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FOURTH EDITION

Strategic Management

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Frank T. Rothaermel Georgia Institute of Technology

FOURTH EDITION

Strategic Management

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STRATEGIC MANAGEMENT, FOURTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2019 by McGraw- Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2017, 2015, and 2013. 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 21 20 19 18

Bound: ISBN 978-1-259-92762-1 (student edition) MHID 1-259-92762-8 (student edition) ISBN 978-1-260-14192-4 (instructor edition) MHID 1-260-14192-6 (instructor edition)

Looseleaf: ISBN 978-1-260-14186-3 MHID 1-260-14186-1

Product Developers: Lai T. 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 Specialists: Brianna Kirschbaum Cover Image: (leadership concept on white background): ©ISerg/iStock/Getty Images RF; (globe): ©sankai/iStock/Getty Images RF Compositor: SPi Global

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: concepts / Frank T. Rothaermel, Georgia Institute of Technology. Description: Fourth Edition. | Dubuque: McGraw-Hill Education, 2018. | Revised edition of the author’s Strategic management, [2017] Identifiers: LCCN 2017049706 | ISBN 9781259927621 (paperback) Subjects: LCSH: Strategic planning. | Management. | BISAC: BUSINESS & ECONOMICS / Management. Classification: LCC HD30.28 .R6646 2018 | DDC 658.4/012—dc23 LC record available at https://lccn.loc.gov/2017049706

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 30

CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 64

CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 106

CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 144

PART TWO / FORMULATION 180

CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 182

CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 218

CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification 264

CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers, and Acquisitions 308

CHAPTER 10 Global Strategy: Competing Around the World 338

PART THREE / IMPLEMENTATION 376

CHAPTER 11 Organizational Design: Structure, Culture, and Control 378

CHAPTER 12 Corporate Governance and Business Ethics 418

PART FOUR / MINICASES 447

HOW TO CONDUCT A CASE ANALYSIS 528

PART FIVE / FULL-LENGTH CASES Available through McGraw-Hill Create www.McGrawHillCreate.com/Rothaermel

CONTENTS IN BRIEF

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MINICASES /

1 Michael Phelps: The Role of Strategy in Olympics and Business 448

2 PepsiCo’s Indra Nooyi: Performance with Purpose 450 3 Yahoo: From Internet Darling to Fire Sale 453 4 How the Strategy Process Killed Innovation at

Microsoft 456

5 Apple: The iPhone Turns 10, so What’s Next? 459 6 Nike’s Core Competency: The Risky Business of

Creating Heroes 463

7 Dynamic Capabilities at IBM 466 8 Starbucks after Schultz: How to Sustain a Competitive

Advantage? 470

9 Business Model Innovation: How Dollar Shave Club Disrupted Gillette 474

10 Competing on Business Models: Google vs. Microsoft 476

11 Can Amazon Trim the Fat at Whole Foods? 481 12 LEGO’s Turnaround: Brick by Brick 484 13 Cirque du Soleil: Searching for a New Blue Ocean 488 14 Wikipedia: Disrupting the Encyclopedia Business 491 15 Disney: Building Billion-Dollar Franchises 494 16 Hollywood Goes Global 498 17 Samsung Electronics: Burned by Success? 503 18 Does GM’s Future Lie in China? 509 19 Flipkart vs. Amazon in India: Who’s Winning? 512 20 Alibaba—China’s Ecommerce Giant: Challenging

Amazon? 516

21 HP’s Boardroom Drama and Divorce 520 22 UBS: A Pattern of Ethics Scandals 524

FULL-LENGTH CASES /

All available through McGraw-Hill Create, www.McGrawHillCreate.com/Rothaermel

Uber Technologies*

Starbucks Corporation*

Netflix, Inc.*

Walmart*

The Walt Disney Company*

Tesla, Inc. >>

Apple Inc. >>

Amazon.com, Inc. >>

Best Buy Co., Inc. >>

Facebook, Inc. >>

McDonald’s Corporation >>

Alphabet’s Google >>

Delta Air Lines, Inc. >>

UPS in India >>

The Movie Exhibition Industry >>+ Space X* + Kickstarter: Using Crowdfunding to Launch a New Board Game + Better World Books and the Triple Bottom Line

General Electric after GE Capital

IBM at the Crossroads

Merck & Co., Inc.

Grok: Action Intelligence for Fast Data

Make or Break at RIM: Launching BlackBerry 10

MINICASES & FULL-LENGTH CASES

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

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CHAPTERCASES /

1 Tesla’s Secret Strategy 5 2 Sheryl Sandberg: Leaning in at Facebook 31 3 Airbnb: Disrupting the Hotel Industry 65 4 Dr. Dre’s Core Competency: Coolness Factor 107 5 The Quest for Competitive Advantage: Apple vs.

Microsoft 145 6 JetBlue Airways: Finding a New Blue Ocean? 183 7 Netflix: Disrupting the TV Industry 219 8 Amazon.com: To Infinity and Beyond 265 9 Little Lyft Gets Big Alliance Partners 309 10 Sweden’s IKEA: The World’s Most Profitable

Retailer 339 11 Zappos: Of Happiness and Holacracy 379 12 Uber: Most Ethically Challenged Tech

Company? 419

STRATEGY HIGHLIGHTS /

1.1 Teach for America: How Wendy Kopp Inspires Future Leaders 12

1.2 Merck: Reconfirming Its Core Values 18 2.1 Starbucks CEO: “It’s Not What We Do” 44 2.2 BP “Grossly Negligent” in Gulf of Mexico

Disaster 55 3.1 BlackBerry’s Bust 71 3.2 The Five Forces in the Airline Industry 75 4.1 Applying VRIO: The Rise and Fall of Groupon 119 4.2 When Will P&G Play to Win Again? 125 5.1 Interface: The World’s First Sustainable

Company 165 5.2 Threadless: Leveraging Crowdsourcing to Design

Cool T-Shirts 166 6.1 Dr. Shetty: “The Henry Ford of Heart

Surgery” 200 6.2 How JCPenney Sailed Deeper into the Red

Ocean 208 7.1 Standards Battle: Which Automotive Technology

Will Win? 230 7.2 GE’s Innovation Mantra: Disrupt Yourself! 248 8.1 Is Coke Becoming a Monster? 276 8.2 The Tata Group: Integration at the Corporate

Level 289 9.1 How Tesla Used Alliances Strategically 315 9.2 Kraft’s Specialty: Hostile Takeovers 326 10.1 The Gulf Airlines Are Landing in the

United States 347 10.2 Walmart Retreats from Germany, and Lidl Invades

the United States 351 11.1 W.L. Gore & Associates: Informality and

Innovation 386 11.2 Sony vs. Apple: Whatever Happened to Sony? 400 12.1 GE’s Board of Directors 430 12.2 Why the Mild Response to Goldman Sachs

and Securities Fraud? 435

CHAPTERCASES & STRATEGY HIGHLIGHTS

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PART ONE / ANALYSIS 2 CHAPTER 1 WHAT IS STRATEGY? 4

CHAPTERCASE 1 Tesla’s Secret Strategy 5

1.1 What Strategy Is: Gaining and Sustaining Competitive Advantage 6

What Is Competitive Advantage? 8 1.2 Vision, Mission, and Values 11

Vision 11 Mission 13 Values 17

1.3 The AFI Strategy Framework 19 1.4 Implications for Strategic Leaders 20

CHAPTERCASE 1 / Consider This... 21

CHAPTER 2 STRATEGIC LEADERSHIP: MANAGING THE STRATEGY PROCESS 30

CHAPTERCASE 2 Sheryl Sandberg: Leaning in at Facebook 31

2.1 Strategic Leadership 32 What Do Strategic Leaders Do? 33 How Do You Become a Strategic Leader? 33 The Strategy Process Across Levels: Corporate, Business, and Functional Managers 36

2.2 The Strategic Management Process 38 Top-Down Strategic Planning 38 Scenario Planning 39 Strategy as Planned Emergence: Top-Down and Bottom-Up 41

2.3 Stakeholders and Competitive Advantage 47 Stakeholder Strategy 48 Stakeholder Impact Analysis 50

2.4 Implications for Strategic Leaders 55

CHAPTERCASE 2 / Consider This... 56

CHAPTER 3 EXTERNAL ANALYSIS: INDUSTRY STRUCTURE, COMPETITIVE FORCES, AND STRATEGIC GROUPS 64

CHAPTERCASE 3 Airbnb: Disrupting the Hotel Industry 65

3.1 The PESTEL Framework 67 Political Factors 68 Economic Factors 68 Sociocultural Factors 70 Technological Factors 70 Ecological Factors 70 Legal Factors 72

3.2 Industry Structure and Firm Strategy: The Five Forces Model 73

Industry vs. Firm Effects In Determining Firm Performance 73 Competition In the Five Forces Model 74 The Threat of Entry 76 The Power of Suppliers 79 The Power of Buyers 80 The Threat of Substitutes 82 Rivalry Among Existing Competitors 83 A Sixth Force: The Strategic Role of Complements 88

3.3 Changes over Time: Entry Choices and Industry Dynamics 90

Entry Choices 90 Industry Dynamics 92

3.4 Performance Differences within the Same Industry: Strategic Groups 93

The Strategic Group Model 93 Mobility Barriers 95

3.5 Implications for Strategic Leaders 96

CHAPTERCASE 3 / Consider This... 97

CHAPTER 4 INTERNAL ANALYSIS: RESOURCES, CAPABILITIES, AND CORE COMPETENCIES 106

CHAPTERCASE 4 Dr. Dre’s Core Competency: Coolness Factor 107

CONTENTS

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4.1 Core Competencies 110 4.2 The Resource-Based View 113

Two Critical Assumptions 114 The Vrio Framework 115 Isolating Mechanisms: How to Sustain A Competitive Advantage 120

4.3 The Dynamic Capabilities Perspective 124 4.4 The Value Chain and Strategic Activity Systems 128

The Value Chain 128 Strategic Activity Systems 130

4.5 Implications for Strategic Leaders 133 Using Swot Analysis to Generate Insights From External and Internal Analysis 134

CHAPTERCASE 4 / Consider This... 135

CHAPTER 5 COMPETITIVE ADVANTAGE, FIRM PERFORMANCE, AND BUSINESS MODELS 144

CHAPTERCASE 5 The Quest for Competitive Advantage: Apple vs. Microsoft 145

5.1 Competitive Advantage and Firm Performance 146 Accounting Profitability 146 Shareholder Value Creation 153 Economic Value Creation 155 The Balanced Scorecard 161 The Triple Bottom Line 164

5.2 Business Models: Putting Strategy into Action 165 The Why, What, Who, and How of Business Models Framework 167 Popular Business Models 168 Dynamic Nature of Business Models 170

5.3 Implications for Strategic Leaders 171

CHAPTERCASE 5 / Consider This... 172

PART TWO / FORMULATION 180 CHAPTER 6 BUSINESS STRATEGY: DIFFERENTIATION, COST LEADERSHIP, AND BLUE OCEANS 182

CHAPTERCASE 6 JetBlue Airways: Finding a New Blue Ocean? 183

6.1 Business-Level Strategy: How to Compete for Advantage 185

Strategic Position 186 Generic Business Strategies 186

6.2 Differentiation Strategy: Understanding Value Drivers 188

Product Features 191 Customer Service 191 Complements 191

6.3 Cost-Leadership Strategy: Understanding Cost Drivers 192

Cost of Input Factors 194 Economies of Scale 194 Learning Curve 196 Experience Curve 199

6.4 Business-Level Strategy and the Five Forces: Benefits and Risks 201

Differentiation Strategy: Benefits and Risks 201 Cost-Leadership Strategy: Benefits and Risks 203

6.5 Blue Ocean Strategy: Combining Differentiation and Cost Leadership 204

Value Innovation 205 Blue Ocean Strategy Gone Bad: “Stuck In the Middle” 207

6.6 Implications for Strategic Leaders 210

CHAPTERCASE 6 / Consider This... 211

CHAPTER 7 BUSINESS STRATEGY: INNOVATION, ENTREPRENEURSHIP, AND PLATFORMS 218

CHAPTERCASE 7 Netflix: Disrupting the TV Industry 219

7.1 Competition Driven by Innovation 221 The Innovation Process 222

7.2 Strategic and Social Entrepreneurship 225 7.3 Innovation and the Industry Life Cycle 227

Introduction Stage 228 Growth Stage 230 Shakeout Stage 233 Maturity Stage 234 Decline Stage 234 Crossing the Chasm 235

7.4 Types of Innovation 242 Incremental vs. Radical Innovation 243 Architectural vs. Disruptive Innovation 245

7.5 Platform Strategy 249 The Platform vs. Pipeline Business Models 249 The Platform Ecosystem 250

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7.6 Implications for Strategic Leaders 254

CHAPTERCASE 7 / Consider This... 254

CHAPTER 8 CORPORATE STRATEGY: VERTICAL INTEGRATION AND DIVERSIFICATION 264

CHAPTERCASE 8 Amazon.com: To Infinity and Beyond 265

8.1 What Is Corporate Strategy? 268 Why Firms Need to Grow 268 Three Dimensions of Corporate Strategy 269

8.2 The Boundaries of the Firm 271 Firms vs. Markets: Make or Buy? 272 Alternatives on the Make-or-Buy Continuum 274

8.3 Vertical Integration along the Industry Value Chain 278

Types of Vertical Integration 279 Benefits and Risks of Vertical Integration 281 When Does Vertical Integration Make Sense? 283 Alternatives to Vertical Integration 284

8.4 Corporate Diversification: Expanding Beyond a Single Market 285

Types of Corporate Diversification 287 Leveraging Core Competencies for Corporate Diversification 291 Corporate Diversification and Firm Performance 293

8.5 Implications for Strategic Leaders 297

CHAPTERCASE 8 / Consider This... 298

CHAPTER 9 CORPORATE STRATEGY: STRATEGIC ALLIANCES, MERGERS, AND ACQUISITIONS 308

CHAPTERCASE 9 Little Lyft Gets Big Alliance Partners 309

9.1 How Firms Achieve Growth 310 The Build-Borrow-Buy Framework 310

9.2 Strategic Alliances 313 Why Do Firms Enter Strategic Alliances? 314 Governing Strategic Alliances 317 Alliance Management Capability 320

9.3 Mergers and Acquisitions 323 Why Do Firms Merge With Competitors? 323 Why Do Firms Acquire Other Firms? 325 M&A and Competitive Advantage 327

9.4 Implications for Strategic Leaders 329

CHAPTERCASE 9 / Consider This... 330

CHAPTER 10 GLOBAL STRATEGY: COMPETING AROUND THE WORLD 338

CHAPTERCASE 10 Sweden’s IKEA: The World’s Most Profitable Retailer 339

10.1 What Is Globalization? 342 Stages of Globalization 343 State of Globalization 344

10.2 Going Global: Why? 346 Advantages of Going Global 346 Disadvantages of Going Global 350

10.3 Going Global: Where and How? 353 Where In the World to Compete? The Cage Distance Framework 353 How Do MNES Enter Foreign Markets? 357

10.4 Cost Reductions vs. Local Responsiveness: The Integration-Responsiveness Framework 358

International Strategy 359 Multidomestic Strategy 360 Global-Standardization Strategy 360 Transnational Strategy 361

10.5 National Competitive Advantage: World Leadership in Specific Industries 362

Porter’s Diamond Framework 364 10.6 Implications for Strategic Leaders 366

CHAPTERCASE 10 / Consider This... 367

PART THREE / IMPLEMENTATION 376 CHAPTER 11 ORGANIZATIONAL DESIGN: STRUCTURE, CULTURE, AND CONTROL 378

CHAPTERCASE 11 Zappos: Of Happiness and Holacracy 379

11.1 Organizational Design and Competitive Advantage 381

Organizational Inertia: The Failure of Established Firms 382 Organizational Structure 384 Mechanistic vs. Organic Organizations 385

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11.2 Strategy and Structure 387 Simple Structure 387 Functional Structure 388 Multidivisional Structure 390 Matrix Structure 394

11.3 Organizing for Innovation 398 11.4 Organizational Culture: Values, Norms, and Artifacts 401

Where Do Organizational Cultures Come From? 403 How Does Organizational Culture Change? 404 Organizational Culture and Competitive Advantage 405

11.5 Strategic Control-and-Reward Systems 407 Input Controls 408 Output Controls 408

11.6 Implications for Strategic Leaders 409

CHAPTERCASE 11 / Consider This... 410

CHAPTER 12 CORPORATE GOVERNANCE AND BUSINESS ETHICS 418

CHAPTERCASE 12 Uber: Most Ethically Challenged Tech Company? 419

12.1 The Shared Value Creation Framework 421 Public Stock Companies and Shareholder Capitalism 421 Creating Shared Value 423

12.2 Corporate Governance 425 Agency Theory 426 The Board of Directors 428 Other Governance Mechanisms 430

12.3 Strategy and Business Ethics 433 Bad Apples vs. Bad Barrels 434

12.4 Implications for Strategic Leaders 437

CHAPTERCASE 12 / Consider This... 438

PART FOUR / MINICASES 447

PART FIVE / FULL-LENGTH CASES All available through McGraw-Hill Create, www.McGrawHillCreate.com/Rothaermel

Company Index 539 Name Index 545 Subject Index 547

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Frank T. Rothaermel Georgia Institute of Technology

FRANK T. ROTHAERMEL (PH.D.) is 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 Stud- ies Fellow. He received a National Science Foundation (NSF) CAREER award, which “is a Foundation-wide activity that offers the National Science Founda- tion’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 entre- preneurship. Frank has published over 30 articles in leading academic 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 economics 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 is the inaugural recipient of the Byars Faculty Excellence Award. Frank currently serves (or served) on the editorial boards of the Strategic Man- agement Journal, Organization Science, Academy of Management Journal, Academy of Manage- ment 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 field work and executive 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, NY), Georgia Institute of Technology, George- town University, ICN Business School (France), Politecnico di Milano (Italy), St. Gallen University (Switzerland), and the University of Washington. He received numerous teaching awards for excel- lence 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. His Strategic Management text has been translated into Mandarin, Korean, and Greek. Several of his case studies are Most Popular among the cases distributed by Harvard Business Publishing.

Frank held visiting professorships at the 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 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.

VISIT THE AUTHOR AT: http://ftrStrategy.com/

ABOUT THE AUTHOR

©Tony Benner

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PREFACE

The market for strategy texts can be broadly separated into two overarching categories: traditional, 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 book to address a needed new category—a third generation of strategy text 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 was overwhelmingly enthusiastic. Enthusiasm and support increased with each subsequent edi- tion. I’m truly grateful for the sustained support.

To facilitate an enjoyable and refreshing reading experience that enhances student learning 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 Dr. 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 informa- tion. 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 information. 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, Google, Tesla, Starbucks, Apple, McDonald’s, 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 success- ful leaders capable of making well-reasoned strategic decisions in a globalized and turbu- lent 21st century.

I’m pleased to introduce the new 4th edition of Strategic Management. My distinctive approach to teaching and transmitting strategy not only offers students a unique learning experience that combines theory and practice, but also provides tight linkages between concepts and cases. In this new 4th edition, I build upon the unique strengths of this prod- uct, and continue to add improvements based upon hundreds of insightful reviews and

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

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important feedback from professors, 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?”

■ Emphasis on diversity 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 an array of firms, including for-profit public (Fortune 100) companies, but also private companies (including startups) as well as non profit organizations. All of them need a good strategy!

■ Global perspective, with a focus on competing around the world, featuring many lead- ing companies from Asia, Europe, and Latin America, as well as the United States. I was fortunate to study, live, and work across the globe, and I attempt to bring this cosmopolitan perspective to bear in this text.

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

■ Industry-leading digital delivery option (Create), adaptive learning system (Smart- Book), 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

teaching notes; there are two types of cases that come with this text: ■ 12 ChapterCases begin and end each chapter, framing the chapter topic

and content. ■ 22 MiniCases (Part 4 of the book), all based on original research, provide

dynamic opportunities for students to apply strategy concepts by assigning them as add-ons to chapters, either as individual assignments or as group work, or by using them for class discussion.

I have taken great pride in authoring all 12 ChapterCases, Strategy Highlights (2 per chapter, for a total of 24), and 22 MiniCases. This additional touch allows quality control and ensures that chapter content and cases use one voice and are closely interconnected. Both types of case materials come with sets of questions to stimulate class discussion or provide guidance for written assignments. The instructor resources offer sample answers that apply chapter content to the cases.

In addition to these in-text cases, 23 full-length Cases, with 20 of them (that is almost 90 percent!) authored or co-authored by me specifically to accompany this textbook, are available through McGraw-Hill’s custom-publishing Create program (www.McGrawHill- Create.com/Rothaermel). Full-length cases NEW to the 4th edition are:

∙ Uber ∙ Netflix ∙ Starbucks ∙ Disney ∙ Walmart ∙ SpaceX

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Popular cases about Apple, Amazon, Facebook, McDonald’s, Tesla, and Best Buy among several others are significantly updated and revised. Robust and structurally updated case teaching notes are also available and accessible through Create; financial data for these cases may be accessed from the Instructor Resource Center in the Connect Library.

What’s New in the 4th Edition? I have revised and updated the 4th 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 4E: ■ New A-head section on “Changes over Time: Entry Choices and Industry Dynamics”

in Chapter 3. ■ New A-head section on “The Value Chain and Strategic Activity Systems” in Chapter 4. ■ New A-head section “Platform Strategy” in Chapter 7. ■ New A-head section “Organizing for Innovation” in Chapter 11 (closed and open

innovation). ■ All new or updated and revised ChapterCases (including: Tesla, Sheryl Sandberg at

Facebook, Airbnb, Uber vs. Lyft, IKEA, and Zappos). ■ All new or updated and revised StrategyHighlights (two per chapter). ■ New or fully updated and revised MiniCases (four new, 18 revised and updated). ■ Fully updated and revised full-length cases, including most popular cases such as

Apple, McDonald’s, Best Buy, Amazon, Facebook, Delta Air Lines, Alphabet’s Google, etc.

In detail:

CHAPTER 1 ■ New ChapterCase: “Tesla’s Secret Strategy.” ■ New Strategy Highlight: “Teach for America: How Wendy Kopp Inspires Future

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

Values” into Chapter 1 (from Chapter 2).

CHAPTER 2 ■ New ChapterCase: “Sheryl Sandberg: Leaning in at Facebook.” ■ Improved chapter flow through moving the updated section on “Stakeholder Strategy”

into Chapter 2 (from Chapter 1).

CHAPTER 3 ■ New ChapterCase: “Airbnb: Disrupting the Hotel Industry.” ■ New A-head section on “Changes over Time: Entry Choices and Industry Dynamics.” ■ Improved chapter flow through moving the updated section on industry and firm

effects into Chapter 3 (from Chapter 1).

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CHAPTER 4 ■ New A-head section on “The Value Chain and Strategic Activity Systems.” ■ New Strategy Highlight: “When Will P&G Play to Win Again?”

CHAPTER 5 ■ New section on “the Why, What, Who, and How of Business Models Framework.” ■ Extended and updated discussion of business models to include new popular applica-

tions and examples, with a more in-depth discussion. ■ Extended and updated discussion of competitive advantage and firm performance

using the ongoing competition between Apple and Microsoft as an example through- out the chapter, including comparing the same two companies along different metrics and approaches to assess competitive advantage. Added a stronger dynamic element.

CHAPTER 6 ■ New section on the learning curve concept applied to Tesla’s manufacturing process

with real-world data and graphic illustration.

CHAPTER 7 ■ New A-head section “Platform Strategy.” ■ New Strategy Highlight “Standards Battle: Which Automotive Technology Will Win?”

CHAPTER 8 ■ Updated and revised ChapterCase featuring Amazon’s corporate strategy through ver-

tical integration and diversification. ■ Updated and expanded section on parent-subsidiary relationship, featuring GM and

(former) subsidiaries Opel and Vauxhall in Europe.

CHAPTER 9 ■ New ChapterCase: “Little Lyft Gets Big Alliance Partners,” featuring the smaller

ride-hailing competitor’s astute use of strategic alliances with strong partners such as GM and Alphabet’s Waymo to compete against Uber.

■ New Strategy Highlight “How Tesla Used Alliances Strategically”.

CHAPTER 10 ■ New section on “Globalization 3.1: Retrenchment?” ■ Updated and revised ChapterCase: “Sweden‘s IKEA: The World’s Most Profitable

Retailer,” highlighting IKEA’s strategy on competing in both developed and emerging economies across the world.

■ New Exhibit 10.4 juxtaposing: “Advantages and Disadvantages of International Expansion”.

■ Updated and revised Strategy Highlight: “Walmart Retreats from Germany, and Lidl Invades the United States,” highlighting how disruptors of the German grocery indus- try (Aldi and Lidl) are challenging Walmart on its home turf.

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CHAPTER 11 ■ New A-head Section “Organizing for Innovation” (closed and open innovation). ■ New Strategy Highlight: “Sony vs. Apple: Whatever Happened to Sony?” ■ New Exhibit 11.11 juxtaposing: “Advantages and Disadvantages of Different Organi-

zational Structures”.

CHAPTER 12 ■ Updated and revised ChapterCase: “Uber: Most Ethically Challenged Tech Company?”

including co-founder and long-time CEO Travis Kalanick’s forced resignation in the wake of several ethics scandals.

■ Updated and revised Strategy Highlight: “Why the Mild Response to Goldman Sachs and Securities Fraud?”

MINICASES ■ Added four-new: Yahoo, IBM, Dollar Shave Club, and Disney. ■ Updated and revised the most popular 18 MiniCases from the third edition. ■ Stronger focus on non-U.S. firms, especially on global competitors from Asia and

Europe. ■ Stronger focus on U.S. companies competing in China and India, facing strong

domestic competitors.

FULL-LENGTH CASES ■ All cases—including the new and revised cases plus all cases from the previous edi-

tions that were authored by Frank T. Rothaermel—are available through McGraw-Hill Create: http://www.mcgrawhillcreate.com/Rothaermel.

■ Added five new, author-written full-length Cases: Netflix, Starbucks, Uber, Walmart, and Disney.

■ Added one new, full-length Case: SpaceX by David R. King ■ Revised and updated the most popular cases including: Amazon, Apple, Alphabet’s

Google, Best Buy, Facebook, McDonald’s, Tesla, Delta Air Lines, and UPS in India, among others.

■ Updated and revised the popular case “The Movie Exhibition Industry” by Steve Gove. ■ Case Strategic Financial Analyses (SFAs) include financial data in e-format for analysis.

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

■ SmartBook, one of the first fully adaptive and individualized study tools, provides students with a personalized learning experience, giving them the opportunity to prac- tice and challenge their understanding of core strategy concepts. SmartBook has been extremely well received by strategy instructors across the globe. It allows the instruc- tor to set up all assignments prior to the semester, to have them auto-released on pre- set dates, and to receive auto-graded progress reports for each student and the entire class. Students love SmartBook because they learn at their own pace, and it helps

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PREFACE xix

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them to study more efficiently by delivering an interactive reading experience through adaptive highlighting and review.

■ Interactive Application Exercises (such as Whiteboard Animation video cases, MiniCase case analyses, click-and-drag activities, and new case exercises for Ama- zon, Apple, Tesla, McDonald’s, Best Buy, and Facebook) that require students to apply key concepts and so to close the knowing and doing gap, while providing instant feedback for the student and progress tracking for the instructor.

■ Running case, an activity that begins with a review of a specific company and its applied strategy using appropriate tools (e.g., PESTEL, Porter’s five forces, VRIO, SWOT, and others). The analysis progresses from a broad perspective to the appro- priate company-level perspective—i.e., from global to industry to strategic group to company and within a firm. Students will develop a complete strategy analysis for the company and consider several scenarios for improving the company’s competitive advantage. The scenarios will include a financial analysis and justification and ulti- mately provide a specific recommendation. Connect provide a running case example for Hewlett-Packard (now HP Inc. and Hewlett Packard Enterprise).

■ Resources for financial analysis (such as strategic financial ratios, templates for strategic financial analysis, and financial ratio reviews) that provide students with the tools they need to compare performance among firms and to refresh or extend their working knowledge of major financial measures in a strategic framework.

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

cases (and Teaching Notes) that accompany Strategic Management (http://www. mcgrawhillcreate.com/Rothaermel). You can create customized course packages in print and/or digital form at a competitive price point.

■ Through CREATE, you will be able to select from 20 author-written cases and 3 instructor-written cases that go specifically with the new 4th edition, as well as cases from Harvard, Ivey Darden, NACRA, and much more! You can: Assemble your own course, selecting the chapters, cases (multiple different 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, pre-loaded in CREATE. Among the pre-loaded solutions, you’ll find options for undergrad, MBA, accelerated, and other strategy courses.

INSTRUCTOR RESOURCES Located in the Connect Library under the Instructor’s Resources tab, instructors will find tested and effective tools to support teaching:

■ The updated and revised 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 application or company examples, teaching tips, PowerPoint references, critical discussion topics, and answers to end-of-chapter exercises.

■ The PowerPoint (PPT) slides, available in an accessible version for individuals with visual impairment, provide comprehensive lecture notes, video links, and company

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examples not found in the textbook. Options include instructor media-enhanced slides as well as notes with outside application examples.

■ The Test Bank includes 100–150 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. It’s tagged by learning objectives, Bloom’s Taxonomy levels, and AACSB compliance requirements. Many questions are new, and especially written for the new 4th edition.

■ 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 Corner, The McKinsey Quarterly, ABC, BBC, CBS, CNN, ITN/Reuters, MSNBC, NBC, PBS, and YouTube.

Any list of acknowledgments will almost always be incomplete, but I would like to thank some special people without whom this text would not have been possible. First and fore- most, 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 conduct 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 provided 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 grateful for Dean Maryam Alavi and Senior Associate Dean Peter Thompson for providing the exceptional leadership that allows faculty to fully focus on research, teaching, and ser- vice. I have been at Georgia Tech for 15 years, and could not have had better colleagues— all of whom are not only great scholars but also fine individuals whom I’m fortunate to have as friends: Marco Ceccagnoli, Annamaria Conti, Jonathan Giuliano, Stuart Graham, Matt Higgins, David Ku, John McIntyre, Alex Oettl, Pian Shu, Eunhee Sohn, and Laurina Zhang. We have a terrific group of current and former PhD students, many of whom had a positive influence on this project, including Shanti Agung (Drexel University), Drew Hess (Washington and Lee University), Kostas Grigoriou (McKinsey), Congshan Li, Jaiswal Mayank (Rider University), Nicola McCarthy, German Retana (INCAE Business School, Costa Rica), Maria Roche, Briana Sell Stenard (Mercer University), Jose Urbina, Carrie Yang (University of Chicago), and Wei Zhang (Singapore Management University).

I was also fortunate to work with McGraw-Hill, and the best editorial and market- ing team in the industry: Michael Ablassmeir (director), Susan Gouijnstook (man- aging director), Lai T. Moy (senior product developer), Debbie Clare (executive marketing manager), Mary E. Powers and Keri Johnson (content project managers), Matt Diamond (senior designer), and Haley Burmeister (editorial coordinator). Bill Teague, content development editor, worked tirelessly and carefully on the fourth edition manu- script. I’m also indebted to Ann Torbert and Karyn Lu for invaluable editorial guidance on prior editions.

