snap to compete effectively. Likewise, Brian Chesky, CEO of Airbnb, argues that Airbnb is able to benefit from global network effects because of listings in 81,000 cities around the globe at all different price points, combined with an inventory of 5 million homes and apartments. This global network effect only grows stronger as more and more guests use the service and become hosts them- selves. Given their importance in the digital economy, we will discuss network effects in much more detail in Chapter 7.

CUSTOMER SWITCHING COSTS. Switching costs are incurred by moving from one supplier to another. Changing vendors may require the buyer to alter product specifications, retrain employees, and/or modify existing processes. Switching costs are onetime sunk costs, which can be quite significant and a formidable barrier to entry. For example, a firm that has used enterprise resource plan- ning (ERP) software from SAP for many years will incur significant switching costs when implementing a new ERP system from Ora- cle.

CAPITAL REQUIREMENTS. Capital requirements describe the “price of the entry ticket” into a new industry. How much capital is required to compete in this industry, and which companies are willing and able to make such investments? Fre- quently related to economies of scale, capital requirements may encompass investments to set up plants with dedicated machinery, run a production process, and cover start-up losses.

Tesla made a sizable capital investment of roughly $150 million when it purchased from Toyota its Fremont, California, manufacturing plant, which it then upgraded with an automated production process that uses robots to produce high-quality cars at large scale.17 It then invested another $5 billion in a battery gigafactory in Nevada.18 With this new factory, Tesla is not only able to secure supplies of lithium-ion batteries, the most critical and expensive component of an all-electric car, but it also now has the capability to build as many as 1 million vehicles a year.19 Any potential new entrant, however, must

network effects The value of a product or service for an individ- ual user increases with the number of total users.

Facebook CEO Mark Zuckerberg speaks about Graph Search, a key com- ponent in finding infor- mation from within a user’s network of friends. With over 2 billion active monthly users, Facebook benefits from winner- take-all network effects and thus is often de- scribed as a digital mo- nopoly. Jeff Chiu/AP Images

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86 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

carefully weigh the required capital investments, the cost of capital, and the expected return on investment.

Taken together, the threat of entry is high when capital requirements are low in compari- son to the expected returns. If an industry is attractive enough, efficient capital markets are likely to provide the necessary funding to enter an industry. Capital, unlike proprietary technology and industry-specific know-how, is a fungible resource that can be relatively eas- ily acquired in the face of attractive returns.

ADVANTAGES INDEPENDENT OF SIZE. Incumbent firms often possess cost and quality advantages that are independent of size. These advantages can be based on brand loyalty, proprietary technology, preferential access to raw materials and distribution channels, favor- able geographic locations, and cumulative learning and experience effects.

Brand Loyalty. Tesla’s loyal customers strengthen the firm’s competitive position and reduce the threat of entry into the all-electric car segment, at least by other start-up compa- nies.20 Unlike GM or Ford, which spend billions each year on advertising, Tesla doesn’t have a large marketing budget. Rather, it relies on word of mouth. Like Apple in its early days, Tesla has its own “cool factor,” as evidenced by its beautifully designed, top-notch quality cars. In fact, when Consumer Reports tested the Model S, the usually understated magazine concluded: “The Tesla Model S is the best car we ever tested.”21 In addition, many Tesla owners feel an emotional connection to the company because they deeply believe in the company’s vision “to accelerate the world’s transition to sustainable energy.”

Preferential Access. Preferential access to raw materials and key components can bestow absolute cost advantages. For example, the lithium-ion batteries that are so critical to all- electric vehicles are not only the most expensive component, but they are also in short sup- ply. With its new battery gigafactory, however, Tesla can afford independence from the few worldwide suppliers (such as Panasonic) and also enjoy an absolute cost advantage.22 This should further reduce the threat of new entry in the all-electric vehicle segment, assuming no radical technological changes are to be expected in battery-cell technology in the next few years.

Favorable Locations. Favorable locations, such as Silicon Valley for Tesla, often present advantages that other locales cannot match easily, including access to human and venture capital, and world-class research and engineering institutions.

Cumulative Learning and Experience. Finally, incumbent firms often benefit from cumu- lative learning and experience effects accrued over long periods of time. Tesla now has more than a dozen years of experience in designing and building high-performance all-electric vehicles of superior quality and design. Attempting to obtain such deep knowledge within a shorter time frame is often costly, if not impossible due to time compression diseconomies, which in turn constitutes a formidable barrier to entry.

GOVERNMENT POLICY. Frequently government policies restrict or prevent new entrants. Until recently, India did not allow foreign retailers such as Walmart or IKEA to own stores and compete with domestic companies in order to protect the country’s millions of small vendors and wholesalers. China frequently requires foreign companies to enter joint ven- tures with domestic ones and to share technology.

In contrast, deregulation in industries such as airlines, telecommunications, and trucking have generated significant new entries. Therefore, the threat of entry is high when restrictive government policies do not exist or when industries become deregulated.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 87

CREDIBLE THREAT OF RETALIATION. Potential new entrants must also anticipate how incumbent firms will react. A credible threat of retaliation by incumbent firms often deters entry. Should entry still occur, however, incumbents are able to retaliate quickly, through initiating a price war, for example. The industry profit potential can in this case easily fall below the cost of capital. Incumbents with deeper pockets than new entrants are able to withstand price competition for a longer time and wait for the new entrants to exit the industry—then raise prices again. Other weapons of retaliation include increased product and service innovation, advertising, sales promotions, and litigation.

Potential new entrants should expect a strong and vigorous response beyond price com- petition by incumbent firms in several scenarios. If the current competitors have deep pock- ets, unused excess capacity, reputational clout with industry suppliers and buyers, a history of vigorous retaliation during earlier entry attempts, or heavy investments in resources spe- cific to the core industry and ill-suited for adaptive use, then they are likely to press these advantages. Moreover, if industry growth is slow or stagnant, incumbents are more likely to retaliate against new entrants to protect their market share, often initiating a price war with the goal of driving out these new entrants.

For example, in the southeastern United States, TV cable company Comcast has entered the market for residential and commercial telephone services and internet connectivity (as an ISP, internet service provider), emerging as a direct competitor for AT&T. Comcast also acquired NBC Universal, combining delivery and content. AT&T responded to Comcast’s threat by introducing U-verse, a product combining high-speed internet access with cable TV and telephone service, all provided over its fast fiber-optic network. To combine media content with delivery capabilities, AT&T acquired TimeWarner in 2018, bringing in-house content providers such as Warner Bros., HBO, and Turner to compete more effectively against Comcast and others.

In contrast, the threat of entry is high when new entrants expect that incumbents will not or cannot retaliate.

THE POWER OF SUPPLIERS The bargaining power of suppliers captures pressures that industry suppliers can exert on an industry’s profit potential. This force reduces a firm’s ability to obtain superior performance for two reasons:

1. Powerful suppliers can raise the cost of production by demanding higher prices for their inputs or by reducing the quality of the input factor or service level delivered.

2. Powerful suppliers are a threat to firms because they reduce the industry’s profit poten- tial by capturing part of the economic value created.

To compete effectively, companies generally need a wide variety of inputs into the produc- tion process, including raw materials and components, labor (via individuals or labor unions, when the industry faces collective bargaining), and services. The relative bargaining power of suppliers is high when

■ The supplier’s industry is more concentrated than the industry it sells to. ■ Suppliers do not depend heavily on the industry for a large portion of their revenues. ■ Incumbent firms face significant switching costs when changing suppliers. ■ Suppliers offer products that are differentiated. ■ There are no readily available substitutes for the products or services that the suppliers

offer. ■ Suppliers can credibly threaten to forward-integrate into the industry.

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88 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

THE POWER OF BUYERS In many ways, the bargaining power of buyers is the flip side of the bargaining power of sup- pliers. Buyers are the customers of an industry. The power of buyers relates to the pressure an industry’s customers can put on the producers’ margins by demanding a lower price or higher product quality. When buyers successfully obtain price discounts, it reduces a firm’s top line (revenue). When buyers demand higher quality and more service, it generally raises production costs. Strong buyers can therefore reduce industry profit potential and a firm’s profitability. Powerful buyers are a threat to the producing firms because they reduce the industry’s profit potential by capturing part of the economic value created.

As with suppliers, an industry may face many different types of buyers. The buyers of an industry’s product or service may be individual consumers—like you or me when we decide which provider we want to use for our wireless devices. In many areas, you can choose between several providers such as AT&T, Verizon, and T-Mobile (which merged with Sprint in a $26 billion deal). Although we might be able to find a good deal when carefully comparing their individual service plans, as individual consumers, we generally do not have significant buyer power. On the other hand, large institutions such as businesses or universities have significant buyer power when deciding which provider to use for their wireless services; this is because they are able to sign up or move several thousand employ- ees at once.

FACTORS THAT INCREASE BUYER POWER. The power of buyers is high when ■ There are a few buyers and each buyer purchases large quantities relative to the size of a

single seller. ■ The industry’s products are standardized or undifferentiated commodities. ■ Buyers face low or no switching costs. ■ Buyers can credibly threaten to backwardly integrate into the industry.

The retail giant Walmart provides perhaps the most potent example of tre- mendous buyer power. Walmart is not only the largest retailer worldwide (with 12,000 stores and over 2 million employees), but it is also one of the largest companies in the world (with $530 billion in revenues in 2019). Walmart is one of the few large big-box global retail chains and frequently purchases large quantities from its suppliers. Walmart leverages its buyer power by exerting tremendous pressure on its suppliers to lower prices and to increase quality or risk losing access to shelf space at the largest retailer in the world. Walmart’s buyer power is so strong that many suppliers co- locate offices next to Walmart’s headquarters in Bentonville, Arkansas,

because such proximity enables Walmart’s strategic leaders to test the suppliers’ latest prod- ucts and negotiate prices.

The bargaining power of buyers also increases when their switching costs are low. Having multiple suppliers of a product category located close to its headquarters allows Walmart to demand further price cuts and quality improvements because it can easily switch from one supplier to the next. This threat is even more pronounced if the products are non-differentiated commodities from the consumer’s perspective. For example, Walmart can easily switch from Rubbermaid plastic containers to Sterlite containers by offering more shelf space to the producer that offers the greatest price cut or quality improvement.

Buyers are also powerful when they can credibly threaten backward integration. Back- ward integration occurs when a buyer moves upstream in the industry value chain, into the seller’s business. Walmart has exercised the threat to backward-integrate by producing a

Niloo138/123RF

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 89

number of products as private-label brands such as Equate health and beauty items, Ol’Roy dog food, and Parent’s Choice baby products.

Powerful buyers have the ability to extract a significant amount of the value created in the industry, leaving little or nothing for producers. In addition, strategic leaders need to be aware of situations when buyers are especially price sensitive. This is the case when

■ The buyer’s purchase represents a significant fraction of its cost structure or procure- ment budget.

■ Buyers earn low profits or are strapped for cash. ■ The quality (cost) of the buyers’ products and services is not affected much by the

quality (cost) of their inputs.

CONTEXT-DEPENDENCIES ON BUYER POWER. With regards to any of the five forces that shape competition, it is important to note that their relative strengths are context- dependent. For example, the Mexican multinational CEMEX, one of the world’s leading cement producers, faces very different buyer power in the United States than domestically. In the United States, cement buyers consist of a few large and powerful construction com- panies that account for a significant percentage of CEMEX’s output. The result? Razor- thin margins. In contrast, the vast majority of CEMEX customers in its Mexican home market are numerous, small, individual customers facing a few large suppliers, with CEMEX being the biggest. CEMEX earns high profit margins in its home market. With the same undifferentiated product, CEMEX competes in two different industry scenarios in terms of buyer strength.

THE THREAT OF SUBSTITUTES Substitutes meet the same basic customer needs as the industry’s product but in a different way. The threat of substitutes is the idea that products or services available from outside the given industry will come close to meeting the needs of current customers.23 For example, many software products are substitutes to professional services, at least at the lower end. Tax preparation software such as Intuit’s TurboTax is a substitute for professional services offered by H&R Block and others. LegalZoom, an online legal documentation service, is a threat to professional law firms. Other examples of substitutes are energy drinks versus cof- fee, videoconferencing versus business travel, e-mail versus express mail, gasoline versus biofuel, and wireless telephone services versus internet-enabled voice and video apps such as Skype, FaceTime (Apple), WhatsApp (Facebook), and WeChat (Tencent).

A high threat of substitutes reduces industry profit potential by limiting the price the industry’s competitors can charge for their products and services. The threat of substitutes is high when

■ The substitute offers an attractive price-performance trade-off. ■ The buyers cost of switching to the substitute is low.

PRICE-PERFORMANCE TRADE-OFF. The movie rental company Redbox, which uses over 40,000 kiosks in the United States to make movie rentals available for just $2, is a substitute for buying movie DVDs. For buyers, video rental via Redbox offers an attractive price- performance trade-off with low switching costs in comparison to DVD ownership. More- over, for customers that view only a few movies a month, Redbox is also a substitute for Netflix’s basic on-demand internet movie streaming service, which costs $8.99 a month. Rather than a substitute, however, Redbox is a direct competitor to Netflix’s DVD rental business, where plans cost $7.99 a month (for one DVD out at a time).

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90 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

LOW-SWITCHING COSTS. In addition to a lower price, substitutes may also become more attractive by offering a higher value proposition.24 In Spain, some 6 million people travel annually between Madrid and Barcelona, roughly 400 miles apart. The trip by car or train takes most of the day, and 90 percent of travelers would choose to fly, creating a highly profitable business for local airlines. This all changed when the Alta Velocidad Española (AVE), an ultramodern high-speed train, was completed in 2008. Taking into account total time involved, high-speed trains are faster than short-haul flights. Passengers travel in greater comfort than airline passengers and commute from one city center to the next, with only a short walk or cab ride to their final destinations.

The AVE example highlights the two fundamental insights provided by Porter’s five forces framework. First, competition must be defined more broadly to go beyond direct industry competitors. In this case, rather than defining competition narrowly as the firm’s closest competitors, airline executives in Spain must look beyond other airlines and consider substi- tute offerings such as high-speed trains. Second, any of the five forces on its own, if sufficiently strong, can extract industry profitability. In the AVE example, the threat of substitutes is limit- ing the airline industry’s profit potential. With the arrival of the AVE, the airlines’ monop- oly on fast transportation between Madrid and Barcelona vanished, and with it the airlines’ high profits. The strong threat of substitutes in this case increased the rivalry among existing competitors in the Spanish air transportation industry.

RIVALRY AMONG EXISTING COMPETITORS Rivalry among existing competitors describes the intensity with which companies within the same industry jockey for market share and profitability. It can range from genteel to cut- throat. The other four forces—threat of entry, the power of buyers and suppliers, and the threat of substitutes—all exert pressure upon this rivalry, as indicated by the arrows pointing toward the center in Exhibit 3.3. The stronger the forces, the stronger the expected competitive intensity, which in turn limits the industry’s profit potential.

Competitors can lower prices to attract customers from rivals. When intense rivalry among existing competitors brings about price discounting, industry profitability erodes. Alternatively, competitors can use non-price competition to create more value in terms of product features and design, quality, promotional spending, and after-sales service and sup- port. When non-price competition is the primary basis of competition, costs increase, which can also have a negative impact on industry profitability. However, when these moves create unique products with features tailored closely to meet customer needs and willingness to pay, then average industry profitability tends to increase because producers are able to raise prices and thus increase revenues and profit margins.

The intensity of rivalry among existing competitors is determined largely by the following factors: ■ Competitive industry structure. ■ Industry growth. ■ Strategic commitments. ■ Exit barriers.

COMPETITIVE INDUSTRY STRUCTURE. The competitive industry structure refers to ele- ments and features common to all industries. The structure of an industry is largely cap- tured by

■ The number and size of its competitors. ■ The firm’s degree of pricing power.

LO 3-4 Examine how competitive industry structure shapes rivalry among competitors.

competitive industry structure Elements and features common to all industries, includ- ing the number and size of competitors, the firms’ degree of pricing power, the type of product or service of- fered, and the height of entry barriers.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 91

■ The type of product or service (commodity or differentiated product). ■ The height of entry barriers.25

Exhibit 3.4 shows different industry types along a continuum from fragmented to con- solidated structures. At one extreme, a fragmented industry consists of many small firms and tends to generate low profitability. At the other end of the continuum, a consolidated indus- try is dominated by a few firms, or even just one firm, and has the potential to be highly profitable. The four main competitive industry structures are

1. Perfect competition 2. Monopolistic competition 3. Oligopoly 4. Monopoly

Perfect Competition. A perfectly competitive industry is fragmented and has many small firms, a commodity product, ease of entry, and little or no ability for each individual firm to raise its prices. The firms competing in this type of industry are approximately similar in size and resources. Consumers make purchasing decisions solely on price, because the com- modity product offerings are more or less identical. The resulting performance of the indus- try shows low profitability. Under these conditions, firms in perfect competition have difficulty achieving even a temporary competitive advantage and can achieve only competi- tive parity. Although perfect competition is a rare industry structure in its pure form, mar- kets for commodities such as natural gas, copper, and iron tend to approach this structure.

Modern high-tech industries are also not immune to the perils of perfect competition. Many internet entrepreneurs learned the hard way that it is difficult to beat the forces of perfect competition. Fueled by eager venture capitalists, about 100 online pet supply stores

EXHIBIT 3.4 Industry Competitive Structures along the Continuum from Fragmented to Consolidated Industry Competitive Structures

Monopolistic Competition

Form

Features

Fr ag

m en

te d

C on

so lid

at ed

Perfect Competition

• Many small firms • Firms are price takers • Commodity product • Low entry barriers

• Many small firms • Firms are price takers • Commodity product • Low entry barriers

• Many firms • Some pricing power • Differentiated product • Medium entry barriers

• Many firms • Some pricing power • Differentiated product • Medium entry barriers

• Few (large) firms • Some pricing power • Differentiated product • High entry barriers

• Few (large) firms • Some pricing power • Differentiated product • High entry barriers

• One firm • Considerable pricing power • Unique product • Very high entry barriers

• One firm • Considerable pricing power • Unique product • Very high entry barriers

Oligopoly Monopoly

Resulting Profit Potential Low High

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92 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

such as pets.com, petopia.com, and pet-store.com had sprung up by 1999, at the height of the internet bubble.26 Cut-throat competition ensued, with online retailers selling products below cost. When many small firms are offering a commodity product in an industry that is easy to enter, no one is able to increase prices and generate profits. To make matters worse, at the same time, category-killers such as PetSmart and PetCo were expanding rapidly, open- ing some 2,000 brick-and-mortar stores in the United States and Canada. The ensuing price competition led to an industry shakeout, leaving online retailers in the dust. Looking at the competitive industry structures depicted in Exhibit 3.4, we might have predicted that online pet supply stores were unlikely to be profitable.

Monopolistic Competition. A monopolistically competitive industry has many firms, a dif- ferentiated product, some obstacles to entry, and the ability to raise prices for a relatively unique product while retaining customers. The key to understanding this industry structure is that the firms now offer products or services with unique features.

The computer hardware industry provides one example of monopolistic competition. Many firms compete in this industry, and even the largest of them (Apple, ASUS, Dell, HP, or Lenovo) have less than 20 percent market share. Moreover, while products between competitors tend to be similar, they are by no means identical. As a consequence, firms selling a product with unique features tend to have some ability to raise prices. When a firm is able to differentiate its product or service offerings, it carves out a niche in the market in which it has some degree of monopoly power over pricing, thus the name “monopolistic competition.” Firms frequently communicate the degree of product differen- tiation through advertising.

Oligopoly. An oligopolistic industry is consolidated with a few large firms, differentiated products, high barriers to entry, and some degree of pricing power. The degree of pricing power depends, just as in monopolistic competition, on the degree of product differentiation.

A key feature of an oligopoly is that the competing firms are interdependent. With only a few competitors in the mix, the actions of one firm influence the behaviors of the others. Each competitor in an oligopoly, therefore, must consider the strategic actions of the other competitors. This type of industry structure is often analyzed using game theory, which attempts to predict strategic behaviors by assuming that the moves and reactions of com- petitors can be anticipated.27 Due to their strategic interdependence, companies in oligopo- lies have an incentive to coordinate their strategic actions to maximize joint performance. Although explicit coordination such as price fixing is illegal in the United States, tacit coor- dination such as “an unspoken understanding” is not.

The express-delivery industry is an example of an oligopoly. The main competitors in this space are FedEx and UPS. Any strategic decision made by FedEx (e.g., to expand delivery services to ground delivery of larger-size packages) directly affects UPS; likewise, any deci- sion made by UPS (e.g., to guarantee next-day delivery before 8:00 a.m.) directly affects FedEx. Other examples of oligopolies include the soft drink industry (Coca-Cola versus Pepsi), airframe manufacturing business (Boeing versus Airbus), home-improvement retail- ing (The Home Depot versus Lowe’s), toys and games (Hasbro versus Mattel), and deter- gents (P&G versus Unilever).28

Companies in an oligopoly tend to have some pricing power if they are able to differenti- ate their product or service offerings from those of their competitors. Non-price competition, therefore, is the preferred mode of competition. This means competing by offering unique product features or services rather than competing based on price alone. When one firm in an oligopoly cuts prices to gain market share from its competitor, the competitor typically will respond in kind and also cut prices. This process initiates a price war, which can be especially detrimental to firm performance if the products are close rivals.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 93

In the early years of the soft drink industry, for example, whenever PepsiCo lowered prices, Coca-Cola followed suit. These actions only resulted in reduced profitability for both companies. In recent decades, both Coca-Cola and PepsiCo have repeatedly demonstrated that they have learned this lesson. They shifted the basis of competition from price-cutting to new product introductions and lifestyle advertising. Any price adjustments are merely short-term promotions. By leveraging innovation and advertising, Coca-Cola and PepsiCo have moved to non-price competition, which in turn allows them to charge higher prices and to improve industry and company profitability.29

Monopoly. An industry is a monopoly when there is only one, often large firm supplying the market. The firm may offer a unique product, and the challenges to moving into the industry tend to be high. The monopolist has considerable pricing power. As a consequence, firm and thus industry profit tends to be high. The one firm is the industry.

In some instances, the government will grant one firm the right to be the sole supplier of a product or service. This is often done to incentivize a company to engage in a venture that would not be profitable if there was more than one supplier. For instance, public utilities incur huge fixed costs to build plants and to supply a certain geographic area. Public utilities supplying water, gas, and electricity to businesses and homes are frequently monopolists. Georgia Power is the only supplier of electricity for some 2.5 million customers in the south- eastern United States. Philadelphia Gas Works is the only supplier of natural gas in the city of Philadelphia, serving some 500,000 customers. These are so-called natural monopolies. Without them, the governments involved believe the market would not supply these prod- ucts or services. In the past few decades, however, more and more of these natural monopo- lies have been deregulated in the United States, including airlines, telecommunications, railroads, trucking, and ocean transportation. This deregulation has allowed competition to emerge, which frequently leads to lower prices, better service, and more innovation.

While natural monopolies appear to be disappearing from the competitive landscape, so-called near monopolies are of much greater interest to strategists. These are firms that have accrued significant market power, for example, by owning valuable patents or proprie- tary technology. In the process, they are changing the industry structure in their favor, gen- erally from monopolistic competition or oligopolies to near monopolies. These near monopolies are firms that have accomplished product differentiation to such a degree that they are in a class by themselves, just like a monopolist. The European Union, for example, views Google with its 90 percent market share in online search as a digital monopoly.30 This is an enviable position in terms of the ability to extract profits by leveraging its data to pro- vide targeted online advertising and other customized services, so long as Google can steer clear of monopolistic behavior, which may attract antitrust regulators and lead to legal repercussions.

INDUSTRY GROWTH. Industry growth directly affects the intensity of rivalry among com- petitors. In periods of high growth, consumer demand rises, and price competition among firms frequently decreases. Because the pie is expanding, rivals are focused on capturing part of that larger pie rather than taking market share and profitability away from one another.

The demand for knee replacements, for example, is a fast-growing segment in the medical products industry. In the United States, robust demand is driven by the need for knee replacements for an aging population as well as for an increasingly obese population. The leading competitors are Zimmer Biomet, DePuy, and Stryker, with a significant share held by Smith & Nephew. Competition is primarily based on innovative design, improved implant materials, and differentiated products such as gender solutions and a range of high-flex

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knees. With improvements to materials and procedures, younger patients are also increas- ingly choosing early surgical intervention. Competitors are able to avoid price competition and, instead, focus on differentiation that allows premium pricing.

In contrast, rivalry among competitors becomes fierce during slow or even negative industry growth. Price discounts, frequent new product releases with minor modifications, intense promotional campaigns, and fast retaliation by rivals are all tactics indicative of an industry with slow or negative growth. Competition is fierce because rivals can gain only at the expense of others; therefore, companies are focused on taking business away from one another. Demand for traditional fast food providers such as McDonald’s, Burger King, and Wendy’s has been declining in recent years. Consumers have become more health-conscious and demand has shifted to alternative restaurants such as Subway, Chick-fil-A, and Chipotle. Attempts by McDonald’s, Burger King, and Wendy’s to steal customers from one another include frequent discounting tactics such as dollar menus. Such competitive tactics are indicative of cut-throat competition and a low profit potential in the traditional hamburger fast food industry.

Competitive rivalry based solely on cutting prices is especially destructive to profitability because it transfers most, if not all, of the value created in the industry to the customers— leaving little, if anything, for the firms in the industry. While this may appear attractive to customers, firms that are not profitable are not able to make the investments necessary to upgrade their product offerings or services to provide higher value, and they eventually leave the industry. Destructive price competition can lead to limited choices, lower product qual- ity, and higher prices for consumers in the long run if only a few large firms survive.

STRATEGIC COMMITMENTS. If firms make strategic commitments to compete in an industry, rivalry among competitors is likely to be more intense. Strategic commitments are firm actions that are costly, long-term oriented, and difficult to reverse. Strategic commit- ments to a specific industry can stem from large, fixed cost requirements, but also from noneconomic considerations.31

EXIT BARRIERS. The rivalry among existing competitors is also a function of an industry’s exit barriers, the obstacles that determine how easily a firm can leave that industry. Exit bar- riers comprise both economic and social factors. They include fixed costs that must be paid regardless of whether the company is operating in the industry or not. A company exiting an industry may still have contractual obligations to suppliers, such as employee health care, retirement benefits, and severance pay. Social factors include elements such as emotional attachments to certain geographic locations. In Michigan, entire communities still depend on GM, Ford, and Chrysler. If any of those carmakers were to exit the industry, communi- ties would suffer. Other social and economic factors include ripple effects through the sup- ply chain. When one major player in an industry shuts down, its suppliers are adversely impacted as well.

An industry with low exit barriers is more attractive because it allows underperforming firms to exit more easily. Such exits reduce competitive pressure on the remaining firms because excess capacity is removed. In contrast, an industry with high exit barriers reduces its profit potential because excess capacity still remains.

To summarize our discussion of the five forces model, Exhibit 3.5 provides a checklist that you can apply to any industry when assessing the underlying competitive forces that shape strategy. The key take-away from the five forces model is that the stronger the forces, the lower the industry’s ability to earn above-average profits, and correspondingly, the lower the firm’s ability to gain and sustain a competitive advantage. Conversely, the weaker the forces, the greater the industry’s ability to earn above-average profits, and correspondingly,

strategic commitments Firm actions that are costly, long-term ori- ented, and difficult to reverse.

exit barriers Obsta- cles that determine how easily a firm can leave an industry.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 95

The threat of entry is high when

✓ The minimum efficient scale to compete in an industry is low.

✓ Network effects are not present.

✓ Customer switching costs are low.

✓ Capital requirements are low.

✓ Incumbents do not possess: Brand loyalty. Proprietary technology. Preferential access to raw materials. Preferential access to distribution channels. Favorable geographic locations. Cumulative learning and experience effects.

✓ Restrictive government regulations do not exist.

✓ New entrants expect that incumbents will not or cannot retaliate.

The power of suppliers is high when

✓ Supplier’s industry is more concentrated than the industry it sells to.

✓ Suppliers do not depend heavily on the industry for their revenues.

✓ Incumbent firms face significant switching costs when changing suppliers.

✓ Suppliers offer products that are differentiated.

✓ There are no readily available substitutes for the products or services that the suppliers offer.

✓ Suppliers can credibly threaten to forward-integrate into the industry.

The power of buyers is high when

✓ There are a few buyers and each buyer purchases large quantities relative to the size of a single seller.

✓ The industry’s products are standardized or undifferentiated commodities.

✓ Buyers face low or no switching costs.

✓ Buyers can credibly threaten to backwardly integrate into the industry.

The threat of substitutes is high when

✓ The substitute offers an attractive price-performance trade-off.

✓ The buyer’s cost of switching to the substitute is low.

The rivalry among existing competitors is high when

✓ There are many competitors in the industry.

✓ The competitors are roughly of equal size.

✓ Industry growth is slow, zero, or even negative.

✓ Exit barriers are high.

✓ Incumbent firms are highly committed to the business.

✓ Incumbent firms cannot read or understand each other’s strategies well.

✓ Products and services are direct substitutes.

✓ Fixed costs are high and marginal costs are low.

✓ Excess capacity exists in the industry.

✓ The product or service is perishable.

EXHIBIT 3.5 The Five Forces Competitive Analysis Checklist Source: Adapted from M.E. Porter (2008, January), “The five competitive forces that shape strategy,” Harvard Business Review.

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the greater the firm’s ability to gain and sustain competitive advantage. Therefore, strategic leaders need to craft a strategic position for their company that leverages weak forces into opportunities and mitigates strong forces because they are potential threats to the firm’s ability to gain and sustain a competitive advantage.

APPLYING THE FIVE FORCES MODEL TO THE U.S. AIRLINE INDUSTRY Applying the model to the U.S. domestic airline industry provides a neat examination of the five competitive forces that shape strategy.32

THREAT OF ENTRY. Entry barriers in the airline industry are relatively low, resulting in new airlines popping up occasionally. To enter the industry (on a small scale, serving a few select cities), a prospective new entrant needs only a couple of airplanes, which can be rented; a few pilots and crew members; some routes connecting city pairs; and gate access in airports. Despite notoriously low industry profitability, Virgin America entered the U.S. market in 2007. Virgin America is the brainchild of Sir Richard Branson, founder and chairman of the Virgin Group, a UK conglomerate of hundreds of companies using the Virgin brand, includ- ing the international airline Virgin Atlantic. Virgin America’s business strategy was to offer low-cost service between major metropolitan cities on the American East and West coasts. In 2016, Alaska Airlines acquired Virgin America for $2.6 billion.

POWER OF SUPPLIERS. In the airline industry, the supplier power is also strong. The pro- viders of airframes (e.g., Boeing and Airbus), makers of aircraft engines (e.g., GE and Rolls- Royce), aircraft maintenance companies (e.g., Goodrich), caterers (e.g., Marriott), labor unions, and airports controlling gate access all bargain away the profitability of airlines.

Let’s take a closer look at one important supplier group to this industry: Boeing and Airbus, the makers of large commercial jets. Airframe manufacturers are powerful suppli- ers to airlines because their industry is much more concentrated (only two firms) than the industry it sells to. Compared to two airframe suppliers, there are hundreds of commer- cial airlines around the world. Given the trend of large airlines merging to create even larger mega-airlines, however, increasing buyer power may eventually balance this out a bit. Nonetheless, the airlines face nontrivial switching costs when changing suppliers because pilots and crew would need to be retrained to fly a new type of aircraft, mainte- nance capabilities would need to be expanded, and some routes may even need to be reconfigured due to differences in aircraft range and passenger capacity. Moreover, while some aircraft can be used as substitutes, Boeing and Airbus offer differentiated products. This fact becomes clearer when considering some of the more recent models from each company. Boeing introduced the 787 Dreamliner to capture long-distance point-to-point travel (close to an 8,000-mile range, sufficient to f ly nonstop from Los Angeles to Sydney), while Airbus introduced the A-380 Superjumbo to focus on high-volume trans- portation (close to 900 passengers) between major airport hubs (e.g., Tokyo’s Haneda Airport and Singapore’s Changi Airport).

When considering long-distance travel, there are no readily available substitutes for com- mercial airliners, a fact that strengthens supplier power. Thus, the supplier power of com- mercial aircraft manufacturers is quite significant. This puts Boeing and Airbus in a strong position to extract profits from the airline industry, thus reducing the profit potential of the airlines themselves.

Although the supplier power of Boeing and Airbus is strong, several factors further moder- ate their bargaining positions somewhat. First, the suppliers of commercial airliners depend

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heavily on the commercial airlines for their revenues. Given the less than expected demand for the A-380, for instance, Airbus announced that it will stop producing the Superjumbo in 2021.33 Rather, Airbus will focus more on its newer and smaller A-350 model, a versatile and fuel-efficient airplane to be deployed on high-traffic point-to-point routes, and thus a direct competitor to Boeing’s 787. As the recent strategic moves by Airbus and Boeing have shown, even a duopoloy (a industry with only two suppliers) in the airframe manufacturing business is not immune to changes in customer demand (power of buyers).

Second, Boeing and Airbus are unlikely to threaten forward integration and become commercial airlines themselves. Third, Bombardier of Canada and Embraer of Brazil, both manufacturers of smaller commercial airframes, have begun to increase the size of the jets they offer and thus now compete with some of the smaller planes such as the Boeing 737 and Airbus A-320. Finally, industry structures are not static, but can change over time. Sev- eral of the remaining large domestic U.S. airlines have merged (Delta and Northwest, United and Continental, and American and U.S. Airways), which changed the industry structure in their favor. There are now fewer airlines, but they are larger. This fact increases their buyer power, which we turn to next.

POWER OF BUYERS. Large corporate customers contract with airlines to serve all of their employees’ travel needs; such powerful buyers further reduce profit margins for air carriers. To make matters worse, consumers primarily make decisions based on price as air travel is viewed as a commodity with little or no differentiation across domestic U.S. carriers. In inflation-adjusted dollars, ticket prices have been falling since industry deregulation in 1978. Thanks to internet travel sites such as Orbitz, Travelocity, and Kayak, price comparisons are effortless. Consumers benefit from cut-throat price competition between carriers and cap- ture significant value. Low switching costs and nearly perfect information in real time com- bine to strengthen buyer power.

THREAT OF SUBSTITUTES. To make matters worse, substitutes are also readily available: If prices are seen as too high, customers can drive a car or use the train or bus. For example, the route between Atlanta and Orlando (roughly 400 miles) used to be one of Delta’s busi- est and most profitable. Given the increasing security requirements at airports and other factors, more people now prefer to drive. Taken together, the competitive forces are quite unfavorable for generating a profit potential in the airline industry: low entry barriers, high supplier power, high buyer power combined with low customer switching costs, and the availability of low-cost substitutes. This type of hostile environment leads to intense rivalry among existing airlines and low overall industry profit potential.

RIVALRY AMONG EXISTING COMPETITORS. As a consequence of the powerful industry forces discussed above, the nature of rivalry among airlines has become incredibly intense. Moreover, the required strategic commitments combined with exit barriers further increase the competitive intensity in the U.S. domestic airline industry.

Strategic Commitments. Significant strategic commitments are required to compete in the airline industry when using a hub-and-spoke system to provide not only domestic but also international coverage. U.S.-based airlines Delta, United, and American have large fixed costs to maintain their network of routes that affords global coverage, frequently in conjunction with foreign partner airlines. These fixed costs in terms of aircraft, gate leases, hangars, maintenance facilities, baggage facilities, and ground transportation all accrue before the airlines sell any tickets. High fixed costs create tremendous pressure to fill empty seats. An airline seat on a specific f light, just like an unbooked hotel room, is

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98 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

perishable. Empty airline seats are often filled through price-cutting. Given similar high fixed costs, other airlines respond in kind. Eventually, a vicious cycle of price-cutting ensues, driving average industry profitability to zero, or even negative numbers (where the companies are losing money). To make matters worse, given their strategic commit- ments, airlines are unlikely to exit an industry. Excess capacity remains, further depress- ing industry profitability.

In other cases, strategic commitments to a specific industry may be the result of more political than economic considerations. Airbus, for example, was created by a number of European governments through direct subsidies to provide a countervailing power to Boe- ing. The European Union in turn claims that Boeing is subsidized by the U.S. government indirectly via defense contracts. Given these political considerations and large-scale strate- gic commitments, neither Airbus nor Boeing is likely to exit the aircraft manufacturing industry even if industry profit potential falls to zero.

Exit Barriers. The U.S. domestic airline industry is characterized by high exit barriers, which further reduces the industry’s overall profit potential. All the large U.S. airlines (American, Delta, and United) have filed for bankruptcy at one point. Due to a unique fea- ture of U.S. Chapter 11 bankruptcy law, companies may continue to operate and reorganize while being temporarily shielded from their creditors and other obligations until renegoti- ated. This implies that excess capacity is not removed from the industry, and by putting pressure on prices further reduces industry profit potential.

CONCLUSION. Although many of the mega-airlines have lost billions of dollars over the past few decades and continue to struggle to generate consistent profitability, other players in the industry have been quite profitable because they were able to extract some of the economic value created. The surprising conclusion, therefore, is that while the mega-airlines themselves frequently struggle to achieve consistent profitability over time, the other players in the industry—such as the suppliers of airframes and aircraft engines, aircraft maintenance companies, IT companies providing reservation and logistics services, caterers, airports, and so on—are quite profitable, all extracting significant value from the air transportation industry. Customers also are better off, as ticket prices have decreased and travel choices increased.

During the mid-2010s, the cash-strapped airlines benefited from a windfall as the price of jet fuel fell from a high of $3.25 per gallon (in the spring of 2011) all the way to $0.80 per gallon (in early 2016), before climbing back to $1.80 (in early 2019). The cost of jet fuel is roughly 50 percent of an airline’s total operating costs. Nonetheless, competition remains intense in this industry.

Taking a closer look at the U.S. domestic airline industry shows how the five forces framework is a powerful and versatile tool to analyze industries. The five forces model allows strategic leaders to analyze all players using a wider industry lens, which in turn enables a deeper understanding of an industry’s profit potential. Moreover, a five forces analysis provides the basis for how a firm should position itself to gain and sustain a com- petitive advantage. We will take up the topic of competitive positioning in Chapter 6 when studying business-level strategy in much more detail.

A SIXTH FORCE: THE STRATEGIC ROLE OF COMPLEMENTS As valuable as the five forces model is for explaining the profit potential and attractiveness of industries, the value of Porter’s five forces model can be further enhanced if one also considers the availability of complements.34

LO 3-5 Describe the strategic role of complements in creating positive-sum co-opetition.

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A complement is a product, service, or competency that adds value to the original prod- uct offering when the two are used in tandem.35 Complements increase demand for the pri- mary product, thereby enhancing the profit potential for the industry and the firm. A company is a complementor to your company if customers value your product or service offering more when they are able to combine it with the other company’s product or ser- vice.36 Firms may choose to provide the complements themselves or work with another company to accomplish this.

CO-OPETITION. For example, in the smartphone industry, Alphabet’s Google comple- ments Samsung. The Korean high-tech company’s smartphones are more valuable when they come with Google’s Android mobile operating system installed. At the same time, Google and Samsung are increasingly becoming competitors. With Google’s acquisition of Motorola Mobility, the online search company launched its own line of smartphones and Chromebooks. This development illustrates the process of co-opetition, which is coopera- tion by competitors to achieve a strategic objective. Samsung and Google cooperate as com- plementors to compete against Apple’s strong position in the mobile device industry, while at the same time Samsung and Google are increasingly becoming competitive with one another. While Google retained Motorola’s patents to use for development in its future phones and to defend itself against competitors such as Samsung and Apple, Alphabet (Google’s parent company) sold the manufacturing arm of Motorola to Lenovo, a Chinese maker of computers and mobile devices.

In 2017, Google acquired HTC’s smartphone engineering group for $1.1 billion. The Taiwanese smartphone maker developed the Google Pixel phone. With this acquisition, Google is making a commitment to handset manufacturing, unlike in the Motorola deal, which was more motivated by intellectual property considerations. Integrating HTC’s smartphone unit within Google will allow engineers to more tightly integrate hardware and software. This in turn will allow Google to differentiate its high-end Pixel phones from the competition, especially Apple’s iPhones and Samsung’s Galaxy line of phones.

3.3 Changes over Time: Entry Choices and Industry Dynamics

ENTRY CHOICES One of the key insights of the five forces model is that the more profitable an industry, the more attractive it becomes to competitors. Let’s assume a firm’s strategic leaders are aware of potential barriers to entry (discussed earlier), but would nonetheless like to contemplate potential market entry because the industry profitability is high and thus quite attractive. Exhibit 3.6 shows an integrative model that can guide the entry choices firms make. Rather

LO 3-6 Explain the five choices required for market entry.

complement A product, service, or com- petency that adds value to the original product offering when the two are used in tandem.

complementor A company that provides a good or service that leads customers to value your firm’s offering more when the two are combined.

co-opetition Cooperation by competitors to achieve a strategic objective.

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100 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

than considering firm entry as a discrete event (i.e., simple yes or no decision), or a discrete event composed of five parts, this model suggests that the entry choices firms make consti- tute a strategic process unfolding over time.

In particular, to increase the probability of successful entry, strategic leaders need to consider the following five questions:37

1. Who are the players? Building on Porter’s insight that competition must be viewed in a broader sense beyond direct competitors, the who are the players question allows strate- gic leaders to not only identify direct competitors but also focus on other external and internal stakeholders necessary to successfully compete in an industry, such as custom- ers, employees, regulators, and communities (see discussion of stakeholder strategy in Chapter 2).

When? -Entry timing

-Stage of industry life cycle -Order of entry

How? -Leverage existing assets -Reconfigure value chains

-Establish niches

What? -Type of entry:

Scale, commitment, product and/or service,

business model etc.

Where? -Leverage existing assets -Reconfigure value chains

-Establish niches

Who? -Identify the players: Incumbents, entrants, suppliers, customer,

other stakeholder

ENTRY CHOICES

EXHIBIT 3.6 Entry Choices

Source: Based on and adapted from M.A., Zachary, P.T. Gianiodis, G. Tyge Payne, and G.D. Markman (2014), “Entry timing: enduring lessons and future directions,” Journal of Management 41: 1409; and Bryce, D.J., and J.H. Dyer (2007, May), “Strategies to crack well- guarded markets,” Harvard Business Review: 84–92.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 101

2. When to enter? This question concerns the timing of entry. Given that our perspective is that of a firm considering potential entry into an existing industry, any first-mover advantages are bygones. Nonetheless, the potential new entrant needs to consider at which stage of the industry life cycle (introduction, growth, shakeout, maturity, or decline) it should enter. We take a deep dive into the industry life cycle and how it unfolds in Chapter 7.

3. How to enter? One of the challenges that strategic leaders face is that often the most attractive industries in terms of profitability are also the hardest to break into because they are protected by entry barriers. Thus, the how to enter question goes to the heart of this problem. ■ One option is to leverage existing assets, that is to think about a new combination

of resources and capabilities that firms already possess, and if needed to combine them with partner resources through strategic alliances. Although Circuit City went bankrupt as an electronics retailer, losing out to Best Buy and Amazon, a few years earlier it recombined its existing expertise in big-box retailing including optimization of supply and demand in specific geographic areas to create CarMax, now the largest used-car dealer in the United States and a Fortune 500 company.

■ Another option is to reconfigure value chains. This approach allowed Skype to enter the market for long-distance calls by combining value chains differently (offering VoIP rather than relying on more expensive fiber-optic cables), and thus compete with incumbents such as AT&T.

■ The third option is to establish a niche in an existing industry, and then use this beachhead to grow further. This is the approach the Austrian maker of Red Bull used when entering the U.S. soft drink market, long dominated by Coca-Cola and PepsiCo. Its energy drink was offered in a small 8.4-ounce (250 ml) can, but priced at multiples compared to Coke or Pepsi. This allowed retailers to stock Red Bull cans in small spaces such as near the checkout counter. In addition, Red Bull ini- tially used many nontraditional outlets as points of sale such as nightclubs and gas stations. This approach created a loyal following from which the energy drink maker could expand its entry into the mainstream carbonated beverage drink in the United States and elsewhere. Indeed, energy drinks are now one of the fastest growing seg- ments in this industry.

4. What type of entry? The what question of entry refers to the type of entry in terms of product market (e.g., smartphones), value chain activity (e.g., R&D for smartphone chips or manufacturing of smartphones), geography (e.g., domestic and/or interna- tional), and type of business model (e.g., subsidizing smartphones when providing ser- vices). Depending on the market under consideration for entry, firms may face unique competitive and institutional challenges. For example, discount carrier Spirit Airlines’ unbundling of its services by charging customers separately for elements such as checked luggage, assigned seating, carry-on items, and other in-flight perks such as drinks met with considerable backlash in 2007 when introduced. Yet this marked the starting point of Spirit Airlines’ strategic positioning as an ultra-low-cost carrier and enabled the com- pany to add many attractive routes, and thus to enter geographic markets it was not able to compete in previously.

5. Where to enter? After deciding on the type of entry, the where to enter question refers to more fine-tuned aspects of entry such as product positioning (high end versus low end), pricing strategy, potential partners, and so forth.

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INDUSTRY DYNAMICS Although the five forces plus complements model is useful in understanding an industry’s profit potential, it provides only a point-in-time snapshot of a moving target. With this model (as with other static models), one cannot determine the changing speed of an indus- try or the rate of innovation. This drawback implies that strategic leaders must repeat their analysis over time to create a more accurate picture of their industry. It is therefore impor- tant that strategic leaders consider industry dynamics.

Industry structures are not stable over time. Rather, they are dynamic. Since a consoli- dated industry tends to be more profitable than a fragmented one (see Exhibit 3.4), firms have a tendency to change the industry structure in their favor, making it more consolidated through horizontal mergers and acquisitions. Having fewer competitors generally equates to higher industry profitability. Industry incumbents, therefore, have an incentive to reduce the number of competitors in the industry. With fewer but larger competitors, incumbent firms can mitigate more effectively the threat of strong competitive forces such as supplier or buyer power.

The U.S. domestic airline industry has witnessed several large, horizontal mergers between competitors, including Delta and Northwest, United and Continental, Southwest and AirTran, as well as American and U.S. Airways. These moves allow the remaining car- riers to enjoy a more benign industry structure. It also allows them to retire some of the excess capacity in the industry as the merged airlines consolidate their networks of routes. The merger activity in the airline industry provides one example of how firms can proac- tively reshape industry structure in their favor. A more consolidated airline industry is likely to lead to higher ticket prices and fewer choices for customers, but also more profit- able airlines.