ACKNOWLEDGMENTS

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ACKNOWLEDGMENTS xxi

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

■ Heidi Bertels (College of Staten Island, CUNY) on the Test Bank and SmartBook ■ John Burr (Purdue University) on the Video Guide ■ Melissa Francisco (University of Central Florida) on the accessible PowerPoint

Presentations

■ Anne Fuller (California State University, Sacramento), on Connect, Teacher’s Resource Manual, and End-of-Chapter Material

■ David R. King (Florida State University) on select Full-length Cases and Full-length Case Teaching Notes

■ Chandran Mylvaganam (Northwood University) on the MiniCase Teaching Notes Shawn Riley (Kutztown University) for his expert reviews on the Case Exercises, Case SFAs, and MiniCase Case Analyses

I’d also like to thank the students at Georgia Tech, in the undergraduate and full-time day MBA, and the evening and executive MBA programs, as well as the executive MBA students from the ICN Business School in Nancy, France, on whom the materials were beta-tested. Their feedback helped fine-tune the content and delivery.

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 pro- spectus to the final teaching and learning package that you hold in your hands. The review- ers have given us the greatest gift of all—the gift of time! These very special people are listed starting on page xxii.

Frank T. Rothaermel Georgia Institute of Technology

Web: ftrStrategy.com Email: [email protected]

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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 and symposiums, from hundreds of reviews from reviewers across the coun- try, and from beta-testing of the first-edition manuscript as well as market reviews of the of subsequent editions on a variety of campuses. 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 improved this product.

Joshua R. Aaron East Carolina University

Moses Acquaah University of North Carolina, Greensboro

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REVIEWERS AND SYMPOSIUM ATTENDEES

THANK YOU . . .

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THANK YOU . . . xxiii

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James W. Bronson University of Wisconsin, Whitewater

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©McGraw-Hill Education

McGraw-Hill Connect® is a highly reliable, easy-to- use homework and learning management solution that utilizes learning science and award-winning adaptive tools to improve student results.

73% of instructors who use Connect

require it; instructor satisfaction increases

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Education products more intelligent, reliable, and precise.

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need internet access to use the eBook as a reference, with full functionality.

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Quality Content and Learning Resources

Connect’s assignments help students contextualize what they’ve learned through application, so they can better understand the material and think critically.

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SmartBook helps students study more efficiently by delivering an interactive reading experience through adaptive highlighting and review.

Homework and Adaptive Learning

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More students earn As and Bs when

they use Connect.

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Connect Insight® generates easy-to-read reports on individual students, the class as a whole, and on specific assignments.

The Connect Insight dashboard delivers data on performance, study behavior, and effort. Instructors can quickly identify students who struggle and focus on material that the class has yet to master.

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Robust Analytics and Reporting

Connect integrates with your LMS to provide single sign-on and automatic syncing of grades. Integration with Blackboard®, D2L®, and Canvas also provides automatic syncing of the course calendar and assignment-level linking.

Connect offers comprehensive service, support, and training throughout every phase of your implementation.

If you’re looking for some guidance on how to use Connect, or want to learn tips and tricks from super users, you can find tutorials as you work. Our Digital Faculty Consultants and Student Ambassadors offer insight into how to achieve the results you want with Connect.

Trusted Service and Support

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PART

Analysis

CHAPTER 1 What Is Strategy?

CHAPTER 2 Strategic Leadership: Managing the Strategy Process

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

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

CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models

1

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Part 1: Analysis

Part 1: Analysis

Part 2: Formulation

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 3: Implementation

Part 2: Formulation

The AFI Strategy Framework

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CHAPTER What Is Strategy?

Chapter Outline

1.1 What Strategy Is: Gaining and Sustaining Competitive Advantage What Is Competitive Advantage?

1.2 Vision, Mission, and Values Vision Mission Values

1.3 The AFI Strategy Framework

1.4 Implications for Strategic Leaders

Learning Objectives

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 disad- vantage, and competitive parity.

LO 1-3 Describe the roles of vision, mission, and values in a firm’s strategy.

LO 1-4 Evaluate the strategic implications of product-oriented and customer-oriented vision statements.

LO 1-5 Justify why anchoring a firm in ethical core values is essential for long-term success.

LO 1-6 Explain the AFI strategy framework.

1

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Tesla’s Secret Strategy

IN 2017, TESLA INC.— an American manufacturer of all-electric cars—boasted a market capitalization1 of over $60 billion, an appreciation of more than 1,400 percent over its initial public offering price in 2010. How can a California startup achieve a market valuation that exceeds that of GM, the largest car manufacturer in the world, making some 10 million vehicles a year? The answer: Tesla’s Secret Strategy. In a blog entry on Tesla’s website in the summer of 2006, 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 generation options.

5. Don’t tell anyone.

Let’s see if Tesla stuck to its strategy. In 2008, Tesla introduced its first car: the Roadster, a $110,000 sports coupe with faster accel- eration 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 com- pleted 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 a base price of $73,500 before tax credits. 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 outstanding 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 Con- sumer Reports (99/100). Tesla manufactures the Model S in the Fremont, California, factory that it purchased from Toyota. By the end of 2016, it had sold some 125,000 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 starting sticker price of the Model X is quite steep, however; thus limiting mass-market appeal. Techni- cal difficulties with its innovative doors delayed its launch until the fall of 2015.

Tesla has now reached Step 3 of its master plan. In 2017, Tesla delivered the company’s newest car: the

Model 3, an all- electric compact luxury sedan, with a starting price of $35,000. Tesla received some 375,000 preorders within three months of unveiling its model. Many of the want-to-be Tesla owners stood in line overnight, eagerly awaiting the open- ing of the Tesla stores to put down a $1,000 deposit to secure a spot on the waiting list for the Model 3, a car they had never even seen, let alone taken for a

test drive. By the time Tesla delivered the first 30 cars of its new Model 3 (to Tesla employees for quality test- ing and appreciation of their hard work), the California car maker had received over 500,000 preorders. This cus- tomer enthusiasm amounted to $500 million in interest- free loans for Tesla. The Model 3 was slated for delivery by late 2017. Tesla hoped to sell 500,000 total vehicles by the end of 2018. To accomplish this ambitious goal, Musk also promised that Tesla would increase its annual production from 50,000 in 2015 to 1 million vehicles a year by 2020.

CHAPTERCASE 1

Tesla’s Model X with falcon wing doors. ©Bloomberg/Getty Images

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LO 1-1

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

WHY IS TESLA SO SUCCESSFUL? In contrast, 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 managers influ- ence firm performance? These are the big questions that define strategic management. Answering these questions requires integrating the knowledge you’ve obtained in your studies of various business disciplines to understand what leads to superior performance, and how you can help your organization achieve it.

Strategic management is the integrative management field that combines analysis, formulation, and implementation in the quest for competitive advantage. Mastery of stra- tegic management 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 organization 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 introduce foundational ideas about strategy and competitive advantage. We then move from thinking about why strategy is important to considering the role an organization’s vision, mission, and values play in its strategy. Next, we take a closer look at the compo- nents of the AFI framework and provide an overview of the entire strategic management process. We conclude this introductory 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 jour- ney to understand strategic management 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 per- formance relative to competitors.4 To achieve superior performance, companies compete for resources: New ventures compete for financial and human capital, existing companies compete for profitable growth, charities compete for donations, universities compete for the best students and professors, sports teams compete for championships, while celebri- ties compete for media attention.

As highlighted in the ChapterCase, Tesla, a new entrant in the automotive industry, is com- peting with established U.S. companies such as GM, Ford, and Chrysler and also with for- eign automakers Toyota, Honda, Mercedes, and BMW, among others, for customers. In any

Step 4 of Musk’s master plan for Tesla aims to pro- vide zero-emission electric power generation options. To achieve this goal, Tesla acquired SolarCity, a solar energy company, for more than $2 billion in the fall of 2016. This joining creates the world’s first fully integrated clean-tech energy company by combining solar power, power storage, and transportation. A successful integration of Tesla and

SolarCity, where Musk is also chairman and an early inves- tor, would allow completion of Step 4 of Tesla’s master plan.

Step 5: “Don’t tell anyone”—thus the ChapterCase title “Tesla’s Secret Strategy.”3

You will learn more about Tesla by reading this chapter; related ques- tions appear in “ChapterCase 1 / Consider This . . . .”

strategic management An integrative management 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 performance relative to competitors.

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competitive situation, a good strategy enables a firm to achieve superior performance relative to its competitors. This leads to the question: What is a good strategy?

1. A diagnosis of the competitive challenge. This element is accomplished through analy- sis 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 accomplished through strategy implementation (Part 3 of the AFI framework).

Let’s revisit ChapterCase 1 to see whether Tesla, Inc. is pursuing a good strategy. Tesla appears to be performing quite well when considering indicators such as stock apprecia- tion, where it outperforms its competitors by a wide margin. The high appreciation of Tesla stock points to investors’ expectations of future growth. By other measures, such as generating profits, Tesla underperforms compared to established car companies. Losses are common for startups early on, especially if the business requires large upfront invest- ments such as building new 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 gaining a competitive advantage. But can Tesla sustain its advantage over time? Let’s use the three elements of a good strategy to assess how Tesla CEO Elon Musk could turn an early lead into a sustainable competitive advantage.

THE COMPETITIVE CHALLENGE. A good strategy needs to start with a clear and criti- cal 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 working to set a new standard in automotive technology. He hopes that zero-emission elec- tric 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 running 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 vehi- cles 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 for- mulate an effective guiding policy in response. The formulated strategy needs to be consis- tent, 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. Without consistency in strategy, moreover, other stakeholders, including investors, also become frustrated.

To address the competitive challenge, Tesla’s current guiding policy is to build a cost- competitive mass-market vehicle such as the new Model 3 (this is also Step 3 in Tesla’s “Secret Strategy,” as discussed in the ChapterCase). Tesla’s formulated strategy is consis- tent with its mission and the competitive challenge identified. It also requires significant strategic commitments such as Tesla’s $5 billion investment in a new lithium-ion battery

Good strategy A strategy is good when it 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; and (3) a set of coherent actions to implement a firm’s guiding policy.

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plant in Nevada, the so-called Gigafactory. Batteries are the most critical component for electric vehicles. To accomplish this major undertaking, Tesla has partnered with Pana- sonic of Japan, a world leader in battery technology.

COHERENT ACTIONS. Finally, a clear guiding policy needs to be implemented with a set of coherent 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 per year by 2020. Tesla’s retooling of its manufacturing facility in Fremont, California, to rely more heavily on cutting-edge robotics as well as its multibillion-dollar investment to secure an uninterrupted supply of lithium-ion batteries are examples of actions coherent with Tesla’s formulated strategy. At the same time, Tesla is further building out its network of charg- ing stations across the United States and globally. To fund this initiative, it announced that using the company’s charging network will no longer be free for new Tesla owners.

To accomplish the lofty goal of making zero-emission electric motors the new standard in automotive technology (rather than gas-powered internal combustion engines), Tesla decided to make 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 manufacturers, such as BMW with its i3 line of vehicles, can employ Tesla’s technology.

In review, to create a good strategy, three steps are crucial. 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.

WHAT IS COMPETITIVE ADVANTAGE? 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 industry average. A firm that achieves superior perfor- mance relative to other competitors in the same industry or the industry average has a competitive advantage.9 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 pro- longed period has a sustainable competitive advantage. Apple, for example, has enjoyed a sustainable 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 Xiaomi and Huawei of China are trying to gain traction.

If a firm underperforms its rivals or the industry average, it has a competitive disadvantage. For example, a 15 percent return on invested capital may sound like

LO 1-2

Define competitive advantage, sustainable competitive advantage, competitive disadvantage, and competitive parity.

competitive advantage Superior performance relative to other competitors in the same industry or the industry average.

competitive disadvantage Underperformance relative to other competitors in the same industry or the industry average.

sustainable competitive advantage Outperforming competitors or the industry average over a prolonged period of time.

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superior firm performance. In the consulting industry, though, where the average return on invested capital 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 declin- ing industry, like newspaper 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 similar to the competitors’ at a lower price. The rewards of superior value creation and capture are profitability and market share. Elon Musk is particularly motivated to address 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 lower prices than his competitors when creating Walmart, the world’s largest retailer. For Musk, Blakely, Walton, and numerous other entrepreneurs and busi- nesspeople, 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.

The important point here is that strategy is about creating superior value, while contain- ing 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 differentiation. In regard to the customer service dimension, Walmart provides acceptable service 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.

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

Spanx founder and CEO Sara Blakely, a graduate of Florida State University, is the world’s youngest female billionaire.

©ZUMA Press Inc/Alamy Stock Photo

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The key to successful strategy is to combine a set of activities to stake out a unique stra- tegic position within an industry. Competitive advantage has to come from performing dif- ferent 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.10 Because resources are limited, manag- ers must carefully consider their strategic choices in the quest for competitive advantage. Trying to be everything to everybody will likely result in inferior performance. In addition, 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 competitive 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 customers 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.11 Be on the lookout for the following major hallmarks of what strategy is not:

1. 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 “ambition is to have the largest audience in the world.”12 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 fundamentals. As we will discuss in the next section, an effective vision and mission can lay the foundation 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 consideration of economic fundamentals, in particular, value cre- ation and costs.

2. A failure to face a competitive challenge is not strategy. If the firm does not define a clear competitive challenge, employees have no way of assessing whether they are making progress in addressing it. Managers 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.

3. 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 strategy, 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 com- petitive advantage. In this text, though, we will reserve the term strategy for describing the firm’s overall efforts to gain and sustain competitive advantage.

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1.2 Vision, Mission, and Values The first step to gain and sustain a competitive advantage is to define an organization’s vision, mission, and values. Managers must ask 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 guardrails 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 identi- fies the primary long-term objective of the organization. Strategic leaders need to begin with the end in mind.13 In fact, early on strategic success is created twice. Leaders create the vision in the abstract by formulating strategies that enhance the chances of gaining and sustaining competitive advantage, before any actions of strategy implementation are taken in a second round of strategy creation. This process is similar to building a house. The future owner must communicate her vision to the architect, who draws up a blueprint of the home for her review. The process is iterated a couple of times until all the home- owner’s ideas have been translated into the blueprint. Only then does the building of the house begin. The same holds for strategic success; it is first created through strategy for- mulation 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 motivates employees at all levels to aim for the same target, while leaving room for indi- vidual 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.14

Employees in visionary companies tend to feel part of something bigger than them- selves. An inspiring vision helps employees find meaning in their work. Beyond monetary rewards, it allows employees to experience a greater sense of purpose. People have an intrinsic motivation to make the world a better place through their work activities.15 This greater individual purpose in turn can lead to higher organizational performance.16 Basing actions on its vision, a firm will build the necessary resources and capabilities through continuous organizational learning, including learning from failure, to translate into reality what begins as a stretch goal or strategic intent.17

To provide meaning for employees in pursuit of the organization’s ultimate goals, vision statements should be forward-looking and inspiring. Strategy Highlight 1.1 shows how Wendy Kopp, the founder of Teach for America, uses an inspiring vision to effec- tively and clearly communicate what TFA ultimately wants to accomplish, while providing a stretch goal.

It’s not surprising that vision statements can be inspiring and motivating in the non- profit sector. Many people would find meaning in wanting to help children attain an excel- lent education (TFA) or wanting to be always there, touching the lives of people in need, the vision of the American Red Cross. But what about for-profit firms?

LO 1-3

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

vision A statement about what an organization ultimately wants to accomplish; it captures the company’s aspiration.

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

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Teach for America: How Wendy Kopp Inspires Future Leaders

unattractive, low-status job into a high-prestige professional opportunity. Kopp works to eliminate educational inequality by enlisting the nation’s most promising future leaders in the effort. Thus to be chosen for TFA is a badge of honor.

In the first four months after creating TFA, Kopp received more than 2,500 applicants. Her marketing consisted of fly- ers in dorm rooms. During its first academic year (1990–91), TFA was able to serve five states and reached some 36,000 students. After 25 years, during the 2015–16 academic year, some 20,000 TFA corps members were teaching in 36 states (and Washington, D.C.) and more than 1,000 schools. To date, TFA has reached over 10 million students.

To see how all three components—vision, mission, and values—work together, see Exhibit 1.1, which provides a snap- shot of aspirations at Teach for America.

While initially targeted at college seniors, today, one-third of all TFA corps members applied as graduate students or professionals. In 2015, TFA added 4,100 new teachers to its corps from over 27,300 applications, representing more than 800 colleges and universities throughout the United States. This equates to about 15 percent acceptance, roughly equiv- alent to the admission rate of highly selective universities such as Northwestern, Cornell, or University of California, Berkeley. TFA’s teaching cohort is also much more diverse than the national average: While some 20 percent of teach- ers nationwide are people of color, about 50 percent of TFA corps members are. TFA corps members receive the same pay as other first-year teachers in the local school district.

Most importantly, TFA makes a significant positive impact on students. Some 95 percent of all school principals work- ing with TFA members say these teachers make a positive difference. 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.

In 2016, after celebrating its 25th anniversary, TFA CEO Elisa Villanueva Beard recalls that she was inspired to sign up for TFA (when a freshman in high school) by Wendy Kopp’s “audacity to believe young people could make a profound dif- ference in the face of intractable problems standing between the ideals of a nation I loved and a starkly disappointing real- ity; who were bound by a fierce belief that all children, from American Indian reservations in South Dakota to Oakland to the Rio Grande Valley to the Bronx, should have the opportu- nity to write their own stories and fulfill their true potential.”18

Strategy Highlight 1.1

Wendy Kopp, Teach for America founder. ©Bloomberg/Getty Images

Teach for America (TFA) is a cadre of future leaders who work to ensure that underprivileged youth get an excellent educa- tion. The nonprofit organization recruits both graduates and professionals to teach for two years in economically disadvan- taged communities in the United States. TFA’s vision is: One day, all children in this nation will have the opportunity to attain an excellent education.

The idea behind TFA was developed by then-21-year-old Wendy Kopp as her college senior thesis (in 1989). Kopp was convinced that young people generally search for meaning in their lives by making a positive contribution to society. The genius of Kopp’s idea was to turn on its head the social perception of teaching—to make what could appear to be an

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VISION One day, all children in this nation will have the opportunity to attain an excellent education.

MISSION Our mission is to enlist, develop, and mobilize as many as possible of our nation’s most promising future leaders to grow and strengthen the movement for educational equity and excellence.

VALUES Transformational Change: We seek to expand educational opportunity in ways that are life- changing for children and transforming for our country. Given our deep belief in children and communities, the magnitude of educational inequity and its consequences, and our optimism about the solvability of the problem, we act with high standards, urgency, and a long-term view.

Leadership: We strive to develop and become the leaders necessary to realize educational excellence and equity. We establish bold visions and invest others in working towards them. We work in purposeful, strategic, and resourceful ways, define broadly what is within our control to solve, and learn and improve constantly. We operate with a sense of possibility, persevere in the face of challenges, ensure alignment between our actions and beliefs, and assume personal responsibility for results.

Team: We value and care about each other, operate with a generosity of spirit, and have fun in the process of working together. To maximize our collective impact, we inspire, challenge, and support each other to be our best and sustain our effort.

Diversity: We act on our belief that the movement to ensure educational equity will succeed only if it is diverse in every respect. In particular, we value the perspective and credibility that individuals who share the racial and economic backgrounds of the students with whom we work can bring to our organization, classrooms, and the long-term effort for change.

Respect & Humility: We value the strengths, experiences, and perspectives of others, and we recognize our own limitations. We are committed to partnering effectively with families, schools, and communities to ensure that our work advances the broader good for all children.

EXHIBIT 1.1 / Teach for America: Vision, Mission, and Values

SOURCE: www.teachforamerica.org.

Visionary companies, such as 3M, General Electric, Procter & Gamble (P&G), and Walmart, provide more aspirational ideas that are not exclusively financial. The upscale retailer Nordstrom’s vision, for example, is to provide outstanding service every day, one customer at a time. Visionary companies often outperform their competitors over the long run. Tracking the stock market performance of companies over several decades, strategy scholars found that visionary companies outperformed their peers by a wide margin.19 A truly meaningful and inspiring vision makes employees feel they are part of something bigger. This is highly motivating and, in turn, can improve firm financial performance.

MISSION Building on the vision, organizations establish a mission, which describes what an organi- zation 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 interchange- ably, but in the strategy process they differ. ■ A vision defines what an organization wants to accomplish ultimately, and thus the

goal can be described by the infinitive form of the verb starting with to. As discussed in Strategy Highlight 1.1, TFA’s vision is to attain an excellent education for all children.

■ A mission describes what an organization does; it defines how the vision is accom- plished and is often introduced with the preposition by. Accordingly, we can recast

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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TFA’s mission that it will achieve its vision 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. (See Exhibit 1.1).

To be effective, firms need to back up their visions and missions with strategic commitments, in which the enterprise undertakes credible actions. Such commitments are costly, long-term oriented, and difficult to reverse.20 However noble the mission state- ment, to achieve competitive advantage companies need to make strategic commitments informed by economic fundamentals of value creation.

As mentioned in the ChapterCase, Tesla is investing billions of dollars to equip its car factory 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 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 translate this vision into reality by providing affordable zero-emission mass- market cars that are the best in class, which captures Tesla’s mission.

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 chang- ing 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.21

Clayton Christensen shares how a customer focus let him help a fast food chain increase sales of milk shakes. The company approached Christensen after it had made several changes to its milk-shake offering based on extensive customer feedback but sales failed to improve. Rather than asking customers what kind of milk shake they wanted, he thought of the problem 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 milk shake?”22 He wanted to know what problem the customers were trying to solve. Surprisingly he found that roughly half of the milk 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 milk-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 underly- ing 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 companies with a competitive advantage.23 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 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

LO 1-4

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

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monopoly, especially in long-distance travel, these companies were initially extremely profitable. 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 automo- bile 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 con- sumer. 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 solu- tions to professional communication needs.” Companies with customer-oriented visions can more easily adapt to changing environments. Exhibit 1.2 provides additional exam- ples 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.24 For example, consider the need to transmit information over long distances. Communication needs have persisted throughout the mil- lennia, but the technology to solve this problem has changed drastically over time.25 Dur- ing 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, railroads handled this task, while an airplane was used when Franklin Delano Roosevelt was president. Today,

EXHIBIT 1.2 / Companies with Customer-Oriented Vision Statements

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.

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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. Chris- tensen recommends that strategic 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 adaptation. 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 trav- eled 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.”26 Instead, Henry Ford’s original vision was to make the automobile accessible to every American. He succeeded, and the automobile dramatically changed how mobility 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 electric power or hydrogen. 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 have greatly constrained 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 micropro- cessor 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 busi- ness. Intel’s customers 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 important. 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” adver- tising campaign in the 1990s that made Intel a household name worldwide.

Intel accomplished superior firm performance over decades through continuous adap- tations to changing market realities. Its formal vision statement lagged behind the firm’s strategic transformations. Intel regularly changed its vision statement after it had accom- plished each successful transformation.27 In such a case, vision statements and firm perfor- mance are clearly not related to one another.

It is also interesting to note that customer-oriented visions also frequently change over time. When Telsa was founded in 2003, its mission was to accelerate the world’s

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transition to sustainable transport. Over the last decade or so, Tesla completed several steps of its initial master plan (as detailed in the opening case), including providing zero- emission electric power generation options (Step 4), through the acquisition of the Solar- City. Tesla, therefore, 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 transition to sustainable energy. To reposition Tesla as an inte- grated clean-tech energy company, in 2017, Tesla changed its official name from Tesla Motors to 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.28

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

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 the employees to understand the company culture. It offers bedrock principles that employees at all levels can use to deal with complexity and to resolve conflict. Such statements can help provide the organi- zation’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 standards 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 behav- ior of individuals within a firm or organization. Strong ethical values have two important functions. 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 company 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. Strategy Highlight 1.2, featuring the pharmaceutical company Merck, provides an example of how values can drive strategic decision making, and what can happen if a company deviates from its core values.

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,

LO 1-5

Justify why anchoring a firm in ethical core values is imperative for long- term success.

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

Organizational core values Ethical standards and norms that govern the behavior of individuals within a firm or organization.

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Merck: Reconfirming Its Core Values 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.29

ENDING RIVER BLINDNESS In 1987, Ray Vagelos, a former Merck scientist turned CEO, announced the company would donate its recently discovered drug Mectizan, without charge, to treat river blindness. For centuries, river blindness—a parasitic disease that leads to loss of eyesight—plagued remote communi- ties 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 treatments, and some 120,000 communities served, the disease had effectively been eradicated. Merck’s current CEO, Kenneth Frazier, announced himself “humbled” by the result of the company’s value-driven actions.30

WITHDRAWING VIOXX In the case of another drug, though, Merck’s values were brought into question. 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 con- tracts and free retreats at exotic resorts.

Merck’s new drug was a blockbuster, generating revenues 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 sup- pressed evidence about Vioxx’s dangerous side effects from

early clinical trials. In 2004, Merck voluntarily 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 discon- tinued. . . . After analyzing the data further and consulting with outside experts, the Merck scientists recommended that we voluntarily withdraw the drug.”31

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 continued 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.32

Strategy Highlight 1.2

Kenneth Frazier, CEO of Merck. ©Bloomberg/Getty Images

especially by the top management team. Unethical behavior by top managers is like a virus that spreads quickly throughout an entire organization. It is imperative that strategic lead- ers set an example of ethical behavior by living the core values. Strategic leaders have a strong influence in setting an organization’s vision, mission, and values. This is the first step in the entire strategic management process, which is captured in the AFI strategy framework to which we turn next.

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1.3 The AFI Strategy Framework How do organizations 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 three broad tasks:

1. Analyze (A) 2. Formulate (F) 3. Implement (I)

The tasks of analyze, formulate, and implement are the pillars of research and knowl- edge about strategic management. Although we will study each of these tasks one at a time, they are highly interdependent and frequently happen simultaneously. Effective managers do not formulate strategy without thinking about how to implement it, for instance. Like- wise, while implementing strategy, managers are analyzing the need to adjust to changing circumstances.

We’ve captured these interdependent relationships in the AFI strategy framework shown in Exhibit 1.3. This framework (1) explains and predicts differences in firm per- formance, and (2) helps managers formulate and implement a strategy that can result in superior performance. In each of the three broad strategy tasks, managers focus on specific questions, listed below. We address these questions in specific chapters, as indicated.

LO 1-6

Explain the AFI strategy framework.

EXHIBIT 1.3 / The 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: Analysis

Part 1: Analysis

Part 2: FormulationPart 2: Formulation

Part 3: Implementation

AFI strategy framework A model that links three interdependent strategic management tasks— analyze, formulate, and implement—that, together, help managers plan and implement a strategy that can improve performance and result in competitive advantage.

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Strategy Analysis (A) Topics and Questions ■ Strategic leadership and the strategy process: What roles do strategic leaders play? What

is the firm’s process for creating strategy and how does strategy come about? What is the relationship between stakeholder strategy and competitive advantage? (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)

■ Internal analysis: What effects do internal resources, capabilities, and core competen- cies 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 relationship between competitive advantage and firm performance? (Chapter 5)

Strategy Formulation (F) Topics and Questions ■ 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 geogra-

phy? (Chapters 8 and 9) ■ Global strategy: How and where should the firm compete: local, regional, national, or

international? (Chapter 10)

Strategy Implementation (I) Topics and Questions ■ 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 1.3 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 strategy process map, presented at the end of Chapter 1, illustrates the steps in the AFI framework in more detail. The different background shades correspond to each step in the AFI framework. This strategy process map highlights the key strategy concepts and frameworks we’ll cover in each chapter. It also serves as a checklist when you conduct a strategic management analysis.

We next turn to the Implications for Strategic Leaders section to provide practical appli- cations 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 defines the competitive challenge, provides a guiding policy, and is implemented by coherent actions. Superior performance is the consequence of a good strategy. Moreover, strategic leaders appreciate the fact that competition is everywhere; this awareness infuses the other elements of strategy. You need a good strategy to deal with competition.

To create a powerful foundation upon which to formulate and implement a good strat- egy, strategic leaders need 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

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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:33

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.

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

CHAPTERCASE 1 Consider This . . .

with energy storage from SolarCity. It provides energy generation via beautiful new solar roofs that look like regu- lar shingles, but cost less, all things considered, and last lon- ger. Tesla also offers its Powerwall to residential consumers, which allows customers to store the solar energy captured on their roofs for later use. Energy generation, therefore, becomes decentralized. 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, consumers 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, including pickup trucks, buses, and heavy-duty semis.

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

strategic flexibility to change in order to meet changing customer needs and exploit exter- nal opportunities. Another important implication of our discussion is that all employees should feel invested in and inspired by the firm’s vision and mission. Different 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.

The strategic leader also realizes that the principles of strategic management can be applied universally to all organizations. Strategy determines performance whether in organizations large or small, multinational Fortune 100 companies, for-profit or nonprofit organizations, in the private or the public sector, and in developed as well as emerging economies. A good strategy is more likely when strategic leaders apply the three-step AFI strategy framework:

1. Analyze the external and internal environments. 2. Formulate an appropriate business and corporate strategy. 3. Implement the formulated strategy through structure, culture, and controls.

Keep in mind that strategic leaders are making decisions under conditions of uncer- tainty 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 management process.

This content is also relevant directly for you beyond the classroom: Applying the tools and frameworks developed in this text allows you to help your organization be more suc- cessful. You can also apply the strategic management toolkit to your own career to pursue your professional and other goals (see the myStrategy modules at the end of each chapter).

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22 CHAPTER 1 What Is Strategy?

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.

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 driv- ers. On average, cars are used less than three hours during a day. 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.34

Questions

1. Do you agree with the assessment that Elon Musk and Tesla successfully fulfilled their first master plan

published in 2006? Why or why not? Buttress your arguments.

2. As of today, does Tesla have a good strategy? Why or why not? How do you know?

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

4. Apply the three-step process for crafting a good strat- egy outlined in the chapter (diagnose the competitive challenge, derive a guiding policy, and implement a set of coherent actions) to each element of the new master plan. On which steps of the new master plan has Tesla made the most progress? Explain. Also, which recommendations would you have for Elon Musk? Support your arguments with examples and observations.

This chapter detailed what strategy and competitive advantage is. It described the roles of vision, mission, and values in a firm’s strategy. It also set the stage for further study of strategic management by introducing the AFI strategy framework, as summarized by the follow- ing learning objectives and related take-away concepts.

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 supe- rior 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, sus- tainable 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

either create more value for customers while keeping 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 competi- tive 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.

TAKE-AWAY CONCEPTS

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CHAPTER 1 What Is Strategy? 23

LO 1-3 / 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 indi- viduals within the firm.

LO 1-4 / 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 commitments and tied to economic fundamentals.

LO 1-5 / 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 1-6 / Explain the AFI strategy framework. ■ The AFI strategy framework (1) explains and

predicts 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 three broad tasks:

1. Analyze (A) 2. Formulate (F) 3. Implement (I)

AFI strategy framework (p. 19) Competitive advantage (p. 8) Competitive disadvantage (p. 8) Competitive parity (p. 9) Core values statement (p. 17)

Good strategy (p. 7) Mission (p. 13) Organizational core values (p. 17) Strategic intentS (p. 11) Strategic management (p. 6)

Strategy (p. 6) Sustainable competitive

advantage (p. 8) Vision (p. 11)

KEY TERMS

DISCUSSION QUESTIONS

1. The text discusses strategic trade-offs that are different between Walmart and Nordstrom even though they are in the same industry. Think of another 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. What characteristics does an effective mission statement have?