In contrast, consolidated industry structures may also break up and become more fragmented. This generally happens when there are external shocks to an industry such as deregulation, new legislation, technological innovation, or globalization. For example, the widespread use of the internet moved the stock brokerage business from an oligopoly controlled by full-service firms such as Merrill Lynch and Morgan Stanley to monopolis- tic competition with many generic online brokers such as Ameritrade, E*Trade, and Scottrade.

Another dynamic to be considered is industry convergence, a process whereby formerly unrelated industries begin to satisfy the same customer need. Industry convergence is often brought on by technological advances. For years, many players in the media industries have been converging due to technological progress in AI, telecommunications, and digital media. Media convergence unites computing, communications, and content, thereby caus- ing significant upheaval across previously distinct industries. Content providers in indus- tries such as newspapers, magazines, TV, movies, radio, and music are all scrambling to adapt. Many standalone print newspapers are closing up shop, while others are trying to figure out how to offer online news content for which consumers are willing to pay.38 Inter- net companies such as Google, Facebook, Instagram (acquired by Facebook), LinkedIn (acquired by Microsoft), Snapchat, Pinterest, and Twitter are changing the industry struc- ture by constantly morphing their capabilities and forcing old-line media companies such as News Corp., Time Warner (now part of AT&T), and Disney to adapt. A wide variety of mobile devices, including smartphones, tablets, and e-readers, provide a new form of con- tent delivery that has the potential to make print media obsolete.

Finally, the convergence of different technology can also lead to the emergence of entirely new industries. Strategy Highlight 3.2 documents the recent rise of the e-sports industry.

industry convergence A process whereby for- merly unrelated indus- tries begin to satisfy the same customer need.

LO 3-7 Appraise the role of industry dynamics and industry convergence in shaping the firm’s external environment.

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 103

From League of Legends to Fortnite: The Rise of e-Sports League of Legends (LoL), the popular multiplayer online battle arena (MOBA) game developed and launched in 2009 by Riot Games of Los Angeles, went from being a small niche game to a billion-dollar business, sparking the explosive growth of the e-sports industry. Although online games have been around for a while, Riot Games was the first company to put e-sports on the map and to bring it into the mainstream culture.

Within just two years of its launch, LoL managed to accrue 1.4 million daily players and 3.5 million monthly average users (MAU). Since then, it has garnered 30 mil- lion daily players and made more than $7 billion in rev- enues. For nearly a decade, LoL was the world’s most popular video game—until Fortnite took over. The explo- sive growth and global popularity of LoL did not go un- noticed: In 2011, the Chinese tech company Tencent (also owner of WeChat, the world’s largest social media

a n d m o b i l e p a y m e n t a p p w i t h s o m e 1 b i l l i o n d a i l y users) bought Riot Games for $400 million. Exhibit 3.7 shows the annual revenues of LoL and Fortnite (FN) over time.

League of Legends is free to download and free to play. Game updates released by Riot Games are also free of charge. How has Riot Games been able to make so much money using this “freemium” business model? It re- lies on four key tactics in its business model: in-game and ancillary transactions, live e-sport events, live-streamed e-sport events, and merchandise sales.

In-game and ancillary transactions are the first source of revenue. Riot Games makes the bulk of its money by selling “champions” (the avatars that fight in the battles; each champion has unique abilities and you unlock more abilities as you go along and win) as well as their “skins” (which change the appearance of the champions) to its extensive user base, offering more than 140 champions with some 800 skins and other accessories, such as

Strategy Highlight 3.2

EXHIBIT 3.7 League of Legends and Fortnite Annual Revenues (in $bn)

LoL 2010 FN 2018LoL 2018FN 2017LoL 2017LoL 2016LoL 2015LoL 2014LoL 2013 0

0.5

1.0

2.0

1.5

2.5

(Continued)

Source: Author’s depiction of publicly available data.

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104 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

name changes. LoL accepts two types of currency: Blue Essence, which are points that can be earned through playing (accomplishing specific missions in a game, for instance) and Riot Points, which are points that can be purchased with real money using prepaid cards.  Since each battle consists of two teams comprising five play- ers, the possible permutations of champions and skins can add up to the billions, and all encounters are unique. Furthermore the LoL in-game store is digital, which means its inventory of items is potentially unlimited. Players also have their own  personal stores based on their selected champions and other individual character- istics. Here, players often find items recommended uniquely for them.

Live e-sport events are a second source of revenue. One key differentiator between LoL and previous e-sports games is its competitive focus. Riot Games hosts a League Championship Series (LCS), which attracts vast audiences and significant media and sponsorship atten- tion. It controls all aspects of the LCS: the music, broad- c a s t i n g , a n d d e c i s i o n s a b o u t w h e r e t o r u n Lo L tournaments, which are hosted in several global loca- tions. Top professional players can earn millions of dol- lars a year (in prize money, sponsorship, and streaming fees), while thousands of players have gone professional making more than $100,000 year. These events are hugely popular and fill venues with tens of thousands of attendees, often dressed in cosplay outfits (that is, as characters from LoL, a movie, book, or other video game). These events not only help to create a unique experience for its visitors, but they also help to generate a commu- nity of like-minded gamers. 

Live-streamed e-sport events delivered via the video platform Twitch.tv (nicknamed “the ESPN of eSports” and now owned by Amazon) are a third source of revenue. These events often have corporate sponsorships ranging from computer hardware companies (e.g., Intel, Razer, and Logitech, etc.) to energy drinks firms (e.g., Red Bull, Monster, and 5-Hour Energy). LoL has a major sponsor- ship deal with Mastercard, a global financial institution best known for its credit cards. Sales of LoL-specific mer- chandise, such as hoodies, T-shirts, hats, and so forth, represent the final source of revenue. 

Riot Games maintains its revenues even as the game continuously evolves. The constant evolution of the game keeps gamers challenged, creative, and engaged. Many can be found in online chat rooms such as Reddit rethink- ing and discussing their strategy with other players, and thus further expanding the gaming community and its global reach. Currently, most of the world’s ranked play- ers are from the United States, China, South Korea, Germany, France, and Sweden (in rank order). The demo- graphics of the players are highly sought after by adver- tisers because most players are between the ages of 15 and 35 years old, a notoriously difficult audience to reach. Yet, it is also highly skewed in terms of gender: 85 percent of the players are male. With virtually no bar- riers to entry, Riot Games managed to build a huge gamer base that continues to grow exponentially and thus cre- ated a new industry.

During LoL’s rise to success, however, Riot Games found itself contending with competitors such as Mine- craft (which Microsoft bought for $2.5 billion in 2014), Dota 2, and others. LoL dominated its competitors until the fall of 2017, when Epic Games (also owned in part by Tencent) released Fortnite. Fortnite is known as a “Battle Royale Game,” that is a multiplayer online game that con- tinues until only one survivor is standing. One main reason Fortnite took off so quickly is that the game, unlike LoL, is available on all consoles and mobile devices. LoL is played on laptop and/or desktops only, and cannot be played on mobile devices or game consoles such Xbox. While both LoL and Fortnite are free to download and play, Fortnite is not only available across all devices but also is less diffi- cult to play than LoL, making it especially attractive for beginning gamers. 

Within the first few months of its launch, Fortnite brought in $1.5 billion in revenues. In its first complete year of existence (2018), Fortnite had $2.4 billion in reve- nues, while LoL’s revenues declined (see Exhibit 3.7). This drop in revenue indicates that some gamers have moved on from LoL to Fortnite, the next big thing. In sum, while Riot Games created the new billion-dollar e-sports indus- try, competition never stands still. As such, Fortnite ap- pears to be gaining a competitive advantage, while LoL may be losing its edge and appeal.39

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 105

3.4 Performance Differences within the Same Industry: Strategic Groups

In further analyzing the firm’s external environment to explain performance differences, we now move to firms within the same industry. As noted earlier in the chapter, a firm occupies a place within a strategic group, a set of companies that pursue a similar strategy within a specific industry in their quest for competitive advantage (see Exhibit 3.1).40 Strategic groups differ from one another along important dimensions such as expenditures on research and development, technology, product differentiation, product and service offer- ings, market segments, distribution channels, and customer service.

To explain differences in firm performance within the same industry, the strategic group model clusters different firms into groups based on a few key strategic dimensions.41 Even within the same industry, firm performances differ depending on strategic group member- ship. Some strategic groups tend to be more profitable than others. This difference implies that firm performance is determined not only by the industry to which the firm belongs, but also by its strategic group membership.

The distinct differences across strategic groups reflect the business strategies that firms pursue. Firms in the same strategic group tend to follow a similar strategy. Companies in the same strategic group, therefore, are direct competitors. The rivalry among firms within the same strategic group is generally more intense than the rivalry among strategic groups: Intra- group rivalry exceeds inter-group rivalry. The number of different business strategies pursued within an industry determines the number of strategic groups in that industry. In most indus- tries, strategic groups can be identified along a fairly small number of dimensions. In many instances, two strategic groups are in an industry based on two different business strategies: one that pursues a low-cost strategy and a second that pursues a differentiation strategy (see Exhibit 3.8). We’ll discuss each of these generic business strategies in detail in Chapter 6.

LO 3-8 Generate a strategic group model to reveal performance differences between clusters of firms in the same industry.

C os

t S tr

uc tu

re

High

Low HighRoutes

Mobility Barrier

Group A Low-cost,

point to point

Group B Differentiated, hub and spoke

Delta United Airlines

American Airlines

Southwest Airlines

JetBlue

Frontier Airlines

Spirit Airlines

Alaska Airlines

EXHIBIT 3.8 Strategic Groups and Mobility Barrier in U.S. Domestic Airline Industry

strategic group The set of companies that pursue a similar strat- egy within a specific industry.

strategic group model A framework that explains differ- ences in firm perfor- mance within the same industry.

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106 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

THE STRATEGIC GROUP MODEL To understand competitive behavior and performance within an industry, we can map the industry competitors into strategic groups. We do this by

■ Identifying the most important strategic dimensions such as expenditures on research and development, technology, product differentiation, product and service offerings, cost structure, market segments, distribution channels, and customer service. These dimensions are strategic commitments based on managerial actions that are costly and difficult to reverse.

■ Choosing two key dimensions for the horizontal and vertical axes, which expose impor- tant differences among the competitors.

■ Graphing the firms in the strategic group, indicating each firm’s market share by the size of the bubble with which it is represented.42

The U.S. domestic airline industry provides an illustrative example. Exhibit 3.8 maps com- panies active in this industry. The two strategic dimensions on the axes are cost structure and routes. As a result of this mapping, two strategic groups become apparent, as indicated by the dashed circles: Group A, low-cost, point-to-point airlines (Alaska Airlines, Frontier Airlines, JetBlue, Southwest Airlines, and Spirit Airlines), and Group B, differentiated air- lines using a hub-and-spoke system (American, Delta, and United). The low-cost, point-to- point airlines are clustered in the lower-left corner because they tend to have a lower cost structure but generally serve fewer routes due to their point-to-point operating system.

The differentiated airlines in Group B, offering full services using a hub-and-spoke route system, comprise the so-called legacy carriers. They are clustered in the upper-right corner because of their generally higher cost structures. The legacy carriers usually offer many more routes than the point-to-point low-cost carriers, made possible by use of the hub-and- spoke system, and thus offer many different destinations. For example, Delta’s main hub is in Atlanta, Georgia.43 If you were to fly from Seattle, Washington, to Miami, Florida, you would likely stop to change planes in Delta’s Atlanta hub on your way.

The strategic group mapping in Exhibit 3.8 provides additional insights:

■ Competitive rivalry is strongest between firms that are within the same strategic group. The closer firms are on the strategic group map, the more directly and intensely they are in competition with one another. After a wave of mergers, the remaining mega-airlines— American, Delta, and United—are competing head-to-head, not only in the U.S. domes- tic market but also globally. They tend to monitor one another’s strategic actions closely. While Delta faces secondary competition from low-cost carriers such as Southwest Air- lines (SWA) on some domestic routes, its primary competitive rivals remain the other legacy carriers. This is because they compete more on providing seamless global ser- vices within their respective airline alliances (SkyTeam for Delta, Oneworld for Ameri- can, and Star Alliance for United) than on low-cost airfares for particular city pairs in the United States. Nonetheless, when Delta is faced with direct competition from SWA on a particular domestic route (say from Atlanta to Chicago), both tend to offer similar low-cost fares.

■ The external environment affects strategic groups differently. During times of economic downturn, for example, the low-cost airlines tend to take market share away from the legacy carriers. Moreover, given their generally higher cost structure, the legacy carriers are often unable to stay profitable during recessions, at least on domestic routes. This implies that external factors such as recessions or high oil prices favor the companies in the low-cost strategic group. On the other hand, given a number of governmental

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 107

restrictions on international air travel, the few airlines that are able to compete globally usually make a tidy profit in this specific industry segment.

■ The five competitive forces affect strategic groups differently. Barriers to entry, for exam- ple, are higher in the hub-and-spoke (differentiated) airline group than in the point-to- point (low-cost) airline group. Following deregulation, many airlines entered the industry, but all of these new players used the point-to-point system. Since hub-and- spoke airlines can offer worldwide service and are protected from foreign competition by regulation to some extent, they often face weaker buyer power, especially from busi- ness travelers. While the hub-and-spoke airlines compete head-on with the point-to- point airlines when they are flying the same or similar routes, the threat of substitutes is stronger for the point-to-point airlines. This is because they tend to be regionally focused and compete with the viable substitutes of car, train, or bus travel. The threat of supplier power tends to be stronger for the airlines in the point-to-point, low-cost stra- tegic group because they are much smaller and thus have weaker negotiation power when acquiring new aircraft, for example. To get around this, these airlines frequently purchase used aircraft from legacy carriers. This brief application of the five forces model leads us to conclude that rivalry among existing competitors in the low-cost, point-to-point strategic group is likely to be more intense than within the differentiated, hub-and-spoke strategic group.

■ Some strategic groups are more profitable than others. Historically, airlines clustered in the lower-left corner tend to be more profitable when considering the U.S. domestic market only. Why? Because they create similar, or even higher, value for their customers in terms of on-time departure and arrival, safety, and fewer bags lost, while keeping their cost structure well below those of the legacy carriers. The point-to-point airlines have generally lower costs than the legacy carriers because they are faster in turning their airplanes around, keep them flying longer, use fewer and older airplane models, focus on high-yield city pairs, and tie pay to company performance, among many other activi- ties that all support their low-cost business model. The point-to-point airlines, therefore, are able to offer their services at a lower cost and a higher perceived value, resulting in more pricing options, and thus creating the basis for a competitive advantage.

MOBILITY BARRIERS Although some strategic groups tend to be more profitable and therefore more attractive than others, mobility barriers restrict movement between groups. These are industry-specific factors that separate one strategic group from another.44 The dimensions to determine a strategic group are mobility barriers, which are strategic commitments. These are actions that are costly and not easily reversed such as the firm’s underlying cost structure because it is based on managerial commitments resulting in hard-to-reverse investments.

The two groups identified in Exhibit 3.8 are separated by the fact that offering interna- tional routes necessitates the hub-and-spoke model. Frequently, the international routes tend to be the remaining profitable routes left for the legacy carriers; albeit the Persian Gulf region carriers, in particular Emirates, Etihad Airways, and Qatar Airways, are beginning to threaten this profit sanctuary.45

This economic reality implies that if carriers in the lower-left cluster wanted to compete globally, they would likely need to change their point-to-point operating model to a hub-and- spoke model. Or they could select a few profitable international routes and service them with long-range aircrafts such as Boeing 787s or Airbus A-380s. Adding international ser- vice to the low-cost model, however, would require managerial commitments resulting in significant capital investments and a likely departure from a well-functioning business

mobility barriers Industry-specific fac- tors that separate one strategic group from another.

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108 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

model. Additional regulatory hurdles reinforce these mobility barriers, such as the difficulty of securing landing slots at international airports around the world.

Despite using its point-to-point operating system, SWA experienced these and many other challenges when it began offering international flights to selected resort destinations such as Aruba, Cabo San Lucas, Cancun, the Bahamas, and Jamaica: changes to its reserva- tion system, securing passports for crew members, cultural-awareness training, learning instructions in foreign languages, and performing drills in swimming pools on how to evacu- ate passengers onto life rafts. All of these additional requirements result in a somewhat higher cost for SWA in servicing international routes.46

3.5 Implications for Strategic Leaders At the start of the strategic management process, it is critical for strategic leaders to con- duct a thorough analysis of the firm’s external environment to identify threats and opportu- nities. The initial step is to apply a PESTEL analysis to scan, monitor, and evaluate changes and trends in the firm’s macroenvironment. This versatile framework allows strategic lead- ers to track important trends and developments based on the source of the external factors: political, economic, sociocultural, technological, ecological, and legal. When applying a PESTEL analysis, the guiding consideration for strategic leaders should be the question of how the external factors identified affect the firm’s industry environment.

Exhibit 3.1 delineates external factors based on the proximity of these external factors by gradually moving from the general to the task environment. The next layer for strategic lead- ers to understand is the industry. Applying Porter’s five forces model allows strategic lead- ers to understand the profit potential of an industry and to obtain clues on how to carve out a strategic position that makes gaining and sustaining a competitive advantage more likely. Follow these steps to apply the five forces model:47

1. Define the relevant industry. In the five forces model, industry boundaries are drawn by identifying a group of incumbent companies that face more or less the same suppliers and buyers. This group of competitors is likely to be an industry if it also has the same entry barriers and a similar threat from substitutes. In this model, therefore, an indus- try is defined by commonality and overlap in the five competitive forces that shape competition.

2. Identify the key players in each of the five forces and attempt to group them into different categories. This step aids in assessing the relative strength of each force. For example, while makers of jet engines (GE, Rolls-Royce, Pratt & Whitney) and local catering ser- vices are all suppliers to airlines, their strengths vary widely. Segmenting different play- ers within each force allows you to assess each force at a fine-grained level.

3. Determine the underlying drivers of each force. Which forces are strong, and which are weak? And why? Keeping with the airline example, why is the supplier power of jet engine manufacturers strong? Because they are supplying a mission-critical, highly dif- ferentiated product for airlines. Moreover, there are only a few suppliers of jet engines worldwide and no viable substitutes.

4. Assess the overall industry structure. What is the industry’s profit potential? Here you need to identify forces that directly influence industry profit potential, because not all forces are likely to have an equal effect. Focus on the most important forces that drive industry profitability.

The final step in industry analysis is to draw a strategic group map. This exercise allows you to unearth and explain performance differences within the same industry. When analyzing a

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 109

firm’s external environment, it is critical to apply the three frameworks introduced in this chapter (PESTEL, Porter’s five forces, and strategic group mapping). Taken together, the external environment can determine up to roughly one-half of the performance differences across firms (see Exhibit 3.2).

Although the different models discussed in this chapter are an important step in the strategic management process, they are not without shortcomings. First, all the models pre- sented are static. They provide a snapshot of what is actually a moving target and do not allow for consideration of industry dynamics. However, changes in the external environment can appear suddenly, for example, through black swan events. Industries can be revolution- ized by innovation. Strategic groups can be made obsolete through deregulation or techno- logical progress. To overcome this important shortcoming, strategic leaders must conduct external analyses at different points in time to gain a sense of the underlying dynamics. The frequency with which these tools need to be applied is a function of the rate of change in the industry. The mobile app industry is changing extremely fast, while the railroad industry experiences a less volatile environment.

Second, the models presented in this chapter do not allow strategic leaders to fully under- stand why there are performance differences among firms in the same industry or strategic group. To better understand differences in firm performance, we must look inside the firm to study its resources, capabilities, and core competencies. We do this in the next chapter by moving from external to internal analysis.

EVEN THOUGH AIRBNB IS, at $31 billion, one of the most valuable private startups in the world and offers more accom- modations than the three largest hotel chains (Marriott, Hilton, and Intercontinental) combined, not all is smooth sailing. In particular, PESTEL factors discussed in this chapter are creat- ing major headwinds for Airbnb. Take regulation, for example.

In 2016, New York state strengthened legislation first passed in 2010 that makes it illegal to rent out entire apartments in residential blocks in New York City for less than 30 days. It remains legal if the renter is living in the apartment at the same time, so “true space sharing” is still possible. Fines start at $1,000 for the first offense and rise to $7,500 for repeat offend- ers. Paris, Berlin, and Barcelona face similar problems and have passed laws with even stiffer penalties, fining offenders up to $100,000. This legislation creates major problems for Airbnb because New York City is by far its largest market, with more than 50,000 accommodations available for rent. In 2018, the city of New York went a step further and sued residential bro- kerage firms (as well as some of their employees) for allegedly using Airbnb in an illegal apartment rental scheme that earned them an estimated $20 million.

The issue for Airbnb is that about one-third of its listings in major metropolitan areas such as New York City are from

hosts with multiple offerings in the same city. Commercial landlords realized quickly that it is more profitable to convert some apartments into short-term rentals and to offer them via Airbnb than to sign long-term rentals with just one ten- ant, which often fall under some form of rent control. Al- though this tactic increases the landlord’s return on investment and profits, it creates all kinds of negative exter- nalities. Neighbors complain about noisy tourists partying all night. Some apartments get ransacked or are used for illegal activities such as drug deals and prostitution. New Yorkers expressed their frustration by scrawling on Airbnb posters: “The dumbest person in your building is passing out keys to your front door!”48

Hotel chains and resort owners have challenged Airbnb in courts and lobbied local governments to pass regulations to limit or prohibit short-term rentals—some of which already have. Residents in New York City, San Francisco, Berlin, Paris, and many other cities have joined this lobby, arguing that companies like Airbnb contribute to a shortage of afford- able housing because they turn entire apartment complexes into hotels and quiet family neighborhoods into daily, all- night party venues. Airbnb is also being criticized for acceler- ating gentrification in some cities.49

CHAPTERCASE 3 Part II

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Is My New Job Going to Be Around in the Next 10 Years?

W hen we think about starting a new job, say, as we finish up a college degree, traditionally it is advis-able to check out the relevant industry trends first. For instance, raises and promotion opportunities tend to be more abundant in industries that are growing rather than retracting. Overall, professional pay scales are better in industries with higher profit margins (such as financial services and pharmaceuticals) than lower profits (such as retailing). Today though, other technological, global, and environmental factors should be considered. We can see examples of ride-hailing firms upending the taxi and rental car industries and online retailing diminishing brick and mor- tar stores, but what do these changes portend for the employment market? A full-time taxi driver used to be a pathway to the middle class in the United States and many other countries. Now these jobs are being replaced by “gig economy” workers, who often have it as a second or third job to try to make ends meet. 

Autonomous driving could have significant impacts on employment options across the entire transportation sector.

However, far more wide-reaching is the still-developing role of artificial intelligence (AI) on business, governments, and the economy as a whole. There are widely ranging view- points on how the inevitable increase of AI will impact the national and global labor markets in the coming years. Thus, there are technological uncertainties for this generation that while not unique, will likely have major effects on employ- ment paths moving forward.

1. Many people approach the job market by thinking about particular firms. What are some advantages of broaden- ing this thought process to consider the industry-level factors of a potential new employer?

2. What industries do you think may offer the best U.S. (or domestic) job opportunities in the future? Which indus- tries do you think may offer the greatest job opportuni- ties in the global market in the future? Use the PESTEL framework and the five forces model to think through a logical set of reasons that some fields will have higher job growth trends than others.