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24 CHAPTER 1 What Is Strategy?

ETHICAL/SOCIAL ISSUES

1. In the discussion about Merck (Strategy Highlight 1.2) it is clear the firm has followed a socially responsible path by donating more than 1 billion drug treatments to remedy river blindness in remote African communities. Yet Merck must also meet shareholder responsibilities and make profits on drugs in use in more affluent societies. How should a responsible firm make these trade-offs?

What steps can strategic leaders take to guide organizations on these challenging issues?

2. The list below shows a sample of various vision/ mission statements. Match the company with its corresponding statement. Also identify whether the statements are principally customer-oriented or product-oriented.

Vision/Mission Statement Type of Statement Matched Company Company

To be our customers’ favorite place and way to eat and drink. 1. Alibaba

To supply the consumer and our customers with the finest, high-quality products.

2. AutoNation

To help women feel great about themselves and their potential. 3. Barnes & Noble

To provide a global trading platform where practically anyone can trade practically anything.

4. CarMax

To operate the best omni-channel specialty retail business in America.

5. Darden Restaurants

To provide our customers great quality cars at great prices with exceptional customer service.

6. Dole Foods

To be financially successful through great people consistently delivering outstanding food, drinks and service in an inviting atmosphere.

7. eBay

To be America’s best run, most profitable automotive retailer. 8. Estée Lauder

Bringing the best to everyone we touch and being the best in everything we do.

9. Facebook

To develop the social infrastructure to give people the power to build a global community that works for all of us.

10. KFC

To give everyone the power to create and share ideas and information instantly, without barriers.

11. Manpower

To be the best worldwide provider of higher-value staffing services and the center for quality employment opportunities.

12. McDonald’s

To sell food in a fast, friendly environment that appeals to pride-conscious, health-minded consumers.

13. Spanx

To build the future infrastructure of commerce. 14. Twitter

3. The “job to do” approach discussed with the Clayton Christensen milk-shake 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 situa- tion you sometimes find frustrating in your own

life or one you hear others complaining about frequently. Instead of focusing on the annoy- ance, 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?

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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. Consider how much you value a specific type of work, or how much you would want to work for a specific organization because 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 man- agement consulting or investment banking pay very well, but their high salaries come with strings attached. Professionals 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 lit- tle or no leisure time, and sometimes even sacrifice their health. People “pay for”—make certain sacrifices for—what they value, because strategic decisions require important trade-offs.35

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 employ- ment 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

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CHAPTER 1 What Is Strategy? 25

SMALL GROUP EXERCISES

//// Small Group Exercise 1 The chapter applies the three elements of a good strat- egy to Tesla for insights into the company’s possible competitive advantage. As a group, choose a differ- ent firm that is well known to the students. Assign the competitive challenges and company guiding policies and search the internet for information about the firm’s actions. As a group discuss key actions the firm has taken and decide if they seem to be coherent. Does the firm demonstrate measures of a competitive advantage? If yes, does it look to be sustainable?

//// Small Group Exercise 2 Strategy Highlight 1.1 discusses the importance of the inspiring vision developed at Teach for America. In your group search the internet for other nonprofit organizations (Red Cross, Habitat for Humanity, etc.). Which of them has vision or mission statements that are appealing to donors, employees, and clients? Do these statements seem relevant in today’s environment or are they outdated? What improvements can you create for these organizational statements?

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26 CHAPTER 1 What Is Strategy?

1. Market capitalization = Share price x Number of shares outstanding. 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 Manage- ment Review, Fall, 58(1): 69–76; Ramsey, M. (2016, Mar. 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; and 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. 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, MA: Harvard Busi- ness Review Press); Rumelt, R. (2011), Good Strategy, Bad Strategy: The Difference and Why It Matters (New York: Crown Business); Porter, M.E. (2008), “The five competitive forces that shape strategy,” Harvard Busi- ness Review, January: 78–93; Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December: 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., and D. King (2015), “Tesla Motors, Inc.,” McGraw- Hill Education Case Study MHE-FTR-032.

6. Khouri, A., and S. Masunaga (2015, May 1), “Tesla’s Elon Musk and his big ideas: A brief history,” Los Angeles Times. 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. fueleconomy.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, and Hoang, H., and F. T. Rothaermel (2016), “How to manage alli- ances strategically,” MIT Sloan Management Review, Fall, 58(1): 69–76; Ramsey, M.

(2016, Mar. 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, Jun. 12), “Tesla Motors offers open licenses to its patents,” The Wall Street Journal. 9. This section draws on Porter, M.E. (2008, Jan.) “The five competitive forces that shape strategy,” Harvard Business Review; Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December; and Porter, M.E. (1989), Competitive Strategy (New York: Free Press). 10. Rumelt, R.P. (2011), Good Strategy, Bad Strategy: The Difference and Why It Mat- ters (New York: Crown); and Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December. 11. Rumelt, R.P. (2011), Good Strategy, Bad Strategy: The Difference and Why It Mat- ters (New York: Crown); and Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December. 12. Koh, Y., and K. Grind (2014, Nov. 6), “Twitter CEO Dick Costolo struggles to define vision,” The Wall Street Journal. 13. Covey, S.R. (1989), The 7 Habits of Highly Effective People: Powerful Lessons in Personal Change (New York: Simon & Schuster). 14. Musk, E. (2011, Sept. 29), “SpaceX vision and mission statement,” presentation to The National Press Club, Washington, DC, http://bit.ly/2frJx4f 15. Frankl, V.E. (1984), Man’s Search for Meaning (New York: Simon & Schuster). 16. Pink, D.H. (2011), The Surprising Truth about What Motivates Us (New York: River- head Books). 17. Hamel, G., and C.K. Prahalad (1989), “Strategic intent,” Harvard Business Review, May–June: 64–65; Hamel, G., and C.K. Prahalad (1994), Competing for the Future (Boston, MA: Harvard Busi- ness School Press); and Collins, J.C., and J.I. Porras (1994), Built to Last: Successful Habits of Visionary Companies (New York: HarperCollins). 18. Quote drawn from 2015 Teach for America annual report (http://bit. ly/2gguko8), which is also a source for this Strategy Highlight. Other sources:

2016–2017 Teach for America press kit (http://bit.ly/2fnrKO2); Simon, S. (2013, Sept. 10), “New study finds Teach for America recruits boost student achieve- ment in math,” Politico; Kopp, W. (2011), A Chance to Make History: What Works and What Doesn’t in Providing an Excel- lent Education for All (Philadelphia, PA: Public Affairs); Xu, Z., J. Hannaway, and C. Taylor (2008, Mar. 27), “Making a dif- ference? 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). 19. Collins, J.C., and J.I. Porras (1994), Built to Last: Successful Habits of Visionary Companies (New York: HarperCollins); Col- lins, J.C. (2001), Good to Great: Why Some Companies Make the Leap . . . And Others Don’t (New York: HarperBusiness). 20. Dixit, A., and B. Nalebuff (1991), Think- ing 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). 21. For academic work on using a problem- solving perspective as the basis for under- standing 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. 22. 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. 23. Germain, R., and M.B. Cooper (1990), “How a customer mission statement affects company performance,” Industrial Market- ing Management 19(2): 47–54; Bart, C.K. (1997), “Industrial firms and the power of mission,” Industrial Marketing Manage- ment 26(4): 371–383; and Bart, C.K. (2001), “Measuring the mission effect in human intel- lectual capital,”Journal of Intellectual Capi- tal 2(3): 320–330. 24. Christensen, C. (1997), The Innovator’s Dilemma (New York: HarperCollins). 25. Kane, Y.I. (2014), Haunted Empire: Apple After Steve Jobs (New York: HarperCollins), 191.

ENDNOTES

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CHAPTER 1 What Is Strategy? 27

26. “The three habits . . . of highly irritating management gurus,” The Economist, October 22, 2009. 27. 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 Chal- lenge Every Company (New York: Currency Doubleday). 28. Bart, C.K., and M.C. Baetz (1998), “The relationship between mission statements and firm performance: An exploratory study,” Jour- nal of Management Studies 35: 823–853. 29. As quoted in: Collins, J. (2009), How the Mighty Fall. And Why Some Companies Never Give In (New York: HarperCollins), 53.

30. http://www.merck.com/about/featured- stories/mectizan1.html. 31. Gilmartin, R.V. (2011, Oct. 6), “The Vioxx recall tested our leadership,” Harvard Business Review Blog Network. 32. The Merck river blindness case and the quote by CEO Kenneth Frazier draw from: http://www.merck.com/about/featured-stories/ 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 Responsibil- ity 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 ventures: profiting from a long-term ori- entation,” Strategic Management Journal 33: 1135–1153. 33. Musk, E. (2016, Jul. 20), “Master Plan, Part Deux,” http://bit.ly/2aa5LHv. 34. Other sources: Ramsey, M. (2016, Jul. 21), “Elon Musk unveils plans for new Tesla vehicle types,” The Wall Street Journal. 35. Based on Stern, S. (2004), “Do scien- tists pay to be scientists?”Management Sci- ence 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).

Final PDF to printer

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CHAPTER Strategic Leadership: Managing the Strategy Process

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

2.3 Stakeholders and Competitive Advantage Stakeholder Strategy Stakeholder Impact Analysis

2.4 Implications for Strategic Leaders

Learning Objectives

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 Describe the roles of corporate, business, and functional managers in strategy formu- lation and implementation.

LO 2-4 Evaluate top-down strategic planning, scenario planning, and strategy as planned emergence.

LO 2-5 Assess the relationship between stake- holder strategy and sustainable competitive advantage.

LO 2-6 Conduct a stakeholder impact analysis.

2

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Sheryl Sandberg: Leaning in at Facebook

IN 2008, FACEBOOK was a scrappy underdog in social media. Myspace was the dominant player, and despite four years of trying, Facebook was still in second place. But Facebook CEO Mark Zuckerberg was about to make a genius move: He persuaded Sheryl Sandberg to leave Google and join Facebook as chief operating officer (COO).

As the new second in command, Sandberg brought all the business skills that Zuckerberg lacked. She had demonstrated her versatility at Google and was already renowned for her sales, business development, public pol- icy, and communications prowess.

In contrast, Zuckerberg was more a computer hacker by heart. He liked working to build the best product to fulfill Face- book’s vision to “make the world more open and connected.” But he pre- ferred coding to business deals, and freely admitted that he lacked the skill set to successfully run a business. The story of the startup got the Hollywood treatment in the film, The Social Network, in 2010.

Today it’s only a partial simplification of their roles to say that Zuckerberg brings in the users, and Sandberg brings in the money. Their close collaboration earns deep respect within both Facebook and Silicon Valley, where many technology companies envy their synergistic leader- ship. To appreciate what she brought to Facebook, look what she achieved at Google.

YEARS IN THE GOOGLEPLEX By the time she left Google, Sandberg was vice president of global online sales and operations. She had joined the company in 2001, leading a staff of 300 to develop the company’s two online advertising programs, AdSense and

AdWords. Today these initiatives drive most of Google’s revenues. Eric Schmidt, Google’s CEO at the time, praised her as a “superstar.” Under her watch, Sandberg’s group had grown to 4,000 employees, or about a quarter of Google’s work force.

FACEBOOK TODAY Sandberg can claim credit for much of the success of Face- book today. As the dominant worldwide social network, it has some 2 billion monthly users. By one report, Ameri- cans spend one-third of their internet time on Facebook, most of it from mobile devices. In 2017, Facebook was the fourth most valuable company on the planet, with a market capitalization of almost $500 billion (just behind Apple, Alphabet, and Microsoft, but ahead of Amazon).

Facebook creates value by matching advertisers with users. Google does the same, but by different means. Google deals in objective recommenda- tions based on its propri- etary search algorithms analyzing billions of websites (e.g., “find the best sitcom on Wednes- day night”). Facebook organizes its own users’ data based on their social network (e.g., “find the best sitcom on Wednes- day night based on what

my friends like”). Together, Google and Facebook capture more than half of all online ad spending, reaching $140 bil- lion in 2017.

COMPARE FACEBOOK’S EARLY YEARS Today’s social media giant was started in 2004 in a dorm room at Harvard by then 19-year-old Mark Zuckerberg and three college pals. Facebook lagged Myspace in money and users. Myspace was acquired by News Corp. for close to $600 million in 2005, while Facebook was kept alive by cash injections from Microsoft, Yahoo, and a Russian investment group. Until 2009, Myspace was rid- ing high with more users.

CHAPTERCASE 2

Sheryl Sandberg, Facebook COO. ©Bloomberg/Getty Images

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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.

SANDBERG TODAY As Facebook’s COO, Sandberg focuses on operations, rev- enue, and international reach. She steps up in unexpected areas when needed, such as when she successfully completed a round of funding for Facebook after its chief financial officer had left suddenly. On numerous occasions she has mitigated Zuckerberg’s public relations challenges. Many consider Sandberg the “professional face” of Facebook.

LEANING IN Sandberg is a vocal advocate for women in leadership. Her popular TED talk, “Why We Have Too Few Women Lead- ers,” has over 7 million views. Her 2013 book, Lean In: Women, Work, and the Will to Lead, shot to the bestseller list. In both, Sandberg speaks about the low number of female leaders in today’s society and how to overcome this

situation. By highlighting both external as well as internal factors, Sandberg provides deep insights of why there are so few women in leadership positions. While her advice to women on dealing with internal factors is not without con- troversy, there is no question that her leaning in has made a difference at Facebook.

In 2012, Sandberg was appointed to the board of direc- tors, making her the first woman to join Facebook’s govern- ing body. Time magazine included Sandberg in its annual list of the 100 Most Influential People, while Forbes maga- zine named her the Most Powerful Woman in Tech in its 2016 annual ranking.1

You will learn more about Sheryl Sandberg and her leadership at Facebook by reading this chapter; related questions appear in “ChapterCase 2 / Consider This. . . .”

HOW DO STRATEGIC LEADERS like Sheryl Sandberg guide their companies to gain and sustain a competitive advantage? 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 considering the role strategic leaders play. We look at how strategic leaders guide and manage the strategy pro- cess across different levels in the organization. We explore some of the frameworks they use to develop strategy. We also move beyond an understanding of competitive advantage solely as superior firm financial performance, and introduce the framework of stakeholder strategy. This allows us to appreciate the role of business in society more broadly. And finally, 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 advantage demonstrate strategic leadership.2 Strategic leadership pertains to executives’ use of power and influence to direct the activities of others when pursuing an organization’s goals.3 Power is defined as the strategic leader’s ability to influence the behavior of other organizational members to do things, including things they would not do otherwise.4 Stra- tegic 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 strate- gic leadership. As chief operating officer, Sandberg has tremendous position power because she is the second in command at Facebook and reports only to CEO Mark Zuckerberg. Sandberg’s business development skills are legend: She transformed a money-losing outfit into a titan of online advertising, with some $30 billion in annual revenues. She designed and implemented Facebook’s business model (how it makes money). In particular, Sand- berg has attracted high-profile advertisers by demonstrating how Facebook can place

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precisely targeted and timed ads when it matches what it knows about each user, based on that person’s social networks, with the advertisers’ targets. Less quantifi- able, but perhaps an even more valuable contribution, Sandberg provides “adult supervision and a professional face” for a firm populated by socially awkward com- puter geeks.5

While the effect of strategic leaders may vary, they clearly matter to firm performance.6 Think of great busi- ness founders and their impact on the companies they built—Mark Zuckerberg at Facebook, Elon Musk at Tesla and SpaceX, Jack Ma at Alibaba, Oprah Winfrey with her media empire, and Jeff Bezos at Amazon. There are also many strategic leaders who have shaped and revitalized existing businesses: Sheryl Sandberg at Facebook, Angela Ahrendts at Apple (former CEO of Burberry, a luxury fashion house), Mary Barra at GM, Indra Nooyi at PepsiCo, Howard Schultz at Starbucks, and Satya Nadella at Microsoft.7

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 oth- ers lead them into decline and sometimes even demise? To answer that question, let’s first consider 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, 67 percent 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).8 Other studies have also found that most man- agers 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 organization.”9 Surprisingly given the advances in information tech- nology, 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 ver- bal 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 Skype, for example.10

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 performance levels reflect the values of the top management team.11 These are the individ- uals at the upper levels of an organization. The theory states that strategic leaders interpret

upper-echelons theory A conceptual framework that views organizational outcomes—strategic choices and performance levels—as reflections of the values of the members of the top management team.

LO 2-2

Outline how you can become a strategic leader.

Indra Nooyi, PepsiCo CEO.

©Bloomberg/Getty Images

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

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 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.

situations through the lens of their unique perspectives, shaped by personal circumstances, values, and experiences. Their leadership actions reflect characteristics of age, education, and career experiences, filtered through personal interpretations 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 “cumu- lative stock returns of almost seven times the general market in the 15 years following their transition points.”12 A lot has happened since the book was published over a decade 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 or at all. 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 observations. Studying these large corporations, Collins found consistent patterns of leadership among the top companies, as pictured in the Level-5 leadership pyramid in Exhibit 2.2.13 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 indi- vidual can move on to the next level of leadership only when the current level has been mastered. 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 we suggest that the model is valuable as well to the individual looking to develop the capacity for greater professional success.

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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 member, 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 organize 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 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 Sheryl Sandberg, the COO. 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.”14 Clearly, Sandberg is a Level-5 executive: She builds enduring greatness at Facebook through a combination of skill, willpower, and humility.

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

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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 created. The strategy process consists of two parts: strategy formulation (which results from strategy analysis) and strategy implementation.

Strategy formulation concerns the choice of strategy in terms of where and how to compete. 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 strategies 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 level. Cor- porate executives at headquarters formulate corporate strategy. Think of corporate exec- utives including Sheryl Sandberg (Facebook), John Flannery (GE), Virginia Rometty (IBM), Mukesh Ambani (Reliance Industries), Mary Barra (GM), or Marillyn Hewson (Lockheed Martin). Corporate executives need to decide in which industries, markets, and geographies their companies should compete. They need to formulate a strategy

LO 2-3

Describe the roles of corporate, business, and functional managers in strategy formulation and implementation.

strategy formulation The part of the strategic management process that concerns the choice of strategy in terms of where and how to compete.

strategy implementation The part of the strategic management process that concerns the organization, coordination, and integration of how work gets done, or strategy execution.

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

Option 1 Cost Leadership

Corporate Where to Compete

Business How to Compete

Functional How to Implement

Function 1 Function 2 ... ... Function n

Option 2 Differentiation

Option 3 Value Innovation

Headquarters

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that can create synergies across business units that may be quite dif- ferent, and determine the boundaries of the firm by deciding whether to enter certain industries and markets and whether to sell certain divi- sions. They are responsible for setting overarching strategic objectives and allocating scarce resources among different business divisions, monitoring performance, and making adjustments to the overall portfo- lio of businesses as needed. The objective of 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 business strategy, including cost leadership, differentiation, or value innovation, in their quest for competi- tive advantage.

Rosalind Brewer, (former) president and CEO of Sam’s Club, pursued a somewhat different business strategy from the strategy of parent com- pany 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 rev- enues 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 close to $500 billion in annual rev- enues and over 11,000 stores globally.15

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 strategy, 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 15,000 employees, is a far-flung internet firm with its various services available in more than 90 languages, and with offices in more than 30 countries.16 Together, they are responsible for the perfor- mance 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 success of this turnaround strategy is stunning: Today Facebook is a mobile advertising pow- erhouse, generating over 80 percent of its revenues ($30 billion annually) from mobile advertising.17

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

Rosalind Brewer, Sam’s Club president and CEO (2012–2017).

©AP Images/April L Brown

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2.2 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 prior section, we gained insight into the corporate, business, and functional levels of strat- egy. Here we turn to the process or method by which strategic leaders formulate and imple- ment 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 how these approaches were developed: strategic planning, then scenario planning, and then strategy as planned emergence. The first two are relatively formal, top-down planning approaches. The third approach begins with a strategic plan but offers a less formal and less stylized approach. Each approach has its strengths and weak- nesses, 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 manage ever more complex firms more effec- tively, they began to use strategic planning.18 Top-down strategic planning, derived from military strategy, is a rational process through which executives attempt to program future success.19 In this approach, all strategic intelligence and decision-making responsibilities are concentrated in the office of the CEO. The CEO, much like a military general, leads the company strategically through competitive battles.

Exhibit 2.4 shows the three steps of analysis, formulation, and implementation in a traditional top-down strategic planning process. Strategic planners provide detailed ana-

lyses of internal and external data and apply it to all quantifiable areas: prices, costs, margins, market demand, head count, and production runs. Five-year plans, revisited regularly, pre- dict future sales based on anticipated growth. Top executives tie the allocation of the annual corporate budget to the strategic plan and moni- tor ongoing performance accordingly. Based on a careful analysis of these data, top managers reconfirm or adjust the company’s vision, mis- sion, and values before formulating corporate, business, and functional strategies. Appropri- ate organizational structures and controls as well as governance 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 formu- lation of strategy is separate from implemen- tation, and thinking about strategy is separate

LO 2-4

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

strategic management process Method put in place by strategic leaders to formulate and implement a strategy, which can lay the foundation for a sustainable competitive advantage.

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

EXHIBIT 2.4 / Top-Down Strategic Planning in the AFI Framework

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

• Corporate Strategy • Business Strategy • Functional Strategy

Analysis

Formulation

Implementation

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

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from doing it. Information flows one way only: from the top down. Another shortcoming of the strategic planning approach is that we simply cannot know the future. There is no data. Unforeseen events can make even the most scientifically developed and formalized plans obsolete. Moreover, strategic leaders’ visions of the future can be downright wrong, a few notable exceptions to the contrary.

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 longtime CEO Steve Jobs, Apple was one of the few successful tech compa- nies using a top-down strategic planning process.20 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.”21 Based on an in-depth study resulting in his 700-page Steve Jobs biography, Walter Isaacson distills Jobs’ 14 lessons in strategic leadership, including: push for perfection, tolerate only “A” players, bend reality, among others.22

The traditional top-down strategy process served Apple well as it became the world’s most valuable company. Apple’s strategy process has become more flexible under Tim Cook, Jobs’ successor as CEO, and the company is trying to incorporate the possibilities of different future scenarios and bottom-up strategic initiatives.23

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 similar fashion to the planning in a fire department.24 There is no way to know where and when the next emergency will arise, nor can we know its magnitude beforehand. Nonetheless, fire chiefs put contingency plans in place to address a wide range of emergencies along different dimensions.

In the same way, scenario planning asks 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 example, new laws might restrict carbon emissions or expand employee health care. Demographic shifts may alter the ethnic diversity of a nation; changing tastes or economic conditions will affect con- sumer behavior. Technological advance 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 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) fluctuations in exchange rates or interest rates; and (5) climate change.25 Managers then formulate strategic plans they could activate and implement should the envisioned optimis- tic or pessimistic scenarios begin to appear.

To model the scenario-planning approach, place the elements in the AFI strategy frame- work in a continuous feedback loop, where analysis leads to formulation to implementa- tion and back to analysis. Exhibit 2.5 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

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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strategic planning approach with one master plan. In the analysis stage, managers brainstorm to identify possible future scenarios. Input from several different levels within the organization 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. Managers may also attach probabilities (highly likely versus unlikely, or 85 percent likely versus 2 percent likely) to different future states.

Although managers often tend to overlook pessimistic future scenarios, it is imperative 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 mar- gins. 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?

Strategic leaders need also consider how black swan events might affect their strategic planning. In the past, most people assumed that all swans are white, so when they first encountered swans that were black, they were surprised.26 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. The BP oil spill was a black swan for many busi- nesses on the Gulf Coast, including the tourism, fishing, and energy industries. We discuss the BP Deepwater Horizon explosion and its consequences in much more detail in Strategy Highlight 2.2, in the next section. Such black swan events were considered to be highly

EXHIBIT 2.5 / Scenario Planning within the AFI Strategy Framework

Feedback Loop

Monitoring Performance

Analysis

Formulation

Implementation

Develop Strategic Plans to Address Future Scenarios

Execute Dominant Strategic Plan

Dis car

d D om

ina nt

Pla n if

Ne ces

sar y

Create Strategic Options

Through Developing Alternative Plan(s)

Identify Multiple Future Scenarios

Activate and Execute

New Plan if Necessary

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

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improbable and thus unexpected, but when they did occur, each had a very profound impact.

The metaphor of a black swan, therefore, describes the high impact of a highly improbable event. In the UPS scenario planning exercise, a ter- rorist 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.

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. 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 con- sider whether to modify further the dominant strategic plan in order to enhance firm per- formance or to activate an alternative strategic plan.

The circular nature of the scenario-planning model in Exhibit 2.5 highlights the con- tinuous interaction among analysis, formulation, and implementation. Through this inter- active process, managers can adjust and modify their actions as new realities emerge. The interdependence among analysis, formulation, and implementation also enhances organi- zational 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.27

In fact, they argue the strategic planning processes are often too regimented and confin- ing. As such, they lack the flexibility needed for quick and effective response. Managers

©Bernd Wolter/Shutterstock .com RF

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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engaged in a more formalized approach to the strategy process may also fall prey to an illusion of control, which describes a tendency by managers to overestimate their ability to control events.28 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 avail- able 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 Chapter 1).

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 society. Moreover, the other two approaches to planning just discussed do not account suf- ficiently for the role employees at all levels of the organization may play. This is because 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 feed- back 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 20 percent in 2017 and expected to double by 2026.29 Given the success of Amazon as the world’s leading online retailer, brick-and-mortar companies such as Best Buy, The Home Depot, JCPenney, Sears, and even Walmart have all been forced to respond and adjust their strategy. Others such as Kmart or Radio Shack filed for Chapter 11 bankruptcy (and later reorganized), while Circuit City, Borders, and others, went out of business altogether. Given the more or less instant global presence of online retailers,30 Alibaba is emerging as the leading internet-based wholesaler connecting manufacturers in China to retailers in the West, as well as a direct online retailer. In a similar fashion, Uber and Lyft, the app- based ride-hailing services, are disrupting the existing taxi and limousine businesses in many metropolitan areas around the world. Having been protected by decades of regula- tions, existing taxi and limo services scramble to deal with the unforeseen competition. Many try through the courts or legislative system to block Uber and Lyft, alleging the ride-sharing services violate safety and other regulations. Another sharing economy new venture, Airbnb, an online platform that allows users to list or rent lodging of residential properties, is facing a similar situation.

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 stylized approach to the development of strategy. To reflect the reality that strategy can be planned or emerge from the bottom up, Exhibit 2.6 shows a more integrative approach to managing the strategy process. Please note that even in strategy as planned emergence, the overall strategy process still unfolds along the AFI framework of analysis, 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. This analysis com- pletes the first stage of the AFI framework (see Exhibit 2.6). Top-level executives then design an intended strategy—the outcome of a rational and structured, top-down strategic plan. Exhibit 2.6 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.

illusion of control A tendency by people to overestimate their ability to control events.

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

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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 pur- sues to explore and develop new products and processes, new mar- kets, 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 emergence approach to formulate strategy. For example, the delivery-by-drone project at Amazon.com was conceived of and invented by a low-level engineer. Even relatively junior employees can come up with strategic initiatives that can make major contributions if the strategy process is sufficiently open and flexible.31

The arrows in Exhibit 2.6 represent different strategic initiatives. In particular, strategic initiatives can bubble up from deep within a firm through:

■ Autonomous actions. ■ Serendipity. ■ Resource-allocation process (RAP).32

AUTONOMOUS ACTIONS. Autonomous actions are strategic initiatives undertaken by lower-level employees on their own volition and often in response to unexpected situa- tions. Strategy Highlight 2.1 illustrates that successful emergent strategies are sometimes the result of autonomous actions by lower-level employees.

EXHIBIT 2.6 / Realized Strategy Is a Combination of Top-Down Intended Strategy and Bottom-Up Emergent Strategy

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

realized strategy Combination of intended and emergent strategy.

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

Amazon Prime Air is a future service that will deliver pack- ages up to five pounds in 30 minutes or less using small drones.

©Amazon/Zuma Press/ Newscom

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

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 offer a similar iced beverage, she requested that headquarters consider adding it to the product lineup. Diana had an internal champion in Howard Behar, then a top Starbucks executive. Behar pre- sented this strategic initiative to the Starbucks executive committee. The committee voted down the idea in a 7:1 vote. Starbucks CEO Howard Schultz commented, “We do coffee; we don’t do iced drinks.”

Diana, however, was undeterred. She experi- mented until she created the iced drink, and then she began to offer 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 numbers. These results persuaded the executive team to give reluctant approval to intro- duce the drink in all Starbucks stores.

You’ve probably guessed by now that we’re talk- ing about Starbucks Frappuccino. Frappuccino is

now a multibillion-dollar business for Starbucks. At one point, this iced drink brought in more than 20 percent of Starbucks’s total revenues, which

were $23 billion in 2017.33

Strategy Highlight 2.1

©Ian Dagnall/Alamy Stock Photo

Functional managers such as Diana, the Starbucks store manager featured in Strategy Highlight 2.1, are much closer to the final products, services, and customers than the more removed corporate- or business-level managers. They also receive much more direct cus- tomer 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, however, 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 execu- tive. This 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 Strategy Highlight 2.1, the Starbucks executive team around CEO Howard Schultz fully supported the Frappuccino strategic initiative, provid- ing the resources and personnel to help it succeed. During his tenure at General Electric, then CEO Jeffrey Immelt decided to move ahead with a strategic initiative to buy the wind energy company Enron Wind from the bankruptcy proceedings of Enron because he saw the

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

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acquisition as supporting the company’s vision and mission.34 But the initiative only sur- vived to get Immelt’s attention because of the tireless persistence of a mid-level engineer who saw its future value. GE provided appropriate resources and structures to grow this emergent strategy into a major strategic initiative that’s now worth billions of dollars.

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 intended as a drug to treat hypertension, are well known.35 Less well known is the discovery of potato chips.36 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 serendipity 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 example, organizes the work of its engineers according to a 70-20-10 rule. The major- ity of the engineers’ work time (70 percent) is focused on its main business (search and ads).37 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 a Proj- ect 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.38 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.39

RESOURCE-ALLOCATION PROCESS. A firm’s resource-allocation process (RAP) determines the way it allocates its resources and can be critical in shaping its real- ized strategy.40 Emergent strategies can result from a firm’s resource-allocation pro- cess (RAP).41 Intel Corp. illustrates this concept.42 Intel was created to produce DRAM (dynamic random-access memory) chips. From the start, producing these chips was the firm’s top-down strategic plan, and initially it worked well. In the 1980s, Japanese com- petitors 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 produce 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 maximize margin-per-wafer-start. Each time functional managers initiated a new production run, they

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

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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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.43

Taken together, a firm’s realized strategy is frequently a combination of top-down stra- tegic intent and bottom-up emergent strategies, as Exhibit 2.6 shows. This type of strategy process is called planned emergence. In that process, organizational structure and sys- tems allow bottom-up strategic initiatives to emerge and be evaluated and coordinated by top management.44 These bottom-up strategic initiatives can be the result of autonomous actions, serendipity, or the resource allocation process.

Exhibit 2.7 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 evaluated and coordinated by top management.

EXHIBIT 2.7 / 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 Areva, 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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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.

2.3 Stakeholders and Competitive Advantage 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 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.45

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 some $650 billion in market capitalization and over 75,000 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 user.46

LO 2-5

Assess the relationship between stakeholder strategy and sustainable competitive advantage.