3. Do these types of macroenvironmental and industry trends affect your thinking about selecting a career field after college? Why or why not? Explain.

mySTRATEGY

Questions 1. How was an internet startup able to disrupt the hotel

industry, long dominated by giants such as Marriott and Hilton, which took decades to become successful worldwide hospitality chains? Explain.

2. Why is it that PESTEL factors can have such a strong impact on the future of a business? Do you support legis- lation such as that passed in New York (and elsewhere), or do you think it has more to do with protecting vested interests such as the hotel industry?

3. Citing the Digital Millennium Copyright Act (DMCA), Airbnb is challenging the New York law and others in the United States, arguing that it merely operates a digi- tal marketplace, and thus is not responsible for the con- tent that users place on its site. Do you think Airbnb has a strong argument? Why or why not?

4. Are you concerned that the concept of the sharing econ- omy could be abused by unscrupulous “entrepreneurs” and thus give the entire novel concept a bad reputation? Why or why not? Explain.

110

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 111

This chapter demonstrated various approaches to ana- lyzing the firm’s external environment, as summarized by the following learning objectives and related take- away concepts.

LO 3-1 / Generate a PESTEL analysis to evaluate the impact of external factors on the firm. ■ A firm’s macroenvironment consists of a wide

range of political, economic, sociocultural, techno- logical, ecological, and legal (PESTEL) factors that can affect industry and firm performance. These external factors have both domestic and global aspects.

■ Political factors describe the influence governmen- tal bodies can have on firms.

■ Economic factors to be considered are growth rates, interest rates, levels of employment, price stability (inflation and deflation), and currency exchange rates.

■ Sociocultural factors capture a society’s cultures, norms, and values.

■ Technological factors capture the application of knowledge to create new processes and products.

■ Ecological factors concern a firm’s regard for environmental issues such as the natural environ- ment, global warming, and sustainable economic growth.

■ Legal factors capture the official outcomes of the political processes that manifest themselves in laws, mandates, regulations, and court decisions.

LO 3-2 / Differentiate the roles of firm effects and industry effects in determining firm performance. ■ A firm’s performance is more closely related to

its managers’ actions (firm effects) than to the external circumstances surrounding it (industry effects).

■ Firm and industry effects, however, are interdepen- dent. Both are relevant in determining firm perfor- mance.

LO 3-3 / Apply Porter’s five competitive forces to explain the profit potential of different industries. ■ The profit potential of an industry is a function of

the five forces that shape competition: (1) threat

of entry, (2) power of suppliers, (3) power of buyers, (4) threat of substitutes, and (5) rivalry among existing competitors.

■ The stronger a competitive force, the greater the threat it represents. The weaker the competitive force, the greater the opportunity it presents.

■ A firm can shape an industry’s structure in its favor through its strategy.

LO 3-4 / Examine how competitive industry structure shapes rivalry among competitors. ■ The competitive structure of an industry is largely

captured by the number and size of competitors in an industry, whether the firms possess some degree of pricing power, the type of product or service the industry offers (commodity or differentiated product), and the height of entry barriers.

■ A perfectly competitive industry is characterized by many small firms, a commodity product, low entry barriers, and no pricing power for individual firms.

■ A monopolistic industry is characterized by many firms, a differentiated product, medium entry bar- riers, and some pricing power.

■ An oligopolistic industry is characterized by few (large) firms, a differentiated product, high entry barriers, and some degree of pricing power.

■ A monopoly exists when there is only one (large) firm supplying the market. In such instances, the firm may offer a unique product, the barriers to entry may be high, and the monopolist usually has considerable pricing power.

LO 3-5 / Describe the strategic role of complements in creating positive-sum co-opetition. ■ Co-opetition (cooperation among competitors)

can create a positive-sum game, resulting in a larger pie for everyone involved.

■ Complements increase demand for the primary product, enhancing the profit potential for the in- dustry and the firm.

■ Attractive industries for co-opetition are character- ized by high entry barriers, low exit barriers, low buyer and supplier power, a low threat of substi- tutes, and the availability of complements.

TAKE-AWAY CONCEPTS

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112 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

LO 3-6 / Explain the five choices required for market entry. ■ The more profitable an industry, the more attrac-

tive it becomes to competitors, who must consider the who, when, how, what, and where of entry.

■ The five choices constitute more than parts of a single decision point; their consideration forms a strategic process unfolding over time. Each choice involves multiple decisions including many dimensions.

■ Who includes questions about the full range of stakeholders, and not just competitors; when, ques- tions about the industry life cycle; how, about over- coming barriers to entry; what, about options among product market, value chain, geography, and business model; and where, about product po- sitioning, pricing strategy, and potential partners.

LO 3-7 / Appraise the role of industry dynamics and industry convergence in shaping the firm’s external environment. ■ Industries are dynamic—they change over time. ■ Different conditions prevail in different industries,

directly affecting the firms competing in these in- dustries and their profitability.

■ In industry convergence, formerly unrelated indus- tries begin to satisfy the same customer need. Such convergence is often brought on by techno- logical advances.

LO 3-8 / Generate a strategic group model to reveal performance differences between clusters of firms in the same industry. ■ A strategic group is a set of firms within a specific

industry that pursue a similar strategy in their quest for competitive advantage.

■ Generally, there are two strategic groups in an in- dustry based on two different business strategies: one that pursues a low-cost strategy and a second that pursues a differentiation strategy.

■ Rivalry among firms of the same strategic group is more intense than the rivalry between strategic groups: intra-group rivalry exceeds inter-group rivalry.

■ Strategic groups are affected differently by the ex- ternal environment and the five competitive forces.

■ Some strategic groups are more profitable than others.

■ Movement between strategic groups is restricted by mobility barriers—industry-specific factors that separate one strategic group from another.

PESTEL model (p. 75) Strategic commitments (p. 94) Strategic group (p. 105) Strategic group model (p. 105) Strategic position (p. 82) Threat of entry (p. 84)

Competitive industry structure (p. 90)

Complement (p. 99) Complementor (p. 99) Co-opetition (p. 99) Entry barriers (p. 84) Exit barriers (p. 94) Firm effects (p. 81)

Five forces model (p. 82) Industry (p. 81) Industry analysis (p. 82) Industry convergence (p. 102) Industry effects (p. 81) Mobility barriers (p. 107) Network effects (p. 85) Nonmarket strategy (p. 76)

KEY TERMS

DISCUSSION QUESTIONS 1. Why is it important for any organization (firms,

nonprofits, etc.) to study and understand its exter- nal environment?

2. How do the five competitive forces in Porter’s model affect the average profitability of an indus- try? For example, in what way might weak forces

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 113

increase industry profits, and in what way do strong forces reduce industry profits? Identify an industry in which many of the competitors seem to be having financial performance problems. Which of the five forces seems to be strongest?

3. This chapter covers the choices firms make in en- tering new markets. Reflect on ChapterCase 3 and

discuss how Airbnb might have answered these questions in Exhibit 3.6.

4. How do mobility barriers affect the structure of an industry? How do they help us explain differences in firm performance?

1. As quoted in Parker, G.G., M.W. Van Alstyne, S.P. Choudary (2016), Platform Revolution: How Networked Markets Are Transforming the Economy—And How to Make Them Work for You (New York: Norton).

2. This ChapterCase is based on: “All eyes on the sharing economy,” The Economist (2013, Mar. 9); “New York deflates Airbnb,” The Economist (2016, Oct. 27); Austin, S., C. Canipe, and S. Slobin (2015, Feb. 18), “The billion dollar startup club,” The Wall Street Journal (updated January 2017), http://graph- ics.wsj.com/billion-dollar-club/; Parker, G.G., M.W. Van Alstyne, S.P. Choudary (2016), Platform Revolution: How Networked Markets Are Transforming the Economy—And How to Make Them Work for You (New York: Norton); Pressler, J. (2014, Sept. 23), “The dumbest per- son in your building is passing out keys to your front door!” New York; Stone, B. (2017), The Upstarts: How Uber, Airbnb, and the Killer Companies of the New Silicon Valley Are Changing the World (New York: Little, Brown and Co.); Tabarrok, A. (2017, Jan. 30), “How Uber and Airbnb won,” The Wall Street Journal. “Interview with Brian Chesky, co- founder and CEO Airbnb.” (34:24 min) Code 2018. Recode, www.youtube.com/ watch?v=nc90n-6dQRo&t=673s.

3. For a detailed treatise on how institutions shape the economic climate and with it firm performance, see: North, D.C. (1990), Institutions, Institutional Change, and Economic Performance (New York: Random House).

4. De Figueireo, R.J.P., and G. Edwards (2007), “Does private money buy public pol- icy? Campaign contributions and regulatory outcomes in telecommunications,” Journal of Economics & Management Strategy 16: 547–576; and Hillman, A.J., G. D. Keim, and D. Schuler (2004), “Corporate political activity: A review and research agenda,” Journal of Management 30: 837–857.

5. Lowenstein, R. (2010), The End of Wall Street (New York: Penguin Press).

6. Brynjolfsson, E., and A. McAfee (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: Norton).

7. “Professor Emeritus Milton Friedman dies at 94,” University of Chicago press release (2006, Nov. 16).

8. Lucas, R. (1972), “Expectations and the neutrality of money,” Journal of Economic Theory 4: 103–124.

9. U.S. Census Bureau (2017, Jul. 1), “Population estimates,” www.census.gov/ quickfacts/fact/table/US/PST045217; “Media companies are piling into the Hispanic mar- ket. But will it pay off?” The Economist (2012, Dec. 15).

10. Woolley, J.L., and R. M. Rottner (2008), “Innovation policy and nanotech entrepreneur- ship,” Entrepreneurship Theory and Practice 32: 791–811; and Rothaermel, F.T., and M. Thursby (2007), “The nanotech vs. the biotech revolution: Sources of incumbent productivity in research,” Research Policy 36: 832–849.

11. See for example: Brynjolfsson, E., and A. McAfee (2014). The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: W. W. Norton & Co.); and McAfee, A., and E. Brynjolfsson (2017). Machine, Platform, Crowd: Harnessing Our Digital Future 1st ed., Kindle edition (New York: W. W. Norton & Co.).

12. Afuah, A. (2009), Strategic Innovation: New Game Strategies for Competitive Advantage (New York: Routledge); Hill, C.W.L., and F.T. Rothaermel (2003), “The performance of in- cumbent firms in the face of radical techno- logical innovation,” Academy of Management Review 28: 257–274; and Bettis, R., and M.A. Hitt (1995), “The new competitive landscape,” Strategic Management Journal 16 (Special Issue): 7–19.

13. For an in-depth discussion of technologi- cal changes in the media industry, see: Rothaermel, F.T., and A. Guenther (2018),

Netflix, Inc., case study MH0043, http://create. mheducation.com; and Sandomirjune, R. (1991, Jun. 9), “Entrepreneurs: Wayne Huizenga’s growth complex,” The New York Times Magazine; “Blockbuster files for bank- ruptcy,” The Economist (2010, Sept. 23); Gandel, S. (2010, Oct. 17), “How Blockbuster failed at failing,” Time; Satel, G. (2014, Sept. 5), “A look back at why Blockbuster really failed and why it didn’t have to,” Forbes; Schmidt, S. (2017, Apr. 26), “Blockbuster has survived in the most curious of places—Alaska,” The Washington Post.

14. Academy of Management, ONE Division, 2013 domain statement; Anderson, R.C. (2009), Confessions of a Radical Industrialist: Profits, People, Purpose—Doing Business by Respecting the Earth (New York: St. Martin’s Press); and Esty, D.C., and A.S. Winston (2009), Green to Gold: How Smart Companies Use Environmental Strategy to Innovate, Create Value, and Build Competitive Advantage, revised and updated (Hoboken, NJ: John Wiley & Sons).

15. This interesting debate unfolds in the fol- lowing articles, among others: Misangyi, V.F., H. Elms, T. Greckhamer, and J.A. Lepine (2006), “A new perspective on a fundamental debate: A multilevel approach to industry, cor- porate, and business unit effects,” Strategic Management Journal 27: 571–590; Hawawini, G., V. Subramanian, and P. Verdin (2003), “Is performance driven by industry- or firm- specific factors? A new look at the evidence,” Strategic Management Journal 24: 1–16; McGahan, A.M., and M.E. Porter (1997), “How much does industry matter, really?” Strategic Management Journal 18: 15–30; Rumelt, R.P. (1991), “How much does indus- try matter?” Strategic Management Journal 12: 167–185; and Hansen, G.S., and B. Wernerfelt (1989), “Determinants of firm performance: The relative importance of economic and orga- nizational factors,” Strategic Management Journal 10: 399–411.

ENDNOTES

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114 CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups

16. The discussion in this section is based on: Magretta, J. (2012), Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston: Harvard Business Review Press); Porter, M.E. (2008, January), “The five competitive forces that shape strategy,” Harvard Business Review; Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press); and Porter, M.E. (1979, March–April), “How competitive forces shape strategy,” Harvard Business Review: 137–145.

17. Hull, D. (2014, Jul. 22), “Tesla idles Fremont production line for Model X upgrade,” San Jose Mercury News; and Vance, A. (2013, Jul. 18), “Why everybody loves Tesla,” Bloomberg Businessweek.

18. Ramsey, M. (2014, Sept. 3), “Tesla to choose Nevada for battery factory,” The Wall Street Journal.

19. Ramsey, M. (2014, Feb. 26), “Tesla plans $5 billion battery factory,” The Wall Street Journal.

20. Walsh, T. (2014, Sept. 2), “The cult of Tesla Motors Inc: Why this automaker has the most loyal customers,” The Motley Fool.

21. “Tesla Model S road test,” Consumer Reports, www.consumerreports.org/cro/tesla/ model-s/road-test.htm.

22. Wang, U. (2013, Nov. 5), “Tesla considers building the world’s biggest lithium-ion battery factory,” Forbes.

23. Whether a product is a substitute (comple- ment) can be estimated by the cross-elasticity of demand. The cross-elasticity estimates the percentage change in the quantity demanded of good X resulting from a 1 percent change in the price of good Y. If the cross-elasticity of demand is greater (less) than zero, the prod- ucts are substitutes (complements). For a de- tailed discussion, see: Allen, W.B., K. Weigelt, N. Doherty, and E. Mansfield (2009), Managerial Economics Theory, Application, and Cases, 7th ed. (New York: Norton).

24. This example, as with some others in the section on the five forces, is drawn from: Magretta, J. (2012), Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston: Harvard Business Review Press).

25. Because the threat of entry is one of the five forces explicitly recognized in Porter’s model, we discuss barriers to entry when in- troducing the threat of entry above. The com- petitive industry structure framework is frequently referred to as the structure- conduct-performance (SCP) model. For a detailed discussion, see: Allen, W.B., K. Weigelt, N. Doherty, and E. Mansfield (2009), Managerial Economics Theory,

Application, and Cases, 7th ed. (New York: Norton); Carlton, D.W., and J.M. Perloff (2000), Modern Industrial Organization, 3rd ed. (Reading, MA: Addison-Wesley); Scherer, F.M., and D. Ross (1990), Industrial Market Structure and Economic Performance, 3rd ed. (Boston: Houghton Mifflin); and Bain, J.S. (1968), Industrial Organization (New York: John Wiley & Sons).

26. Besanko, D., E. Dranove, M. Hanley, and S. Schaefer (2010), The Economics of Strategy, 5th ed. (Hoboken, NJ: John Wiley & Sons).

27. Dixit, A., S. Skeath, and D.H. Reiley (2009), Games of Strategy, 3rd ed. (New York: Norton).

28. When there are only two main competi- tors, it’s called a duopoly and is a special case of oligopoly.

29. Yoffie, D.B., and R. Kim (2011, June), “Coca-Cola in 2011: In Search of a New Model,” Harvard Business School Case 711- 504 (revised August 2012). See also: Yoffie, D.B., and Y. Wang (2002, January), “Cola Wars Continue: Coke and Pepsi in the Twenty- First Century,” Harvard Business School Case 702-442 (revised January 2004, et seq).

30. “Trustbusting in the internet age: Should digital monopolies be broken up?” The Economist (2014, Nov. 29); and “Internet mo- nopolies: Everybody wants to rule the world,” The Economist (2014, Nov. 29).

31. See: Chang, S-J., and B. Wu (2013), “Institutional barriers and industry dynamics,” Strategic Management Journal 35: 1103–1123. Discussion of this new and insightful research offers an opportunity to link the PESTEL analy- sis to the five forces analysis. The study focuses on the competitive interaction between incum- bents and new entrants as a driver of industry evolution. It investigates the impact of institu- tional characteristics (political, legal, and socio- cultural norms in PESTEL analysis) unique to China on productivity and exit hazards of in- cumbents versus new entrants. China’s environ- ment created a divergence between productivity and survival that shaped industry evolution. It also offers an illustration of the role that liability of newness plays in new entrant survival.

32. This example is drawn from: Porter, M.E. (2008), “The five competitive forces that shape strategy,” An Interview with Michael E. Porter: The Five Competitive Forces that Shape Strategy, Harvard BusinessPublishing video; “Everyone else in the travel business makes money off airlines,” The Economist (2012, Aug. 25); “How airline ticket prices fell 50% in 30 years (and nobody noticed),” The Atlantic (2013, Feb. 28); U.S. gallon of jet fuel prices; author’s interviews with Delta Air Lines executives.

33. Wall, R. (2019, Feb. 14), “Airbus to retire the A380, the superjumbo that never quite took off,” The Wall Street Journal.

34. Brandenburger, A.M., and B. Nalebuff (1996), Co-opetition (New York: Currency Doubleday); and Grove, A.S. (1999), Only the Paranoid Survive (New York: Time Warner).

35. Milgrom, P., and J. Roberts (1995), “Complementarities and fit strategy, structure, and organizational change in manufacturing,” Journal of Accounting and Economics 19, no. 2-3: 179–208; and Brandenburger, A.M., and B. Nalebuff (1996), Co-opetition (New York: Currency Doubleday).

36. In this recent treatise, Porter also high- lights positive-sum competition. See: Porter, M.E. (2008, January), “The five competitive forces that shape strategy,” Harvard Business Review.

37. This discussion is based on: Zachary, M.A., P.T. Gianiodis, G. Tyge Payne, and G.D. Markman (2014), “Entry timing: Enduring les- sons and future directions,” Journal of Management 41: 1388–1415; and Bryce, D.J., and J.H. Dyer (2007, May), “Strategies to crack well-guarded markets,” Harvard Business Review: 84-92. I also gratefully acknowledge the additional input received by Professors Zachary, Gianiodis, Tyge Payne, and Markman.

38. “Reading between the lines,” The Economist (2009, Mar. 26); and “New York Times is near web charges,” The Wall Street Journal (2010, Jan. 19).

39. Based on: Chokshi, N. (2018, Aug. 27), “What you might not know about e-sports, soon to be a $1 billion industry,” The New York Times; Grey, A. (2018, July 3), “The explosive growth of eSports,” World Economic Forum; Fisher, S.D. (2014, January/February), “The rise of eSports: League of Legends article se- ries,” white paper, Foster Pepper PLLC; Segal, D. (2014, Oct. 10), “Behind League of Legends, e-sports’ main attraction,” The New York Times; and data drawn from statista.com and “How much money does League of Legends make?” www.youtube.com/ watch?v=1ug-YKLwkaA.

40. Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press); Hatten, K.J., and D.E. Schendel (1977), “Heterogeneity within an industry: Firm con- duct in the U.S. brewing industry,” Journal of Industrial Economics 26: 97–113; and Hunt, M.S. (1972), Competition in the Major Home Appliance Industry, 1960–1970, unpublished doctoral dissertation, Harvard University.

41. This discussion is based on: McNamara, G., D.L. Deephouse, and R. Luce (2003),

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 115

“Competitive positioning within and across a strategic group structure: The performance of core, secondary, and solitary firms,” Strategic Management Journal 24: 161–181; Nair, A., and S. Kotha (2001), “Does group member- ship matter? Evidence from the Japanese steel industry,” Strategic Management Journal 22: 221–235; Cool, K., and D. Schendel (1988), “Performance differences among strategic group members,” Strategic Management Journal 9: 207–223; Hunt, M.S. (1972), Competition in the Major Home Appliance Industry, 1960–1970, unpublished doctoral dis- sertation, Harvard University; Hatten, K.J., and D.E. Schendel (1977), “Heterogeneity within an industry: Firm conduct in the U.S. brewing industry,” Journal of Industrial Economics 26: 97–113; and Porter, M.E. (1980), Competitive Strategy: Techniques for

Analyzing Industries and Competitors (New York: Free Press), 102.

42. In Exhibit 3.8, United Airlines is the big- gest bubble because it merged with Continental in 2010, creating the largest airline in the United States. Delta is the second- biggest airline in the United States after merging with Northwest Airlines in 2008.

43. American’s hub is at Dallas-Fort Worth; Continental’s is at Newark, New Jersey; United’s is at Chicago; and U.S. Airways’ is at Charlotte, North Carolina.

44. Caves, R.E., and M.E. Porter (1977), “From entry barriers to mobility barriers,” Quarterly Journal of Economics 91: 241–262.

45. Carey, S. (2015, Mar. 16.), “U.S. airlines battling gulf carriers cite others’ experience,” The Wall Street Journal.

46. Carey, S. (2014, Oct. 14), “Steep learning curve for Southwest Airlines as it flies over- seas,” The Wall Street Journal.

47. Porter, M.E. (2008, January), “The five competitive forces that shape strategy,” Harvard Business Review; and Magretta, J. (2012), Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston: Harvard Business Review Press): 56–57.

48. Pressler, J. (2014, Sept. 23), “The dumbest person in your building is passing out keys to your front door!” New York Magazine.

49. Greenberg, Z. (2018, Jul. 18), “New York City looks to crack down on Airbnb amid housing crisis,” The New York Times; and Barbanel, J. (2018, Nov. 11), “New York City raids condo building in crackdown on Airbnb rentals,” The Wall Street Journal.

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Chapter Outline

4.1 From External to Internal Analysis

4.2 Core Competencies Resources and Capabilities

4.3 The Resource-Based View Resource Heterogeneity and Resource Immobility The VRIO Framework Isolating Mechanisms: How to Sustain a Competitive Advantage

4.4 The Dynamic Capabilities Perspective Core Rigidities Dynamic Capabilities Resource Stocks and Resource Flows

4.5 The Value Chain and Strategic Activity Systems The Value Chain Strategic Activity Systems

4.6 Implications for Strategic Leaders Using SWOT Analysis to Generate Insights from External and Internal Analysis

CHAPTER

4 Learning Objectives

After studying this chapter, you should be able to:

LO 4-1 Explain how shifting from an external to internal analysis of a firm can reveal why and how internal firm differences are the root of competitive advantage.

LO 4-2 Differentiate among a firm’s core competencies, resources, capabilities, and activities.

LO 4-3 Compare and contrast tangible and intangible resources.

LO 4-4 Evaluate the two critical assumptions about the nature of resources in the resource-based view.

LO 4-5 Apply the VRIO framework to assess the competitive implications of a firm’s resources.

LO 4-6 Evaluate different conditions that allow a firm to sustain a competitive advantage.

LO 4-7 Outline how dynamic capabilities can enable a firm to sustain a competitive advantage.

LO 4-8 Apply a value chain analysis to understand which of the firm’s activities in the process of transforming inputs into outputs generate differentiation and which drive costs.

LO 4-9 Identify competitive advantage as residing in a network of distinct activities.