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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 freedom to explore ideas, among other perks.47 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 massively. The com- pany 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 cre- ate value for society. Recently, this relationship received more critical scrutiny due to major shocks to free market capitalism.48 In particular, the implicit trust relationship between the corporate world and society at large has deteriorated because of the arrival of several black swans. One of the first black swan events of the 21st century occurred when the account- ing 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 black swan event occurred in the fall of 2008 with the global financial crisis, which shook the entire free market system to its core.49 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 unsustainable 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.

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. 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 black swan events in the business world differed in their specifics, two common features are pertinent to our study of strategic management.50 First, these events demonstrate 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 (or inac- tions) within a few organizations, or compounded across a specific industry or govern- ment. The second pertinent feature relates to stakeholders—organizations, groups, and individuals that can affect or be affected by a firm’s actions.51 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 2.8, internal stakeholders include employees (including executives, managers, and workers), stockholders, and board members. External stakeholders include

stakeholders Organizations, groups, and individuals that can affect or are affected by a firm’s actions.

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customers, suppliers, alliance partners, creditors, unions, communities, governments at various levels, and the media.

All stakeholders make specific contributions to a firm, which in turn provides differ- ent types of benefits to different stakeholders. Employees contribute their time and talents to the firm, receiving wages and salaries in exchange. Shareholders contribute capital in the hope 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 taxes, provide employment, and not pollute the environment. The firm, therefore, is embedded in a multifaceted exchange relationship with a number of diverse internal and external stakeholders.

If any stakeholder withholds participation in the firm’s exchange relationships, it can negatively affect firm performance. The aerospace company Boeing, for example, 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. Or think about the dif- ferent stakeholders in the global financial crisis discussed above. Borrows who signed up for subprime mortgages are stakeholders (in this case, customers) of financial institutions. When they defaulted in large numbers, they threatened the survival of these financial insti- tutions and, ultimately, of the entire financial system.

Stakeholder strategy is an integrative approach to managing a diverse set of stakehold- ers effectively in order to gain and sustain competitive advantage.52 The unit of analysis is the web of exchange relationships a firm has with its stakeholders (see Exhibit 2.8). Stakeholder strategy allows firms to analyze and manage how various external and inter- nal stakeholders interact to jointly create and trade value.53 A core tenet of stakeholder strategy 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

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

EXHIBIT 2.8 / Internal and External Stakeholders in an Exchange Relationship with the Firm

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

Co nt

rib ut

io ns

Co nt

rib ut

io ns

• Employees • Stockholders • Board Members

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to improve firm performance, thereby enhancing the firm’s competitive advantage and the likelihood of its continued survival.54

Taken together, strategy scholars have provided several arguments as to why effective stakeholder management can benefit firm performance:55

■ 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 organi-

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

stable 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.56 In 2016, the top five companies in this ranking were Apple, Alphabet, Amazon, Berkshire Hathaway (the conglomerate led by Warren Buffett), and Disney. Because of its continued inno- vation 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 stakeholders. The firm needs to ensure that its primary stakeholders—the firm’s share- holders 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 impact analysis takes strategic leaders through a five-step process of recognizing stake- holders’ claims. In each step, they must pay particular attention to three important stake- holder attributes: power, legitimacy, and urgency.57

■ 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 other- wise appropriate.

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

Exhibit 2.9 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

LO 2-6

Conduct a stakeholder impact analysis.

stakeholder impact analysis A decision tool with which managers can recognize, prioritize, 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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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 opera- tion of the firm. Any of these groups, if their needs are not met, can materially affect the company’s operations.

For example, Boeing opened a new airplane factory in South Carolina to move produc- tion away from its traditional plant near Seattle, Washington. South Carolina is one of 28 states in the United States that falls under the 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 lead to fewer work interruptions due to strikes and Boeing hopes to higher productivity and improvements along other performance dimensions (like on-time deliv- ery of new airplanes). In 2014, Boeing announced that its new 787 Dreamliner jet would be exclusively built in its nonunionized South Carolina factory.58

STEP 2: IDENTIFY STAKEHOLDERS’ INTERESTS. In Step 2, strategic leaders ask, “What are our stakeholders’ interests and claims?” Managers 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 own- ership plans (ESOPs). These plans allow employees to purchase stock at a discounted rate or use company stock as an investment 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 stakeholders who merely own stock. The latter are investors who are primarily interested in the increased value of their stock holdings

EXHIBIT 2.9 / Stakeholder Impact

Analysis

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

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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 activ- ists, such as Bill Ackman, Carl Icahn, or T. Boone Pickens, tend to buy equity stakes in a corporation that they believe is underperforming to put public pressure on a company to change its strategy. Examples include the takeover battle at Dell Computer (which founder Michael Dell subsequently took private), the pressure on PepsiCo 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.59 As a result of a sustained competi- tive advantage over the last decade, Apple had not only become the most valuable com- pany on the planet 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 but- tress 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 activ- ist 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. Con- sumer boycotts, for example, can be a credible threat to a company’s behavior. Some consumers boycotted Nestlé products when the firm promoted infant formula over breast milk in developing countries. PETA60 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.61 During one holiday season, the Dutch government blocked Sony’s entire holiday season shipment of PlayStation game systems, 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 incident led to an 18-month investigation in which Sony inspected over 6,000 sup- plier 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 stakehold- ers?” 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.62 According to the CSR perspective, strategic

corporate social responsibility (CSR) A framework that helps firms recognize and address the economic, legal, social, and philanthropic expectations that society has of the business enterprise at a given point in time.

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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.63 CSR pro- vides strategic leaders with a conceptual model that more completely describes a society’s expectations and can guide strategic decision making more effectively. In particular, CSR has four components:

■ Economic responsibilities ■ Legal responsibilities ■ Ethical responsibilities ■ Philanthropic responsibilities64

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 steward- ship. 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 pri- mary objective, as captured in his famous quote: “There is one and only one social respon- sibility 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.”65

Legal Responsibilities. Laws and regulations are a society’s codified ethics, embody- ing 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 regulations, including but not limited to labor, consumer protection, and environmen- tal 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 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 over- all risk pool of insurers is less healthy.66

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 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

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leaders are called upon to do what society deems just and fair. Starbucks, for example, developed an ethical sourcing policy to help source coffee of the highest quality, while adhering to fair trade and responsible growing practices. On the other hand, Starbucks has been criticized for not paying an adequate amount of taxes in the United Kingdom. Albeit entirely legal, Starbucks did pay very little in corporate income taxes since opening its first store in the United Kingdom in 1998 (around $13.5 million total). In an attempt to silence the critics, to stop protests, and to please the British government, Starbucks volunteered an additional tax payment of $16 million for the 2013–14 tax year, despite having no legal obligation to do so.67

Philanthropic Responsibilities. Philanthropic responsibilities are often subsumed under the idea of corporate citizenship, reflecting the notion of voluntarily giving back to soci- ety. Over the years, Microsoft’s corporate philanthropy program has donated more than $3 billion in cash and software to people who can’t afford computer technology.68

The pyramid in Exhibit 2.10 summarizes the four components of corporate social responsibility.69 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 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, legiti- macy, and urgency helps to prioritize the legitimate claims and to address them accord- ingly. Strategy Highlight 2.2 describes how the U.S. government legitimized claims by thousands of businesses and individuals in the aftermath of the BP oil spill in the Gulf of Mexico, causing the claims to become of great urgency to BP.

EXHIBIT 2.10 / The Pyramid of Corporate Social Responsibility SOURCE: Adapted from Carroll, A. B. (1991), “The pyramid of corporate social responsibility: Toward the moral management of organizational stakeholders,” Business Horizons, July–August: 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

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BP “Grossly Negligent” in Gulf of Mexico Disaster On April 20, 2010, an explosion occurred on BP’s Deepwater Horizon oil drilling rig off the Louisiana coastline, killing 11 work- ers. 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 disas- ter 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.

Technical issues aside, many experts argued that BP’s problems were sys- temic, because BP’s strate- gic leaders had repeatedly failed to put an adequate safety culture in place. In 2005, for example, BP experienced a catastrophic accident at a Texas oil refin- ery, which killed 15 work- ers. A year later, a leaking BP pipeline caused the largest oil spill ever on Alaska’s North Slope. BP’s strategic focus on cost reductions, initi- ated by its strategic leaders a few years earlier, may have significantly compromised safety across the board. In a fall 2014 ruling, a federal judge declared that BP’s measures to cut costs despite safety risks “evince an extreme devia- tion from the standard of care and a conscious disregard of known risks.”70

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 power- ful 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 pow- erful. Moreover, their claims were backed by the U.S. govern- ment, 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. Additional fines and other environ- mental 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 in coming years.

Moreover, claiming that BP displayed a “lack of business integrity” in handling the gulf oil spill, the Environmental Protection Agency (EPA) banned BP from any new contracts with the U.S. government. This put BP at a major competitive disadvantage, because it is unable to acquire new leases for oil field exploration in the United States, or to continue as a major supplier of refined fuel to the armed forces, among other federal contracts.71

Strategy Highlight 2.2

SOURCE: U.S. Coast Guard

2.4 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 organization’s strategy. To gain and sustain a competitive advantage, strategic leaders need to put an effective strategic management process in place. They need to design a process

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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.

Strategic leaders also need to consider the rate of change and firm size, both of which factors affect the effectiveness of a chosen strategy process. The rate of change, internally and externally, can suggest the more useful planning approach. In a slow-moving and sta- ble environment, 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 planning. Smaller firms may find it easier to implement strategy as planned emer- gence when feedback loops are short and the ability to respond quickly is keen.

For instance, a nuclear power provider such as Areva 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 a tremendous impact as seen in Chernobyl, Russia, and Fukushima, Japan, so power providers need to be prepared. Areva might use scenario planning to prepare for such a black swan event. Contrast this with fast-moving environments. Internet-based com- panies, such as 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.

Strategic leaders are also mindful of the organization’s internal and external stakehold- ers, 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.

Here we conclude our discussion of the strategic management process, which marks the end of the “getting started” portion of the AFI framework. The next three chapters cover the analysis part of the framework, where we begin by studying external and internal analyses before taking a closer look at competitive advantage, firm performance, and business models.

During her decade as a strategic leader at Facebook, Sheryl Sandberg has seen the firm become the most successful social network ever, anywhere. But Facebook has new challenges.

First, there are continued concerns about user privacy. Facebook has long been criticized for alleged lax handling of user information and an opaque privacy policy that changed frequently. More recently, the hot-button privacy issue came up again as Facebook stopped merging the user data obtained from the messaging app WhatsApp, which it bought for almost $20 billion in 2014, with its own. In response to a

CHAPTERCASE 2 Consider This . . .

court ruling in Germany, Face- book announced it would pause the ongoing merging process. This, however, will decrease Facebook’s ability to finely tar- get its ads based on a user’s fine- grained social profile.

Next, critics attacked Face- book for the rise of fake news items populating users’ news

Facebook CEO Mark Zuckerberg and Facebook COO Sheryl Sandberg.

(left): ©David Ramos/Getty Images, (right): ©Justin Sullivan/ Getty Images

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 57

feeds. This rise stems from Facebook’s algorithms that give prominence to information with higher user engagement. Outrageous headlines—a hallmark of fake news items— solicit high levels of user interest. Some critics complained that populating news feeds with misinformation skewed the outcome of the 2016 U.S. presidential election. CEO Mark Zuckerberg dismissed this charge as a “pretty crazy idea.” Nonetheless, Facebook decided to follow Google’s lead and to bar fake news sites from using its online advertising, thereby reducing their prominence.

The issue of fake news in some ways points to a larger crisis: The ever louder criticism that Facebook is now more a news organization than a simple social network. Critics want to see a higher degree of responsibility, simi- lar to that shown by traditional publishers. Roughly half of Americans of all ages (and a higher percentage of youth) get their political news on Facebook. Facebook maintains that it is agnostic on news content (real news, anyway). Sandberg has publicly addressed the fake news issue directly, but less so Facebook’s responsibilities as a new kind of news publisher.

The issue may not go away. It did not help Facebook’s case that in late 2016 news broke that Facebook had already developed a censorship tool, one that could be used to let the firm monitor news for quality control. Apparently the censor- ship tool is meant to persuade China to let Facebook back

into the country. In China, access to news is heavily managed by the state; China is potentially the largest single online market in the world.72

Questions

1. Describe Sheryl Sandberg’s strategic leadership. Which qualities stand out to you, and why? Is she an effective strategy leader? Why, or why not?

2. What current challenges (as detailed in this Chap- terCase) is Facebook facing? How should Sand- berg deal with each of them? Please make specific recommendations.

3. What are the main issues Sandberg brings to the fore in her TED talk, titled “Why We Have Too Few Women Leaders”? You can view the 15-minute talk here: http://bit.ly/1czSD6n. How can your awareness of these issues help you to be a more effective strategic leader? How can these issues be addressed?

4. Rumors persist that Sandberg might pursue a politi- cal career in the future (she was chief of staff to Larry Summers, former Treasury secretary under President Bill Clinton). Do you think Sandberg would make a good politician? Do you think the required qualities of strategic leadership are the same or similar in business and politics? Why or why not? Support your arguments.

This chapter examined the role strategic leaders play, delineated different processes to create strategy, and explained how to conduct a stakeholder impact analy- sis. We summarize the discussion in the following learning objectives 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 advan- tage 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 stra- tegic leader. ■ To become an effective strategic leader, you need

to develop skills to move sequentially through five different 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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58 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

LO 2-3 / Describe 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 func- tional areas for competitive advantage.

■ Functional managers are responsible for implement- ing business strategy within a single functional area.

LO 2-4 / Evaluate top-down strategic plan- ning, scenario planning, and strategy as planned emergence. ■ Top-down strategic planning is a sequential, lin-

ear process that works reasonably well when the environment 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 process from deep within the organization. They have the potential to shape a firm’s strategy.

■ A firm’s realized strategy is generally a combination of its top-down intended strategy and bottom-up emergent strategy, resulting in planned emergence.

LO 2-5 / Assess the relationship between stakeholder strategy and sustainable competi- tive advantage. ■ Stakeholders are individuals or groups that

have a claim or interest in the performance and

continued survival of the firm. They make spe- cific contributions for which they expect rewards in return.

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

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

■ Several recent black swan events eroded the pub- lic’s trust in business as an institution and in free market capitalism as an economic system.

■ 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 2-6 / 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 expec- tations of good citizenship.

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

■ Stakeholder impact analysis is a five-step process 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 stakeholders?

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

Autonomous actions (p. 43) Black swan events (p. 40) corporate social responsibility

(CSR). (p. 52) Dominant strategic plan (p. 41) Emergent strategy (p. 43)

Illusion of control (p. 42) Intended strategy (p. 42) Level-5 leadership

pyramid (p. 34) Planned emergence (p. 46) Realized strategy (p. 43)

Resource-allocation process (RAP) (p. 45)

Scenario planning (p. 39) Serendipity (p. 45) Stakeholders (p. 48) Stakeholder impact analysis (p. 50)

KEY TERMS

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CHAPTER 2 Strategic Leadership: Managing the Strategy Process 59

Stakeholder strategy (p. 49) Strategic business unit (SBU) (p. 37) Strategic initiative (p. 43)

Strategic leadership (p. 32) Strategic management process (p. 38) Strategy formulation (p. 36)

Strategy implementation (p. 36) Top-down strategic planning (p. 38) Upper-echelons theory (p. 33)

DISCUSSION QUESTIONS

1. In what situations is top-down planning likely to be superior 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? What do you see as the primary responsibilities of corporate-level executives? When might the business-level managers bear more responsibility for considering how to respond to an issue?

In what situations might the functional-level man- agers have a primary responsibility for consider- ing an issue? How should the organization ensure the proper attention to each level of strategy as needed?

3. Identify an industry that is undergoing intense competition or is being featured in the business press. Discuss how scenario planning might be used by companies to prepare for future events. Can some industries benefit more than others from this type of process? Explain why.

ETHICAL/SOCIAL ISSUES

1. BP’s experience in the Gulf of Mexico has made it the poster company for how not to manage stakeholder relationships effectively (see Strategy Highlight 2.2). What advice would you give to BP’s managers to help them continue to rebuild stakeholder relationships in the Gulf region and beyond? How can BP repair its damaged repu- tation? Brainstorm ways that top management might leverage the experience gained by reactions in the Gulf and use that knowledge to motivate local managers and employees in other locales to build stakeholder relationships proactively so that BP avoids this type of negative publicity.

2. This chapter discusses some of the key strategic leadership issues (such as privacy and fake news) facing Facebook leaders Sheryl Sandberg and Mark Zuckerberg. Consider other firms men- tioned in the chapter such as Amazon, PepsiCo, Uber, VW, and Starbucks. What social and ethical issues do the leaders of these firms face today? Choose a firm or industry and explore the rel- evant controversial issues it faces. How should strategic leaders address the major issues you have identified?

SMALL GROUP EXERCISES

//// Small Group Exercise 1 In many situations, promising ideas emerge from the lower levels of an organization, only to be discarded before they can be implemented. It was only extraor- dinary tenacity and disregard for the policy of selling only corporate-approved drinks that permitted the Frappuccino to “bloom” within Starbucks (see Strat- egy Highlight 2.1).

Some scholars have suggested that companies set aside up to 2 percent of their budgets for any manager with budget control to be able to invest in new ideas within the company.73 Thus, someone with a $100,000 annual budget to manage would be able to invest $2,000 in cash or staff time toward such a project. Multiple managers could go in together for somewhat larger funds or time amounts. Through such a process,

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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 version of the stakeholder impact analysis. On a personal level, your internal stakeholders might be immediate family members, and close personal friends. External stakeholders could be neigh- bors, 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 stake- holder 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

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60 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

the organization could generate a network of “angel investors.” Small funds or staff time could be invested in a variety of projects. Approval mechanisms would be easier for these small “seed-stock” ideas, to give them a chance to develop before going for bigger funding at the top levels of the organization.

What problems would need to be addressed to introduce this angel-network idea into a firm? Use a firm someone in your group has worked for or knows well to discuss possible issues of widely distributing small funding level approvals across the firm.

//// Small Group Exercise 2 Form small groups of three to four students. Search the internet on the following topic and debate your findings.

The chapter includes a discussion of black swan events that were improbable and unexpected yet had an extreme impact on the well-being of individuals,

firms, and nations. Nassim Nicholas Taleb, author of The Black Swan, has argued that policy makers and decision makers need to focus on building more robust organizations or systems rather than on improving predictions of events. This notion is reflected in the response to the predicted increase in powerful storms and storm surges. Hurricanes Katrina (which devas- tated New Orleans and parts of the Gulf Coast) and Sandy (which wreaked havoc on the New Jersey coast) have stimulated discussions about how to not only build a more resilient infrastructure and buildings, but also develop more flexible and effective responses.

For each group, search the internet for options and plans to (1) build more sustainable communities that would help areas cope with superstorms, or droughts, and (2) organize responses to black swan events more effectively. Brainstorm additional recommendations that you might make to policy makers.

1. This ChapterCase is based on: Auletta, K. (2011, July 11), “A woman’s place,” The New Yorker, July 11; Holms, A. (2013, Mar. 4), “Maybe you should the read book: The Sheryl Sandberg backlash,” The New Yorker; Kantor, J. (2013, Feb. 21), “A titan’s how-to on breaking the glass ceiling,” The New York Times; “The 2013 Time 100 [The 100 Most

Influential People],” Time, April 18, 2013; Rothaermel, F.T., and M. McKay (2015), “Facebook, Inc.,” McGraw-Hill Education Case Study 121159420477; Sandberg, S. (2010), “Why We Have Too Few Women Leaders,” TED talk, http://bit.ly/1czSD6n; Sandberg, S. (2013), Lean In: Women, Work, and the Will to Lead (New York: Knopf);

Vara, V. (2015, Mar. 8), “Sheryl Sandberg’s divisive pitch to #LeanInTogether,” The New Yorker; “Imperial ambitions,” The Economist, April 9, 2016; “How to win friends and influ- ence people,” The Economist, April 9, 2016; “Robber barons and silicon sultans,” The Economist, January 3, 2015; “The feminist mystique,” The Economist, March 16, 2013;

ENDNOTES

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“The World’s Most Powerful Women in Tech 2016,” Forbes, June 6, 2016; and 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). 2. Finkelstein, S., D.C. Hambrick, and A.A. Cannella (2008), Strategic Leadership: The- ory and Research on Executives, Top Manage- ment Teams, and Boards (Oxford, UK: Oxford University Press), 4. 3. Finkelstein, S., D.C. Hambrick, and A.A. Cannella (2008), Strategic Leadership: The- ory and Research on Executives, Top Manage- ment Teams, and Boards (Oxford, UK: Oxford University Press); and Yulk, G. (1998), Lead- ership in Organizations, 4th ed. (Englewood Cliffs, NJ: Prentice Hall). 4. Pfeffer, J. (1994), Managing with Power: Politics and Influence in Organizations (Boston, MA: Harvard Business School Press). 5. “The acceptable face of Facebook,” The Economist, July 21, 2011. 6. Hambrick, D.C., and E. Abrahamson (1995), “Assessing managerial discretion across industries: A multimethod approach,” Academy of Management Journal 38: 1427–1441. 7. “The 100 best performing CEOs in the World,” Harvard Business Review, November 2016. 8. Bandiera, O., A. Prat, and R. Sadun (2012), “Managerial capital at the top: Evidence from the time use of CEOs,” London School of Eco- nomics and Harvard Business School Working Paper; and “In defense of the CEO,” The Wall Street Journal, January 15, 2013. The patterns of how CEOs spend their time have held in a number of different studies across the world. 9. Finkelstein, S., D.C. Hambrick, and A.A. Cannella (2008), Strategic Leadership: The- ory and Research on Executives, Top Manage- ment Teams, and Boards (Oxford, UK: Oxford University Press), 17. 10. Bandiera, O., A. Prat, and R. Sadun (2012), “Managerial capital at the top: Evi- dence 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, January 15, 2013. 11. 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 organization as a reflection of its top managers,” Academy of Management Review 9: 193–206. 12. Collins, J.C. (2001), Good to Great: Why Some Companies Make the Leap . . . And Oth- ers Don’t (New York: HarperBusiness), 3.

13. Collins, J.C. (2001), Good to Great: Why Some Companies Make the Leap . . . And Oth- ers Don’t (New York: HarperBusiness). 14. As quoted in Auletta, K. (2011, July 11), “A woman’s place,” The New Yorker. 15. 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. 16. 2016 Facebook Annual Report. 17. 2016 Facebook Annual Report; and Seetharaman, D. (2016, April 28), “Facebook revenue soars on ad growth,” The Wall Street Journal. 18. For a superb treatise of the history of strategy, see Freedman, L. (2013), Strategy: A History (New York: Oxford University Press). 19. This discussion is based on Mintzberg, H. (1993), The Rise and Fall of Strategic Plan- ning: Reconceiving Roles for Planning, Plans, and Planners (New York: Simon & Schuster); and Mintzberg, H. (1994), “The fall and rise of strategic planning,” Harvard Business Review, January–February: 107–114. 20. Isaacson, W. (2011), Steve Jobs (New York: Simon & Schuster). See also: Isaacson, W. (2012, Apr.), “The real leadership lessons of Steve Jobs,” Harvard Business Review. 21. Jobs, S. (1998, May 25) “There is sanity returning,” BusinessWeek. 22. Isaacson, W. (2011), Steve Jobs (New York: Simon & Schuster). See also: Isaacson, W. (2012, Apr.), “The real leadership lessons of Steve Jobs,” Harvard Business Review. 23. “CEO Tim Cook pushes employee- friendly benefits long shunned by Steve Jobs,” The Wall Street Journal, November 12, 2012. 24. Grove, A.S. (1996), Only the Paranoid Survive: How to Exploit the Crisis Points that Challenge Every Company (New York: Cur- rency Doubleday). 25. UPS 2014 Investor Conference Presenta- tions, Thursday, November 13; and UPS 2013 Annual Report. 26. Talib, N.N. (2007), The Black Swan: The Impact of the Highly Improbable (New York: Random House). 27. 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), “The fall and rise of strategic planning,” Harvard Business Review, January-February: 107–114. 28. Thompson, S.C. (1999), “Illusions of control: How we overestimate our personal influence,” Current Directions in Psychologi- cal Science 8: 187–190. 29. “FTI Consulting projects U.S. online retail sales to approach $440 billion in 2017:

online market share expected to nearly double by 2026,” Global Newswire, November 1, 2016, http://bit.ly/2gChcMs. 30. Kotha, S., V. Rindova, and F.T. Rothaermel (2001), “Assets and actions: Firm-specific factors in the internationaliza- tion of U.S. internet firms,” Journal of Inter- national 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. 31. Kantor, J., and D. Streitfeld (2015, Aug. 15), “Inside Amazon: Wrestling big ideas in a bruising workplace,” The New York Times. 32. Arthur, B.W. (1989), “Competing tech- nologies, 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, MA: Harvard Business School Press); Bower, J.L., and C.G. Gilbert (2005), From Resource Allocation to Strat- egy (Oxford, UK: Oxford University Press); Burgelman, R.A. (1983), “A model of the interaction of strategic behavior, corporate context, and the concept of strategy,” Acad- emy of Management Review 8: 61–71; and Burgelman, R.A. (1983), “A process model of internal corporate venturing in a major diver- sified firm,” Administrative Science Quarterly 28: 223–244. 33. 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). 34. John Rice, GE vice chairman, president, and CEO, GE Technology Infrastructure (2009, May 11), presentation at Georgia Institute of Technology. 35. See MiniCase “Strategy and Serendipity: A Billion-Dollar Bonanza,” http://mcgrawhill- create.com/rothaermel. 36. This example is drawn from: “Crispy ‘Saratoga chips’ potato chips invented in Sara- toga,” at www.saratoga.com/news/saratoga- chips.cfm; and “George Crum,” at http:// lemelson.mit.edu/resources/george-crum. 37. Levy, S. (2011), In the Plex: How Google Thinks, Works, and Shapes Our Lives (New York: Simon & Schuster). 38. Mayer, M. (2006, May 11), “Nine les- sons learned about creativity at Google,”

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62 CHAPTER 2 Strategic Leadership: Managing the Strategy Process

presentation at Stanford Technology Ventures Program. 39. Barr, A., and R. Winkler (2015, Aug. 10), “Google creates parent company called Alphabet in restructuring,” The Wall Street Journal. 40. Bower, J.L., and C.G. Gilbert (2005), From Resource Allocation to Strategy (Oxford, UK: Oxford University Press). 41. Bower, J.L. (1970), Managing the Resource Allocation Process (Boston, MA: 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 interaction of strategic behav- ior, corporate context, and the concept of strategy,” Academy of Management Review 8: 61–71; and Burgelman, R.A. (1983), “A pro- cess model of internal corporate venturing in a major diversified firm,” Administrative Sci- ence Quarterly 28: 223–244. 42. Burgelman, R.A. (1994), “Fading memo- ries: A process theory of strategic business exit in dynamic environments,” Administrative Science Quarterly 39: 24–56. 43. Burgelman, R.A., and A.S. Grove (1996), “Strategic dissonance,” California Manage- ment Review 38: 8–28. 44. Grant, R.M. (2003), “Strategic plan- ning 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 evolution in relentlessly shifting organi- zations,” Administrative Science Quarterly 42: 1–34; Farjourn, M. (2002), “Towards an organic perspective 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: Manag- ing strategic dynamics for corporate longev- ity,” Strategic Management Journal 28(10): 965–979. 45. Smith, A. (1776), An Inquiry into the Nature and Causes of the Wealth of Nations, 5th ed. (published 1904) (London: Methuen and Co.). 46. Levy, S. (2011), In the Plex: How Google Thinks, Works, and Shapes Our Lives (New York: Simon & Schuster); and www. wolframalpha.com/input/?i=google. 47. “The HP Way,” see www.hpalumni.org/ hp_way.htm; and Packard, D. (1995), HP Way: How Bill Hewlett and I Built Our Com- pany (New York: HarperCollins). 48. This discussion draws on: Carroll, A.B., and A.K. Buchholtz (2012), Business &

Society: Ethics, Sustainability, and Stake- holder Management (Mason, OH: South- Western Cengage); Porter, M.E., and M.R. Kramer (2011), “Creating shared value: How to reinvent capitalism—and unleash innovation and growth,” Harvard Business Review, January–February; 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 Man- agement Annals 4: 403–445; and Porter, M.E., and M.R. Kramer (2006), “Strategy and soci- ety: The link between competitive advantage and corporate social responsibility,” Harvard Business Review, December: 80–92. 49. 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). 50. 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. 51. 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 Manage- ment (Oxford, UK: Blackwell), 189–207; and Freeman, E.R. (1984), Strategic Manage- ment: A Stakeholder Approach (Boston, MA: Pitman). 52. To acknowledge the increasing impor- tance of stakeholder strategy, the Strategic Management Society (SMS)—the lead- ing association for academics, business executives, and consultants interested in strategic management—has recently created a stakeholder strategy division; see http:// strategicmanagement.net/. Also see Ander- son, 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: Profit- ing from Collaborative Business Relation- ships (San Francisco: Berrett-Koehler). 53. Parmar, B.L., R.E. Freeman, J.S. Har- rison, A.C. Wicks, L. Purnell, and S. De Colle (2010), “Stakeholder theory: The state of the art,” Academy of Management Annals 4: 406.

54. 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. 55. 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. 56. “The World’s Most Admired Compa- nies,” Fortune (2016), http://fortune.com/ worlds-most-admired-companies/. 57. 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 iden- tification and salience,” Academy of Manage- ment Review 22: 853–886. 58. Ostrower, J. (2014, July 30), “Boeing to build stretched 787–10 in South Carolina,” The Wall Street Journal. 59. Benoit, D. (2014, Feb. 10), “Icahn ends Apple push with hefty profit,” The Wall Street Journal. 60. People for the Ethical Treatment of Ani- mals (PETA) is an animal-rights organization. 61. 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 Competi- tive Advantage (Hoboken, NJ: Wiley). 62. This discussion draws on: Carroll, A.B., and A.K. Buchholtz (2012), Business & Soci- ety: Ethics, Sustainability, and Stakeholder Management (Mason, OH: South-Western Cengage); Carroll, A.B. (1991), “The pyramid of corporate social responsibility: Toward the moral management of organizational stake- holders,” Business Horizons, July–August: 39–48; and Carroll, A.B. (1979), “A three- dimensional, conceptual model of corporate social performance,” Academy of Management Review 4: 497–505. 63. For an insightful but critical treatment of this topic, see the 2003 Canadian documen- tary film The Corporation. 64. For recent empirical findings concern- ing the relationship between corporate social responsibility 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 Man- agement Journal, 33: 1304–1320; Wang, T., and P. Bansal (2012), “Social responsibility in new ventures: Profiting from a long-term orientation,”Strategic Management Journal 33: 1135–1153; and Jayachandran, S., K. Kalaignanam, and M. Eilert (2013), “Prod- uct and environmental social performance:

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Varying effect on firm performance,” Strate- gic Management Journal, 34: 1255–1264. 65. Friedman, M. (1970, Sept. 13), “The social responsibility of business is to increase its profits,” The New York Times Magazine. 66. Armour, S. (2015, Oct. 25), “ACA premi- ums jump 25%; administration acknowledges extended enrollment,” The Wall Street Journal. 67. “Wake up and smell the coffee: Star- bucks’s tax troubles are a sign of things to come for multinationals,” The Economist, December 15, 2012. 68. Gates, B. (2008, Aug. 11), “How to help those left behind,” Time. 69. Carroll, A.B. (1991), “The pyramid of corporate social responsibility: Toward the

moral management of organizational stake- holders,” Business Horizons, July–August: 39–48. 70. Gilbert, D., and J. Scheck (2014, Sept. 4), “BP is found grossly negligent in Deepwater Horizon disaster,” The Wall Street Journal. 71. Kent, S., and C.M. Matthews (2016, Apr. 26), “BP results still hurt by Gulf of Mexico spill,” The Wall Street Journal; Gilbert, D., and J. Scheck (2014, Sept. 4), “BP is found grossly negligent in Deepwater Horizon disaster,” The Wall Street Journal; Gara, T. (2012, Nov. 28), “U.S. government slams BP’s ‘lack of business integrity,’” The Wall Street Journal; “BP and the Deepwater Horizon disaster,” The Economist, November 15, 2012; Fowler, T. (2012), “BP slapped with record fine,” The Wall Street Journal, November 15;

and Fowler, T. (2012, Mar. 4), “BP, plaintiffs reach settlement in Gulf oil spill,” The Wall Street Journal. 72. Huddleston Jr., T. (2016, Dec. 8), “Sheryl Sandberg says fake news on Facebook didn’t sway the election,” Fortune; “False news items are not the only problem besetting Face- book,” The Economist, November 26, 2016; and Isaac, M. (2016, Nov. 22), “Facebook said to create censorship tool to get back into China,” The New York Times; White, Z., B. White, and T. Romm (2016, Oct. 23), “Liber- als wary as Facebook’s Sandberg eyed for Treasury,” Politico. 73. Hamel, G. (2007), The Future of Manage- ment (Boston, MA: Harvard Business School Publishing).

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

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 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

Learning Objectives

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.

3

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Airbnb: Disrupting the Hotel Industry

IN 2007, BRIAN CHESKY and Joe Gebbia were roommates in San Francisco. 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 gigs were hit-and-miss for the aspiring industrial designers, they could not afford their rent payments. On a whim, they decided to send out an e-mail on the distribution list for an upcoming 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 accommodations, well, consider networking in your jam-jams. That’s right. For an affordable alternative to hotels in the city, imagine your- self 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.”

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 scien- tist Nathan Blecharczyk, one of Gebbia’s former room- mates, 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 example, Twitter, the social net- working and news site, 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 (a fact the Airbnb founders

only learned after the event), and so confer- ence organizers didn’t drive any traffic to Airbnb’s site.

Not to be discour- aged, Airbnb decided to take advantage of the anticipated short- age of hotel rooms in Denver, Colorado, the site of the Democratic National Convention (DNC) in the sum- mer of 2008. After all hotels were booked, the founders prepared media releases with titles such as “Grass-

roots Housing for Grassroots Campaign,” which Obama supporters loved. As luck would have it, Airbnb was cov- ered 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 presiden- tial candidates on 1,000 cereal boxes. After sending sam- ples to their press contacts and subsequent coverage in the media, the limited edition cereal sold out quickly, providing enough cash to keep going with Airbnb a bit longer.

The fledgling venture’s breakthrough came in 2009 when it was accepted into a program run by Y Combinator, a start-up incubator 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 oppor- tunities, including with venture capitalists looking to fund the next “big thing.” In 2010, Airbnb received fund- ing from Sequoia Capital, one of the most prestigious venture capital firms in Silicon Valley, having provided early-stage capital to companies such as Apple, Google,

CHAPTERCASE 3

©Mike Windle/Getty Images Entertainment/Getty Images

“Brian Chesky, Joe Gebbia, and Nathan Blecharczyk founded Airbnb on a shoestring budget in 2008. Today, Airbnb is the largest hospitality platform globally.”

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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,

or Intercontinental? One reason is that Airbnb, now the world’s largest accommodation provider, owns no real estate. Instead, Airbnb 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 some 2,500 employ- ees (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 metropolitan 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 in an industry. We then move from a static analysis of a firm’s industry environment to a dynamic understanding 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.

Oracle, PayPal, YouTube, and WhatsApp. Although not a first mover in the peer-to-peer rental space, Airbnb, while at Y Combinator, was the first one to figure out that a sleek website with professional photos of available rentals made all the difference. In addition, Airbnb developed a seamless transaction experience between hosts and guests, allowing it to make a bit over 10 percent on each transaction conducted on its rental 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 try- ing to pay rent or mortgages to keep their homes.

In 2017, a mere 10 years after the two roommates had sent out the fateful e-mail inviting complete strangers to share their apartment with them, Airbnb was valued at a whopping $31 billion! This makes Airbnb the fourth most valuable private company on the planet, just after Uber ($68

billion); Didi Chuxing, basically China’s version of Uber ($50 billion); and Xiaomi, a Chinese smartphone maker (46 billion). Even more stunning, Airbnb’s $31 billion valuation exceeds that of Marriott, the world’s largest hotel chain. 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 various travel needs. In this sense, Airbnb is a new entrant that competes in the global hotel industry. Indeed, with more than 3 mil- lion listings in over 65,000 cities basically anywhere in the world (except North Korea), Airbnb offers more accom- modations than the three biggest hotel chains combined: Marriott, Hilton, and Intercontinental.1

You will learn more about Airbnb by reading this chapter; related questions appear in “ChapterCase3 / Consider This. . . .”

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3.1 The PESTEL Framework A firm’s external environment consists of all the factors that can affect its potential to gain and sustain a competitive advantage. By analyzing the factors in the external environment, strategic leaders can mitigate threats and leverage opportunities. One common approach to understanding how external factors impinge upon a firm is to consider the source or prox- imity of these factors. For example, external factors in the firm’s general environment are ones that managers have little direct influence over, such as macroeconomic factors (e.g., interest or currency exchange rates). In contrast, external factors in the firm’s task environ- ment are ones that managers 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. With more open markets and international trade in recent decades, the PESTEL factors have become more global. Such factors create both opportunities and threats.

LO 3-1

Generate a PESTEL analysis to evaluate the impact of external factors on the firm.

PESTEL model A framework that categorizes and analyzes an important set of external factors (political, economic, sociocultural, technological, ecological, and legal) that might impinge upon a firm. These factors can create both opportunities and threats for the firm.

EXHIBIT 3.1 / The Firm within Its External Environment, Industry, and Strategic Group, Subject to PESTEL Factors

External Environment

Political Economic

Sociocultural

TechnologicalEcological

Firm

Industry

External Environment

Legal

Strategic Group

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POLITICAL FACTORS Political factors result from the processes and actions of government bodies that can influ- ence the decisions and behavior of firms.2

Although political factors are located in the firm’s general environment, where firms traditionally wield little influence, companies nevertheless increasingly work to shape and influence this realm. They do so by applying nonmarket strategies—that is, through lobbying, public relations, contributions, litigation, and so on, in ways that are favor- able to the firm.3 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 aggressive 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 below.

ECONOMIC FACTORS Economic factors in a firm’s external environment are largely macroeconomic, affecting economy-wide phenomena. Managers need to consider how the following five macroeco- nomic 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 cur- rent business 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 competition among firms frequently decreases. During economic booms, businesses expand operations 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 benefit 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 $4 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.4 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.

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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).5 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 managers 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, automobiles, computers, 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, pos- sibly 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 direct 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.6 Inflation tends to go with lower economic growth. Countries such as Argen- tina, Brazil, Mexico, and Poland experienced periods of extremely high inflation rates in recent decades.

Deflation describes a decrease in the overall price level. A sudden and pronounced drop in demand generally causes deflation, which in turn forces sellers to lower prices to moti- vate 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, deflation is actually a serious threat to economic growth because it distorts expectations about the future.7 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 persistent deflation.

CURRENCY EXCHANGE RATES. The currency exchange rate determines how many dol- lars one must pay for a unit of foreign currency. It is a critical variable for any com- pany that buys or sells products and services across national borders. For example, if the U.S. dollar appreciates 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, or John Deere tractors 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 BMW 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 are relatively more expensive. At the same time, Chinese purchasing power increases, which in turn allows their businesses to purchase more U.S. capital goods such as sophisticated machinery and other cutting-edge technologies.

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In summary, economic factors affecting businesses are ever-present and rarely static. Managers 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 sociocul- tural 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 population 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. The most recent U.S. census revealed that 55 million Americans (16.4 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 (spe- cializing 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 pro- mote their products and services.8

TECHNOLOGICAL FACTORS Technological factors capture the application of knowledge to create new processes and products. Major innovations in process technology include lean manufacturing, Six Sigma quality, and biotechnology. The nanotechnology revolution, which is just beginning, prom- ises significant upheaval for a vast array of industries ranging from tiny medical devices to new-age materials for earthquake-resistant buildings.9 Recent product innovations include the smartphone, wearable devices such as smart watches, and high-performing electric cars such as the Tesla Model S. As discussed in the ChapterCase, Airbnb launched a radi- cal 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.10 Not surprisingly, changes in the technological environment bring both opportunities and threats for companies. Given the importance of a firm’s inno- vation strategy to competitive advantage, we discuss the effect of technological factors in greater detail in Chapter 7.

Strategy Highlight 3.1 details how BlackBerry fell victim by not paying sufficient atten- tion to the PESTEL factors.

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

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BlackBerry’s Bust A pioneer in smartphones, BlackBerry was the undisputed industry leader in the early 2000s. IT managers preferred BlackBerry. Its devices allowed users to receive e-mail and other data in real time globally, with enhanced security fea- tures. For executives, a BlackBerry was not just a tool to increase productivity—and to free them from their laptops— but also an important status symbol. As a consequence, by 2008 BlackBerry’s market cap had peaked at $75 billion. Yet by 2017, this lofty valuation had fallen by almost 95 percent to a mere $3.9 billion. What happened?

Being Canadian, Jim Balsillie, BlackBerry’s longtime co- CEO, not surprisingly sees ice hockey as his favorite sport. He likes to quote Wayne Gretzky, whom many consider the best ice hockey player ever: “Skate to where the puck is going to be, not to where it is.” Alas, BlackBerry did not follow that advice. BlackBerry fell victim to two important PESTEL factors in its external environment: sociocultural and technological.

Let’s start with technology. The introduction of the iPhone by Apple in 2007 changed the game in the mobile device industry. Equipped with a camera, the iPhone’s slick design offered a user interface with a touchscreen including a virtual keyboard. The iPhone connected seamlessly to cel- lular networks and Wi-Fi. Combined with thousands of apps

via the Apple iTunes store, the iPhone provided a powerful user experience, or as the late Steve Jobs said, “the internet in your pocket.”

However, BlackBerry engineers and executives initially dismissed the iPhone as a mere toy with poor security fea- tures. Everyday users thought differently. They had less con- cern for encrypted software security than they had desire for having fun with a device that allowed them to text, surf the web, take pictures, play games, and do e-mail. Although BlackBerry devices were great in productivity applications, such as receiving and responding to e-mail via typing on its iconic physical keyboard, they provided a poor mobile web browsing experience.

The second external development that helped erode BlackBerry’s dominance was sociocultural. Initially, mobile devices were issued top-down by corporate IT departments. The only available device for execs was a company-issued BlackBerry. This made life easy for IT departments ensur- ing network security. Consumers, however, began to bring their personal iPhones to work and used them for corporate communication and productivity applications. This bottom- up groundswell of the BYOT (“bring your own technology”) movement forced corporate IT departments to open up their services beyond the BlackBerry.

Caught in the oncoming gale winds of two PESTEL factors—technological and sociocultural—BlackBerry was pushed backward in the smartphone market. Unlike Gretzky, it failed to skate where the puck was going to be and there- fore continued to focus on its existing customer base of corporate IT departments and government. Later, feeble modifications in product lineup appeared to be “too little, too late.” Apple continued to drive innovation in the smartphone industry by bringing out more advanced iPhone models and enhancing the usefulness of its apps for the various business and productivity applications.

Let’s think about the rapid progress in mobile computing. BlackBerry, once an undisputed leader in the smartphone industry, did not recognize early enough or act upon changes in the external environment. Consumer preferences changed quickly as the iPhone and later the iPad became available. Professionals brought their own Apple or other devices to work instead of using company-issued BlackBerrys. Although the Canadian technology company made a valiant effort to make up lost ground with its new BlackBerry 10 operating system and several new models, it was too little, too late.11

Strategy Highlight 3.1

NHL great Wayne Gretzky, shown here in 1999, his final season with the New York Rangers, holds the record for most career regular-season goals. ©AP Images/JIM ROGASH

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the organizations we create. Managers can no longer separate the natural and the business worlds; they are inextricably linked.12

Negative examples come readily to mind, as many business organizations have con- tributed to the pollution of air, water, and land, as well as depletion of the world’s natural resources. BP’s infamous oil spill in the Gulf of Mexico destroyed fauna and flora along the U.S. shoreline from Texas to Florida. This disaster led to a decrease 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 (see Strategy Highlight 2.2).

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 emis- sions 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 integrated with SolarCity to provide clean-tech energy services for its customers, including decentral- ized solar power generation and storage via its Powerwall.

LEGAL FACTORS Legal factors include the official outcomes of political processes as manifested in laws, mandates, 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. Governments 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 compa- nies. European targets include Apple, Amazon, Facebook, Google, and Microsoft—the five largest U.S. tech companies—but also start- ups such as Uber, the taxi-hailing mobile app. Europe’s policy makers seek to retain control

over important industries ranging from transportation to the internet to ensure that prof- its earned in Europe by Silicon Valley firms are taxed locally. The EU 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 wariness extends beyond tax revenue: The euro- zone has much stronger legal requirements and cultural expectations concerning data privacy. Taken together, political/legal environments can have a direct bearing on a firm’s performance.

Multiple PESTEL factors, for instance, are affecting the implementation of autonomous vehicles for commercial and private use. Companies such as Uber, Alphabet (through its Waymo unit), and Tesla are ready to deploy driverless cars, but political and legal factors are providing serious challenges and are delaying the widespread use of autonomous vehicles.

The Waymo driverless car, displayed during a 2016 Google event in San Francisco, marks another step in an effort to revolutionize the way people get around. Instead of driving themselves, people will be chauffeured in software-controlled vehicles if Waymo, automakers, and ride-hailing services such as Uber realize their vision.

©AP Images/Eric Risberg

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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, elements such as entry and exit barri- ers, number and size of companies, and types of products and services offered. In a series of empirical studies, academic researchers have found that about 20 percent of a firm’s profitability depends on the industry it is in.13 To more fully comprehend how external factors affect firm strategy and performance, we take a closer look in this chapter at an industry’s underlying structure.

Firm effects attribute firm performance to the actions strategic leaders take. 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 competitive advantage

For now, the key point is that strategic leaders’ actions tend to be more important in determining firm performance than the forces exerted on the firm by its external envi- ronment.14 Empirical research studies indicate that a firm’s strategy can explain up to 55 percent of its performance.15 Exhibit 3.2 shows these findings.

Although a firm’s industry is not quite as important as the firm’s strategy within its industry, they jointly determine roughly 75 percent of overall firm performance. The remaining 25 percent relates partly to business cycles and other effects.

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 companies facing more or less the same set of suppliers and buyers. Firms competing in the same industry tend to offer similar products or services to meet specific customer needs. Although the PESTEL framework allows us to scan, monitor, and evaluate the external environment 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 implications for one firm’s strategic position within an industry. A firm’s strategic position relates to its ability to create value for customers (V) while containing the cost to do so (C). Competitive advantage flows to

firm effects Firm performance attributed to the actions managers take.

LO 3-2

Differentiate the roles of firm effects and industry effects in determining firm performance.

industry effects Firm performance attributed to the structure of the industry in which the firm competes.

EXHIBIT 3.2 / Industry, Firm, and Other Effects Explaining Superior Firm Performance

Up to 55%

~25%

~20%

Other Effects (Business Cycle Effects,

Unexplained Variance)

Firm Effects

Industry Effects

industry A group of incumbent companies that face more or less the same set of suppliers and buyers.

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 profile based on the difference between value creation and cost (V − C ).

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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).

Michael Porter developed the highly influential five forces model to help managers 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 hundreds of detailed case studies, Porter derived two key insights that form the basis of his seminal five forces model:

1. Rather than defining competition narrowly as the firm’s closest competitors to explain and predict a firm’s performance, 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 substitutes.

2. The profit potential of an industry is neither random nor entirely determined by industry-specific factors. Rather, it is a function of the five forces that shape competi- tion: threat of entry, power of suppliers, power of buyers, threat of substitutes, and rivalry among existing firms.

COMPETITION IN THE FIVE FORCES MODEL Because the five forces model has especially powerful implications for strategy and com- petitive advantage, we will explore it in some detail. We start with the concept of competi- tion. The first major insight this model provides is that competition involves more than just creating economic value; firms must also capture a significant share of it or they will see the economic value they create lost to suppliers, customers, or competitors. Firms create economic value by expanding as much as possible the gap between the value (V) the firm’s product or service generates and the cost (C) to produce it. Economic value thus equals V minus 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.

In Porter’s five forces model, competition is more broadly defined beyond the firm’s clos- est competitors (e.g., Nike versus Under Armour, The Home Depot versus Lowe’s, Merck ver- sus Pfizer, and so on) to include other industry forces: buyers, suppliers, potential new entry of other firms, and the threat of substitutes. Competition 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, but also with the strength of the other competitive forces that are attempt- ing to extract part or all of the economic value the firm creates. When faced with competition in this broader sense, strategy explains how a firm is able to achieve superior performance.

The second major insight from the five forces model is that it enables managers to not only understand their industry environment but also shape their firm’s 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 perspective of a strategic leader of an existing firm competing for advantage in an established industry, the company should be positioned in a way that relaxes the con- straints 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.

Strategy Highlight 3.2 provides an overview of the five competitive forces that shape strategy, with an application to the U.S. domestic airline industry. We will take up the topic of competitive positioning in Chapter 6 when studying business-level strategy in more detail.

Taking a closer look at the U.S. domestic airline industry in Strategy Highlight 3.2 shows how the five forces framework is a powerful and versatile tool to analyze industries.

five forces model A framework that identifies five forces that determine the profit potential of an industry and shape a firm’s competitive strategy.

LO 3-3

Apply Porter’s five competitive forces to explain the profit potential of different industries.

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The Five Forces in the Airline Industry Although many of the mega-airlines such as American, Delta, and United have lost billions of dollars over the past few decades and continue to struggle to generate consistent profitability, other players in this industry have been quite profitable because they were able to extract some of the eco- nomic value created. The airlines, however, benefited from a windfall because the prices for jet fuel fell from a high of $3.25 per gallon (in 2011) to $1.50 (in 2015), giving some reprieve to cash-strapped airlines. Nonetheless, competition remains intense in this industry.

Entry barriers are relatively low, resulting in a number of new airlines popping up. 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. Indeed, despite notoriously low industry profitability, Virgin America entered the U.S. mar- ket in 2007. Virgin America is the brainchild of Sir Richard Branson, founder and chairman of the Virgin Group, a UK con- glomerate of hundreds of companies using the Virgin brand, including the international airline Virgin Atlantic. Its business strategy is to offer low-cost service between major metropoli- tan cities on the American East and West Coasts. (In 2016, Alaska Airlines acquired Virgin America for $2.6 billion).

To make matters worse, substitutes are also read- ily available: If prices are seen as too high, customers can drive their cars or use the train or bus. As an example, the route between Atlanta and Orlando (roughly 400 miles) used to be one of Delta’s busiest and most profitable. Given the increasing security delays at airports, more and 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 hos- tile environment leads to intense rivalry among existing air- lines and low overall industry profit potential.

In the airline industry, the supplier power is also strong. The providers of airframes (e.g., Boeing or Airbus), makers of aircraft engines (e.g., GE or Rolls-Royce), air- craft maintenance companies (e.g., Goodrich), caterers (e.g., Marriott), labor unions, and airports controlling gate access all bargain away the profitability of airlines. Moreover, large corporate customers can contract with airlines to serve all of their employees’ travel needs; such powerful buyers fur- ther reduce profit margins for air carriers. To make matters worse, consumers primarily make decisions based on price.

As a consequence of these powerful industry forces, the nature of rivalry among airlines is incredibly intense. 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 compari- sons are effortless. Consumers benefit from cut-throat price competition between carriers and capture significant value. Low switching costs and nearly perfect information combine to strengthen buyer power.

The surprising conclusion is that while the mega-airlines themselves (i.e., American, Delta, and United) frequently struggle to make a profit, the other players in the industry— such as the suppliers of aircraft engines, aircraft mainte- nance companies, IT companies providing reservation and logistics services, caterers, airports, and so on—are quite profitable, all extracting significant value from the air trans- portation industry. Customers also are better off, as ticket prices have decreased and travel choices increased.17

Strategy Highlight 3.2

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. More- over, a five forces analysis provides the basis for how a firm should position itself to gain and sustain a competitive advantage. We are now ready to look more closely at each of the five competitive forces.

As Exhibit 3.3 shows, Porter’s model identifies five key competitive forces that managers need to consider when analyzing the industry environment and formulating competitive strategy:

1. Threat of entry. 2. Power of suppliers.

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3. Power of buyers. 4. Threat of substitutes. 5. Rivalry among existing competitors.

THE THREAT OF ENTRY The threat of entry describes the risk that potential competitors will enter the industry. Potential new entry depresses industry profit potential in two major ways:

1. With the threat of additional capacity coming into an industry, incumbent firms may lower prices to make entry appear less attractive to the potential new competitors, which would in turn reduce the overall industry’s profit potential, especially in indus- tries with slow or no overall growth in demand. Consider the market for new micro- waves. 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. The threat of entry by additional competitors may force incumbent firms to spend more to satisfy their existing customers. This spending 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 offerings. Starbucks has over 13,000 U.S. stores and more than 25,000 globally. By raising the value of its offering in the eyes of the con- sumers, it slows others from entering the industry or from rapidly expanding. This allows Starbucks to hold at bay smaller regional competitors, such as Peet’s Coffee & Tea, with fewer than 200 stores mostly on the West Coast, and prevents smaller national chains, such as Caribou Coffee, with 415 stores nationally, from increasing the level of competi- tion. 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 competi- tors to enter. There are, however, a number of important barriers to entry that raise the costs for potential competitors and reduce the threat of entry. Entry barriers, which are

EXHIBIT 3.3 / Porter’s Five Forces Model SOURCE: Porter, M. E. (2008, Jan.). “The five competitive forces that shape strategy,” Harvard Business Review.

Rivalry among

Existing Competitors

Bargaining Power of Suppliers

Bargaining Power of Buyers

Threat of New Entrants

Threat of Substitute Products or Services

threat of entry The risk that potential competitors will enter an industry.

entry barriers Obstacles that determine how easily a firm can enter an industry and often significantly predict industry profit potential.

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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 in ChapterCase 1 when featuring Tesla, a U.S. manufacturer of all-electric vehicles. Usually entrants into the broad automobile industry need large-scale production 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 is moving more into the mass market.

To benefit from economies of scale, Tesla is introducing new models, helping it move away from small-scale and costly production of niche vehicles to larger production runs of cars with a stronger mass-market appeal. Tesla’s first vehicle, the Roadster (costing over $110,000) was more or less a prototype to prove the viability of an all-electric car that outper- forms 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 (over $70,000). Tesla’s manufacturing scale increased more than 50-fold, from some 2,500 Roadsters to 125,000 Model S’s. The all-electric car company is 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 new company to break into the mass market and manufacture many more cars. Tesla CEO Elon Musk set an audacious goal of selling 500,000 cars a year by 2018, which is needed for the company to be profitable.18 Tesla’s new product introductions over time are motivated by an attempt to capture benefits that accrue to economies of scale. To capture benefits from economies of scale including lower unit cost, Musk hopes that Tesla can increase its production volume from a mere 50,000 vehicles in 2015 to 1 million cars a year by 2020.

NETWORK EFFECTS. Network effects describe the positive effect that one user of a product or service has on the value of that product or ser- vice 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 2 billion active users worldwide, enjoys tremendous net- work effects, making it difficult for more recent entrants such as Google Plus to compete effectively. We will discuss network effects in more detail in Chapter 7.

network effects The value of a product or service for an individual user increases with the number of total users.

Facebook CEO Mark Zuckerberg speaks about Facebook Graph Search, intro- duced in 2013. Facebook’s 2 billion active users reinforce its strong network effects.

©AP Images/Jeff Chiu

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CUSTOMER SWITCHING COSTS. Switching costs are incurred by moving from one sup- plier 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 planning (ERP) software from SAP for many years will incur significant switching costs when implementing a new ERP system from Oracle.

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? Frequently 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 the Fremont, California, manufacturing plant from Toyota and upgraded it with a highly automated production process using robots to produce cars of the highest quality at large scale.19 This strategic commitment, however, is dwarfed by the $5 billion that Tesla is investing to build its battery “gigafactory” in Nevada.20 The new factory allows Tesla to not only secure supplies of lithium-ion batteries, the most critical and expensive compo- nent of an all-electric car, but also build as many as 1 million vehicles a year.21 In such cases, the likelihood of entry is determined by not only the level of capital investment required to enter the industry, but also the expected return on investment. The potential new entrant must carefully weigh the required capital investments, the cost of capital, and the expected return. Taken together, the threat of entry is high when capital requirements are low in comparison 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 easily 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 loy- alty, proprietary technology, preferential access to raw materials and distribution channels, favorable geographic locations, and cumulative learning and experience effects.

Tesla has loyal customers, which strengthens its competitive position and reduces the threat of entry into the all-electric car segment, at least by other start-up compa- nies.22 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. It luckily has its own “cool factor” of being different, similar to Apple in its early days. Tesla can back this per- ception with beautifully designed cars of top-notch quality made domestically in Califor- nia. Indeed, when Consumer Reports tested the Model S, the usually understated magazine concluded: “The Tesla Model S is the best car we ever tested.”23 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 to raw materials and key components can bestow absolute cost advantages. As mentioned, lithium-ion batteries are not only the most expensive and critical parts of an all-electric vehicle, but they are also in short supply. Tesla’s new bat- tery “gigafactory” will afford it independence from the few worldwide suppliers, such as Panasonic of Japan, and also likely bestow an absolute cost advantage.24 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.

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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.

Finally, incumbent firms often benefit from cumulative learning and experience effects accrued over long periods of time. Tesla now has more than 10 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, 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 truck- ing have generated significant new entries. Therefore, the threat of entry is high when restrictive government policies do not exist or when industries become deregulated.

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 specific 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.

In contrast, the threat of entry is high when new entrants expect that incumbents will not or cannot retaliate. 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.

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 perfor- mance for two reasons: 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. Powerful suppliers are a threat to firms because they reduce the industry’s profit potential by capturing part of the economic value created.

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To compete effectively, companies generally need a wide variety of inputs into the pro- duction process, including raw materials and components, labor (via individuals or labor unions, when the industry faces collective bargaining), and services. The relative bargain- ing 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.

In Strategy Highlight 3.2, we noted that the airline industry faces strong supplier power. Let’s take a closer look at one important supplier group to this industry: Boeing and Airbus, the makers of large commercial jets. The reason airframe manufacturers are powerful sup- pliers to airlines is 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 com- mercial 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, main- tenance 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 of the aircraft can be used as substitutes, Boeing and Airbus offer differentiated prod- ucts. This fact becomes clearer when considering the most recent models from each com- pany. Boeing introduced the 787 Dreamliner to capture long-distance point-to-point travel (close to an 8,000-mile range, sufficient to fly nonstop from Los Angeles to Sydney), while Airbus introduced the A-380 Superjumbo to focus on high-volume transportation (close to 900 passengers) between major airport hubs (e.g., Tokyo’s Haneda Airport and Singapore’s Changi International Airport). When considering long-distance travel, there are no readily available substitutes for commercial airliners, a fact that strengthens supplier power.

All in all, the vast strengths of these factors lead us to conclude that the supplier power of commercial 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 moderate their bargaining positions somewhat. First, the suppliers of commercial airliners depend heavily on commercial airlines for their revenues. 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 Boeings 737 and Airbus A-320. Finally, industry structures are not static, but can change over time. In the past few years, several 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 but even larger airlines remaining. This fact increases their buyer power, which we turn to next.

THE POWER OF BUYERS In many ways, the bargaining power of buyers is the flip side of the bargaining power of suppliers. Buyers are the customers of an industry. The power of buyers concerns the

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pressure an industry’s customers can put on the producers’ margins in the industry 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 pro- ducing 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, Sprint, T-Mobile, or Verizon. 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, because they are able to sign up or move several thousand employees at once.

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.

In addition, companies 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 qual-

ity (cost) of their inputs.

The retail giant Walmart provides perhaps the most potent example of tremendous 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 some $500 billion in revenues in 2017). Walmart is one of the few large big-box global retail chains and frequently purchases large quantities from its suppliers. Walmart lever- ages 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 managers to test the suppliers’ latest products 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.

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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 number of products as private-label brands such as Equate health and beauty items, Ol’Roy dog food, and Parent’s Choice baby products. Taken together, powerful buyers have the ability to extract a significant amount of the value created in the industry, leaving little or nothing for producers.

In regard 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 companies that account for a significant percent- age 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.25 For exam- ple, 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 coffee, videoconferencing versus business travel, e-mail versus express mail, gasoline versus biofuel, and wireless telephone services versus Voice over Internet Protocol (VoIP), offered by Skype or now many apps such as Facebook’s WhatsApp or Tencent’s WeChat.

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.

The movie rental company Redbox, which uses 44,000 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. Moreover, for customers that view only a few movies a month, Redbox is also a substitute for Netflix’s on-demand internet movie streaming service, which costs $9.99 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).

In addition to a lower price, substitutes may also become more attractive by offering a higher value proposition.26 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 ultra- modern high-speed train, was completed in 2008. Taking into account total time involved,

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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 con- sider substitute 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 limiting the airline industry’s profit potential. With the arrival of the AVE, the airlines’ monopoly 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 support. 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 follow- ing factors:

■ Competitive industry structure. ■ Industry growth. ■ Strategic commitments. ■ Exit barriers.

COMPETITIVE INDUSTRY STRUCTURE. The competitive industry structure refers to elements and features common to all industries. The structure of an industry is largely captured by

■ The number and size of its competitors. ■ The firm’s degree of pricing power. ■ The type of product or service (commodity or differentiated product). ■ The height of entry barriers.27

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

LO 3-4

Examine how competitive industry structure shapes rivalry among competitors.

competitive industry structure Elements and features common to all industries, including the number and size of competitors, the firms’ degree of pricing power, the type of product or service offered, and the height of entry barriers.

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industry 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 commodity product offerings are more or less identical. The resulting performance of the industry 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 such as pets.com, petopia.com, and pet-store.com had sprung up by 1999, at the height of the internet bubble.28 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 rap- idly, opening some 2,000 brick-and-mortar stores in the United States and Canada. The

EXHIBIT 3.4 / Industry Competitive Structures along the Continuum from Fragmented to Consolidated Industry Competitive Structures

Monopolistic Competition

Form

Features

Fr ag

me nt

ed

Co ns

ol id

at ed

Perfect Competition

• Many small firms • Firms are price takers • Commodity product • Low entry barriers

• Many firms • Some pricing power • Differentiated product • Medium entry barriers

• Few (large) firms • Some pricing power • Differentiated product • 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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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 pre- dicted that online pet supply stores were unlikely to be profitable.