LO 4-10 Conduct a SWOT analysis to generate insights from external and internal analysis and derive strategic implications.

Internal Analysis: Resources, Capabilities, and Core Competencies

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117

Five Guys’ Core Competency: “Make the Best Burger, Don’t Worry about Cost”

JERRY MURRELL, the founder of Five Guys Burgers and Fries, grew up in northern Michigan. He attended a Catho- lic high school and did so poorly academically that one of the nuns told him, “If you don’t study, you’ll be flipping burgers.”1 Little did she know that this prophecy would be- come reality. Today, Five Guys claims the title of the fastest- growing restaurant chain in the United States, with some 1,500 locations worldwide and revenues of $2 billion. And Jerry Murrell’s personal net worth is hundreds of millions of dollars. How did this come about?

In the 1980s, while looking for entrepreneurial opportu- nities in the Washington, D.C., area, Jerry Murrell was sell- ing insurance. During his leisure time, he and his family would often visit nearby Ocean City, Maryland, where the boardwalk was filled with fast food vendors—many of them selling fries—but only one always had a long line in front of it: Thrashers. One day while reading the text on the potato bags, Murrell noticed the potatoes came from Rick Miles in Rigby, Idaho. The Thrashers encounter brought back mem- ories of Push ’Em Up Tony, a hamburger stand in Murrell’s Michigan hometown. Although it offered only hamburgers, people from all over town would drive to Tony’s for burgers. Murrell has always loved burgers and fries, so, while ob- serving Thrashers in action and recalling good times at Push ’Em Up Tony, he came up with an idea: Open a stand that offers only hamburgers and fries. Keep it simple—this might work.

Murrell excitedly shared his idea with his wife, Janie, but she was not impressed and told him he’d be better off keeping his day job. Her reaction left him undeterred. He went on to seek funding from banks for his new venture, but they all thought he was crazy for wanting to go up against such multinational fast food giants as McDonald’s and Burger King. Still determined and with one last op- tion to explore, Murrell asked his two older sons, who were both in high school at the time, whether they wanted to go to college. Both boys said they’d rather do some- thing else. With that, Murrell took their college fund and used it to open the first Five Guys store in Arlington, Virginia, in 1986.

Murrell named the hamburger joint after himself and his four sons at the time (a fifth son would arrive later). From the get-go, they opted not to put a lot of money into the business, to find a place out of the way where the rent was low, and to focus on making the best burgers and fries. They reasoned that if people started buying their product and kept buying it, then they would know that their burg- ers and fries were good. They also decided not to spend any money on marketing, figuring that their customers would be their best salespeople. To their surprise, their little hole-in-the-wall offering takeout-only burgers and fries became instantly popular and profitable.

For the next few years, Five Guys focused on the nuts and bolts of the hamburger business. They obsessed about every detail: store layout and design, the quality of the buns and never-frozen beef, how to fry the potatoes and from where they should be sourced (they eventually set- tled on Rick Miles in Idaho, the Thrashers supplier). Murrell even had his sons conduct a blind taste test of 16 varieties of mayonnaise to find the perfect one. The winner was the most expensive brand, which was supplied by only one vendor who was notorious for being difficult to deal with, but they went with it, taking to heart their father’s instructions: “Make the best burger. Don’t worry about cost.”

Five Guys burgers are made to order and can be cus- tomized with 15 fresh toppings, including grilled mush- rooms, green peppers, and jalapenos, all of which can be added at no extra charge. The focus on making the best burgers and fries has resulted in a higher cost structure than that of the fast-casual restaurant segment, which in- cludes Shake Shack and Smashburger. Additionally, Five Guys prices are based on actual ingredient costs plus mar- gin; therefore, the prices are not only several times more than what you would pay for a fast food burger, but they also fluctuate based on the cost of inputs. Not once, how- ever, did the Murrells worry about jeopardizing the quality of their product to keep prices low or even consistent—not even when, in 2005, a hurricane destroyed most of the tomato crop in Florida, causing prices for this ingredient to increase almost threefold.

It took the Murrells 17 years to perfect their recipe for success. During that time, they had only five stores in the Washington, D.C., area, all owned and operated by the fam- ily. Despite Jerry Murrell’s strong opposition, his boys con- vinced him to start franchising. He was partly persuaded to

CHAPTERCASE 4 Part I

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118

do so after reading Franchising for Dummies by Wendy’s founder Dave Thomas.

As Exhibit 4.1 shows, by 2003, Five Guys was ready for prime time. Within just 18 months, all regional franchises in the United States were sold out. By 2010, Five Guys started moving beyond the United States, first to Canada and then to the United Kingdom in 2013. During 2015– 2018, Five Guys’ international expansion picked up speed with store openings in France, Ireland, Kuwait, United Arab Emirates, Saudi Arabia, and Spain. Within the next

five years, Five Guys is planning to expand into 20 more countries.

While Jerry and Janie Murrell are now retired, their five sons and now also their grandchildren are involved in leadership positions in the company. Despite now being a global, multibil- lion-dollar enterprise, Five Guys is still owned and operated by the Murrell family. And the nun who taught Jerry in high school was right: He ended up flipping burgers for the rest of his life.2

Part II of this ChapterCase appears in Section 4.6.

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1986 Five Guys

opens first store 

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2019

Five Guys has 1,500 stores with another

1,500 locations in development.

International presence in

Canada, Europe, Hong Kong, the Middle East, and

the UK.

Annual revenues of $2 billion.

N um

be r o

f S to

re s

ONE OF THE KEY messages of this chapter is that a firm’s ability to gain and sus- tain competitive advantage is partly driven by core competencies—unique strengths that are embedded deep within a firm. Core competencies allow a firm to differenti-

ate its products and services from those of its rivals, creating higher value for the customer or offering products and services of comparable value at lower cost.

How was Five Guys so successful in a highly competitive industry dominated by fast food giants like McDonald’s and Burger King, as well as direct competitors claiming to be “better burger” joints such as Smashburger, BurgerFi, and Shake Shack? By some estimates, Five Guys captured 50 percent of the market share in the “better burger” segment in the 2010s.3 How did Five Guys achieve a cult-like following despite having higher menu prices and longer wait times? In short, how did Five Guys gain and sustain a competitive advan- tage in this highly competitive industry? The answer to all these questions is found in Five Guys’ core competency: delivering a customized, made-to-order burger and hand-cut fries using only the highest-quality ingredients available.

EXHIBIT 4.1 Five Guys’ Growth in Number of Stores, 1986–2019

Source: Author’s depiction of publicly available data (fitted trend line).

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 119

To gain a better understanding of why and how differences within firms are at the root of competitive advantage, we begin this chapter by shifting the focus from an outward- looking external analysis to an inward-looking internal analysis of the firm. Next, we closely examine a firm’s core competencies. We then introduce the resource-based view of the firm to provide an analytical model that allows us to assess resources, capabilities, and competencies and their potential for creating a sustainable competitive advantage. Subse- quently, we discuss the dynamic capabilities perspective, a model that emphasizes a firm’s ability to modify and leverage its resource base to gain and sustain a competitive advan- tage in a constantly changing environment. We then turn our attention to the value chain analysis to gain a deeper understanding of the internal activities a firm engages in when transforming inputs into outputs. Next, we take a closer look at strategic activity systems. Here, a firm’s competitive advantages resides in a network of interconnected and reinforc- ing activities. We conclude with Implications for Strategic Leaders, with a particular focus on how to use a SWOT analysis to obtain strategic insights from combining external with internal analysis.

4.1 From External to Internal Analysis In this chapter, we study analytical tools to explain why differences in firm performance exist even within the same industry. For example, why does Five Guys outperform McDonald’s, Burger King, In-N-Out Burger, Smashburger, and others in the (hamburger) restaurant industry? Since these companies compete in the same industry and face similar external opportunities and threats, the source for some of the observable performance difference must be found inside the firm. In Chapter 3, when discussing industry, firm, and other effects in the context of superior performance, we noted that up to 55 percent of the overall performance differences is explained by firm-specific effects (see Exhibit 3.2). Therefore, looking inside the firm to analyze its resources, capabilities, and core compe- tencies allows us to understand the firm’s strengths and weaknesses. Linking these insights from a firm’s internal analysis to the ones from an external analysis allows manag- ers to determine their strategic options. Ideally, strategic leaders want to leverage their firms’ internal strengths to exploit external opportunities, and to mitigate internal weak- nesses and external threats.

Exhibit 4.2 depicts how and why we move from the firm’s external environment to its internal environment. To formulate and implement a strategy that enhances the firm’s chances of gaining and sustaining competitive advantage, the firm must have certain types of resources and capabilities that combine to form core competencies. The best firms con- scientiously identify their core competencies, resources, and capabilities to survive and suc- ceed. Firms then determine how to manage and develop internal strengths to respond to the challenges and opportunities in their external environment. In particular, firms conduct the evaluation and development of internal strengths in the context of external PESTEL forces and competition within its industry through application of the five forces model and the strategic group map (see Chapter 3).

The firm’s response must be dynamic. Rather than creating a onetime and thus a static fit, the firm’s internal strengths need to change with its external environment in a dynamic fashion. At each point the goal should be to develop resources, capabilities, and competen- cies that create a strategic fit with the firm’s environment. The forward motion and overall

LO 4-1 Explain how shifting from an external to internal analysis of a firm can reveal why and how internal firm differences are the root of competitive advantage.

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120 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

trends of those environmental forces must also be considered. The rest of this chapter will provide a deeper understanding of the sources of competitive advantage that reside within a firm.

4.2 Core Competencies Products and services make up the visible side of competition. But residing deep within the firm lies a diverse set of invisible elements around which companies also compete; these are the core competencies. Core competencies are unique strengths embedded deep within a firm (see Exhibit 4.2). Core competencies allow a firm to differentiate its prod- ucts and services from those of its rivals, creating higher value for the customer or offer- ing products and services of comparable value at lower cost. Core competencies find their expression in the structures, processes, and routines that strategic leaders put in place. The important point here is that competitive advantage is frequently the result of a firm’s core competencies.4

Take Five Guys, featured in the ChapterCase, as an example of a company with a clearly defined core competency: A superior ability to deliver fresh, customized hamburgers as well as hand-cut fries using only the highest quality ingredients. By doing things differently than rivals, Five Guys was able to build and hone its core competency over a long period. Strat- egy is as much about deciding to do things differently from rivals, as it is about deciding not to do certain things at all. From the start, Five Guys was clear and consistent about what it would do and what it would not do.

What did Five Guys decide to do? Five Guys sources only the highest quality ingredients, including fresh, never frozen ground beef for its burgers; freshly baked buns from local

LO 4-2 Differentiate among a firm’s core competencies, resources, capabilities, and activities.

core competencies Unique strengths, em- bedded deep within a firm, that are critical to gaining and sustaining competitive advantage.

EXHIBIT 4.2 Inside the Firm: Competitive Advantage based on Core Competencies, Resources, and Capabilities

Political Economic

Sociocultural

TechnologicalEcological

Industry

External Environment

External Environment

Legal

Inside the Firm: Core Competencies,

Resources, and Capabilities

Strategic Group

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 121

bakeries; potatoes from Idaho; tomatoes from Florida; and so forth. Five Guys further differentiates itself from its competitors by offering a wide range of free toppings from classics like ketchup and lettuce to specialties like grilled mushrooms, jalapenos, and green peppers. Some of Five Guys’ ingredients cost four times the amount that other chains pay. Its fries are hand-cut from potatoes grown in Idaho north of the 42nd parallel and cooked in pure peanut oil. Five Guys keeps its store designs simple, functional, and consistent: Its iconic red and white tiles are often seen in shopping malls, where many of its stores are located.

What did Five Guys decide NOT to do? It would not, for instance, bloat its menu and offer up to 125 items, as McDonald’s did over the years. Instead, it kept its menu simple: burgers, fries, and hot dogs. This simplicity allowed each Five Guys team to deliver on its core com- petency: custom, made-to-order, high-quality burgers for each of its patrons. In fact, it took Five Guys almost 30 years before deciding to add milkshakes to its menu. This new and popular item is available with free mix-in flavors such classic chocolate, vanilla, strawberry, and Oreo, as well as flavors unique to Five Guys such as bacon.

Five Guys does not have drive-throughs. Because its food, unlike fast food, is made to order, drive-through wait times would be too long. It does not offer food delivery, regard- less of who asks for it—not even when an admiral from the Pentagon requested a special lunch delivery for 25 people. Jerry Murrell declined politely. The next day Five Guys hung up a 22-foot-long banner that read “ABSOLUTELY NO DELIVERY.” Business from the Pentagon picked up after that. Even former President Barack Obama has been seen waiting in line. As part of its heritage as a takeout only place, Five Guys does not encourage its patrons to linger; for instance, it does not offer free WiFi and while the seat- ing is functional, it isn’t really that comfortable. Five Guys’ focus is to get the customer in and out in an expedient and efficient manner to increase throughput especially during peak lunch hours.

Five Guys also does not spend any money on marketing. Murrell believes that happy customers are the best salespeople for the company as they will share their experience with their friends. This word-of-mouth publicity is even more potent now with the prevalence of social media. Over the years local press has provided free publicity as well, showering Five Guys with hundreds of glowing reviews. Many of these reviews can be found framed and hanging on the bathroom walls of its stores. Much of its early fame can also be attributed to Zagat, one of the most important restaurant guides in the United States.

These multiple and varied activities, when combined, reinforce Five Guys’ core compe- tency, which enables the hamburger joint to differentiate its product offerings, to create higher perceived value for its customers, and to command premium prices for its prod- ucts. It is important to note that before expanding geographically, the Murrells spent nearly two decades within just their five northern Virginia stores perfecting the core competency. The initial stores were staffed and operated by family members. But once they started to franchise, Five Guys needed to maintain delivery of the core competency—this time to mul- tiple stores across the United States. Five Guys was able to replicate its unique structure, processes, and routines, including its diverse set of strategic activities, which included a supply chain that sourced only fresh, quality ingredients. Considering that core competen- cies and their underlying knowledge often do not travel easily across geographic distances, this was no small feat.5

Thus, as much as competition is about products and services, it is also about developing, nurturing, honing, and leveraging core competencies. For a closer look of the core compe- tency of Beats by Dr. Dre, see Strategy Highlight 4.1.

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122 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

Dr. Dre’s Core Competency: Coolness Factor In 2014, Andre Young—aka Dr. Dre—was celebrated as the first hip-hop billionaire after Apple acquired Beats Elec- tronics for $3 billion. Dr. Dre has a long track record as a successful music producer, rapper, and entrepreneur. Known for his strong work ethic, he expects nothing less than perfection from the people he works with—similar to some of the personality attributes ascribed to the late Steve Jobs, co-founder and longtime CEO of Apple.

Although Dr. Dre created and subsequently sold several successful music record labels, as an entrepreneur, he is best known as co-founder of Beats Electronics with Jimmy Iovine, also an entrepreneur and record and film producer. Both are considered to be some of the best-connected businesspeople in the music industry, with personal net- works spanning hundreds and comprising both famous and up-and-coming artists. 

Founded in 2008, Beats Electronics is known globally for its premium consumer headphones, Beats by Dr. Dre, which Dr. Dre claims allows the listeners to hear all the music.6  Since early 2014, the company has been offering Beats Music, a streaming music subscription service. With this product and service, Beats strives to “bring the energy, emotion, and excitement of playback in the recording studio to the listening experience and introduce an entirely new generation to the possibilities of premium sound entertain- ment.”7 However, many acoustics experts maintain that play- back of digitally compressed MP3 audio files is inferior to high fidelity. Also, the sound quality of Beats headphones is considered poor compared to that of other premium-brand headphones such as Bose, JBL, Sennheiser, and others.

Why then would Apple pay $3 billion to acquire Beats Electronics—its largest acquisition to date? Two main rea- sons: First, Apple hopes that some of Beats’ coolness will spill over to its brand, which has become somewhat stale. The iPhone, for example, is now a standardized commod- ity given successful imitations by Samsung, Huawei, and Xiaomi. Second, although Apple is the world’s largest music vendor boasting 800 million iTunes accounts, the music industry is being disrupted. Content delivery of music and video is shifting from ownership via downloads to streaming on demand (renting). As a consequence, music downloads have declined in the past few years.

B E AT S ’ C O O L N E S S FAC TO R Beats by Dr. Dre achieved an unprecedented coolness factor with celebrity

endorsements not only from music icons but also athletes, actors, and other stars. Before Beats, no musician endorsed audio headphones in the same way as a basketball player such as Michael Jordan endorsed his line of Nike shoes, Air Jordan. Dr. Dre was the first legendary music producer to endorse premium headphones. In addition, he created cus- tom Beats for stars such as Justin Bieber, Lady Gaga, and Nicki Minaj. Other music celebrities including Skrillex, Lil Wayne, and will.i.am endorsed Beats by wearing them in their music videos and at live events and mentioning them on social media. But Beats did not stop at musicians. Famous athletes—basketball superstars LeBron James and Kobe Bryant, tennis champion Serena Williams, and soccer stars Cristiano Ronaldo and Neymar Jr.—wear Beats by Dr. Dre in public and endorse the brand in advertisements.

D I S R U P T I O N I N C O N T E N T D E L I V E R Y Online streaming is quickly replacing ownership through down- loads.  The shift from owning content to renting it on demand is disrupting the content delivery business. This disruption is most visible in movies, as the success of Netflix demonstrates, but is also gaining steam in music.

After disrupting the music download space with iTunes in 2003, Apple found its service being disrupted by leaders in the music streaming industry. Then, in 2013, it created iTunes Radio as an initial attempt at online music streaming. How- ever, that attempt failed to meet with much success until Apple acquired Beats Music, which turned Apple  into a

Strategy Highlight 4.1

Dr. Dre, left, and Jimmy Iovine are co-founders of Beats. Following Apple’s acquisition of Beats, Dre and Iovine continue to work together to keep Beats relevant and tied to current artists. In 2018, Iovine left his role at Apple with day-to-day decision authority to work as a consultant to Apple. Kevin Mazur/WireImage/Getty Images.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 123

For an overview of the core competencies of different companies with application examples, see Exhibit 4.3.

Company Core Competencies Application Examples

Amazon • Superior IT and AI capabilities.

• Superior customer service.

• Diversification across different industries.

• Establishing an ecosystem, combining hardware with software around its Amazon Echo platform.

• Online retailing: Largest selection of items online.

• Full vertical integration in retail, from warehouse to delivery.

• Cloud computing: Largest provider through Amazon Web Services (AWS).

Apple • Superior industrial design in integration of hardware and software.

• Superior marketing and retailing experience.

• Establishing and maintaining an ecosystem of products and services that reinforce one another in a virtuous fashion.

• Creation of innovative and category-defining mobile devices and software services that take the user’s experience to a new level (e.g., iMac, iPod, iTunes, iPhone, iPad, Apple Watch, Apple TV, Apple Pay, and Apple Card).

Beats Electronics

• Superior marketing: creating a perception of coolness.

• Establishing an ecosystem, combining hardware (headphones) with software (streaming service).

• Beats by Dr. Dre and Beats Music.

Coca-Cola Co. • Superior marketing and distribution. • Leveraging one of the world’s most recognized brands (based on its original “secret formula”) into a diverse lineup of soft drinks.

• Global availability of products.

ExxonMobil • Superior at discovering and exploring fossil-fuel– based energy sources globally.

• Focus on oil and gas (fossil fuels only, not renewables).

Facebook • Superior IT and AI capabilities to provide reliable social network services globally on a large scale.

• Superior algorithms to offer targeted online ads.

• Connecting over 2 billion social media users worldwide.

• News feed, timeline, graph search, and stories.

Five Guys • Superior ability to deliver fresh, customized hamburgers as well as hand-cut fries using the highest- quality ingredients.

• Hamburgers and fries.

EXHIBIT 4.3 Company Examples of Core Competencies and Applications

dominant player again—this time in the music streaming space. By 2019, Apple Music had surpassed market leader Spotify in paid U.S. subscribers, but it trailed the Swedish rival globally.  Coming on strong is Amazon with its Prime Music and Music Unlimited services. In the “coolness space,” Apple faces a formidable rival in music streaming service Tidal, founded by rap mogul Jay-Z. Tidal has exclusive re- lease contracts with superstar artists such as Kanye West, Rihanna, and Beyoncé (who is married to Jay-Z). Tidal, how- ever, had only 4.2 million paid subscribers by the end of 2018.

In addition to new strategic initiatives in financial ser- vices and online gaming, Apple announced a further major

push into the entertainment industry in 2019. The firm is now making its Apple TV app, which will carry original content, available on competitors’ devices. Apple TV also will serve as a portal log-on where users can view content from Apple as well as from AT&T’s HBO or CBS’s Showtime. This strategic initiative marks a stark shift in Apple’s focus on a closed ecosystem. With this strategic pivot, Apple is moving into the $100 billion entertainment industry and will compete head-on with other tech companies such as Amazon and Netflix, as well as old-line companies such as Comcast (part-owner of Hulu, a streaming service) and AT&T, which owns WarnerMedia (including HBO).8

(Continued)

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124 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

Company Core Competencies Application Examples

Google (a subsidiary of Alphabet)

• Superior in creating proprietary algorithms based on large amounts of data collected online.

• Superior AI capability.

• Software products and services for the internet and mobile computing, including some mobile devices (Pixel phone, Chromebook).

• Online search, Android mobile operating system, Chrome OS, Chrome web browser, Google Play, AdWords, AdSense, Google docs, Gmail, etc.

IKEA • Superior in designing modern functional home furnishings at low cost.

• Superior retail experience.

• Fully furnished room setups, practical tools for all rooms, do-it-yourself.

McKinsey • Superior in developing practice-relevant knowledge, insights, and frameworks in strategy.

• Management consulting; in particular, strategy consulting provided to company and government leaders.

Netflix • Superior in creating proprietary algorithms-based individual customer preferences.

• DVD-by-mail rentals, streaming media (including proprietary) content, connection to game consoles.

Tesla • Superior engineering expertise in designing high- performance battery-powered motors and power trains.

• Superior ability to provide complementary assets.

• Superior expertise in decentralized power storage and management based on renewable (solar) energy.

• Model S, Model X, Model 3, and Model Y.

• Network of proprietary charging stations, spanning entire United States and most of the rest of the world.

• Powerwall, solar roof tiles, and complete rooftop solar systems.

Uber • Superior mobile-app–based transportation and logistics expertise focused on cities, but on global scale.

• Uber, UberX, UberBlack, UberLUX, UberSUV, etc.

RESOURCES AND CAPABILITIES Because core competencies are critical to gaining and sustaining competitive advantage, it is important to understand how they are created. Companies develop core competencies through the interplay of resources and capabilities. Exhibit 4.4 shows this relationship. Resources are any assets such as cash, buildings, machinery, or intellectual property that a firm can draw on when crafting and executing a strategy. Resources can be either tangible or intangible. Capabilities are the organizational and managerial skills necessary to orches- trate a diverse set of resources and to deploy them strategically. Capabilities are by nature intangible. They find their expression in a company’s structure, routines, and culture.

As shown in Exhibit 4.4, such competencies are demonstrated in the company’s activities, which can lead to competitive advantage, resulting in superior firm performance. Activities are distinct and fine-grained business processes such as order taking, the physical delivery of products, or invoicing customers. Each distinct activity enables firms to add incre- mental value by transforming inputs into goods and services. In the interplay of resources and

resources Any assets that a firm can draw on when formulating and implementing a strategy.

capabilities Organizational and managerial skills necessary to orchestrate a diverse set of resources and deploy them strategically.

activities Distinct and fine-grained business processes that enable firms to add incremen- tal value by transforming inputs into goods and services.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 125

capabilities, resources reinforce core competencies, while capabilities allow managers to orchestrate their core competencies. Strategic choices find their expression in a set of specific firm activities, which leverage core competencies for competitive advantage. The arrows lead- ing back from competitive advantage to resources and capabilities indicate that superior per- formance in the marketplace generates profits that to some extent need to be reinvested into the firm (retained earnings) to further hone and upgrade a firm’s resources and capabilities in its pursuit of achieving and maintaining a strategic fit within a dynamic environment.

We should make two more observations about Exhibit 4.4 before moving on. First, core competencies that are not continuously nourished will eventually lose their ability to yield a competitive advantage. And second, in analyzing a company’s success in the market, it can be too easy to focus on the more visible elements or facets of core competencies such as superior products or services. While these are the outward manifestations of core competen- cies, what is even more important is to understand the invisible part of core competencies.

As to the first point, let’s consider the consumer electronics industry. For some years, Best Buy outperformed Circuit City based on its strengths in customer-centricity (segmenting customers based on demographic, attitudinal, and value tiers, and configuring stores to serve the needs of the customer segments in that region), employee development, and exclusive branding. Although Best Buy outperformed Circuit City (which filed for bankruptcy in 2009), more recently Best Buy did not hone and upgrade its core competencies sufficiently to compete effectively against Amazon, the world’s largest online retailer. Amazon does not have the overhead expenses associated with maintaining buildings or human sales forces; therefore, it has a lower cost structure and thus can undercut in-store retailers on price. When a firm does not invest in continual upgrading or improving core competencies, its competi- tors are more likely to develop equivalent or superior skills, as Amazon did. This insight will allow us to explain differences between firms in the same industry, as well as competitive dynamics, over time. It will also help us to identify the strategy that firms use to both gain and sustain a competitive advantage, as well as to weather an adverse external environment.

As to the second point, we will soon introduce tools to clarify the more opaque aspects of a firm’s core competencies. We start by looking at both tangible and intangible resources.

EXHIBIT 4.4 Linking Core Competencies, Resources, Capabilities, and Activities to Competitive Advantage

Competitive Advantage

Activities Core

Competencies

Reinvest, Hone, & Upgrade

Reinforce Leverage

Orchestrate

Reinvest, Hone, & Upgrade

Resources

Capabilities

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126 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

4.3 The Resource-Based View To gain a deeper understanding of how the interplay between resources and capabilities cre- ates core competencies that drive firm activities leading to competitive advantage, we turn to the resource-based view of the firm. This model systematically aids in identifying core competencies.9 As the name suggests, this model sees resources as key to superior firm per- formance. As Exhibit 4.5 illustrates, resources fall broadly into two categories: tangible and intangible. Tangible resources have physical attributes and are visible. Examples of tangible resources are labor, capital, land, buildings, plant, equipment, and supplies. Intangible  resources have no physical attributes and thus are invisible. Examples of intangible resources are a firm’s culture, its knowledge, brand equity, reputation, and intellectual property.

Consider Google (since 2015 a subsidiary of Alphabet, which is a holding company over- seeing a diverse set of activities). Alphabet’s tangible resources, valued at $59 billion, include its headquarters (The Googleplex)10 in Mountain View, California, and numerous server farms (clusters of computer servers) across the globe.11 The Google brand, an intan- gible resource, is valued at over $300 billion (number one worldwide)—almost seven times higher than the value of Alphabet’s tangible assets.12

Google’s headquarters exemplifies both tangible and intangible resources. The Googleplex is a piece of land on which sits a futuristic building, and thus a tangible resource. However, the location of the company in the heart of Silicon Valley is an intangible resource in that it provides the company with several benefits. One is access to a valuable network of contacts, which

includes a large and computer-savvy work force, as well as graduates and knowledge spillovers from numerous nearby universities; all this adds to Google’s technical and mana- gerial capabilities.13 Another benefit is Google’s proximity to Silicon Valley, which contains the highest concentration of venture capital firms in the United States. Venture capitalists tend to prefer local investments because the more local they are, the closer they can be monitored. Thus, their proximity to Google can be viewed as a mutual bene- fit.14 In fact, initial funding to Google came from the well-known venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital, both located in Silicon Valley.

Competitive advantage is more likely to spring from intangible rather than tangible resources. Tangible assets, such as build- ings or computer servers, can be bought on the open market by anyone who has the necessary cash. However, a brand name must be built, often over long periods of time. In fact, it took mainstay firms such

LO 4-3 Compare and contrast tangible and intangible resources.

EXHIBIT 4.5 Tangible and Intangible Resources

INTANGIBLE

• Culture

• Knowledge

• Brand Equity

• Reputation

• Intellectual Property

Invisible, No Physical Attributes

• Patents

• Designs

• Copyrights

• Trademarks

• Trade Secrets

TANGIBLE

Visible, Physical Attributes

• Labor

• Capital

• Land

• Buildings

• Plant

• Equipment

• Supplies

Resources

resource-based view A model that sees certain types of resources as key to superior firm performance.

tangible resources Resources that have physical attributes and thus are visible.

intangible resources Resources that do not have physical attributes and thus are in- visible.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 127

as Apple, Microsoft, Visa, McDonald’s, and AT&T—five of the global top-10 most valu- able brands—many years to build their value and to earn brand recognition in the market- place. Yet, more recent companies such as Google (founded in 1998; brand value of over $300 billion), Amazon (founded in 1994; brand value of over $200 billion), Facebook (founded in 2004; brand value of over $160 billion), and the Chinese technology compa- nies Tencent and Alibaba (founded in 1998 and 1999, respectively, each with brand values of over $110 billion) all accomplished their enormous brand valuations fairly quickly, largely due to their ubiquitous internet presence.15

Note that the resource-based view of the firm uses the term resource much more broadly than previously defined. In the resource-based view of the firm, a resource includes any assets as well as any capabilities and competencies that a firm can draw upon when formu- lating and implementing strategy. In addition, the usefulness of the resource-based view to explain and predict competitive advantage rests upon two critical assumptions about the nature of resources, to which we turn next.

RESOURCE HETEROGENEITY AND RESOURCE IMMOBILITY The two assumptions critical to the resource-based model are: (1) resource heterogeneity and (2) resource immobility.16 What does this mean? In the resource-based view, a firm is assumed to be a unique bundle of resources, capabilities, and competencies. The first critical assumption— resource heterogeneity—comes from the insight that bundles of resources, capabilities, and com- petencies differ across firms. This insight requires looking more critically at the resource bundles of firms competing in the same industry (or even the same strategic group), because each bundle is unique to some extent. For example, Southwest Airlines (SWA) and Alaska Airlines (AS) both compete in the same strategic group (low-cost, point-to-point airlines, see Exhibit 3.8). But they draw on different resource bundles. SWA’s employee productivity tends to be higher than that of AS, because the two companies differ along human and organiza- tional resources. At SWA, job descriptions are informal and employees pitch in to “get the job done.” Pilots may help load luggage to ensure an on-time departure; flight attendants clean airplanes to help turn them around at the gate within 15 minutes from arrival to departure. This allows SWA to keep its planes flying for longer and lowers its cost structure, savings that SWA passes on to passengers in lower ticket prices.

The second critical assumption—resource immobility—describes the insight that resources tend to be “sticky” and don’t move easily from firm to firm. Because of that stickiness, the resource differences that exist between firms are difficult to replicate and, therefore, can last for a long time. For example, SWA has enjoyed a sustained competitive advantage, allowing it to outperform its competitors over several decades. That resource difference is not due to a lack of imitation attempts, though. Continental and Delta both attempted to copy SWA, with Continental Lite and Song airline offerings, respectively. Neither airline, however, was able to successfully imitate the resource bundles and firm capabilities that make SWA unique. Combined, these insights tell us that resource bundles differ across firms, and such differences can persist for long periods. These two assumptions about resources are critical to explaining superior firm performance in the resource-based model.

Note, by the way, that the critical assumptions of the resource-based model are fundamen- tally different from the way in which a firm is viewed in the perfectly competitive industry structure introduced in Chapter 3. In perfect competition, all firms have access to the same resources and capabilities, ensuring that any advantage that one firm has will be short-lived. That is, when resources are freely available and mobile, competitors can move quickly to acquire resources that are utilized by the current market leader. Although some commodity markets approach this situation, most other markets include firms whose resource endowments

LO 4-4 Evaluate the two critical assumptions about the nature of resources in the resource-based view.

resource heterogeneity Assumption in the resource-based view that a firm is a bundle of resources and capabilities that differ across firms.

resource In the re- source-based view of the firm, a resource in- cludes any assets as well as any capabilities and competencies that a firm can draw upon when formulating and implementing strategy.

resource immobility Assumption in the resource-based view that a firm has resources that tend to be “sticky” and that do not move easily from firm to firm.

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128 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

differ. The resource-based view, therefore, delivers useful insights to managers about how to formulate a strategy that will enhance the chances of gaining a competitive advantage.

THE VRIO FRAMEWORK One important tool for evaluating a firm’s resource endowments is a framework that answers the question, What resource attributes underpin competitive advantage? This framework is implied in the resource-based model, identifying certain types of resources as key to superior firm performance.17 For a resource to be the basis of a competitive advantage, it must be

Valuable, Rare, and costly to Imitate. And finally, the firm itself must be Organized to capture the value of the resource.

Following the lead of Jay Barney, one of the pioneers of the resource-based view of the firm, we call this model the VRIO framework.18 According to this model, a firm can gain and sustain a competitive advantage only when it has resources that satisfy all of the VRIO crite- ria. Keep in mind that resources in the VRIO framework are broadly defined to include any assets as well as any capabilities and competencies that a firm can draw upon when formu- lating and implementing strategy. So to some degree, this presentation of the VRIO model summarizes all of our discussion in the chapter so far.

Exhibit 4.6 captures the VRIO framework in action. You can use this decision tree to decide if the resource, capability, or competency under consideration fulfills the VRIO requirements. As you study the following discussion of each of the VRIO attributes, you will see that the attributes accumulate. If the answer is “yes” four times to the attributes listed in the decision tree, only then is the resource in question a core competency that underpins a firm’s sustainable competitive advantage.

VALUABLE. A valuable resource is one that enables the firm to exploit an external opportu- nity or offset an external threat. This has a positive effect on a firm’s competitive advantage. In particular, a valuable resource enables a firm to increase its economic value creation

LO 4-5 Apply the VRIO framework to assess the competitive implications of a firm’s resources.

VRIO framework A theoretical frame- work that explains and predicts firm-level competitive advantage.

valuable resource One of the four key cri- teria in the VRIO frame- work. A resource is valuable if it helps a firm exploit an external opportunity or offset an external threat.

Sustainable Competitive Advantage

Is the Resource, Capability, or Competency...

and Is the Firm...

V aluable?

R are?

O rganized to Capture

Value?

Temporary Competitive Advantage

Competitive Parity

Competitive Disadvantage

YES

YES

YES YES

NO

NO

NO

I mitation Costly?

Temporary Competitive Advantage

NO

EXHIBIT 4.6 Applying the VRIO Framework to Reveal Competitive Advantage

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 129

(V – C). Revenues rise if a firm is able to increase the perceived value of its product or service in the eyes of consumers by offering superior design and adding attractive features (assuming costs are not increasing). Production costs, for example, fall if the firm is able to put an efficient manufacturing process and tight supply chain management in place (assum- ing perceived value is not decreasing).

Five Guys’ superior ability to deliver fresh, customized hamburgers as well as hand-cut fries using the highest-quality ingredients is certainly valuable because it enables the firm to command a premium price due to its perceived higher value creation. Although Five Guys excels at driving up the perceived value of its offerings, it also needs to control costs to ensure that this valuable resource can lay the foundation for a competitive advantage.

RARE. A resource is rare if only one or a few firms possess it. If the resource is common, it will result in perfect competition where no firm is able to maintain a competitive advantage (see discussion in Chapter 3). A resource that is valuable but not rare can lead to competi- tive parity at best. A firm is on the path to competitive advantage only if it possesses a valu- able resource that is also rare.

When Five Guys was founded in 1986, its superior ability to deliver made-to-order ham- burgers from the freshest ingredients and hand-cut fries made from the best potatoes was certainly rare, as was its restaurant concept: It was neither a fast food place nor a traditional sit-down establishment. It offered a limited menu, no drive-through option, and a self-service format. This remains the case and Five Guys has managed to charge premium prices for its product—prices that are multiple times higher than that of its fast food competitors. Today, restaurant models like Five Guys are called fast-casual restaurants, a term that didn’t come into the dining vernacular until the 2000s, despite well-known Five Guys’ competitors such as Chipotle Mexican Grill (founded in 1993) coming onto the scene much earlier.

To further underscore that Five Guys was rare on multiple fronts is the fact that its more direct competitors (and imitators) in the “better burger” segment—Shake Shack (founded in 2004), Smashburger (founded in 2007), and Burger Fi (founded in 2011)—were not launched until much later. This head start gave Five Guys the ability to perfect its core competencies over a long period of time before it decided to franchise (see Exhibit 4.1). Moreover, because it was so early to the fast-casual dining market, Five Guys was able to enjoy a first-mover advantage, including locking up the best store locations and perhaps more importantly the best suppliers (e.g., Rick Miles of Rigby, Idaho, is Five Guys’ sole supplier of potatoes).

COSTLY TO IMITATE. A resource is costly to imitate if firms that do not possess the resource are unable to develop or buy the resource at a reasonable price. If the resource in question is valuable, rare, and costly to imitate, then it is an internal strength and a core competency. If the firm’s competitors fail to duplicate the strategy based on the valuable, rare, and costly-to- imitate resource, then the firm can achieve a temporary competitive advantage.

For more than 30 years now, Five Guys has delivered fresh, made-to-order premium burg- ers and fries. In doing so consistently, Five Guys enjoys a cult-like following by its custom- ers. This led to its 50 percent market share in the “better burger” segment during the 2010s. In addition, Five Guys spent almost 20 years refining, honing, upgrading, and eventually perfecting its core competency before franchising nationally. This in turn enabled Five Guys to more easily duplicate its core competency in different geographic areas as it franchised throughout the United States and beyond.

Although it may appear to be a simple business model (“make the best burger”), it is by no means simplistic. Coordinating a multilayered supply chain of a fairly large number of high-quality, fresh ingredients is a complex undertaking. For example, making sure there are no foodborne illnesses requires strict adherence to established food-handling protocols and

rare resource One of the four key criteria in the VRIO framework. A resource is rare if the number of firms that possess it is less than the number of firms it would require to reach a state of perfect competition.

costly-to-imitate resource One of the four key criteria in the VRIO framework. A re- source is costly to imi- tate if firms that do not possess the resource are unable to develop or buy the resource at a comparable cost.

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130 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

Tiffany & Co. has developed a core competency–elegant jewelry design and craftsmanship delivered through a superior customer experience– that is valuable, rare, and costly for competitors to imitate. The company vigorously protects its trademarks, including its Tiffany Blue Box, but it never trademarked the so-called Tiffany setting for diamond rings, used now by many jewelers. The term has been co- opted for advertising by other retailers (including Costco), which now maintain it is a generic term commonly used in the jewelry industry. Lucas Oleniuk/Toronto Star/Getty Images

best practices in every one of its 1,500 stores. In addition, much of Five Guys’ business was built around Jerry Murrell’s gut feeling— something that cannot be imitated. In fact, Murrell himself cannot articulate the many “strategic hunches” he has had over the years.19

Unlike Five Guys, imitators such as Shake Shack, Smashburger, and Burger Fi franchised almost immediately after launching. The Five Guys’ imitators moved so rapidly because of their relatively late entry in the market, and thus in their attempt to compete nationwide with Five Guys. In doing so, however, the imitators dis- covered that it is quite costly to imitate Five Guys’ core compe- tency. Moreover, given that most of these chains franchised more

or less immediately, they were unable to perfect their competency before expanding. Taken together, the combination of the three resource attributes (V + R + I) has allowed Five Guys to enjoy a competitive advantage (see Exhibit 4.6).

Direct Imitation. A firm that enjoys a competitive advantage, however, attracts significant attention from its competitors. They will attempt to negate a firm’s resource advantage by directly imitating the resource in question (direct imitation) or through working around it to provide a comparable product or service (substitution).

We usually see direct imitation, as a way to copy or imitate a valuable and rare resource, when firms have difficulty protecting their advantage. (We discuss barriers to imitation shortly.) Direct imitation can be swift if the firm is successful and intellectual property (IP) protection such as patents or trademarks, for example, can be easily circumvented.

Crocs, the maker of the iconic plastic clog, fell victim to direct imitation. Launched in 2002 as a spa shoe at the Fort Lauderdale, Florida, boat show, Crocs experienced explosive growth, selling millions of pairs each year and reaching over $650 million in revenue in 2008. Crocs are worn by people in every age group and across all walks of life, including internet entrepreneur and Google co-founder Sergey Brin, celebrities such as Matt Damon, Heidi Klum, Adam Sandler, and even the Duchess of Cambridge Kate Middleton. To pro- tect its unique shoe design, the firm owns several patents. Given Crocs’ explosive growth, however, numerous cheap imitators have sprung up to copy the colorful and comfortable plastic clog. Despite the patents and celebrity endorsements, other firms were able to copy the shoe, taking a big bite into Crocs’ profits. Indeed, Crocs’ share price plunged from a high of almost $75 to less than $1 in just 13 months.20

This example illustrates that competitive advantage cannot be sustained if the underlying capability can easily be replicated and can thus be directly imitated. Competitors simply cre- ated molds to imitate the shape, look, and feel of the original Crocs shoe. Any competitive advantage in a fashion-driven industry, moreover, is notoriously short-lived if the company fails to continuously innovate or build such brand recognition that imitators won’t gain a foothold in the market. Crocs was more or less a “one-trick pony.”

The ChapterCase notes that Five Guys’ imitators in the “better burger” segment were all founded only after Five Guys started to franchise in 2003. Not only did Five Guys have an almost 20-year lead in perfecting its core competency, but also within 18 months of starting to franchise it sold out of U.S. territory, and its franchisees had locked up most of the best locations. Given the timing of Five Guys’ competitors’ entry, the success of Five Guys clued them in that the fast-casual burger segment is highly profitable, and thus they set out on a direct imitation attempt. First-mover advantages in combination with a perfected core com- petency, however, allowed Five Guys to make such direct imitation attempts quite difficult, and thus to sustain its competitive advantage.

Substitution. The second avenue of imitation for a firm’s valuable and rare resource is through substitution. This is often accomplished through strategic equivalence. Take the example

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of Jeff Bezos launching and developing Amazon.21 Before Amazon’s inception, the retail book industry was dominated by a few large chains and many independent bookstores. As the inter- net was emerging in the 1990s, Bezos was looking for options in online retail. He zeroed in on books because of their non-differentiated commodity nature and easiness to ship. In purchas- ing a printed book online, customers knew exactly what they would be shipped, because the products were identical, whether sold online or in a brick-and-mortar store. The only difference was the mode of transacting and delivery. Taking out the uncertainty of online retailing to some extent made potential customers more likely to try this new way of shopping.

The emergence of the internet allowed Bezos to come up with a new distribution system that negated the need for retail stores and thus high real estate costs. Bezos’ new business model of ecommerce not only substituted for the traditional fragmented supply chain in book retailing, but also allowed Amazon to offer lower prices due to its lower operating costs. Amazon uses a strategic equivalent substitute to satisfy a customer need previously met by brick-and-mortar retail stores.

Combining Imitation and Substitution. In some instances, firms are able to combine direct imitation and substitution when attempting to mitigate the competitive advantage of a rival. With its Galaxy line of smartphones, Samsung has been able to imitate successfully the look and feel of Apple’s iPhones. Samsung’s Galaxy smartphones use Google’s Android operating system and apps from Google Play as an alternative to Apple’s iOS and iTunes Store. Samsung achieved this through a combination of direct imitation (look and feel) and substitution (using Google’s mobile operating system and app store).22 

More recently Amazon has opened a new chapter in its competitive moves by its acquisi- tion of the brick-and-mortar Whole Foods in 2017. As we will see in ChapterCase 8, Amazon’s entry into high-end groceries involves both imitation and substitution.

ORGANIZED TO CAPTURE VALUE. The final criterion of whether a rare, valuable, and costly-to-imitate resource can form the basis of a sustainable competitive advantage depends on the firm’s internal structure. To fully exploit the competitive potential of its resources, capabilities, and competencies, a firm must be organized to capture value—that is, it must have in place an effective organizational structure and coordinating systems. (We will study organizational design in detail in Chapter 11.)

Before Apple or Microsoft had any significant share of the personal computer market, Xerox’s Palo Alto Research Center (PARC) invented and developed an early word-processing application, the graphical user interface (GUI), the Ethernet, the mouse as a pointing device, and even the first personal computer. These technology breakthroughs laid the foundation of the desktop-computing industry.23 Xerox’s invention competency built through a unique com- bination of resources and capabilities was clearly valuable, rare, and costly to imitate with the potential to create a competitive advantage.

Due to a lack of appropriate organization, however, Xerox failed to appreciate and exploit the many breakthroughs made by PARC in computing software and hardware. Why? Because the innovations did not fit within the Xerox business focus at the time. Under pres- sure in its core business from Japanese low-cost competitors, Xerox’s top management was busy pursuing innovations in the photocopier business. Xerox was not organized to appreci- ate the competitive potential of the valuable, rare, and inimitable resources generated at PARC, if not in the photocopier field. Such organizational problems were exacerbated by geography: Xerox headquarters is on the East Coast in Norwalk, Connecticut, across the country from PARC on the West Coast in Palo Alto, California.24 Nor did it help that devel- opment engineers at Xerox headquarters had a disdain for the scientists engaging in basic research at PARC. In the meantime, both Apple and Microsoft developed operating sys- tems, graphical user interfaces, and application software.

organized to capture value One of the four key criteria in the VRIO framework. The characteristic of having in place an effective organizational structure, processes, and systems to fully exploit the competitive potential of the firm’s resources, capabilities, and competencies.

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If a firm is not effectively organized to exploit the competitive potential of a valuable, rare, and costly-to-imitate (VRI) resource, the best-case scenario is a temporary competitive advantage (see Exhibit 4.6). In the case of Xerox, where management was not supportive of the resource, even a temporary competitive advantage would not be realized even though the resource meets the VRI requirements.

In summary, for a firm to gain and sustain a competitive advantage, its resources and capabilities need to interact in such a way as to create unique core competencies (see Exhibit 4.4). Ultimately, though, only a few competencies may turn out to be those specific core competencies that fulfill the VRIO requirements.25 A company cannot do everything equally well and must carve out a unique strategic position for itself, making necessary trade-offs.26 Strategy Highlight 4.2 demonstrates application of the VRIO framework.

ISOLATING MECHANISMS: HOW TO SUSTAIN A COMPETITIVE ADVANTAGE Although VRIO resources can lay the foundation of a competitive advantage, no competi- tive advantage can be sustained indefinitely.27 Several conditions, however, can potentially protect a successful firm by making it more difficult for competitors to imitate the resources, capabilities, and competencies that underlie its competitive advantage. Those conditions include barriers to imitation, which are important examples of isolating  mechanisms that prevent rivals from competing away the advantage a firm may enjoy. They include:28

■ Better expectations of future resource value. ■ Path dependence. ■ Causal ambiguity. ■ Social complexity. ■ Intellectual property (IP) protection.