Monopolistic Competition. A monopolistically competitive industry has many firms, a differentiated product, some obstacles to entry, and the ability to raise prices for a rela- tively 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 com- petitors 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 differentiation 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 oth- ers. 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 competitors can be anticipated.29 Due to their strategic interdependence, companies in oligopolies have an incentive to coordinate their strategic actions to maximize joint perfor- mance. Although explicit coordination such as price fixing is illegal in the United States, tacit coordination 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 decision 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 retailing (The Home Depot versus Lowe’s), toys and games (Hasbro versus Mattel), and detergents (P&G versus Unilever).30

Companies in an oligopoly tend to have some pricing power if they are able to differen- tiate their product or service offerings from those of their competitors. Non-price competi- tion, 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.

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 demon- strated 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.31

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Monopoly. An industry is a monopoly when there is only one, often large firm supply- ing 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 conse- quence, 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. As examples, Georgia Power is the only supplier of electricity for some 2.5 million customers in the southeastern United States. Philadelphia Gas Works is the only supplier of natural gas in the city of Philadelphia, Pennsylvania, serving some 500,000 customers. These are so-called natural monopolies. Without them, the governments involved believe the market would not supply these products or services. In the past few decades, however, more and more of these natural monopolies have been deregulated in the United States, including airlines, telecommu- nications, railroads, trucking, and ocean transportation. This deregulation has allowed compe- tition 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 proprietary technology. In the process, they are changing the industry structure in their favor, generally 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.”32 This is an envi- able position in terms of the ability to extract profits by leveraging its data to provide tar- geted 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 competitors. 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 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 knees. With improvements to materials and procedures, younger patients are also increasingly choosing early surgical

The prosthetic for knee replacement is a fast-growing market segment in the medical products industry.

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intervention. Competitors are able to avoid price competition and, instead, focus on dif- ferentiation 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 quality, 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 com- mitments to a specific industry can stem from large, fixed cost requirements, but also from noneconomic considerations.33

For example, 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 interna- tional coverage. U.S. airlines Delta, United, and American have large fixed costs to main- tain 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, mainte- nance 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 flight is perishable, just like hotel rooms not filled. 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 prof- itability to zero, or even negative numbers (where the companies are losing money). To make matters worse, given their strategic commitments, airlines are unlikely to exit an industry. Excess capacity remains, further depressing 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 Boeing. The European Union in turn claims that Boeing is subsidized by the U.S. govern- ment indirectly via defense contracts. Given these political considerations and large-scale strategic commitments, neither Airbus nor Boeing is likely to exit the aircraft manufactur- ing industry even if industry profit potential falls to zero.

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 barriers

strategic commitments Firm actions that are costly, long-term oriented, and difficult to reverse.

exit barriers Obstacles that determine how easily a firm can leave an industry.

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comprise both economic and social factors. They include fixed costs that must be paid regard- less 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, communities would suffer. Other social and economic factors include ripple effects through the supply 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. All of the large airlines featured in Strategy Highlight 3.2 (American, Delta, and United) have filed for bankruptcy at one point. Due to a unique feature of U.S. Chapter 11 bankruptcy law, however, companies may continue to operate and reorganize while being temporarily shielded from their creditors and other obligations until renegotiated. This implies that excess capacity is not removed from the industry, and by putting pressure on prices further reduces industry profit potential.

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 correspond- ingly, the greater the firm’s ability to gain and sustain competitive advantage. Therefore, managers 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.

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

A complement is a product, service, or competency that adds value to the original product offering when the two are used in tandem.35 Complements increase demand for the primary 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 service.36 Firms may choose to provide the complements themselves or work with another company to accomplish this.

For example, in the smartphone industry, Alphabet’s Google complements Samsung. The Korean high-tech company’s smartphones are more valuable when they come with Google’s Android 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 illus- trates the process of co-opetition, which is cooperation by competitors to achieve a strategic objective. Samsung and Google cooperate as complementors 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.

complement A product, service, or competency 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.

LO 3-5

Describe the strategic role of complements in creating positive-sum co-opetition.

co-opetition Coopera- tion by competitors to achieve a strategic objective.

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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), “The five competitive forces that shape strategy,” Harvard Business Review, January.

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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 phone more from the competition, especially Apple’s newly released iPhone X and Samsung’s Galaxy 8 line of phone, including the Note 8.

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 above), but would nonetheless like to contem- plate potential market entry because the industry profitability is high and thus quite attrac- tive. Exhibit 3.6 shows an integrative model that can guide the entry choices firms make.

LO 3-6

Explain the five choices required for market entry.

EXHIBIT 3.6 / Entry Choices SOURCE: Based on and adapted from Zachary, M.A., 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), “Strategies to crack well-guarded markets,” Harvard Business Review, May: 84–92.

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

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Rather 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 constitute 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 strategic 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 customers, employ- ees, regulators, and communities (see discussion of stakeholder strategy in Chapter 2).

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 are taking a deep dive into the industry life cycle and how it unfolds over time 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 optimiza- tion 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 of is to reconfigure value chains. This approached 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 beach- head 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 8.3-ounce 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 initially 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 segments 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 services). 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

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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 company to add many attractive routes, and thus to enter geographic mar- kets 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.

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 managers must repeat their analy- sis over time to create a more accurate picture of their industry. It is therefore important that managers consider industry dynamics.

Industry structures are not stable over time. Rather, they are dynamic. Since a consolidated 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 miti- gate the threat of strong competitive forces such as supplier or buyer power more effectively.

The U.S. domestic airline industry (featured in Strategy Highlight 3.2) 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 carriers 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 proactively 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 profitable airlines.

In contrast, consolidated industry structures may also break up and become more frag- mented. This generally happens when there are external shocks to an industry such as deregulation, new legislation, technological innovation, or globalization. For example, the emergence of the internet moved the stock brokerage business from an oligopoly controlled by full-service firms such as Merrill Lynch and Morgan Stanley to monopolistic competi- tion with many generic online brokers such as Ameritrade, E*Trade, and Scottrade.

Another dynamic to be considered is industry convergence, a process whereby for- merly 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 IT, telecommunications, and digital media. Media convergence unites computing, communications, and content, thereby causing significant upheaval across previously distinct industries. Content pro- viders in industries 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 Internet companies such as Google, Facebook, Instagram (acquired by Facebook), LinkedIn (acquired by Microsoft), Snap, Pinterest, and Twitter are changing the industry structure by constantly morphing their capabilities and forcing old-line media companies

LO 3-7

Appraise the role of industry dynamics and industry convergence in shaping the firm’s external environment.

industry convergence A process whereby formerly unrelated industries begin to satisfy the same customer need.

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such as News Corp., Time Warner, and Disney to adapt. A wide variety of mobile devices, including smartphones, tablets, and e-readers, provide a new form of content delivery that has the potential to make print media obsolete.

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).39 Stra- tegic 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 dimen- sions.40 Even within the same industry, firm performances differ depending on strategic group membership. Some strategic groups tend to be more profitable than others. This dif- ference 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 industries, 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 strate- gies: one that pursues a low-cost strategy and a second that pursues a differentiation strategy (see Exhibit 3.7). We’ll discuss each of these generic business strategies in detail in Chapter 6.

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 struc- ture, 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 important 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.41

The U.S. domestic airline industry (featured in Strategy Highlight 3.2) provides an illustrative example. Exhibit 3.7 maps companies active in this industry. The two strate- gic 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 airlines using a hub-and-spoke system

LO 3-8

Generate a strategic group model to reveal performance differences between clusters of firms in the same industry.

strategic group The set of companies that pursue a similar strategy within a specific industry.

strategic group model A framework that explains differences in firm performance within the same industry.

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(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.42 If you were to fly from Seattle, Washington, to Miami, Florida, you would stop to change planes in Delta’s Atlanta hub on your way.

The strategic group mapping in Exhibit 3.7 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. domestic 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 South- west Airlines (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 American, 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 eco- nomic 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

EXHIBIT 3.7 / Strategic Groups and Mobility Barrier in U.S. Domestic Airline Industry

Co st

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

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legacy carriers are often unable to stay profitable during recessions, at least on domes- tic 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 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 example, 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 com- petition by regulation to some extent, they often face weaker buyer power, especially from business 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 strategic group because they are much smaller and thus have weaker negotia- tion 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 dif- ferentiated, 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 activities 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.43 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 3.7 are separated by the fact that offering inter- national 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 up-and- coming Persian Gulf region carriers, in particular Emirates, Etihad Airways, and Qatar Airways, are beginning to threaten this profit sanctuary.44

This economic reality implies that if carriers in the lower-left cluster, such as SWA or JetBlue, would like 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

mobility barriers Industry-specific factors that separate one strategic group from another.

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international routes and service them with long-range aircrafts such as Boeing 787s or Airbus A-380s. Adding international service to the low-cost model, however, would require manage- rial commitments resulting in significant capital investments and a likely departure from a well-functioning business model. Additional regulatory hurdles reinforce these mobility bar- riers, 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 destina- tions such as Aruba, Cabo San Lucas, Cancun, the Bahamas, and Jamaica: changes to its reservation system, securing passports for crew members, cultural-awareness training, learning instructions in foreign languages, and performing drills in swimming pools on how to evacuate passengers onto life rafts. All of these additional requirements result in a somewhat higher cost for SWA to servicing international routes.45

3.5 Implications for Strategic Leaders At the start of the strategic management process, it is critical for managers to conduct a thorough analysis of the firm’s external environment to identify threats and opportunities. 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 managers 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 managers to understand is the industry. Applying Porter’s five forces model allows strategic leaders 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:46

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 sup- pliers 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 industry 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 services are all suppliers to airlines, their strengths vary widely. Seg- menting different players 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.

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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 ana- lyzing a firm’s external environment, it is critical to apply the three frameworks intro- duced 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 perfor- mance differences across firms (see Exhibit 1.1).

Although the different models discussed in this chapter are an important step in the strategic management process, they are not without shortcomings. First, all of the models presented 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 envi- ronment can appear suddenly, for example, through black swan events. Industries can be revolutionized by innovation. Strategic groups can be made obsolete through deregula- tion or technological 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 understand 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 valu- able private startups in the world and offers more accommo- dations 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 creating major headwinds for Airbnb. Take regulation, for example. In late 2016, New York state strengthened legisla- tion first passed in 2010. In particular, it is illegal in New York to rent out entire apartments in residential blocks for less than 30 days. (It still remains legal if the renter is living in the apartment at the same time, so “true space sharing” is still possible.) Fines increased to $1,000 for the first offense, rising to $7,500 for repeat offenders. This creates major prob- lems for Airbnb because New York City is by far the largest market for the internet venture, with some 35,000 accommo- dations available for rent.

The issue for Airbnb is that about one-third of those list- ings are from hosts with multiple offerings in the same city. In particular, commercial landlords found out that it is more profitable to convert some apartments into short-term rentals

CHAPTERCASE 3 Consider This . . .

and to offer them via Airbnb than to sign long-term rentals with just one tenant, which often fall under some sort of rent control in New York City. Although this tactic increases the landlord’s return on investment and profits, it creates all kinds of negative externalities. Neighbors complain about noisy tourists partying all night. Some apartments get ransacked or are used for illegal activities such as drug deals and prostitu- tion. New Yorkers expressed their frustration by scrawling on Airbnb posters: “The dumbest person in your building is pass- ing out keys to your front door!” On a more macro level, some argue that Airbnb drives out affordable rental space in many metropolitan cities where apartments are already scarce. Other cities such as Paris, Berlin, and Barcelona face similar problems and passed laws with stiff penalties, fining offend- ers over $100,000!

Questions

1. Have you ever used Airbnb, either as a renter or a host? What were some of the positives and some of the nega- tives of your experience? Explain.

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

2. 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 world- wide hospitality chains? Explain.

3. Why is it that PESTEL factors can have such a strong impact on the future of a business? Do you support legislation 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?

4. 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 digital marketplace, and thus is not responsible for the content that users place on its site. Do you think Airbnb has a strong argument? Why or why not?

5. 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 reputa- tion? Why or why not? Explain.

This chapter demonstrated various approaches to ana- lyzing the firm’s external environment, as summa- rized 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, tech- nological, 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 govern- mental 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 interde- pendent. Both are relevant in determining firm performance.

LO 3-3 / Apply Porter’s five competi- tive 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.

TAKE-AWAY CONCEPTS

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 99

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 com- petitors in an industry, whether the firms possess some degree of pricing power, the type of prod- uct 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 industry and the firm.

■ Attractive industries for co-opetition are characterized by high entry barriers, low exit barriers, low buyer and supplier power, a low threat of substitutes, and the availability of complements.

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, questions about the industry life cycle; how, about overcoming barriers to entry; what, about options among product market, value chain, geography, and business model; and where, about prod- uct positioning, 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 indus-

tries, directly affecting the firms competing in these industries and their profitability.

■ In industry convergence, formerly unrelated industries begin to satisfy the same customer need. Such convergence is often brought on by technological 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 spe-

cific industry that pursue a similar strategy in their quest for competitive advantage.

■ Generally, there are two strategic groups in an industry based on two different business strate- gies: 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 external 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.

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

Competitive industry structure (p. 83)

Complement (p. 88) Complementor (p. 88) Co-opetition (p. 88) Entry barriers (p. 76) Exit barriers (p. 87)

Firm effects (p. 73) Five forces model (p. 74) Industry (p. 73) Industry analysis (p. 73) Industry convergence (p. 92) Industry effects (p. 73) Mobility barriers (p. 95)

Network effects (p. 77) PESTEL model (p. 67) Strategic commitments (p. 87) Strategic group (p. 93) Strategic group model (p. 93) Strategic position (p. 73) Threat of entry (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 the indus- try? For example, in what way might weak forces 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 entering new markets (LO 3-6). 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 firm differences in performance?

ETHICAL/SOCIAL ISSUES

1. One of the world’s largest car manufacturers, Volkswagen (VW), admitted to criminal wrong- doing in 2017. The firm confirmed that it sys- tematically cheated on emissions tests related to its two-liter diesel engines. These engines were designed in 2005 to meet more rigorous U.S. emission standards taking effect in 2007. Appar- ently the new engines did not perform as planned and the company then designed a software feature to artificially pass the emissions testing process. Road testing in 2014 uncovered a large differ- ence between EPA-measured emissions and the actual output of the vehicles. This was then further investigated by several legal entities. In September 2015 the CEO of VW lost his job over the scandal. The financial cost to the firm is cur- rently more than $20 billion and could go above $25 billion in fines and consumer compensation

for nearly 11 million vehicles with this “defeat device” software.47

a. The external environment of the global auto- mobile industry is quite complex. Regula- tions vary from country to country and in the United States even from one state to another in some cases. Firms must be prepared to antici- pate and respond to these external forces. It appears VW’s response to the design issue, in this case, was neither ethical nor legal. Why do you think VW made the decisions it did regarding this emissions problem in the late 2000s? What could VW have done differently?

b. In January 2017, a U.S. grand jury indicted six current and former VW executives for their alleged role in the emissions scandal and its subsequent cover-up. The U.S. Justice

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 101

Department decided to bring charges against these executives after a 16-month criminal investigation by the FBI. In the past, it has been rare for executives to be personally indicted for company misconduct. Do you agree with the decision to go after individual managers in this case? Why or why not?

c. What are the competitive implications of the actions of VW? Does this situation impact the industry rivalry that is discussed in the five forces model, for instance?

2. The chapter notes that national governments provide incentives for industry growth. One such example is for the purchase of electric vehicles (EVs). Norway, for example, has provided tax discounts for electric vehicles since the 1990s. Norway waives a substantial automobile import

tax on EVs sold inside the country. Largely as a result of these policies, 22 percent of the auto- mobiles owned in Norway were electric powered in 2015. This compares with 0.5 percent in the United States, 0.8 percent in China, and 1.1 per- cent in the United Kingdom in 2015.48

a. What is the appropriate role for governments to encourage or discourage certain purchas- ing behaviors? You may note many national governments have for decades collected addi- tional taxes on tobacco and alcohol products as a measure to try to moderate consumption of these items.

b. As a strategist in a major firm, how would you seek to position your company in light of such current and potential future governmental policies?

SMALL GROUP EXERCISES

//// Small Group Exercise 1 Your group is a team of KraftHeinz Co. (www. kraftheinzcompany.com) marketing interns. The com- pany has asked you to propose new guidelines for help- ing it promote food to children in a socially responsible way. As the fifth-largest consumer packaged food and beverage company globally, KraftHeinz’s 2016 sales exceeded $26 billion. The company projects steady growth, but would like your help in boosting growth. One of Kraft’s largest brands is Oscar Mayer Lunch- ables, described as making lunch fun and targeted to busy parents who want a quick lunch to send with their children to school or keep on hand as an after-school snack. One of the options is Lunchables with Juice, Nachos Cheese Dip, and Salsa. However, controversy is growing about the social responsibility of directly marketing to children when the food is unhealthy— high in fat, sugar, and salt, but low in nutrition. There is a societal concern with the growing rate of obesity in children and the increased incidence of diabetes that results from childhood obesity.

Kraft would like to have a reputation as a socially responsible company. Accordingly, Kraft would like to create internal guidelines that will help it market Lunchables (as well as other packaged food items) responsibly and gain the approval of medical profes- sionals, parents, and watchdog groups.49

1. Visit the Kraft food website (www.lunchables. com) and review the Lunchables products, as well as other packaged food products that Kraft offers. Discuss among your group members the extent to which the product options are healthy choices.

2. Identify other actions that Kraft might take to demonstrate that it is a food company that genu- inely cares about children’s health and a company that would like to help reverse the trend of increas- ing childhood obesity.

3. If your group believes that the company is not responsible for personal choices that consumers make to eat unhealthy food, then describe how the company should respond to activist groups and public health officials that are urging compa- nies to stop producing and marketing unhealthy foods.

//// Small Group Exercise 2 One industry with an impact on both undergraduate and MBA students is textbook publishing. Traditional printed textbooks are being challenged on one hand by self-publishing firms offering very low prices for spe- cific instructor materials, and on the other hand by a need to offer digital resources that substitute for printed materials. Large textbook publishers are increasingly

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Is My Job the Next One Being Outsourced?

T he outsourcing of IT programming jobs to India is now commonly understood after years of this trend. How-ever, more recently some accounting functions have also begun to flow into India’s large technically trained and English-speaking work force. For example, the number of U.S. tax returns completed in India rose dramatically from 2003 to 2011 (25,000 in 2003 to 1.6 million in 2011). Some estimate that over 20 million U.S. tax returns will be prepared in India within the next few years. Outsourcing accounting functions may affect the job and career prospects for accounting-oriented business school graduates. Tax accountants in Bangalore, India, are much cheaper than those in Boston or Baltimore. Moreover, tax accountants in India often work longer hours and can there- fore process many more tax returns than U.S.-based CPAs and tax accountants during the crunch period of the U.S. tax filing system.51 Other services once thought to be immune to off- shoring are also experiencing vulnerability. One example is the rise in medical tourism for major medical treatments to handle

everything from joint replacements, weight loss, dental prob- lems, and infertility. It is estimated that over 14 million patients traveled from one country to another seeking medical treatment in 2016 alone.52

1. Which aspects of accounting do you think are more likely to resist the outsourcing trends just discussed? Think about what aspects of accounting are the high-value activities versus the routine standardized ones. (If it’s been a while since you took your accounting courses, reach out for information to some- one in your strategy class who is an accounting major.)

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 opportunities in the global market in the future? Use the PESTEL frame- work 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.

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

investing in adaptive learning systems such as Wiley- PLUS, Cengage MindTap, and McGraw-Hill Connect. Complicating factors for the publishers is the chang- ing business model of renting textbooks (printed and electronic). U.S. university book rental was about 25 percent of student purchasing volume in 2015.50

Use the five forces model (with complements) to think through the various impacts such technology

shifts may have on the textbook industry. Include in your response answers to the following questions.

1. How should managers of a textbook publishing company respond to such changes?

2. Will the shifts in technology and business models be likely to raise or lower the textbook industry profits? Explain.

1. This ChapterCase is based on: “All eyes on the sharing economy,” The Economist, March 9, 2013; “New York deflates Airbnb,” The Economist, October 27, 2016; Austin, S., C. Canipe, and S. Slobin (2015, Feb. 18), “The billion dollar startup club,” The Wall Street Journal (updated January 2017),

http://graphics.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 person 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 Val- ley Are Changing the World (New York: Little, Brown and Co.); Tabarrok, A. (2017, Jan. 30), “How Uber and Airbnb won,” The Wall Street Journal.

ENDNOTES

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 103

2. For a detailed treatise on how institutions shape the economic climate and with it firm performance, see: North, D.C. (1990), Institu- tions, Institutional Change, and Economic Performance (New York: Random House). 3. 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 activ- ity: A review and research agenda,” Journal of Management 30: 837–857. 4. Lowenstein, R. (2010), The End of Wall Street (New York: Penguin Press). 5. Brynjolfsson, E., and A. McAfee (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: Norton). 6. “Professor Emeritus Milton Friedman dies at 94,” University of Chicago press release, November 16, 2006. 7. Lucas, R. (1972), “Expectations and the neutrality of money,” Journal of Economic Theory 4: 103–124. 8. “Media companies are piling into the His- panic market. But will it pay off?” The Econo- mist, December 15, 2012. 9. Woolley, J.L., and R. M. Rottner (2008), “Innovation policy and nanotech entrepre- neurship,” 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. 10. Afuah, A. (2009), Strategic Innovation: New Game Strategies for Competitive Advan- tage (New York: Routledge); Hill, C.W.L., and F.T. Rothaermel (2003), “The performance of incumbent 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. 11. For an in-depth discussion of BlackBerry and the smartphone industry, see Burr, J.F., F.T. Rothaermel, and J. Urbina (2015), Case MHE-FTR-020 (0077645065), “Make or Break at RIM: Launching BlackBerry 10,” http://create.mheducation.com; Dvorak, P. (2011), “BlackBerry maker’s issue: Gadgets for work or play?” The Wall Street Journal, September 30; Dyer, J., H. Gregersen, C.M. Christensen (2011), The Innovator’s DNA: Mastering the Five Skills of Disruptive Innovators (Boston, MA: Harvard Business Review Press); Ycharts.com.

12. 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 Compa- nies Use Environmental Strategy to Innovate, Create Value, and Build Competitive Advan- tage, revised and updated (Hoboken, NJ: John Wiley & Sons). 13. This interesting debate unfolds in the following 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, corporate, 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 Manage- ment Journal 24: 1–16; McGahan, A.M., and M.E. Porter (1997), “How much does industry matter, really?” Strategic Man- agement Journal 18: 15–30; Rumelt, R.P. (1991), “How much does industry 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. 14. Misangyi, V.F., H. Elms, T. Greckhamer, and J.A. Lepine (2006), “A new perspec- tive on a fundamental debate: A multilevel approach to industry, corporate, 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 mat- ter, really?” Strategic Management Journal 18: 15–30; Rumelt, R.P. (1991), “How much does industry matter?” Strategic Management Journal 12: 167–185; and Hansen, G.S., and B. Wernerfelt (1989), “Determinants of firm performance: The relative importance of eco- nomic and organizational factors,” Strategic Management Journal 10: 399–411. 15. Misangyi, V.F., H. Elms, T. Greckhamer, and J.A. Lepine (2006), “A new perspec- tive on a fundamental debate: A multilevel approach to industry, corporate, and business unit effects,” Strategic Management Journal 27: 571–590; Hawawini, G., V. Subrama- nian, and P. Verdin (2003), “Is performance driven by industry- or firm-specific fac- tors? 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 Man- agement Journal 18: 15–30; Rumelt, R.P. (1991), “How much does industry 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. 16. The discussion in this section is based on: Magretta, J. (2012), Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston, MA: Harvard Business Review Press); Porter, M.E. (2008, Jan.), “The five competitive forces that shape strat- egy,” Harvard Business Review; Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press); and Porter, M.E. (1979), “How competitive forces shape strategy,” Harvard Business Review, March–April: 137–145. 17. Strategy Highlight 3.2 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 Busi- nessPublishing video; “Everyone else in the travel business makes money off airlines,” The Economist, August 25, 2012; “How airline ticket prices fell 50% in 30 years (and nobody noticed),” The Atlantic, February 28, 2013; U.S. gallon of jet fuel prices; author’s inter- views with Delta executives. 18. Musk continues to upgrade expectations. In 2015 he set the 500,000 benchmark to be met by 2020. A year later the deadline was set for 2018. Stoll, D., and M. Ramsey (2015), “Tesla first-quarter car deliveries rise above 10,000,” The Wall Street Journal; Goliya, K., and A. Sage (2016, May 5), “Tesla puts pedal to the metal, 500,000 cars planned in 2018,” Reuters. 19. Hull, D. (2014, July 22), “Tesla idles Fre- mont production line for Model X upgrade,” San Jose Mercury News; and Vance, A. (2013, July 18), “Why everybody loves Tesla,” Bloomberg Businessweek. 20. Ramsey, M. (2014, Sept. 3), “Tesla to choose Nevada for battery factory,” The Wall Street Journal. 21. Ramsey, M. (2014, Feb. 26), “Tesla plans $5 billion battery factory,” The Wall Street Journal. 22. Walsh, T. (2014, Sept. 2), “The cult of Tesla Motors Inc: Why this auto- maker has the most loyal customers,” The Motley Fool.

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

23. Tesla Model S road test, Consumer Reports, http://www.consumerreports.org/cro/ tesla/model-s/road-test.htm. 24. Wang, U. (2013, Nov. 5), “Tesla considers building the world’s biggest lithium-ion bat- tery factory,” Forbes. 25. Whether a product is a substitute (complement) can be estimated by the cross- elasticity of demand. The cross-elasticity estimates the percentage change in the quan- tity 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 products are substitutes (complements). 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). 26. 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, MA: Harvard Business Review Press). 27. Because the threat of entry is one of the five forces explicitly recognized in Porter’s model, we discuss barriers to entry when introducing the threat of entry above. The competitive 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), Manage- rial 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, MA: Houghton Mifflin); and Bain, J.S. (1968), Industrial Organization (New York: John Wiley & Sons). 28. Besanko, D., E. Dranove, M. Hanley, and S. Schaefer (2010), The Economics of Strategy, 5th ed. (Hoboken, NJ: John Wiley & Sons). 29. Dixit, A., S. Skeath, and D.H. Reiley (2009), Games of Strategy, 3rd ed. (New York: Norton). 30. When there are only two main competi- tors, it’s called a duopoly and is a special case of oligopoly. 31. Yoffie, D.B., and R. Kim (2011), “Coca- Cola in 2011: In Search of a New Model,” Harvard Business School Case 711-504, June (revised August 2012). See also, Yoffie, D.B., and Y. Wang (2002, Jan.), “Cola Wars Continue: Coke and Pepsi in the Twenty-First

Century,” Harvard Business School Case 702-442 (revised January 2004, et seq). 32. “Trustbusting in the internet age: Should digital monopolies be broken up?” The Economist, November 29, 2014; and “Internet monopolies: Everybody wants to rule the world,” The Economist, November 29, 2014. 33. See Chang, S-J., and B. Wu (2013), “Institutional barriers and industry dynam- ics,” Strategic Management Journal 35: 1103–1123. Discussion of this new and insightful research offers an opportunity to link the PESTEL analysis to the five forces analysis. The study focuses on the competi- tive interaction between incumbents and new entrants as a driver of industry evolution. It investigates the impact of institutional characteristics (political, legal, and socio- cultural norms in PESTEL analysis) unique to China on productivity and exit hazards of incumbents versus new entrants. China’s environment created a divergence between productivity and survival that shaped indus- try evolution. It also offers an illustration of the role that liability of newness plays in new entrant survival. 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), “The five competitive forces that shape strategy,” Harvard Business Review, January. 37. This discussion is based on Zachary, M.A., P.T. Gianiodis, G. Tyge Payne, and G.D. Markman (2014), Entry timing: Endur- ing lessons and future directions, Journal of Management, 41: 1388-1415; and Bryce, D.J.,+ and J.H. Dyer (2007), Strategies to crack well-guarded markets, Harvard Busi- ness Review, May: 84-92. I also gratefully acknowledge the additional input received by Professors Zachary, Gianiodis, Tyge Payne, and Markman. 38. “Reading between the lines,” The Econo- mist, March 26, 2009; and “New York Times is near web charges,” The Wall Street Journal, January 19, 2010.

39. Porter, M.E. (1980), Competitive Strat- egy: Techniques for Analyzing Industries and Competitors (New York: Free Press); Hatten, K.J., and D.E. Schendel (1977), “Heterogeneity within an industry: Firm conduct in the U.S. brewing industry,” Jour- nal 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.

40. This discussion is based on: McNa- mara, G., D.L. Deephouse, and R. Luce (2003), “Competitive positioning within and across a strategic group structure: The performance of core, secondary, and soli- tary firms,” Strategic Management Journal 24: 161–181; Nair, A., and S. Kotha (2001), “Does group membership matter? Evidence from the Japanese steel industry,” Strategic Management Journal 22: 221–235; Cool, K., and D. Schendel (1988), “Performance differences among strategic group mem- bers,” Strategic Management Journal 9: 207–223; Hunt, M.S. (1972), Competition in the Major Home Appliance Industry, 1960– 1970, unpublished doctoral dissertation, 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), Com- petitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press), 102

41. In Exhibit 3.7, United Airlines is the biggest bubble because it merged with Conti- nental 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.

42. 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.

43. Caves, R.E., and M.E. Porter (1977), “From entry barriers to mobility barriers,” Quarterly Journal of Economics 91: 241–262.

44. Carey, S. (2015, Mar. 16.), “U.S. airlines battling gulf carriers cite others’ experience,” The Wall Street Journal.

45. Carey, S. (2014, Oct. 14), “Steep learning curve for Southwest Airlines as it flies over- seas,” The Wall Street Journal.

46. Porter, M.E. (2008), “The five competi- tive forces that shape strategy,” Harvard Business Review, January; and Magretta, J. (2012), Understanding Michael Porter: The

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CHAPTER 3 External Analysis: Industry Structure, Competitive Forces, and Strategic Groups 105

Essential Guide to Competition and Strategy (Boston, MA: Harvard Business Review Press): 56–57. 47. “U.S. indicts six Volkswagen executives in emissions scandal,” The Wall Street Jour- nal, January 11, 2017, and “Volkswagen’s emissions bill could surpass $25 billion,” The Wall Street Journal, February 1, 2017. 48. Markovich, T. (2017, Feb. 27), “Norway Looks to Eliminate Gas and Diesel Auto Sales by 2025 with EV and Plug-In Incentives”, Car & Driver; Cobb, J. (2016, Jan. 18), “Top

Six Plug-in Vehicle Adopting Countries – 2015,” HybridCars.com. 49. Corporate website; Orciari, M. (2013, Mar. 12), “Industry self-regulation permits junk food ads in programming popular with children,” Yale News, accessed online; Moss, M. (2013, Feb. 24), “How the fast food indus- try creates and keeps selling the crave,” The New York Times Magazine. 50. Benson-Armer, R., J. Sarakatsannis and K. Wee (2014, Aug.), “The future of text- books,” McKinsey on Society.

51. The myStrategy module is based on: Friedman, T. (2005), The World Is Flat: A Brief History of the Twenty-first Century (New York: Farrar, Strauss & Giroux); and ValueNotes, http://www.sourcingnotes.com/ content/view/197/54/. 52. “Medical Tourism Statistics and Facts,” Patients Beyond Borders web- site, accessed April 27, 2017, at http:// www.patientsbeyondborders.com/ medical-tourism-statistics-facts.

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CHAPTER Internal Analysis: Resources, Capabilities, and Core Competencies

Chapter Outline

4.1 Core Competencies

4.2 The Resource-Based View Two Critical Assumptions The VRIO Framework Isolating Mechanisms: How to Sustain a Competitive Advantage

4.3 The Dynamic Capabilities Perspective

4.4 The Value Chain and Strategic Activity Systems  The Value Chain Strategic Activity Systems

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

Learning Objectives

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

LO 4-2 Compare and contrast tangible and intan- gible resources.

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

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

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

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

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

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

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

4

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Dr. Dre’s Core Competency: Coolness Factor

IN 2014, DR. DRE —whose real name is Andre Young— was celebrated as the first hip-hop billionaire after Apple acquired Beats Electronics for $3 billion. Dr. Dre has a long track record as a suc- cessful music producer, rapper, and entrepreneur. Known for his strong work ethic, he expects nothing less than perfec- tion from the people he works with—similar to some of the personal- ity attributes ascribed to the late Steve Jobs, co-founder and longtime CEO of Apple.

Although Dr. Dre cre- ated and subsequently sold several successful music record labels, as an entre- preneur he is best known as co-founder of Beats Elec- tronics 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 networks spanning hundreds of 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 he claims allows the listeners to “hear all the music.” Since early 2014, the company also offers the stream- ing music subscription service Beats Music. Beats’ vision is 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 entertainment.”1 Many acoustics experts maintain, however, that playback of digitally compressed MP3 audio files is infe- rior in comparison to high fidelity. Moreover, the sound qual- ity of Beats headphones is considered poor in comparison to other premium-brand headphones such as those by Bose, JBL, Sennheiser, and others.

Why then would Apple pay $3 billion to acquire Beats Electronics? This was by far the largest acquisition in Apple’s history. Two main reasons: First, Apple is hoping that some of Beats’ coolness will spill over to its brand, which has become somewhat stale. Apple’s iPhones, for example, have become a somewhat standardized commodity given the successful imitation by Samsung and others, although Apple has high expectations for its 10th anniversary iPhone, released in the

fall of 2017. Second, although Apple is the world’s largest music vendor with 800 mil- lion accounts on iTunes Store, the industry is being disrupted. Con- tent deliv ery, especially in music but also video (think Netflix), is mov- ing rapidly from own- ership via downloads to streaming on demand. As a consequence, music downloads have been declining in the past few years.

BEATS’ COOLNESS FACTOR Beats by Dr. Dre achieved an unprecedented coolness fac- tor 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 legend- ary music producer to endorse premium headphones. In addition, he created custom Beats for stars such as Justin Bieber, Lady Gaga, and Nicki Minaj. Other music celebri- ties 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 super- stars LeBron James and Kobe Bryant, tennis player Serena Williams, and soccer stars Cristiano Ronaldo and Neymar Jr.—wear Beats by Dr. Dre in public and endorse the brand in advertisements.

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. ©Kevin Mazur/WireImage/Getty Images

CHAPTERCASE 4

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DISRUPTION IN CONTENT DELIVERY Content delivery is rapidly moving from ownership through downloads to renting via online streaming. This disruption in the business model is most visible in movies, as the suc- cess of Netflix demonstrates, but is also gaining steam in music. Apple is a laggard in music streaming when compared to leaders such as Pandora with 250 million users and Spo- tify with 100 million users (of whom 50 million are paying customers). Apple’s initial attempt at online music stream- ing service, iTunes Radio created in 2013, has been falling flat. After disrupting the music download space with iTunes in 2003, Apple is now being disrupted by others that lead in music streaming. Apple is hoping that by acquiring Beats

Music it can become a leader in the music streaming space. Renamed Apple Music, the service now has 20 million paid subscribers. Yet it faces competition in the “coolness space”? with the music streaming service Tidal, founded by rap mogul Jay Z. Tidal has exclusive release contracts with superstar artists such as Kanye West, Rihanna, and Beyoncé (who is married to Jay Z). Tidal, however, only has some 2 million paid subscribers. The network provider Sprint, nonetheless, acquired one-third of Tidal in 2017.2

You will learn more about Beats Electronics by reading this chapter; related questions appear in “ChapterCase 4 / Consider This. . . .”

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 differentiate 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. So what are core com- petencies of Beats by Dr. Dre? Beats succeeds not because it provides the best possible acoustic experience, but because it functions as a fashion statement that communicates coolness.3 The iconic headphones are worn by celebrities from music, movies, and sports. Even fashion designer Marc Jacobs had models wear Beats headphones during runway shows. The extent to which Beats succeeds at product placements with celebrities across the world is unprecedented. The genius behind Beats is creating a perception that if you want to be as cool as one of your heroes, you need to shell out hundreds of dollars to wear plastic headphones in public.

Beats’ unique strengths in establishing a brand that communicates coolness is built upon Dr. Dre’s intuition and feel for music and cultural trends; Dr. Dre is one of music’s sav- viest marketing minds. Although the sound quality of Beats headphones is good enough, they mainly sell as a fashion accessory for their coolness factor and brand image. Dr. Dre relies on gut instinct in making decisions, while shunning market research. This approach is quite similar to Apple’s late co-founder Steve Jobs who made no secret of his disdain for market research because he believed that consumers don’t really know what they want until someone else shows it to them.

Beats’ core competency in marketing allows the company to differentiate its products from rival offerings because it is able to create higher perceived value for its customers. In turn, Beats’ core competency affords the firm a competitive advantage. It is hugely successful: Beats holds some 65 percent market share in the premium headphone market, priced at $100 and up. Beats’ competitive advantage was rewarded with a $3 billion acqui- sition by Apple.

In this chapter, we study analytical tools to explain why differences in firm performance exist even within the same industry. For example, why does Beats Electronics outperform Audio-Technica, Bose, JBL, Skullcandy, Sennheiser, and Sony in the high-end, premium headphone market? Since these companies compete in the same industry and face similar external opportunities and threats, the source for some of the observable performance dif- ference must be found inside the firm. When discussing industry, firm, and other effects in

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explaining superior performance, we noted that up to 55 percent of the overall performance differences is explained by firm-specific effects (see Exhibit 3.2). Looking inside the firm to analyze its resources, capabilities, and core competencies allows us to understand the firm’s strengths and weaknesses. Linking these insights from a firm’s internal analysis to the ones derived in Chapter 3 on external analysis allows managers to determine their strategic options. Ideally, firms want to leverage their internal strengths to exploit external opportunities, and to mitigate internal weaknesses and external threats.

Exhibit 4.1 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 consci- entiously 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 and strategic group.

The firm’s response is 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 fash- ion. At each point the goal should be to develop resources, capabilities, and competencies that create a strategic fit with the firm’s environment. The forward motion of those envi- ronmental forces must also be considered. The chapter will provide a deeper understanding of the sources of competitive advantage that reside within a firm.

To gain a better understanding of why and how firm differences explain competitive advantage, we begin this chapter by taking a closer look at core competencies. Next, we 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. We discuss the dynamic capabilities perspective, a model that emphasizes a firm’s ability to modify and leverage its resource base to gain

EXHIBIT 4.1 / Inside the Firm: Competitive Advantage based on Core Competencies, Resources, and Capabilities

Political Economic

Sociocultural

TechnologicalEcological

Industry

Legal

Inside the Firm: Core Competencies,

Resources, and Capabilities

Strategic Group

External Environment

External Environment

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and sustain a competitive advantage 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 net- work of interconnected and reinforcing activities. We conclude with Implications for Stra- tegic Leaders, with a particular focus on how to use the SWOT analysis to obtain strategic insights from combining external with internal analysis.

4.1 Core Competencies Let’s begin by taking a closer look at core competencies. These are unique strengths, embedded deep within a firm. Core competencies allow a firm to differentiate 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. The important point here is that competitive advantage can be driven by core competencies.4

Take Honda as an example of a company with a clearly defined core competency. Its life began with a small two-cycle motorbike engine. Through continuous learning over several decades, and often from lessons learned from failure, Honda built the core compe- tency to design and manufacture small but powerful and highly reliable engines for which it now is famous. This core competency results from superior engineering know-how and

skills carefully nurtured and honed over several decades. Honda’s business model is to find a place to put its engines. Today, Honda engines can be found everywhere: in cars, SUVs, vans, trucks, motorcycles, ATVs, boats, generators, snowblowers, lawn mowers and other yard equipment, and even small airplanes. Due to their superior performance, Honda engines have been the most popular in the Indy Rac- ing League (IRL) since 2006. Not coincidentally, this was also the first year in its long history that the Indy 500 was run without a single engine problem.

One way to look at Honda is to view it as a company with a distinct competency in engines and a business model of find- ing places to put its engines. That is, underneath the products and services that make up the visible side of competition lies a diverse set of invisible competencies that make this happen. These invisible core competencies reside deep within the firm. Companies, therefore, compete as much in the product and service markets as they do in developing and leverag- ing core competencies. Although invisible by themselves,

core competencies find their expression in superior products and services. Exhibit 4.2 identifies the core competencies of a number of companies, with application examples.

Since 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 4.3 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 tan- gible or intangible. Capabilities are the organizational and managerial skills necessary to

LO 4-1

Differentiate among a firm’s core competencies, resources, capabilities, and activities.

Honda promotes its expertise with engines by sponsoring race car driver Danica Patrick.

©AP Images/Julio Cortez

core competencies Unique strengths, embed- ded deep within a firm, that are critical to gaining and sustaining competitive advantage.

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.

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Company Core Competencies Application Examples

Amazon.com • Superior IT capabilities.

• Superior customer service.

• Online retailing: Largest selection of items online.

• 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 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 Pay, and Apple Watch).

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

• Superior algorithms to offer targeted online ads.

• Connecting 2 billion social media users worldwide.

• News feed, timeline, graph search, and stories.

General Electric

• Superior expertise in industrial engineering, designing and implementing efficient management processes, and developing and training leaders.

• Providing products and services to solve tough engineering problems in energy, health care, and aerospace, among other sectors.

Google (a subsidiary of Alphabet)

• Superior in creating proprietary algorithms based on large amounts of data collected online.

• 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.

Honda • Superior engineering of small but powerful and highly reliable internal combustion engines.

• Motorcycles, cars, ATVs, sporting boats, snowmobiles, lawn mowers, small aircraft, 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 expertise in decentralized power storage and management based on renewable (solar) energy.

• Model S, Model X, and Model 3.

• 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.

EXHIBIT 4.2 / Company Examples of Core Competencies and Applications

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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.

As shown in Exhibit 4.3, such competencies are demonstrated in the company’s activi- ties, which can lead to competitive advantage, resulting in superior firm performance. Activities are distinct and fine-grained business processes such as order taking, the physi- cal delivery of products, or invoicing customers. Each distinct activity enables firms to add incremental value by transforming inputs into goods and services. In the interplay of resources and 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 leading back from competitive advantage to resources and capabilities indicate that superior performance in the marketplace generates profits that can 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 4.3 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 manifestation of core competencies, what is even more important is to understand the invisible part of core com- petencies. 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 competen- cies sufficiently to compete effectively against Amazon.com, the world’s largest online retailer. Amazon does not have the overhead expenses associated with maintaining build- ings 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

EXHIBIT 4.3 / Linking Core Competencies, Resources, Capabilities, and Activities to Competitive Advantage

Competitive AdvantageActivities

Core Competencies

Reinvest, Hone, & Upgrade

Reinforce Leverage

Orchestrate

Reinvest, Hone, & Upgrade

Capabilities

Resources

activities Distinct and fine-grained business processes that enable firms to add incremental value by transforming inputs into goods and services.

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core competencies, its competitors are more likely to develop equivalent or superior skills, as did Amazon. This insight will allow us to explain differences between firms in the same industry, as well as competitive dynamics, over time. It also will help us identify the strat- egy with which firms gain and sustain a competitive advantage and weather an adverse external environment.

As to the second point, we will soon introduce tools to help bring more opaque aspects of a firm’s core competencies into the daylight to be seen with clarity. We start by looking at both tangible and intangible resources.

4.2 The Resource-Based View To gain a deeper understanding of how the interplay between resources and capabilities creates 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.5 As the name suggests, this model sees resources as key to superior firm performance. As Exhibit 4.4 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. Exam- ples of intangible resources are a firm’s culture, its knowledge, brand equity, reputation, and intellectual property.

Consider Google (since 2015 a subsid- iary of Alphabet, which is a holding com- pany overseeing a diverse set of activities). Alphabet’s tangible resources, valued at $34 billion, include its headquarters (The Googleplex)6 in Mountain View, California, and numerous server farms (clusters of computer servers) across the globe.7 The Google brand, an intangible resource, is valued at roughly $230 billion (number one worldwide)—almost seven times higher than the value of Alphabet’s tangible assets.8

Google’s headquarters provides examples of both tangible and intangible resources. The Googleplex is a piece of land with a futuris- tic building, and thus a tangible resource. The location of the company in the heart of Silicon Valley is an intangible resource that provides access to a valuable network of contacts and gives the company several benefits. It allows Google to tap into a large and computer-savvy work force and access graduates and knowl- edge spillovers from a large number of uni- versities, which adds to Google’s technical and managerial capabilities.9 Another benefit

LO 4-2

Compare and contrast tangible and intangible resources.

EXHIBIT 4.4 / 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.

intangible resources Resources that do not have physical attributes and thus are invisible.

tangible resources Resources that have physical attributes and thus are visible.

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stems from Silicon Valley’s designation as having the largest concentration of venture capital in the United States. This proximity benefits Google because venture capitalists tend to pre- fer local investments to ensure closer monitoring.10 Google received initial funding 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 buildings 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. Google (founded in 1998) and Amazon.com (founded in 1994, and with a brand value of $100 billion) accomplished their enormous brand valuations fairly quickly due to a ubiquitous internet presence, while the other companies in the global top-10 most valuable brands—Apple, Microsoft, AT&T, Facebook, Visa, Verizon, McDonald’s, and IBM—took much longer to build value and have it recognized in the marketplace.11

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.

TWO CRITICAL ASSUMPTIONS Two assumptions are critical in the resource-based model: (1) resource heterogeneity and (2) resource immobility.12 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 competencies differ across firms. This insight ensures that ana- lysts look 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 both compete in the same stra- tegic group (low-cost, point-to-point airlines, see Exhibit 3.7). But they draw on different resource bundles. SWA’s employee productivity tends to be higher than that of Alaska Airlines, because the two companies differ along human and organizational resources. At SWA, job descriptions are informal and employees pitch in to “get the job done.” Pilots may help load luggage to ensure an on-time departure; flight attendants clean airplanes to help turn them around at the gate within 15 minutes from arrival to departure. This allows SWA to keep its planes flying for longer and lowers its cost structure, savings that SWA passes on to passengers in lower ticket prices.

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 assump- tions about resources are critical to explaining superior firm performance in the resource- based model.

LO 4-3

Evaluate the two critical assumptions behind the resource-based view.

resource heterogeneity Assumption in the resource-based view that a firm is a bundle of resources and capabil- ities that differ across firms.

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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Note, by the way, that the critical assumptions of the resource-based model are fun- damentally 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 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 Our tool for evaluating a firm’s resource endowments is a framework that answers the ques- tion of 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.13 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.14 According to this model, a firm can gain and sustain a competitive advantage only when it has resources that satisfy all of the VRIO criteria. 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 formulating and implementing strategy. So to some degree, this presentation of the VRIO model summarizes all of our discussion in the chapter so far.

Exhibit 4.5 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

EXHIBIT 4.5 / Applying the VRIO Framework to Reveal Competitive Advantage

Sustainable Competitive Advantage

Is the Resource, Capability, or Competency...

and Is the Firm...

Valuable?

Rare?

Organized to Capture

Value?

Temporary Competitive Advantage

Competitive Parity

Competitive Disadvantage

YES

YES

YES YES

NO

NO

NO

Imitation Costly?

Temporary Competitive Advantage

NO

VRIO framework A the- oretical framework that explains and predicts firm-level competitive advantage.

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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 opportunity or offset an external threat. This has a positive effect on a firm’s competi- tive advantage. In particular, a valuable resource enables a firm to increase its economic value creation (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 attrac- tive 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 (assuming perceived value is not decreasing). Beats Electronics’ ability to design and market premium headphones that bestow a certain air of coolness upon wearers is a valuable resource. The profit margins for Beats designer headphones are astronomical: The production cost for its headphones is estimated to be no more than $15, while they retail for $150 to $450, with some special editions over $1,000. Thus, Beats’ competency in design- ing and marketing premium headphones is a valuable resource in the VRIO framework.

RARE. A resource is rare if only one or a few firms possess it. If the resource is com- mon, 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 competitive parity at best. A firm is on the path to competitive advantage only if it pos- sesses a valuable resource that is also rare. Beats Electronics’ ability and reach in product placement and celebrity endorsements that build its coolness factor are certainly rare. No other brand in the world, not even Apple or Nike, has such a large number of celebrities from music, movies, and sports using its product in public. Thus, this resource is not only valuable but also rare.

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.

Beats’ core competency in establishing a brand that communicates coolness is built upon the intuition and feel for music and cultural trends of Dr. Dre, one of music’s savviest marketing minds. Although the sound quality of Beats headphones is good enough, they mainly sell as a fashion accessory for their coolness factor and brand image. Because its creator Dr. Dre relies on gut instinct in making decisions rather than market research, this resource is costly to imitate. Even if a firm wanted to copy Beats’ core competency—how would it go about it? The music and trend-making talent as well as the social capital of Dr. Dre and Jimmy Iovine, two of the best-connected people in the music industry, might be impossible to replicate. Even Apple with its deep talent pool decided not to build its own line of premium headphones but rather opted to acquire Beats Electronics’ line for $3 billion, and to put employment contracts in place that make Dr. Dre and Jimmy Iovine senior executives at Apple Inc. The combination of the three resource attributes (V + R + I) has allowed Beats Electronics to enjoy a competitive advantage (see Exhibit 4.5).

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 imitat- ing the resource in question (direct imitation) or through working around it to provide a comparable product or service (substitution).

LO 4-4

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

valuable resource One of the four key criteria in the VRIO framework. A resource is valuable if it helps a firm exploit an external opportunity or offset an external threat.

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 resource 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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Direct Imitation. We usually see direct imitation, as a way to copy or imitate a valuable and rare resource, when firms have diffi- culty protecting their advantage. (We discuss barriers to imitation shortly.) Direct imitation is swift if the firm is successful and intel- lectual 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 rev- enue in 2008. Crocs are worn by people in every age group and walk of life, including celebrities Sergey Brin, Matt Damon, Heidi Klum, Adam Sandler, and even Kate Middleton, the Duchess of Cambridge. To protect its unique shoe design, the firm owns several patents. Given Crocs’ explosive growth, however, numerous cheap imi- tators 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.15

This example illustrates that competitive advantage cannot be sustained if the underlying capability can easily be replicated and can thus be directly imitated. Com- petitors simply created molds to imitate the shape, look, and feel of the original Crocs shoe. Any competitive advantage in a fashion-driven industry, moreover, is notori- ously 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.”

Beats Electronics, on the other hand, created an ecosystem of hardware (Beats by Dr. Dre) and software (Beats Music) that positively reinforce one another. Beats by Dr. Dre are the installed base that drives demand for Beats Music (now called Apple Music). As Apple Music’s music streaming and celebrity-curated playlists become more popular, demand for Beats headphones further increases. With increasing demand, Apple Music services also become more valuable as its proprietary algorithms have more data to work with. Continu- ous innovation by churning out new headphone designs combined with the unique cool- ness factor of Dr. Dre make direct imitation attempts difficult. 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 of Jeff Bezos launching and developing Amazon.com.16 Before Amazon’s incep- tion, the retail book industry was dominated by a few large chains and many independent mom-and-pop bookstores. As the internet was emerging in the 1990s, Bezos was looking for options in online retail. He zeroed in on books because of their non-differentiated com- modity nature and easiness to ship. In purchasing 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 cus- tomers 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.

Tiffany & Co. has developed a core competency–elegant jewelry design and crafts- manship delivered through a superior customer experience–that is valuable, rare, and costly for competi- tors to imitate. The company vigorously protects its trade- marks, including its Tiffany Blue Box, but it never trade- marked 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/Getty Images

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Combining Imitation and Substitution. In some instances, firms are able to combine direct imitation and substitution when attempting to mitigate the competitive advan- tage 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).17 

More recently Amazon has opened a new chapter in its competitive moves by its acqui- sition 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 mar- ket, 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 break- throughs laid the foundation of the desktop-computing industry.18 Xerox’s invention competency built through a unique combination 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 pressure 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 appreciate the competitive potential of the valuable, rare, and inimi- table 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.19 Nor did it help that development engineers at Xerox headquarters had a dis- dain for the scientists engaging in basic research at PARC. In the meantime, both Apple and Microsoft developed operating systems, graphical user interfaces, and application software.

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 competi- tive advantage (see Exhibit 4.5). In the case of Xerox, where management was not support- ive 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 4.3). Ultimately, though, only a few competencies may turn out to be those specific core competencies that fulfill the VRIO requirements.20 A company cannot do everything equally well and must carve out a unique strategic position for itself, making necessary trade-offs.21 Strategy Highlight 4.1 demonstrates application of the VRIO framework.

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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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 exam- ple, 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.com has become the global leader in ecom- merce, 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 recent 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 Grou- pon 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 compet- itor 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 busi- ness 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 analy- sis 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 spe- cific 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 Chi- cago). 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 commu- nities; Black Biz Hookup serving African-American business owners and operators; Jdeal, a Jewish group-buying site in New York City; and so on).

Strategy Highlight 4.1

(continued)

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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.23 Several conditions, however, can offer some protection to a successful firm by making it more difficult for competitors to imitate the resources, capabilities, or competencies that underlie its competitive advantage. Barriers to imitation are important examples of isolating mechanisms because they prevent rivals from competing away the advantage a firm may enjoy; they include:24

■ Better expectations of future resource value. ■ Path dependence. ■ Causal ambiguity. ■ Social complexity. ■ Intellectual property (IP) protection.

This link ties isolating mechanisms directly to one of the criteria in the resource-based view 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, which 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 allows a firm to gain a competitive advantage. If such better expectations can be systematically repeated over time, it may help in sustaining a competitive advantage.

A real estate developer illustrates the role that the future value of a resource can play. She must decide when and where to buy land for future development. Her firm may gain a competitive advantage if she buys a parcel of land for a low cost in an undeveloped rural area 40 miles north of San Antonio, Texas—in anticipation that it will increase in value with shifting demographics. Let’s assume, several years later, that an interstate highway is built near her firm’s land. With the highway, suburban growth explodes as many new neighborhoods and shopping malls are built. Her firm is now able to develop this particu- lar piece of property to build high-end office or apartment buildings. The value creation far exceeds the cost, and her firm gains a competitive advantage. The resource has sud- denly become valuable, rare, and costly to imitate, gaining the developer’s firm a competi- tive advantage.

LO 4-5

Evaluate different conditions that allow a firm to sustain a competitive advantage.

“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 experi- ence 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 4.5).22

isolating mechanisms Barriers to imitation that prevent rivals from competing away the advantage a firm may enjoy.

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Other developers could have bought the land, but once the highway was announced, the cost of the developer’s land and that of adjacent land would have risen drastically, reflecting the new reality and thus negating any potential for competitive advantage. The developer had better expectations than her competitors of the future value of the resource, in this case the land she purchased. If this developer can repeat such “better expectations” over time in a more or less systematic fashion, her firm is likely to have a sustainable competitive advantage. If she cannot, she was simply lucky. Although luck can play a role in gaining an initial competitive advantage, it is not a basis for a sustain- able competitive advantage.

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.25 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.26 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. manufacturing sector has suffered in recent decades, the carpet industry has flour- ished. Companies not clustered near Dalton face a disadvantage because they cannot read- ily 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 South to escape restrictions placed upon them in the North, such as higher taxation or the demands of unionized labor. Second, technological 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 accident explains why today almost all U.S. carpet mills are located in a relatively small region, including world leaders Shaw Industries 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 invest- ments, tends to lead to inferior results, due to time compression diseconomies.27

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 compression issues. The California Air Resource Board (CARB) in 1990 passed a man- date 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 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.28 Several stakeholders, 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 elec- tric 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.

path dependence A situation in which the options one faces in the current situation are limited by decisions made in the past.

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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 over 6 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 meantime, Nissan sold over 250,000 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 2017.29 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 mar- ketplace. This is because competition did not stand still either. In the meantime, Tesla (featured in ChapterCase 1) is hoping that its new Model 3 will take the mass market of electric cars by storm, as it is priced at some $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, capabili- ties, and competencies must be built and organized effectively over time, often through a painstaking 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, man- agers 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 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, leading 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 difficult. Even Apple’s managers 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? Is it the timing of the com- pany’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 operations? Or is it a combination of these factors? If the link between cause and effect is ambiguous for Apple’s managers, it is that much more difficult for others seeking to copy a valuable resource, capability, or competency.

causal ambiguity A situation in which the cause and effect of a phenomenon are not readily apparent.

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SOCIAL COMPLEXITY Social complexity describes situations in which different social and business systems interact. There is frequently no causal ambiguity as to how the indi- vidual 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 sys- tems are combined. Copying the emerging complex social systems is difficult for competi- tors because neither direct imitation nor substitution is a valid approach. The interactions between different systems create too many possible permutations for a system to be under- stood 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 10.30 This gives you some idea of how complexity might increase when we com- bine different systems with many different parts.

In reality, firms may manage thousands of employees from all walks of life. Their inter- actions 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 advantage, 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 seed 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 context. Looking at individual elements of success without taking social com- plexity into account is a recipe for inferior performance, or worse.

INTELLECTUAL PROPERTY PROTECTION. Intellectual property (IP) protection is a crit- ical intangible resource that can also help sustain a competitive advantage. The five major forms of IP protection are:31

■ Patents ■ Designs ■ 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 provides 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 abil- ity 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.32 Rewards to IP-protected products or services, however, can be high.

Marillyn Hewson is CEO of Lockheed Martin, a global player in aerospace, defense, security, and advanced technology. Facing ever more complex challenges, such firms only thrive with a strong organization and a powerful CEO like Hewson.

©Bloomberg/Getty Images

social complexity A situation in which dif- ferent social and busi- ness systems interact with one another.

intellectual property (IP) protection A critical intangible resource that can pro- vide a strong isolating mechanism, and thus help to sustain a com- petitive advantage.

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During a little over 14 years on the market, Pfizer’s Lipitor, the world’s best-selling drug, accumulated over $125 billion in sales.33

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.34 In a similar fashion, Dr. Dre 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 inven- tion can be used by others. Patents, for example, usually expire 20 years after a patent is filed with the U.S. Patent and Trademark Office. In the next few years, patents protecting roughly $100 billion 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 ingre- dients as the original patent-protected formulation) such as Teva Pharmaceutical Industries of Israel enter the market, 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.35 Drug prices fall by 20 to 80 percent once generic formulations become available.36

Taken together, each of the five isolating mechanisms discussed here (or combi- nations thereof) allow a firm to extend its competitive advantage. Although no com- petitive advantage 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 complex, or when the firm possesses strong intellectual property protection.

4.3 The Dynamic Capabilities Perspective 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 may even go out of business.

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 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.37

A core competency can turn into a core rigidity if a firm relies too long on the com- petency without honing, refining, and upgrading as the environment changes.38  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. Strategy Highlight 4.2 shows how Procter & Gamble failed to hone and upgrade its core competencies. As a consequence, P&G’s strategy was no longer a good fit with a changing environment, leading to a competitive disadvantage.

The reason reinvesting, honing, and upgrading of resources and capabilities are so cru- cial to sustaining any competitive advantage is to prevent competencies from turning into

LO 4-6

Outline how dynamic capabilities can enable a firm to sustain a competitive advantage

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.

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When Will P&G Play to Win Again? With revenues of some $65 billion and business in basically every country except North Korea, Procter & Gamble (P&G) is the world’s largest consumer products company. Some of its category-defining brands include Ivory soap, Tide detergent, Febreze air freshener, Crest toothpaste, and Pampers diapers. Among its many offerings, P&G has more than 20 consumer brands in its lineup that each achieve over $1 billion in annual sales. P&G’s iconic brands are a result of a clearly formulated and effectively implemented business strategy. The company pursues a differentiation strategy and attempts to create higher perceived value for its customers than its competitors by delivering products with unique features and attributes.

Creating higher perceived value generally goes along with higher product costs due to greater R&D and promotion expenses, among other things. Successful differentiators are able to command a premium price for their products, but they must also control their costs. Detailing how P&G created many market-winning brands, P&G’s long-term CEO A.G. Lafley pub- lished (with strategy consultant Roger Martin) the best-selling book Playing to Win: How Strategy Really Works in 2013.

In recent years, however, P&G’s strategic position has weak- ened considerably, and P&G seems to be losing rather than win- ning. P&G lost market share in key “product-country combinations,” including beauty in the United States and oral care in China, amid an overall lackluster performance in many emerging economies. As a consequence, profits have declined. With P&G’s sustained competitive disadvantage, its stock market valuation has fallen—by some $50 billion in 2015 alone. Meanwhile, its competitors such as Unilever, Colgate-Palmolive, and Kimberly-Clark posted strong gains. Many wonder, when will P&G play to win again?

Some of P&G’s problems today are the result of attempt- ing to achieve growth via an aggressive acquisition strategy in the 2000s. Given the resulting larger P&G revenue base, future incremental revenue growth for the entire company was harder to achieve. A case in point is P&G’s $57 billion acquisi- tion of Gillette in 2005, engineered by then-CEO Lafley. The

value of this acquisition is now being called into question. Although Gillette dominates the retail space of the $3 billion wet shaving industry, P&G was caught off guard by how quickly razor sales moved online. Turned off by the high prices and the inconvenience of shopping for razors in locked display cases in retail stores, consumers flocked to online options in droves. The online market for razor blades has grown from basically zero just a few years ago to $300 million. Although this is currently only 10 percent of the overall market, the online market continues to grow rapidly. Disruptive online startups such as Dollar Shave Club and Harry’s offer low-cost solutions via monthly subscription plans online.

Perhaps even more troubling is that P&G focused mainly on the U.S. market to leverage its existing competencies. Rather than inventing new category-defining products, P&G added more features to its established brands such as Olay’s extra-moisturizing creams and ultra-soft and sensitive Char- min toilet paper, while raising prices. Reflecting higher value creation based on its differentiation strategy, P&G gener- ally charges a 20 to 40 percent premium for its products in comparison to retailers’ private-label and other brands. The strategic decision to focus on the domestic market, combined with incrementally adding minor features to its existing prod- ucts, created serious problems for P&G.39

Strategy Highlight 4.2

©Zhang Peng/LightRocket/Getty Images

core rigidities (see Exhibit 4.3). This ability to hone and upgrade lies at the heart of the dynamic capabilities perspective. We defined capabilities as the organizational and mana- gerial skills necessary to orchestrate a diverse set of resources and to deploy them strate- gically. Capabilities are by nature intangible. They find their expression in a company’s structure, routines, and culture.