Each isolating mechanism is directly related to one of the criteria in the resource-based view used to assess the basis of competitive advantage: costly (or difficult) to imitate. If one, or any combination, of these isolating mechanisms is present, a firm may strengthen its basis for competitive advantage, increasing its chance to be sustainable over a longer period of time.

BETTER EXPECTATIONS OF FUTURE RESOURCE VALUE. Sometimes firms can acquire resources at a low cost. This acquisition can lay the foundation for a competitive advantage later, when expectations about the future of the resource turn out to be more accurate than those held by competitors. Better expectations of the future value of a resource allow a firm to gain a competitive advantage. If such better expectations can be systematically repeated over time, then it can help a firm develop a sustainable competitive advantage.

Let’s see how the concept of better expectations of future resource value works in the case of Jane, a real-estate developer looking to purchase land. Jane must decide when and where to buy land for future development. If she buys a parcel of land for a low cost in an undeveloped rural area 40 miles north of San Antonio, Texas, her firm may gain a competi- tive advantage—if it anticipates the land will increase in value with shifting demographics. Now, let’s assume, several years later, an interstate highway gets built near this land. With the highway, suburban growth explodes. New neighborhoods emerge and several new shop- ping malls are erected. Jane’s firm is now able to further develop the property she pur- chased. It decides, for instance, to build high-end office and apartment buildings to accommodate the suburban growth. Thus, the value creation resulting from the purchase of the land ends up far exceeding its initial cost. This in turn allows Jane’s firm to gain a com- petitive advantage over other real estate developers in the area.

LO 4-6 Evaluate different conditions that allow a firm to sustain a competitive advantage.

isolating mechanisms Barriers to imitation that prevent rivals from com- peting away the advan- tage a firm may enjoy.

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Applying VRIO: The Rise and Fall of Groupon After graduating with a degree in music from Northwestern University, Andrew Mason spent a couple of years as a web designer. In 2008, the then 27-year-old founded Groupon, a daily-deal website that connects local retailers and other merchants to consumers by offering goods and services at a discount. Groupon creates marketplaces by bringing the brick-and-mortar world of local commerce onto the internet. The company basically offers a “group-coupon.” If more than a predetermined number of Groupon users sign up for the offer, the deal is extended to all Groupon users. For example, a local spa may offer a massage for $40 instead of the regular $80. If more than say 10 people sign up, the deal becomes reality. The users prepay $40 for the coupon, which Groupon splits 50-50 with the local merchant. Inspired by how Amazon has become the global leader in ecommerce, Mason’s strategic vision for Groupon was to be the global leader in local commerce.

Measured by its explosive growth, Groupon became one of the most successful internet startups, with over 260 million subscribers and serving more than 500,000 merchants in the United States and some 50 countries. Indeed, Groupon’s success attracted a $6 billion buyout offer by Google in early 2011, which Mason declined. In November 2011, Groupon held a successful initial public offering (IPO), valued at more than $16 billion with a share price of over $26. But a year later, Groupon’s share price had fallen 90 percent to just $2.63, resulting in a market cap of less than $1.8 billion. In early 2013, Mason posted a letter for Groupon employees on the web, arguing that it would leak anyway, stating, “After four and a half intense and wonderful years as CEO of Groupon, I’ve decided that I’d like to spend more time with my family. Just kidding—I was fired today.”

Although Groupon is still in business, it is just one competitor among many and not a market leader. What went wrong? The implosion of Groupon’s market value can be explained using the VRIO framework. Its competency to drum up more business for local retailers by offering lower prices for its users was certainly valuable. Before Groupon, local merchants used online and classified ads, direct mail, yellow pages, and other venues to reach customers. Rather than using one-way communication,

Groupon facilitates the meeting of supply and demand in local markets. When Groupon launched, such local market-making competency was also rare. Groupon, with its first-mover advantage, seemed able to use technology in a way so valuable and rare it prompted Google’s buyout offer. But was it costly to imitate? Not so much.

The multibillion-dollar Google offer spurred potential competitors to reproduce Groupon’s business model. They discovered that Groupon was more of a sales company than a tech venture, despite perceptions to the contrary. To target and fine-tune its local deals, Groupon relies heavily on human labor to do the selling. Barriers to entry in this type of business are nonexistent because Groupon’s competency is built more on a tangible resource (labor) than on an intangible one (proprietary technology). Given that Groupon’s valuable and rare competency was not hard to imitate, hundreds of new ventures (so-called Groupon clones) rushed in to take advantage of this opportunity. Existing online giants such as Google, Amazon (via LivingSocial), and Facebook also moved in. The spurned Google almost immediately created its own daily-deal version with Google Offers.

Also, note that the ability to imitate a rare and valuable resource is directly linked to barriers of entry, which is one of the key elements in Porter’s five forces model (threat of new entrants). This relationship allows linking internal analysis using the resource-based view to external analysis with the five forces model, which also would have predicted low industry profit potential given low or no barriers to entry.

To make matters worse, these Groupon clones are often able to better serve the needs of local markets and specific population groups. Some daily-deal sites focus only on a specific geographic area. As an example, Conejo Deals meets the needs of customers and retailers in Southern California’s Conejo Valley, a cluster of suburban communities. These hyper-local sites tend to have much deeper relationships and expertise with merchants in their specific areas. Since they are mostly matching local customers with local businesses, moreover, they tend to foster more repeat business than the one-off bargain hunters that use Groupon (based in Chicago). In addition, some daily-deal sites often target specific groups. They have greater expertise in matching their users with local retailers (e.g., Daily Pride serving LGBT communities;

Strategy Highlight 4.2

(Continued)

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134 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

Other developers could have purchased the precise parcel of land that Jane bought. But if they decided to do this only after construction of the highway was announced, then they would have had to pay a much higher price for this land (and the land adjacent to it). Why? Because in order to reflect the new reality of being located next to an interstate, the price of the land would have increased. In other words, the expectations of the future value of the land would have adjusted upwardly. This increase in the price of the land to reflect its future value, in turn, would have negated any potential for competitive advantage.

All these factors together led Jane to develop better expectations of the future value of the resource than her competitors did—in this case, the land she purchased. If Jane is able to repeat these better expectations over time in a more or less systematic fashion, then her firm will likely gain a sustainable competitive advantage. Otherwise, the decision to purchase this particular piece of land may just be considered a stroke of luck. Although luck can play a role in gaining an initial competitive advantage, it is not a basis for sustaining one.

PATH DEPENDENCE. Path dependence describes a process in which the options one faces in a current situation are limited by decisions made in the past.30 Often, early events—sometimes even random ones—have a significant effect on final outcomes.

The U.S. carpet industry provides an example of path dependence.31 Roughly 85 percent of all carpets sold in the United States and almost one-half of all carpets sold worldwide come from carpet mills located within 65 miles of one city: Dalton, Georgia. While the U.S. manu- facturing sector has suffered in recent decades, the carpet industry has flourished. Companies not clustered near Dalton face a disadvantage because they cannot readily access the required know-how, skilled labor, suppliers, low-cost infrastructure, and so on needed to be competitive.

But why Dalton? Two somewhat random events combined. First, the boom after World War II drew many manufacturers to the South to escape restrictions placed upon them in the North, such as higher taxation or the demands of unionized labor. Second, technologi- cal progress allowed industrial-scale production of tufted textiles to be used as substitutes for the more expensive wool. This innovation emerged in and near Dalton. This historical acci- dent explains why today almost all U.S. carpet mills are located in a relatively small region, including world leaders Shaw Industries Group and Mohawk Industries.

Path dependence also rests on the notion that time cannot be compressed at will. While management can compress resources such as labor and R&D into a shorter period, the push will not be as effective as when a firm spreads out its effort and investments over a longer period. Trying to achieve the same outcome in less time, even with higher investments, tends to lead to inferior results, due to time compression diseconomies.32

Consider GM’s problems in providing a competitive alternative to the highly successful Toyota Prius, a hybrid electric vehicle. Its problems highlight path dependence and time

path dependence A situation in which the options one faces in the current situation are limited by decisions made in the past.

Black Biz Hookup serving African-American business owners and operators; Jdeal, a Jewish group-buying site in New York City; and so on).

“Finding your specific group” or “going hyper local” allows these startups to increase the perceived value added for their users over and above what Groupon can offer. Although Groupon aspires to be the global leader, there is really no advantage to global scale in serving local markets. This is because daily-deal sites are best suited to market experience goods, such as haircuts at a local barber

shop or a meal in a specific Thai restaurant. The quality of these goods and services cannot be judged unless they are consumed. Creation of experience goods and their consumption happens in the same geographic space.

Once imitated, Groupon’s competency to facilitate local commerce using an internet platform was neither valuable nor rare. As an application of the VRIO model would have predicted, Groupon’s competitive advantage as a first mover would only be temporary at best (see Exhibit 4.6).29

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compression issues. The California Air Resource Board (CARB) in 1990 passed a mandate for introducing zero-emissions cars, which stipulated that 10 percent of new vehicles sold by carmakers in the state must have zero emissions by 2003. This mandate not only accelerated research in alternative energy sources for cars, but also led to the development of the first fully electric production car, GM’s EV1. GM launched the car in California and Arizona in 1996. Competitive models followed, with the Toyota RAV EV and the Honda EV. In this case, regulations in the legal environment fostered innovation in the automobile industry (see the discussion of PESTEL forces in Chapter 3).

Companies not only feel the nudge of forces in their environment but can also push back. The California mandate on zero emissions, for example, did not stand.33 Several stakehold- ers, including the car and oil companies, fought it through lawsuits and other actions. CARB ultimately gave in to the pressure and abandoned its zero-emissions mandate. When the mandate was revoked, GM recalled and destroyed its EV1 electric vehicles and terminated its electric-vehicle program. This decision turned out to be a strategic error that would haunt GM a decade or so later. Although GM was the leader among car companies in electric vehicles in the mid-1990s, it did not have a competitive model to counter the Toyota Prius when its sales took off in the early 2000s. The Chevy Volt (a plug-in hybrid), GM’s first major competition to the Prius, was delayed by over a decade because GM had to start its electric-vehicle program basically from scratch. While GM sold about 50,000 Chevy Volts worldwide, Toyota sold some 10 million Prius cars. Moreover, when Nissan introduced its all-electric Leaf in 2010, GM did not have an all-electric vehicle in its lineup. In the mean- time, Nissan sold over 400,000 Leafs worldwide.

Not having an adequate product lineup during the early 2000s, GM’s U.S. market share dropped below 20 percent in 2009 (from over 50 percent a few decades earlier), the year it filed for bankruptcy. GM subsequently reorganized under Chapter 11 of the U.S. bank- ruptcy code, and relisted on the New York Stock Exchange in 2010.

Collaborating with LG Corp. of Korea, GM introduced the Chevy Bolt, an all-electric vehicle in 2017.34 Although some of its features, such as a 230-mile range on a single charge, look attractive, it remains to be seen if the Chevy Bolt will do well in the marketplace. This is because competition did not stand still either. In the meantime, Tesla (featured in Chapter- Case 1) is hoping that its new Model 3 will take the mass market of electric cars by storm, as it is priced at $35,000, much lower than its luxury cars (Model S and Model X).

One important take-away here is that once the train of new capability development has left the station, it is hard to jump back on because of path dependence. Moreover, firms cannot compress time at will; indeed, learning and improvements must take place over time, and existing competencies must constantly be nourished and upgraded.

Strategic decisions generate long-term consequences due to path dependence and time- compression diseconomies; they are not easily reversible. A competitor cannot imitate or create core competencies quickly, nor can one buy a reputation for quality or innovation on the open market. These types of valuable, rare, and costly-to-imitate resources, capabilities, and competencies must be built and organized effectively over time, often through a pains- taking process that frequently includes learning from failure.

CAUSAL AMBIGUITY. Causal ambiguity describes a situation in which the cause and effect of a phenomenon are not readily apparent. To formulate and implement a strategy that enhances a firm’s chances of gaining and sustaining a competitive advantage, managers need to have a hypothesis or theory of how to compete. A hypothesis is simply a specific statement that proposes an explanation of a phenomenon (such as competitive advantage), while a theory is a more generalized explanation of what causes what, and why. This implies that managers need to have some kind of understanding about what causes superior or

causal ambiguity A situation in which the cause and effect of a phenomenon are not readily apparent.

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inferior performance, and why. Comprehending and explaining the underlying reasons of observed phenomena is far from trivial, however.

Everyone can see that Apple has had several hugely successful innovative products such as the iMac, iPod, iPhone, and iPad, combined with its hugely popular iTunes services, lead- ing to a decade of a sustainable competitive advantage. These successes stem from Apple’s set of V, R, I, and O core competencies that supports its ability to continue to offer a variety of innovative products and to create an ecosystem of products and services.

A deep understanding, however, of exactly why Apple has been so successful is very dif- ficult. Even Apple’s strategic leaders may not be able to clearly pinpoint the sources of their success. Is it the visionary role that the late Steve Jobs played? Is it the rare skills of Apple’s uniquely talented design team around Jonathan Ive (who left Apple in 2019)? Is it the tim- ing of the company’s product introductions? Is it Apple CEO Tim Cook who adds superior organizational skills and puts all the pieces together when running the day-to-day opera- tions? Or is it a combination of these factors? If the link between cause and effect is ambigu- ous for Apple’s strategic leaders, it is that much more difficult for others seeking to copy a valuable resource, capability, or competency.

SOCIAL COMPLEXITY. Social complexity describes situations in which different social and business systems interact. There is frequently no causal ambiguity as to how the individual systems such as supply chain management or new product development work in isolation. They are often managed through standardized business processes such as Six Sigma or ISO 9000. Social complexity, however, emerges when two or more such systems are combined. Copying the emerging complex social systems is difficult for competitors because neither direct imitation nor substitution is a valid approach. The interactions between different sys- tems create too many possible permutations for a system to be understood with any accuracy. The resulting social complexity makes copying these systems difficult, if not impossible, resulting in a valuable, rare, and costly-to-imitate resource that the firm is organized to exploit.

Look at it this way. A group of three people has three relationships, connecting every person directly with one another. Adding a fourth person to this group doubles the number of direct relationships to six. Introducing a fifth person increases the number of relation- ships to 10.35 This gives you some idea of how complexity might increase when we combine different systems with many different parts.

In reality, firms may manage thousands of employees from all walks of life. Their interac- tions within the firm’s processes, procedures, and norms make up its culture. Although an observer may conclude that Zappos’ culture, with its focus on autonomous teams in a flat hierarchy to provide superior customer service, might be the basis for its competitive advan- tage, engaging in reverse social engineering to crack Zappos’ code of success might be much more difficult. Moreover, an organizational culture that works for online retailer Zappos, led by CEO and chief happiness officer Tony Hsieh, might wreak havoc for an aerospace and defense company such as Lockheed Martin, led by CEO Marillyn Hewson. This implies that one must understand competitive advantage within its organizational and industry con- text. Looking at individual elements of success without taking social complexity into account is a recipe for inferior performance, or worse.

INTELLECTUAL PROPERTY PROTECTION. Intellectual property (IP) protection is a critical intangible resource that can also help sustain a competitive advantage. The five major forms of IP protection are36

■ Patents ■ Designs

social complexity A situation in which differ- ent social and business systems interact with one another.

Marillyn Hewson is CEO of Lockheed Martin, a global player in aero- space, defense, security, and advanced technol- ogy. Facing ever more complex challenges, such firms only thrive with an effective organization and a highly skilled CEO like Hewson. MANDEL NGAN/Contributor/ Getty Images

intellectual property (IP) protection A critical intangible re- source that can provide a strong isolating mech- anism, and thus help to sustain a competitive advantage.

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■ Copyrights ■ Trademarks ■ Trade secrets

The intent of IP protection is to prevent others from copying legally protected products or services. In many knowledge-intensive industries that are characterized by high research and development (R&D) costs, such as smartphones and pharmaceuticals, IP protection pro- vides not only an incentive to make these risky and often large-scale investments in the first place, but also affords a strong isolating mechanism that is critical to a firm’s ability to capture the returns to investment. Although the initial investment to create the first version of a new product or service is quite high in many knowledge-intensive industries, the marginal cost (i.e., the cost to produce the next unit) after initial invention is quite low.

For example, Microsoft spends billions of dollars to develop a new version of its Windows operating system; once completed, the cost of the next “copy” is close to zero because it is just software code distributed online in digital form. In a similar fashion, the costs of devel- oping a new prescription drug, a process often taking more than a decade, are estimated to be over $2.5 billion.37 Rewards to IP-protected products or services, however, can be high. During a little over 14 years on the market, Pfizer’s Lipitor, the world’s best-selling drug, accumulated over $125 billion in sales.38

IP protection can make direct imitation attempts difficult, if not outright illegal. A U.S. court, for example, has found that Samsung infringed in some of its older models on Apple’s patents and awarded some $600 million in damages.39 In a similar fashion, Dr. Dre (fea- tured in Strategy Highlight 4.1) attracted significant attention and support from other artists in the music industry when he sued Napster, an early online music file-sharing service, and helped shut it down in 2001 because of copyright infringements.

IP protection does not last forever, however. Once the protection has expired, the invention can be used by others. Patents, for example, usually expire 20 years after they are filed with the U.S. Patent and Trademark Office. In the next few years, patents protecting roughly $100 bil- lion in sales of proprietary drugs in the pharmaceutical industry are set to expire. Once this happens, producers of generics (drugs that contain the same active ingredients as the original patent-protected formulation) such as Teva Pharmaceutical Industries of Israel enter the mar- ket, and prices fall drastically. Pfizer’s patent on Lipitor expired in 2011. Just one year later, of the 55 million Lipitor prescriptions, 45 million (or more than 80 percent) were generics.40 Drug prices fall by 20 to 80 percent once generic formulations become available.41

Taken together, each of the five isolating mechanisms discussed here (or combinations thereof) allows a firm to extend its competitive advantage. Although no competitive advan- tage lasts forever, a firm may be able to protect its competitive advantage (even for long periods) when it has consistently better expectations about the future value of resources, when it has accumulated a resource advantage that can be imitated only over long periods of time, when the source of its competitive advantage is causally ambiguous or socially com- plex, or when the firm possesses strong intellectual property protection.

4.4 The Dynamic Capabilities Perspective CORE RIGIDITIES A firm’s external environment is rarely stable (as discussed in Chapter 3). Rather, in many industries, the pace of change is ferocious. Firms that fail to adapt their core competencies to a changing external environment not only lose a competitive advantage but also may go out of business.

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We’ve seen the merciless pace of change in consumer electronics retailing in the United States. Once a market leader, Circuit City’s core competencies were in efficient logistics and superior customer service. But the firm neglected to upgrade and hone them over time. As a consequence, Circuit City was outflanked by Best Buy and online retailer Amazon, and the company went bankrupt. Best Buy encountered the same difficulties competing against Amazon just a few years later. Core competencies might form the basis for a competitive advantage at one point, but as the environment changes, the very same core competencies might later turn into core rigidities, retarding the firm’s ability to change.42

A core competency can turn into a core rigidity if a firm relies too long on the compe- tency without honing, refining, and upgrading as the environment changes.43 Over time, the original core competency is no longer a good fit with the external environment, and it turns from an asset into a liability. The reason reinvesting, honing, and upgrading of resources and capabilities are so crucial to sustaining any competitive advantage is to prevent competen- cies from turning into core rigidities (see Exhibit 4.4). This ability to hone and upgrade lies at the heart of the dynamic capabilities perspective. We defined capabilities as the organiza- tional and managerial skills necessary to orchestrate a diverse set of resources and to deploy them strategically. Capabilities are by nature intangible. They find their expression in a company’s structure, routines, and culture.

DYNAMIC CAPABILITIES The dynamic capabilities perspective adds, as the name suggests, a dynamic or time element. In particular, dynamic capabilities describe a firm’s ability to create, deploy, modify, recon- figure, upgrade, or leverage its resources over time in its quest for competitive advantage.44 Dynamic capabilities are essential to move beyond a short-lived advantage and create a sus- tained competitive advantage. For a firm to sustain its advantage, any fit between its internal strengths and the external environment must be dynamic. That is, the firm must be able to change its internal resource base as the external environment changes. The goal should be to develop resources, capabilities, and competencies that create a strategic fit with the firm’s environment. Rather than creating a static fit, the firm’s internal strengths should change with its external environment in a dynamic fashion.

Not only do dynamic capabilities allow firms to adapt to changing market conditions, but they also enable firms to create market changes that can strengthen their strategic posi- tion. These market changes implemented by proactive firms introduce altered circum- stances, to which more reactive rivals might be forced to respond. Apple’s dynamic capabilities allowed it to redefine the markets for mobile devices and computing, in particu- lar in music, smartphones, and media content. For the portable music market through its iPod and iTunes store, Apple generated environmental change to which Sony and others had to respond. With its iPhone, Apple redefined the market for smartphones, again creat- ing environmental change to which competitors such as Samsung, BlackBerry, and Nokia needed to respond. Apple’s introduction of the iPad redefined the media and tablet com- puting market, forcing competitors such as Amazon and Microsoft to respond. With the Apple Watch it is attempting to shape the market for computer wearables in its favor. Dynamic capabilities are especially relevant for surviving and competing in markets that shift quickly and constantly, such as the high-tech space in which firms such as Apple, Google, Microsoft, and Amazon compete.

In the dynamic capabilities perspective, competitive advantage is the outflow of a firm’s capacity to modify and leverage its resource base in a way that enables it to gain and sustain competitive advantage in a constantly changing environment. Given the accelerated pace of

core rigidity A former core competency that turned into a liability because the firm failed to hone, refine, and upgrade the competency as the environment changed.

dynamic capabilities A firm’s ability to create, deploy, modify, reconfig- ure, upgrade, or lever- age its resources in its quest for competitive advantage.

dynamic capabilities perspective A model that emphasizes a firm’s ability to modify and leverage its resource base in a way that enables it to gain and sustain competitive advantage in a constantly changing environment.

LO 4-7 Outline how dynamic capabilities can enable a firm to sustain a competitive advantage.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 139

technological change, in combination with deregulation, globalization, and demographic shifts, dynamic markets today are the rule rather than the exception. As a response, a firm may create, deploy, modify, reconfigure, or upgrade resources so as to provide value to cus- tomers and/or lower costs in a dynamic environment. The essence of this perspective is that competitive advantage is not derived from static resource or market advantages, but from a dynamic reconfiguration of a firm’s resource base.

RESOURCE STOCKS AND RESOURCE FLOWS One way to think about developing dynamic capabilities and other intangible resources is to distinguish between resource stocks and resource f lows.45 In this perspective, resource stocks are the firm’s current level of intangible resources. Resource flows are the firm’s level of investments to maintain or build a resource. A helpful metaphor to explain the differences between resource stocks and resource f lows is a bathtub that is being filled with water (see Exhibit 4.7).46 The amount of water in the bathtub indicates a com- pany’s level of a specific intangible resource stock—such as its dynamic capabilities, new product development, engineering expertise, innovation capability, reputation for qual- ity, and so on.47

Intangible resource stocks are built through investments over time. In the exhibit, these investments are represented by the four faucets, from which water f lows into the tub. Investments in building an innovation capability, for example, differ from invest- ments made in marketing expertise. Each investment flow would be represented by a dif- ferent faucet. How fast a firm is able to build an intangible resource—how fast the tub fills—depends on how much water comes out of the faucets and how long the faucets are left open. Intangible resources are built through continuous investments and experience over time.

Organizational learning also fosters the increase of intangible resources. Many intangible resources, such as IBM’s expertise in cognitive computing, take a long time to build. IBM’s

Outflows Leakage, Forgetting

Inflows Investments in Resources

Intangible Resource Stocks (Dynamic Capabilities, New Product Development,

Engineering Expertise, Innovation Capability, Reputation for Quality, Supplier Relationships, Employee Loyalty, Corporate Culture, Customer Goodwill, Know-How, Patents, Trademarks . . .)

EXHIBIT 4.7 The Bathtub Metaphor: The Role of Inflows and Outflows in Building Stocks of Intangible Resources Source: Figure based on metaphor used in I. Dierickx and K. Cool (1989), “Asset stock accumulation and sustainability of competitive advantage,” Management Science 35: 1504–1513.

resource stocks The firm’s current level of intangible resources.

resource flows The firm’s level of invest- ments to maintain or build a resource.

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140 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

quest for cognitive computing began in 1997 after its Deep Blue computer (based on artifi- cial intelligence) beat reigning chess champion Garry Kasparov. It has invested close to $25 billion to build a deep capability in cognitive computing with the goal to take advantage of business opportunities in big data and analytics. Its efforts were publicized when its Watson, a supercomputer capable of answering questions posed in natural language, went up against 74-time Jeopardy! quiz-show champion Ken Jennings and won. Watson has dem- onstrated its skill in many professional areas where deep domain expertise is needed for making decisions in more or less real time: a wealth manager making investments, a doctor working with a cancer patient, an attorney working on a complex case, or even a chef in a five-star restaurant creating a new recipe. Moreover, cognitive computer systems get better over time as they learn from experience.

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

According to the dynamic capabilities perspective, the strategic leaders’ task is to decide which investments to make over time (i.e., which faucets to open and how far) in order to best position the firm for competitive advantage in a changing environment. Moreover, stra- tegic leaders also need to monitor the existing intangible resource stocks and their attrition rates due to leakage and forgetting. This perspective provides a dynamic understanding of capability development to allow a firm’s continuous adaptation to and superior perfor- mance in a changing external environment.

4.5 The Value Chain and Strategic Activity Systems

THE VALUE CHAIN The value chain describes the internal activities a firm engages in when transforming inputs into outputs.48 Each activity the firm performs along the horizontal chain adds incremental value—raw materials and other inputs are transformed into components that are assembled into finished products or services for the end consumer. Each activity the firm performs along the value chain also adds incremental costs. A careful analysis of the value chain allows strategic leaders to obtain a more detailed and fine-grained under- standing of how the firm’s economic value creation (V − C) breaks down into distinct activities that help determine perceived value (V) and the costs (C) to create it. The value chain concept can be applied to basically any firm—those in manufacturing industries, high-tech, or service.

DISTINCT ACTIVITIES. A firm’s core competencies are deployed through its activities (see Exhibit 4.4). A firm’s activities, therefore, are one of the key internal drivers of performance differences across firms. Activities are distinct actions that enable firms to add incremental value at each step by transforming inputs into goods and services. Managing a supply chain, running the company’s IT system and websites, and providing customer support are all examples of distinct activities. Activities are narrower than functional areas such as market- ing because each functional area comprises a set of distinct activities.

Five Guys’ core competency is to offer a simple menu of fresh, high-quality burgers and fries and a great customer experience. To command a premium price for these products and

LO 4-8 Apply a value chain analysis to understand which of the firm’s activities in the process of transforming inputs into outputs generate differentiation and which drive costs.

value chain The inter- nal activities a firm engages in when trans- forming inputs into out- puts; each activity adds incremental value.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 141

service, Five Guys needs to engage in number of distinct activities. Though it may seem simple, the ability to implement diverse sets of distinct activities every day across multiple geographic locations is no small feat.

The activities begin with sourcing ingredients. From the start, the Murrell sons have always selected only the best ingredients without knowing their cost. They viewed cost as a distraction from their ability to identify and select only the freshest, tastiest, highest-quality toppings and condiments. For example, the mayonnaise they selected after a blind taste test turned out to be the most expensive brand on the market. It also happened to be sold by a notoriously difficult vendor, but they stuck with him because he offered the best mayon- naise. In addition, sourcing locally is also important to the Five Guys brand. The 15 free toppings that Five Guys offers are locally sourced whenever possible. Likewise, the fresh- baked buns are local as well, in that they come from bakeries that Five Guys built near their stores so they could guarantee their freshness.

In most chain restaurants, fries are a simple side dish; for Five Guys, however, fries are a speciality made with great care. According to founder Jerry Murrell, while fries might look like the easiest item to make, they are actually the hardest. Unlike other fast food chains that dump dehydrated frozen fries into hot oil, Five Guys hand-cuts Idaho potatoes that are only grown north of the 42nd parallel and then soaks them in water to rinse off the starch. Soak- ing prevents the potatoes from absorbing the pure peanut oil as they are cooked, which gives them their unique Five Guys signature texture and taste.

Obsessing about every detail does not end at the supply chain. The Murrell family also obsesses over how to lay out each store, in particular the cooking area. Unlike other ham- burger chains that use the same grill for their meat and buns, Five Guys uses a dedicated grill for its burgers and a separate toaster for buns. Although this approach requires addi- tional equipment, and thus increases cost and operational complexity, it allows for perfectly grilled burgers and perfectly toasted buns. This all contributes to Five Guys’ higher per- ceived value among customers, which then allows the firm to charge premium prices for the products using a simple cost-plus-margin formula.

Each activity that Five Guys engages in is focused on delivering premium burgers and fries. How to maintain this effort if the company were to franchise weighed heavily on Jerry Murrell’s mind. He worried that the distinct activities needed to deliver what Five Guys stood for could not be duplicated away from the five original Washington, D.C.-area stores. In particular, he worried that if the activities could not be copied exactly, then they could control neither the quality of the product nor the customer experience. This lack of control could then lead to a diminished brand and risk the loss of Five Guys’ hard-earned reputation. It is not surprising, then, that Five Guys waited as long as it did to franchise. It felt it needed to develop the perfect system for its distinct activities before it could expand beyond the home area. When Five Guys opened its store in Richmond, Virginia, a mere 100 miles from its first store in Arlington, Jerry Murrell couldn’t sleep for weeks, despite knowing he had a perfect system in place.49 Today, this set of distinct activities needs to be repeated in each and every locale where Five Guys operates, which is now some 1,500 stores worldwide.

Exhibit 4.8 shows a generic value chain and how the transformation process from inputs to outputs comprises a set of distinct activities. When these activities generate value greater than the costs to create them, the firm obtains a profit margin—this assumes that the market price the firm is able to command also exceeds those costs.

A generic value chain needs to be modified to capture the activities of a specific busi- ness. Retail chain American Eagle Outfitters, for example, needs to identify suitable store locations, either build or rent stores, purchase goods and supplies, manage distribution and store inventories, operate stores both in the brick-and-mortar world and online, hire and

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142 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

motivate a sales force, create payment and IT systems or partner with vendors, engage in promotions, and ensure after-sales services including returns. A maker of semiconductor chips such as Intel, on the other hand, needs to engage in R&D, design and engineer semi- conductor chips and their production processes, purchase silicon and other ingredients, set up and staff chip fabrication plants, control quality and throughput, engage in marketing and sales, and provide after-sales customer support.

PRIMARY AND SUPPORT ACTIVITIES. As Exhibit 4.8 illustrates, the value chain is divided into primary and support activities. The primary activities add value directly as the firm transforms inputs into outputs—from raw materials through production phases to sales and marketing and finally customer service, specifically

■ Supply chain management. ■ Operations. ■ Distribution. ■ Marketing and sales. ■ After-sales service.

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

■ Research and development (R&D). ■ Information systems. ■ Human resources. ■ Accounting and finance. ■ Firm infrastructure including processes, policies, and procedures.

To help a firm achieve a competitive advantage, each distinct activity performed needs to either add incremental value to the product or service offering or lower its relative cost. Discrete and specific firm activities are the basic units with which to understand com- petitive advantage because they are the drivers of the firm’s relative costs and level of

EXHIBIT 4.8 A Generic Value Chain: Primary and Support Activities

Su pp

ly C

ha in

M an

ag em

en t

After-Sales Service

M ar

ke tin

g &

S al

es

Di st

ri bu

tio n

O pe

ra tio

ns

Primary Activities

Research & Development

Information Systems

Human Resources

Accounting & Finance

Firm Infrastructure, including Processes, Policies, & Procedures

Support Activities

Margin Margin

primary activities Firm activities that add value directly by trans- forming inputs into out- puts as the firm moves a product or service horizontally along the internal value chain.

support activities Firm activities that add value indirectly, but are necessary to sustain primary activities.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 143

differentiation the firm can provide to its customers. Although the resource-based view of the firm helps identify the integrated set of resources and capabilities that are the building blocks of core competencies, the value chain perspective enables strategic leaders to see how competitive advantage flows from the firm’s distinct set of activities. This is because a firm’s core competency is generally found in a network linking different but distinct activities, each contributing to the firm’s strategic position as either low-cost leader or differentiator.

STRATEGIC ACTIVITY SYSTEMS A strategic activity system conceives of a firm as a network of interconnected activities that can be the foundation of its competitive advantage.50 A strategic activity system is socially complex and causally ambiguous. While one can easily observe one or more elements of a strategic activity system, the capabilities necessary to orchestrate and manage a network of distinct activities within the entire system cannot be so easily observed. As such, a strategic activity system is difficult to imitate in its entirety, and this difficulty enhances a firm’s pos- sibility of developing a sustainable competitive advantage based on a set of distinct but interconnected activities.

Let’s assume Firm A’s strategic activity system, which lays the foundation of its competi- tive advantage, consists of 25 interconnected activities. Attracted by Firm A’s competitive advantage, competitor Firm B closely monitors this activity system and begins to copy it through direct imitation. Turns out, Firm B is very good at copying, managing to achieve a 90 percent accuracy rate. Will Firm B be able to negate Firm A’s competitive advantage as a result? Far from it. Recall that Firm A’s activity system comprises 25 interconnected activ- ities. Because each of these activities is copied with just 90 percent accuracy, that means Firm B’s ability to copy the entire system accurately is 0.9 × 0.9 × 0.9 . . ., repeated 25 times, or 0.925 = 0.07. In other words, Firm B will only be able to imitate Firm A with a total accuracy rate of 7 percent. What this example demonstrates is that using imitation as a path to competitive advantage is extremely difficult because quickly compounding proba- bilities render copying an entire activity system nearly impossible.

RESPONDING TO CHANGING ENVIRONMENTS. Strategic activity systems need to evolve over time if a firm is to sustain a competitive advantage. In contrast, failure to create a dynamic strategic fit generally leads to a competitive disadvantage, because the external environment changes and also because a firm’s competitors get better in developing their own activity systems and capabilities. Strategic leaders, therefore, need to adapt their firm’s activity system by upgrading value-creating activities in response to changing environments. To gain and sustain competitive advantage, strategic leaders may add new activities, remove activities that are no longer relevant, and upgrade activities that have become stale or some- what obsolete. Each of these changes would require changes to the resources and capabili- ties involved, and as such, would reconfigure the entire strategic activity system.

Let’s consider The Vanguard Group, one of the world’s largest investment companies.51 It serves individual investors, financial professionals, and institutional investors such as state retirement funds. Vanguard’s mission is to help clients reach their financial goals by being their highest-value provider of investment products and services.52 Since its founding in 1929, Vanguard has emphasized low-cost investing and quality service for its clients. Vanguard’s average expense ratio (fees as a percentage of total net assets paid by investors) is generally the lowest in the industry.53 The Vanguard Group also is a pioneer in passive index-fund investing. Rather than picking individual stocks and trading frequently as done in traditional money management, a mutual fund tracks the performance of an index (such as

LO 4-9 Identify competitive advantage as residing in a network of distinct activities.

strategic activity system The conceptu- alization of a firm as a network of intercon- nected activities.

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144 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

the Standard & Poor’s 500 or the Dow Jones 30), and discourages active trading and encourages long-term investing.

Despite this innovation in investing, to gain and sustain a competitive advantage, Vanguard’s strategic activity system needed to evolve over time as the company grew and market conditions as well as competitors changed. Let’s compare how The Vanguard Group’s strategic activity developed over more than 20 years, from 1997 to 2019.

EVOLVING A SYSTEM OVER TIME. In 1997, The Vanguard Group had less than $500 million of assets under management. It pursued its mission of being the highest-value provider of invest- ment products and services through its unique set of interconnected activities depicted in Exhibit 4.9. The six larger ovals depict Vanguard’s strategic core activities: strict cost control, direct distribution, low expenses with savings passed on to clients, offering of a broad array of mutual funds, efficient investment management approach, and straightforward client communi- cation and education. These six strategic themes were supported by clusters of tightly linked activities (smaller circles), further reinforcing the strategic activity network.

The needs of Vanguard’s customers, however, have changed since 1997. Exhibit 4.10 shows Vanguard’s strategic activity system in 2019. Some 20 years later, The Vanguard Group had grown more than 10 times in size, from a mere $500 billion (in 1997) to more than $5 trillion (in 2019) of assets under management.54

Again, the large ovals in Exhibit 4.10 symbolize Vanguard’s strategic core activities that help it realize its strategic position as the low-cost leader in the industry. However, the system evolved over time as Vanguard’s strategic leaders added a new core activity—customer segmentation—to the six core activities already in place in 1997 (still valid in 2019). Vanguard’s managers put in place the customer-segmentation core activity, along with two new support activities, to address a new customer need that could not be met with its older configuration. Its 1997 activity system

1997 Wary of

small growth funds

A broad array of mutual funds

excluding some fund categories

Very low expenses,

savings passed on to clients

Straightforward client

communication and education

Efficient investment management approach

offering good, consistent performance

Strict cost control

Direct distribution

Emerging market funds

Limited international

funds Redemption

fees

Employee bonuses tied

to cost savings

No broker-dealer

relation

No commissions to brokers

Only three retail locations

Limited advertising

budget

No first-class travel for executives

Long-term investment

Shareholder education

Online information

access

Actively spread

philosophy

Reliance on word of mouth

Emphasis on bonds and equity index

funds

In-house management for standard

funds

No-load requirements

No marketing changes

EXHIBIT 4.9 The Vanguard Group’s Activity System in 1997 Source: Adapted from N. Siggelkow (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 146.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 145

did not allow Vanguard to continue to provide quality service targeted at different customer segments at the lowest possible cost. The 2019 activity-system configuration allows Vanguard to customize its service offerings: It now separates its more traditional customers, who invest for the long term, from more active investors, who trade more often but are attracted to Vanguard funds by the firm’s high performance and low cost.

The core activity Vanguard added to its strategic activity system was developed with great care, to ensure that it not only fit well with its existing core activities but also further reinforced its activity network. For example, the new activity of “Create best-selling index funds” also relies on direct distribution; it is consistent with and further reinforces Vanguard’s low-cost leadership position. As a result of achieving its “best-selling” goal, Vanguard is now the world’s second-largest investment-management company, just behind BlackRock, with over $6 trillion of assets under management. This allows Vanguard to benefit from economies of scale (e.g., cost savings accomplished through a larger number of customers served and a greater amount of assets managed), further driving down cost. In turn, by lowering its cost structure, Vanguard can offer more customized services without raising its overall cost. Despite increased custom- ization, Vanguard still has one of the lowest expense ratios in the industry. Even in a changing environment, the firm continues to pursue its strategy of low-cost investing combined with quality service. If firms add activities that don’t fit their strategic positioning (e.g., if Vanguard added local retail offices in shopping malls, thereby increasing operating costs), they create “strategic misfits” that are likely to erode a firm’s competitive advantage.

The Vanguard Group’s core competency of low-cost investing while providing quality service for its clients is accomplished through a unique set of interconnected primary and support activities including strict cost control, direct distribution, low expenses with savings passed on to clients, a broad array of mutual funds, an efficient investment management approach, and straightforward client communication and education.

Economies of scale

A broad array of mutual funds

excluding some fund categories

Very low expenses

passed on to clients

Straightforward client

communication and education

Efficient investment management approach customizes solutions

Strict cost control

Direct distribution

Customer segmentation

Emerging market funds

Limited international

funds Redemption

fees

Employee bonuses tied

to cost savings

No broker-dealer

relation

No commissions to brokers

Only three retail locations

Limited advertising

budget

No first-class travel for executives

Long-term investment

Shareholder education

Online information

access

Actively spread

philosophy

Reliance on word of mouth

Emphasis on bonds and equity index

funds

In-house management for standard

funds

No-load requirements

Create best-selling index funds

Keep traditional investors

2019

EXHIBIT 4.10 The Vanguard Group’s Activity System in 2019

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146 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

In summary, a firm’s competitive advantage can result from its unique network of activi- ties. The important point, however, is that a static fit with the current environment is not sufficient; rather, a firm’s unique network of activities must evolve over time to take advan- tage of new opportunities and mitigate emerging threats. Moreover, by using activity-based accounting (which first identifies distinct activities in an organization and then assigns costs to each activity based on estimates of all resources consumed) and by benchmarking the competition, one can identify key activities. In Chapter 5, we look more closely at how to measure and assess competitive advantage.

4.6 Implications for Strategic Leaders We’ve now reached a significant point: We can combine external analysis from Chapter 3 with the internal analysis just introduced. Together the two allow you to begin formulating a strategy that matches a firm’s internal resources and capabilities to the demands of the external industry environment. Ideally, strategic leaders want to leverage their firm’s inter- nal strengths to exploit external opportunities, while mitigating internal weaknesses and external threats. Both types of analysis in tandem allow managers to formulate a strategy that is tailored to their company, creating a unique fit between the company’s internal resources and the external environment. A strategic fit increases the likelihood that a firm is able to gain a competitive advantage. If a firm achieves a dynamic strategic fit, it is likely to be able to sustain its advantage over time.

USING SWOT ANALYSIS TO GENERATE INSIGHTS FROM EXTERNAL AND INTERNAL ANALYSIS We synthesize insights from an internal analysis of the company’s strengths and weaknesses with those from an analysis of external opportunities and threats using the SWOT analysis. Internal strengths (S) and weaknesses (W) concern resources, capabilities, and competen- cies. Whether they are strengths or weaknesses can be determined by applying the VRIO framework. A resource is a weakness if it is not valuable. In this case, the resource does not allow the firm to exploit an external opportunity or offset an external threat. A resource, however, is a strength and a core competency if it is valuable, rare, costly to imitate, and the firm is organized to capture at least part of the economic value created.

External opportunities (O) and threats (T) are in the firm’s general environment and can be captured by PESTEL and Porter’s five forces analyses (discussed in the previous chap- ter). An attractive industry as determined by Porter’s five forces, for example, presents an external opportunity for firms not yet active in this industry. On the other hand, stricter regulation for financial institutions, for example, might represent an external threat to banks.

A SWOT analysis allows a strategic leader to evaluate a firm’s current situation and future prospects by simultaneously considering internal and external factors. The SWOT analysis encourages strategic leaders to scan the internal and external environments, looking for any relevant factors that might affect the firm’s current or future competitive advantage. The focus is on internal and external factors that can affect—in a positive or negative way—the firm’s ability to gain and sustain a competitive advantage. To facilitate a SWOT analysis, managers use a set of strategic questions that link the firm’s internal environment to its external envi- ronment, as shown in Exhibit 4.11, to derive strategic implications. In this SWOT matrix, the horizontal axis is divided into factors that are external to the firm (the focus of Chapter 3) and the vertical axis into factors that are internal to the firm (the focus of this chapter).

To conduct a SWOT analysis, strategic leaders start by gathering information to link internal factors (strengths and weaknesses) to external factors (opportunities and threats).

LO 4-10 Conduct a SWOT analysis to generate insights from external and internal analysis and derive strategic implications.

SWOT analysis A framework that allows managers to synthesize insights obtained from an internal analysis of the company’s strengths and weaknesses (S and W) with those from an analysis of external opportunities and threats (O and T) to derive strategic implications.

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 147

Next, they use the SWOT matrix shown in Exhibit 4.11 to develop strategic alternatives for the firm. Developing strategic alternatives is a four-step (but not necessarily linear) process:

1. Focus on the Strengths–Opportunities quadrant (top left) to derive “offensive” alterna- tives by using an internal strength to exploit an external opportunity.

2. Focus on the Weaknesses–Threats quadrant (bottom right) to derive “defensive” alterna- tives by eliminating or minimizing an internal weakness to mitigate an external threat.

3. Focus on the Strengths–Threats quadrant (top right) to use an internal strength to mini- mize the effect of an external threat.

4. Focus on the Weaknesses–Opportunities quadrant (bottom left) to shore up an internal weakness to improve its ability to take advantage of an external opportunity.

Lastly, strategic leaders carefully evaluate the pros and cons of each strategic alternative to select one or more alternatives to implement. They need to carefully explain their decision rationale, including why they rejected the other strategic alternatives.

Although the SWOT analysis is a widely used management framework, a word of caution is in order. A problem with this framework is that a strength can also be a weakness and an opportunity can also simultaneously be a threat. Earlier in this chapter, we discussed the location of Google’s headquarters in Silicon Valley and near several universities as a key resource for the firm. Most people would consider this a strength for the firm. However, California has a high cost of living and is routinely ranked among the worst of the states in terms of “ease of doing business.” In addition, this area of California is along major earth- quake fault lines and is more prone to natural disasters than many other parts of the coun- try. So is the location a strength or a weakness? The answer is “it depends.”

In a similar fashion, is global warming an opportunity or threat for car manufacturers? If governments enact higher gasoline taxes and make driving more expensive, it can be a threat. If, however, carmakers respond to government regulations by increased innovation through developing more fuel-efficient cars as well as low- or zero-emission engines such as hybrid or electric vehicles, it may create more demand for new cars and lead to higher sales.

To make the SWOT analysis an effective management tool, strategic leaders must first conduct a thorough external and internal analysis, as laid out in Chapters 3 and 4. This sequential process enables you to ground the analysis in rigorous theoretical frameworks before using SWOT to synthesize the results from the external and internal analyses in order to derive a set of strategic options.

You have now acquired the toolkit with which to conduct a complete strategic analysis of a firm’s internal and external environments. In the next chapter, we consider various ways to assess and measure competitive advantage. That chapter will complete Part 1, on strategy analysis, in the AFI framework (see Exhibit 1.4).

EXHIBIT 4.11 Strategic Questions within the SWOT Matrix

External to Firm In

te rn

al t

o Fi

rm

Opportunities Threats

Strengths How can the firm use internal strengths to take advantage of external opportunities?

How can the firm use internal strengths to reduce the likelihood and impact of external threats?

Weaknesses How can the firm overcome internal weaknesses that prevent it from taking advantage of external opportunities?

How can the firm overcome internal weaknesses that will make external threats a reality?

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148 CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies

TO STAND OUT IN A saturated burger market dominated by such giants as McDonald’s and Burger King, Five Guys pur- sues a differentiation strategy that helps it to create a higher perceived value among its customers. One key differentiating feature is its product: Each Five Guys burger is made from never-frozen ground beef nestled atop a toasted, freshly baked bun. Each burger is also made to order and can be customized with any of 15 toppings—all of which can be add