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The dynamic capabilities perspective adds, as the name suggests, a dynamic or time ele- ment. In particular, dynamic capabilities describe a firm’s ability to create, deploy, mod- ify, reconfigure, upgrade, or leverage its resources over time in its quest for competitive advantage.40 Dynamic capabilities are essential to move beyond a short-lived advantage and create a sustained 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 stra- tegic 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.

A lack of strategic fit with a changing environment created at least two problems for Procter & Gamble in recent years (see Strategy Highlight 4.2). First, following the deep recession of 2008–2009, U.S. consumers moved away from higher-priced brands, such as those offered by P&G, to lower-cost alternatives. Moreover, P&G’s direct rivals in branded goods, such as Colgate-Palmolive, Kimberly-Clark, and Unilever, were faster in cutting costs and prices in response to more frugal customers. P&G also fumbled launches of reformulated products such as Tide Pods (detergent sealed in single-use pouches) and the Pantene line of shampoos and conditioners. The decline in U.S. demand hit P&G espe- cially hard because the domestic market delivers about one-third of sales, but almost two- thirds of profits for the company. Second, by focusing on the U.S. market, P&G not only missed out on the booming growth years that the emerging economies experienced during the 2000s, but it also left these markets to its rivals. As a consequence, Colgate-Palmolive, Kimberly-Clark, and Unilever all outperformed P&G in recent years.

As a result of its sustained competitive disadvantage, P&G also had a revolving door in its executive suites. From 2013 to 2015, P&G went through three CEOs. After 30 years with P&G, the former Army Ranger Robert McDonald was appointed CEO in 2009, but was replaced in spring 2013 in the face of P&G’s deteriorating performance. The company’s board of directors brought back A.G. Lafley. This was an interesting choice because Lafley had pre- viously served as P&G’s CEO from 2000 to 2009, and some of the strategic decisions that led to a weakening of P&G’s strategic position were made under his watch. Lafley served a sec- ond term as CEO from 2013 to 2015. In late 2015, P&G named David Taylor as the new CEO, again promoting from within, while Lafley served as executive chairman until June 2016.

To strengthen its competitive position, P&G launched two strategic initiatives. First, P&G began to refocus its portfolio on the company’s 70 to 80 most lucrative product- market combinations, which are responsible for 90 percent of P&G’s revenues and almost all of its profits. Some argue that P&G had become too big and spread out to compete effectively in today’s dynamic marketplace. To refocus on core products such as Tide, Pampers, and Olay (these three brands account for more than 50 percent of the company’s revenues), P&G has sold or plans to divest almost 100 brands in its far-flung product port- folio, including well-known brands such as Iams pet food, Duracell batteries, Wella sham- poos, Clairol hair dye, and CoverGirl makeup, but mainly a slew of lesser-known brands.

Part of this strategic initiative is also to expand P&G’s presence in large emerging economies. As an example, P&G launched Tide in India and Pantene shampoos in Brazil. Moreover, P&G began to leverage its Crest brand globally, to take on Colgate-Palmolive’s global dominance in toothpaste. Yet, the relatively strong dollar in recent years is hurt- ing P&G’s international results. Second, P&G implemented strict cost-cutting measures through eliminating all spending not directly related to selling. As part of its cost-cutting initiative, P&G also eliminated thousands of jobs.

The goal of the two strategic initiatives is to increase the perceived value of P&G’s brands in the minds of the consumer, while lowering production costs. The combined effort should—if successful—increase P&G’s economic value creation (V − C). The hope is that P&G’s revised

dynamic capabilities A firm’s ability to create, deploy, modify, reconfig- ure, upgrade, or lever- age its resources in its quest for competitive advantage.

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business strategy would strengthen its strategic position and help it achieve a better strategic fit with the new environment. This should increase the likelihood that P&G can achieve a competitive advantage again. Through a number of investments in its intangible resource base, P&G is upgrading its dynamic capabilities, which had been neglected for a number of years as the consumer-products company failed to change with a changing environment.

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 position. 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 particular in music, smartphones, and media content. For the portable music market through its iPod and iTunes store, Apple generated environmental change to which Sony and others had to respond. With its iPhone, Apple redefined the market for smart- phones, again creating environmental change to which competitors such as Samsung, Black- Berry, and Google (with its Motorola Mobility unit) needed to respond. Apple’s introduction of the iPad redefined the media and tablet computing market, forcing competitors such as Amazon and Microsoft to respond. With the introduction of the Apple Watch it is attempting to shape the market for computer wearables in its favor. 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 technological change, in combination with deregulation, globalization, and demo- graphic 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 customers 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.

One way to think about developing dynamic capabilities and other intangible resources is to distinguish between resource stocks and resource flows.41 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 dif- ferences between resource stocks and resource flows is a bathtub that is being filled with water (see Exhibit 4.6).42 The amount of water in the bathtub indicates a company’s level of a specific intangible resource stock—such as its dynamic capabilities, new-product devel- opment, engineering expertise, innovation capability, reputation for quality, and so on.43

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

How fast 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 quest for cognitive computing began in 1997 after its Deep Blue computer (based on arti- ficial 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 advan- tage of business opportunities in big data and analytics. Its efforts were publicized when its

dynamic capabilities perspective A model that emphasizes a firm’s ability to mod- ify and leverage its resource base in a way that enables it to gain and sustain com- petitive advantage in a constantly changing environment.

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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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 demonstrated its skill in many professional areas where deep domain expertise is needed when 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. Signif- icant 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 managers’ 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, managers 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.

4.4 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.44  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

EXHIBIT 4.6 / 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.

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 . . .)

LO 4-7

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

value chain The internal activities a firm engages in when transforming inputs into outputs; each activity adds incremental value.

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value chain allows managers to obtain a more detailed and fine-grained understanding of how the firm’s economic value creation (V − C) breaks down into a distinct set of activities that help determine perceived value (V) and the costs (C) to create it. The value chain con- cept can be applied to basically any firm, from those in manufacturing industries to those in high-tech ones or service firms.

A firm’s core competencies are deployed through its activities (see Exhibit 4.3). 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, run- ning the company’s IT system and websites, and providing customer support are all exam- ples of distinct activities. Activities are narrower than functional areas such as marketing, because each functional area is made up of a set of distinct activities.

To build its uniquely cool brand image, Beats Electronics engages in a number of dis- tinct activities. Its iconic Beats headphones are designed by Dr. Dre. To create special edi- tions such as lightweight Beats for sports, Dr. Dre taps into his personal network and works with basketball stars such as Kobe Bryant. Once designed, Beats manufactures its high- end headphones (before the Apple acquisition, that was done in conjunction with Monster Cable Products, a California-based company). Other distinct activities concern the market- ing and sales of its products. Beats has not only marketing savvy in product placement and branding with a large number of celebrities across different fields, but it also uses the same savvy in other distinct activities such as packaging and product presentation to create a premium unboxing experience and superb displays in retail outlets—especially important now that its products are in Apple stores.  In sum, a number of distinct activities along the value chain are performed to create Beats by Dr. Dre, from initial design to a unique sales experience and after-sales service.

As shown in the generic value chain in Exhibit 4.7, the transformation process from inputs to outputs is composed of a set of distinct activities. When a firm’s distinct activi- ties generate value greater than the costs to create them, the firm obtains a profit mar- gin (see Exhibit 4.7), assuming the market price the firm is able to command exceeds the costs of value creation. A generic value chain needs to be modified to capture the

EXHIBIT 4.7 / A Generic Value Chain: Primary and Support Activities

Su pp

ly Ch

ai n

M an

ag em

en t

After-Sales Service

M ar

ke tin

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Sa le

s

Di st

rib ut

io n

Op er

at io

ns

Primary Activities

Research & Development

Information Systems

Human Resources

Accounting & Finance

Firm Infrastructure, including Processes, Policies, & Procedures

Support Activities

Margin Margin

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activities of a specific business. Retail chain American Eagle Outfitters, for example, needs to identify suitable store locations, either build or rent stores, purchase goods and supplies, manage distribution and store inventories, operate stores both in the brick-and- mortar world and online, hire and motivate a sales force, create payment and IT systems or partner with vendors, engage in promotions, and ensure after-sales services including returns. A maker of semiconductor chips such as Intel, on the other hand, needs to engage in R&D, design and engineer semiconductor chips and their production processes, pur- chase 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.

As shown in Exhibit 4.7, 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 competi- tive advantage because they are the drivers of the firm’s relative costs and level of differen- tiation 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 managers to see how competi- tive 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 activi- ties.45  Strategic activity systems are socially complex and causally ambiguous, thus enhancing the possibility that a competitive advantage can be sustained over time. While one can easily observe several elements of a strategic activity system, the capabilities nec- essary to orchestrate and manage the network of distinct activities cannot be so easily observed and therefore are difficult to imitate.

Let’s assume Firm A’s activity system, which lays the foundation of its competitive 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. Moreover, Firm B is very good at copying; it achieves a 90 percent accuracy rate. Will Firm B, as the imitator, be able to copy Firm A’s activity

primary activities Firm activities that add value directly by transforming inputs into outputs as the firm moves a prod- uct or service horizon- tally along the internal value chain.

support activities Firm activities that add value indirectly, but are necessary to sustain pri- mary activities.

LO 4-8

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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system and negate its competitive advantage? Far from it. Firm A’s activity system is based on 25 interconnected activities. Because each of Firm A’s 25 activities is copied with a 90 percent accuracy, Firm B’s overall copying accuracy of the entire system is 0.9 × 0.9 × 0.9 . . . , repeated 25 times. The probabilities quickly compound to render copying an entire activity system nearly impossible. In this case, Firm B’s “success” in copying Firm A’s activity system is 0.925 = 0.07, meaning that Firm B’s resulting activ- ity system will imitate Firm A’s with only a 7 percent accuracy rate. Thus, the concept of the strategic activity system demonstrates the difficulty of using imitation as a path to competitive advantage.

Strategic activity systems need to evolve over time if a firm is to sustain a competi- tive advantage. Procter & Gamble’s difficulties discussed in Strategy Highlight 4.2 show what happens if a firm’s strategic activity system does not evolve. This 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. Managers need to adapt their firm’s strategic activity system by upgrading value-creating activities that respond to changing environments. To gain and sustain competitive advan- tage, strategic leaders may add new activities, remove activities that are no longer relevant, and upgrade activities that have become stale or somewhat obsolete. Each of these changes would require changes to the resources and capabilities involved.

Let’s consider The Vanguard Group, one of the world’s largest investment compa- nies.46  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.47 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.48 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 the Standard & Poor’s 500 or the Dow Jones 30), and discourages active trading and encourages long-term investing.

Despite this innovation in investing, Vanguard’s strategic activity system needed to evolve over time as the company grew and market conditions as well as competitors changed, in order to gain and sustain a competitive advantage. Let’s compare how The Vanguard Group’s strategic activity developed over the past 20 years, from 1997 to 2017.

In 1997, The Vanguard Group had less than $500 million of assets under management. It pursued its mission of being the highest-value provider of investment products and ser- vices through its unique set of interconnected activities depicted in Exhibit 4.8. The six larger ovals depict Vanguard’s strategic core activities: strict cost control, direct distribu- tion, low expenses with savings passed on to clients, offering of a broad array of mutual funds, efficient investment management approach, and straightforward client communica- tion 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 4.9 shows Vanguard’s strategic activity system in 2017. Twenty years later, The Vanguard Group had grown some eight times in size, from a mere $500 billion (in 1997) to $4 trillion (in 2017) of assets under management.49

Again, the large ovals in Exhibit 4.9 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 management added a new core activity— customer segmentation—to the six core activities already in place in 1997 (still valid in 2017).

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EXHIBIT 4.8 / The Vanguard Group’s Activity System in 1997 SOURCE: Adapted from N. Siggelkow (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 146.

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 2017

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

2017

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

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 fur- ther 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 $5 trillion of assets under management. This allows Vanguard to ben- efit 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 customization, Vanguard still has one of the low- est 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 activi- ties 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 sav- ings passed on to clients, a broad array of mutual funds, an efficient investment manage- ment approach, and straightforward client communication and education.

In summary, a firm’s competitive advantage can result from its unique network of activities. 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 advantage 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 core competence. In Chapter 5, we take a closer look at how to measure and assess competitive advantage.

4.5 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 your firm’s internal resources and capabilities to the demands of the external industry environment. Ideally, strategic leaders want to leverage their firm’s internal strengths to exploit external opportunities, while mitigating internal weaknesses and external threats. Both types of analysis in tandem allow managers to formulate a strat- egy 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.

LO 4-9

Conduct a SWOT analysis to generate insights from external and internal analysis and derive strategic implications.

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USING SWOT ANALYSIS TO GENERATE INSIGHTS FROM EXTERNAL AND INTERNAL ANALYSIS We synthesize insights from an internal analysis of the company’s strengths and weak- nesses with those from an analysis of external opportunities and threats using the SWOT analysis. Internal strengths (S) and weaknesses (W) concern resources, capabilities, and competencies. 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 imi- tate, 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 reg- ulation for financial institutions, for example, might represent an external threat to banks.

A SWOT analysis allows the strategist to evaluate a firm’s current situation and future prospects by simultaneously considering internal and external factors. The SWOT analysis encourages managers 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 environment, as shown in Exhibit 4.10, to derive strategic implications. In this SWOT matrix, the horizon- tal 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).

In a first step, managers gather information for a SWOT analysis in order to link internal factors (Strengths and Weaknesses) to external factors (Opportunities and Threats). Next, managers use the SWOT matrix shown in Exhibit 4.10 to develop strategic alternatives for the firm using a four-step 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.

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.

EXHIBIT 4.10 / Strategic Questions within the SWOT Matrix

In te

rn al

to F

ir m

External to Firm

Strategic Questions 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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In a final step, the strategist needs to carefully evaluate the pros and cons of each strate- gic alternative to select one or more alternatives to implement. Managers need to carefully explain their decision rationale, including why other strategic alternatives were rejected.

Although the SWOT analysis is a widely used management framework, a word of cau- tion 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. How- ever, California has a high cost of living and is routinely ranked among the worst of the U.S. states in terms of “ease of doing business.” In addition, this area of California is along major earthquake fault lines and is more prone to natural disasters than many other parts of the country. 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 gov- ernments 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, the strategist must first con- duct a thorough external and internal analysis, as laid out in Chapters 3 and 4. This sequen- tial process enables the strategist 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 1.3).

ALTHOUGH MANY  observers are convinced that Apple pur- chased Beats Electronics for the coolness of its brand and to gain a stronger position in the music industry, others are suggesting that what Apple is really buying are the talents that Beats co-founder Jimmy Iovine and Dr. Dre bring to the table. Since the death of Steve Jobs, Apple’s visionary leader, the company has been lacking the kind of inspired personal- ity it needs to remain a cultural icon. The critics argue that what Apple really needs is someone with a creative vision combined with a wide-reaching industry network and the ability to close a deal, especially in music where the person- alities of celebrities are known to be idiosyncratic. In music jargon, Apple is in need of a “front man.” With the acquisi- tion of Beats, it got two of the greatest creative talents in the music industry, with a long successful track record and deep and far-reaching networks.

CHAPTERCASE 4  Consider This . . .

Iovine is of the opinion that Beats had always belonged with Apple. Iovine and Dr. Dre set out to model Beats Electronics after Apple’s unique ability to marry culture and technology. Intrigu- ingly, both Iovine and Dr. Dre took on senior positions at Apple. They continue to link Beats with today’s top talent, even as some celebrities, such as Ariana Grande and Rihanna, take a leaf from the Beats playbook. Some singers now burnish personal brands with limited release headphones from other vendors; Grande’s wireless Cat Ear Headphones (Brookstone, $150) and Rihanna’s bedazzled tiara (Friends/Dolce & Gabanna, $9,000) are just two examples.

That Beats’ founders keep ongoing roles indicates how much Apple’s culture has changed under CEO Tim Cook.

Dr. Dre and Jimmy Iovine of Beats.

©Kevin Mazur/WireImage/ Getty Images

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

Indeed, Iovine and Dr. Dre were not the first superstars from flashy industries he brought to Apple. In 2013, Apple hired former Burberry CEO Angela Ahrendts to head its retail opera- tions. Bringing in superstars from the flashy industries of music or fashion to Apple, let alone into senior executive roles, would have been unthinkable under Jobs. Under his top-down leader- ship, only Apple products introduced to the public by himself in well-rehearsed theatrical launches were allowed to shine.

Questions

1. Which music streaming service do you use, if any? Why are you using this particular service and not others? Are you a paid subscriber? Why or why not?

2. The ChapterCase argues that Beats Electronics’ core competency lies in its marketing savvy and in Dr. Dre’s

coolness factor. Do you agree with this assessment? Why or why not?

3. If you believe that Apple bought Beats Electronics to bring Jimmy Iovine and Dr. Dre into Apple, what are the potential downsides of this multibillion-dollar “acqui-hire” (an acquisition to hire key personnel)?

4. If Beats Electronics’ core competencies are indeed intangibles, such as coolness and marketing savvy, do you think these competencies will remain as valuable under Apple’s ownership? Why or why not?

5. The ChapterCase provides at least three theories why Apple purchased Beats Electronics. Briefly sketch each of them. Which of those do you believe is most accu- rate, and why?

This chapter demonstrated various approaches to ana- lyzing the firm’s internal environment, as summarized by the following learning objectives and related take- away concepts.

LO 4-1 / Differentiate among a firm’s core com- petencies, resources, capabilities, and activities. ■ Core competencies are unique, deeply embedded,

firm-specific strengths that allow companies to differentiate their products and services and thus create more value for customers than their rivals, or offer products and services of acceptable value at lower cost.

■ Resources are any assets that a company can draw on when crafting and executing strategy.

■ Capabilities are the organizational and manage- rial skills necessary to orchestrate a diverse set of resources to deploy them strategically.

■ Activities are distinct and fine-grained business pro- cesses that enable firms to add incremental value by transforming inputs into goods and services.

LO 4-2 / Compare and contrast tangible and intangible resources. ■ Tangible resources have physical attributes and

are visible.

■ Intangible resources have no physical attributes and are invisible.

■ Competitive advantage is more likely to be based on intangible resources.

LO 4-3 / Evaluate the two critical assump- tions behind the resource-based view. ■ The first critical assumption—resource

heterogeneity—is that bundles of resources, capa- bilities, and competencies differ across firms. The resource bundles of firms competing in the same industry (or even the same strategic group) are unique to some extent and thus differ from one another.

■ The second critical assumption—resource immobility—is 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.

LO 4-4 / Apply the VRIO framework to assess the competitive implications of a firm’s resources. ■ For a firm’s resource to be the basis of a competi-

tive advantage, it must have VRIO attributes:

TAKE-AWAY CONCEPTS

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 137

valuable (V), rare (R), and costly to imitate (I). The firm must also be able to organize (O) in order to capture the value of the resource.

■ A resource is valuable (V) if it allows the firm to take advantage of an external opportunity and/or neutralize an external threat. A valuable resource enables a firm to increase its economic value cre- ation (V − C).

■ A resource is rare (R) 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.

■ A resource is costly to imitate (I) if firms that do not possess the resource are unable to develop or buy the resource at a comparable cost.

■ The firm is organized (O) to capture the value of the resource if it has an effective organizational structure, processes, and systems in place to fully exploit the competitive potential.

LO 4-5 / Evaluate different conditions that allow a firm to sustain a competitive advantage. ■ Several conditions make it costly for competitors

to imitate the resources, capabilities, or compe- tencies that underlie a firm’s competitive advan- tage: (1) better expectations of future resource value, (2) path dependence, (3) causal ambiguity, (4) social complexity, and (5) intellectual prop- erty (IP) protection.

■ These barriers to imitation are isolating mecha- nisms because they prevent rivals from competing away the advantage a firm may enjoy.

LO 4-6 / Outline how dynamic capabilities can enable a firm to sustain a competitive advantage. ■ To sustain a competitive advantage, any fit

between a firm’s internal strengths and the exter- nal environment must be dynamic.

■ Dynamic capabilities allow a firm to create, deploy, modify, reconfigure, or upgrade its resource base to gain and sustain competitive advantage in a constantly changing environment.

LO 4-7 / Apply a value chain analysis to understand which of the firm’s activities in the process of transforming inputs into

outputs generate differentiation and which drive costs. ■ The value chain describes the internal activities

a firm engages in when transforming inputs into outputs.

■ Each activity the firm performs along the hori- zontal chain adds incremental value and incre- mental costs.

■ A careful analysis of the value chain allows man- agers to obtain a more detailed and fine-grained understanding of how the firm’s economic value creation breaks down into a distinct set of activi- ties that helps determine perceived value and the costs to create it.

■ When a firm’s set of distinct activities is able to generate value greater than the costs to create it, the firm obtains a profit margin (assuming the market price the firm is able to command exceeds the costs of value creation).

LO 4-8 / Identify competitive advantage as residing in a network of distinct activities. ■ A strategic activity system conceives of a firm as

a network of interconnected firm activities. ■ A network of primary and supporting firm activi-

ties can create a strategic fit that can lead to a competitive advantage.

■ To sustain a competitive advantage, firms need to hone, fine-tune, and upgrade their strategic activity systems over time, in response to changes in the external environment and to moves of competitors.

LO 4-9 / Conduct a SWOT analysis to gener- ate insights from external and internal analysis and derive strategic implications. ■ Formulating a strategy that increases the chances

of gaining and sustaining a competitive advan- tage is based on synthesizing insights obtained from an internal analysis of the company’s strengths (S) and weaknesses (W) with those from an analysis of external opportunities (O) and threats (T).

■ The strategic implications of a SWOT analy- sis should help the firm to leverage its internal strengths to exploit external opportunities, while mitigating internal weaknesses and external threats.

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

Activities (p. 112) Capabilities (p. 110) Causal ambiguity (p. 122) Core competencies (p. 110) Core rigidity (p. 124) Costly-to-imitate

resource (p. 116) Dynamic capabilities (p. 126) Dynamic capabilities perspec-

tive (p. 127) Intangible resources (p. 113)

Intellectual property (IP) protec- tion (p. 123)

Isolating mechanisms (p. 120) Organized to capture

value (p. 118) Path dependence (p. 121) Primary activities (p. 130) Rare resource (p. 116) Resource-based view (p. 113) Resource flows (p. 127) Resource heterogeneity (p. 114)

Resource immobility (p. 114) Resource stocks (p. 127) Resources (p. 110) Social complexity (p. 123) Strategic activity system (p. 130) Support activities (p. 130) SWOT analysis (p. 134) Tangible resources (p. 113) Valuable resource (p. 116) Value chain (p. 128) VRIO framework (p. 115)

KEY TERMS

DISCUSSION QUESTIONS

1. Why is it important to study the internal resources, capabilities, and activities of firms? What insights can be gained?

2. a. Conduct a value chain analysis for McDon- ald’s. What are its primary activities? What are its support activities? Identify the activi- ties that add the most value for the customer. Why? Which activities help McDonald’s to contain cost? Why?

b. In the past few years, McDonald’s has made a lot of changes to its menu, adding more healthy choices and more higher-priced items, such as those offered in McCafé (e.g., pre- mium roast coffee, antibiotic-free chicken, and fruit smoothies), and has also enhanced its in-restaurant services (e.g., free, unlimited Wi-Fi; upgraded interiors). Did McDonald’s

new priorities—in terms of a broader, healthier menu and an improved in-restaurant experience—require changes to its traditional value chain activities? If so, how? Try to be as specific as possible in comparing the McDonald’s from the recent past (focusing on low-cost burgers) to the McDonald’s of today.

3. The resource-based view of the firm identifies four criteria that managers can use to evaluate whether particular resources and capabilities are core competencies and can, therefore, provide a basis for sustainable competitive advantage. Are these measures independent or interdependent? Explain. If (some of) the measures are interde- pendent, what implications does that fact have for managers wanting to create and sustain a com- petitive advantage?

ETHICAL/SOCIAL ISSUES

1. As discussed in this chapter, resources that are valuable, rare, and costly to imitate can help create a competitive advantage. In many cases, firms try to “reverse-engineer” a particular

feature from a competitor’s product for their own uses. It is common, for example, for smartphone manufacturers to buy the new- est phones of their competitors and take them

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 139

apart to see what new components and features the models have implemented. However, this sort of corporate behavior does not stop with hardware products. With hundreds of millions of users and rapid growth, China is considered to be one of the most lucrative online markets worldwide. Baidu (baidu.com), a Chinese web services company, has allegedly adapted many of the search tools that Google uses. Baidu, however, modifies its searches inside China (its major market) to accommodate government guidelines. In protest over these same guide- lines, in 2010 Google left the Chinese market and is running its Chinese search operations from Hong Kong. Google no longer censors its online searches as requested by the Chinese government. Baidu has an estimated 78 percent market share in online search in China, and Google less than 15 percent.50

It is legal to take apart publicly available prod- ucts and services and try to replicate them and

even develop work-arounds for relevant patents. But is it ethical? If a key capability protected by patents or trademarks in your firm is being reverse-engineered by the competition, what are your options for a response? Also, how do you evaluate Google’s decision to move its servers to Hong Kong?

2. The chapter mentions that one type of resource flow is the loss of key personnel who move to another firm. Assume that the human resources department of your firm has started running ads and billboards for open positions near the office of your top competitor. Your firm is also run- ning Google ads on a keyword search for this same competitor. Is there anything unethical about this activity? Would your view change if this key competitor had just announced a major layoff?

SMALL GROUP EXERCISES

//// Small Group Exercise 1 Brand valuations were mentioned in the chapter as a potential key intangible resource for firms. Some product brands are so well established the entire cat- egory of products (including those made by competi- tors) may be called by the brand name rather than the product type. In your small group, develop two or three examples of this happening in the marketplace. In any of the cases noted, does such brand valuation give the leading brand a competitive advantage? Or does it produce confusion in the market for all prod- ucts or services in that category? Provide advice to the leading brand as to how the firm can strengthen the brand name.

//// Small Group Exercise 2 Strategy Highlight 4.1 explains the rise and fall of Groupon. The company’s strategic vision was to be the global leader in local commerce, based on a core competency that could be described as

“local market-making.” Numerous competitors took advantage of low barriers to entry and the easy imi- tation of Groupon’s combined competency of some technology skills with sales skills, so that Groupon found its competitive advantage was only tempo- rary. Groupon continues to compete but needs your advice on how to build dynamic capabilities that might help it pursue the vision of becoming a global leader in local commerce. How might Groupon rein- vest or upgrade its technology and sales skills so it builds a global customer base? For example, are there new products or services that would meet the needs of global clients in each of the local markets? Should they try to compete with the newer “hyper- local” offerings or move in a different direction? Brainstorm ways that Groupon might add value for its customers. How might Groupon build relation- ships with clients that are more socially complex, making Groupon’s competencies more difficult to imitate?

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Looking Inside Yourself: What Is My Competitive Advantage?

W e encourage you to apply what you have learned about competitive advantage to your career. Spend a few minutes looking at yourself to discover your own competitive advantage. If you have previous work experi- ence, these questions should be from a work environment per- spective. If you do not have any work experience yet, use these questions to evaluate a new workplace or as strategies for pre- senting yourself to a potential employer.

1. Write down your own strengths and weaknesses. What sort of organization will permit you to really leverage your strengths and keep you highly engaged in your work (person–organization fit)? Do some of your weaknesses need to be mitigated through additional training or mentor- ing from a more seasoned professional?

2. Personal capabilities also need to be evaluated over time. Are your strengths and weaknesses different today from what they were five years ago? What are you doing to make sure your capabilities are dynamic?

3. Are some of your strengths valuable, rare, and costly to imitate? How can you organize your work to help capture the value of your key strengths (or mitigate your weak- nesses)? Are your strengths specific to one or a few employers, or are they more generally valuable in the marketplace? In general, should you be making investments in your human capital in terms of company-specific or market-general skills?

4. As an employee, how could you persuade your boss that you could be a vital source of sustainable competitive advantage? What evidence could you provide to make such an argument?

mySTRATEGY

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

1. Source: “People Aren’t Hearing All The Music,” Beats By Dre. www.beatsbydre.com/ aboutus. 2. www.beatsbydre.com; Hufford, A. and H. Karp (2017, Jan. 23), “Sprint to Buy 33% of Jay Z’s Tidal Music Service,” The Wall Street Journal. Eels, J., “Dr. Dre and Jimmy Iovine’s school for innova- tion,” The Wall Street Journal November 5, 2014; Brownlee, M. (2014, Aug. 30), “The truth about Beats by Dre!,” August 30, YouTube video, www.youtube.com/ watch?v=ZsxQxS0AdBY; “The sound of music,” The Economist, August 24, 2014; Karp, H., “Apple’s new Beat: What Steve Jobs and Dr. Dre have in common,” The Wall Street Journal, June 6, 2014; Cohen, M., “Apple buys Beats to regain music mojo,” The Wall Street Journal, May 29, 2014; “Can you feel the Beats?” The Econo- mist, May 28, 2014; Karp, H., “Apple-Beats Electronics: The disrupter is disrupted,” The Wall Street Journal, May 9, 2014; Karp, H., and D. Wakabayashi, “Dr. Dre, Jimmy Iovine would both join Apple in Beats

deal,” The Wall Street Journal, May 9, 2014; “Beats nicked,”The Economist, May 13, 2014; and “The legacy of Napster,” The Economist,September 13, 2013. 3. The discussion of Beats Electronics throughout the chapter is based on: www. beatsbydre.com; Eels, J. (2014, Nov. 5), “Dr. Dre and Jimmy Iovine’s school for innova- tion,” The Wall Street Journal; Brownlee, M. (2014, Aug. 30), “The truth about Beats by Dre!”, YouTube video, www.youtube. com/watch?v=ZsxQxS0AdBY; “The sound of music,” The Economist, August 24, 2014; Karp, H. (2014, June 6), “Apple’s new Beat: What Steve Jobs and Dr. Dre have in com- mon,” The Wall Street Journal; Cohen, M. (2014, May 29), “Apple buys Beats to regain music mojo,” The Wall Street Journal; “Can you feel the Beats?” The Economist, May 28, 2014; Karp, H. (2014, May 9), “Apple-Beats Electronics: The disrupter is disrupted,” The Wall Street Journal; Karp, H., and D. Wakabayashi (2014, May 9), “Dr. Dre, Jimmy Iovine would both join Apple in Beats deal,” The Wall Street Journal; “Beats nicked,” The

Economist, May 13, 2014; and “The legacy of Napster,” The Economist, September 13, 2013. 4. Prahalad, C.K., and G. Hamel (1990), “The core competence of the corporation,” Harvard Business Review, May–June. 5. This discussion is based on: Amit, R., and P.J.H. Schoemaker (1993), “Strategic assets and organizational rent,” Strategic Manage- ment Journal 14: 33–46; Peteraf, M. (1993), “The cornerstones of competitive advantage,” Strategic Management Journal 14: 179–191; Barney, J. (1991), “Firm resources and sus- tained competitive advantage,” Journal of Management 17: 99–120; and Wernerfelt, B. (1984), “A resource-based view of the firm,” Strategic Management Journal 5: 171–180. 6. Google is working to outdo the existing Googlepex headquarters in Mountain View. In 2015, the company sought permission to build a 3.4 million-square-foot campus across four pieces of land near the edge of San Francisco Bay. The futuristic site, to be completed in 2020, will be covered by canopy structures that can be rearranged in a flexible manner. See “Silicon Valley headquarters:

ENDNOTES

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CHAPTER 4 Internal Analysis: Resources, Capabilities, and Core Competencies 141

Googledome, or temple of doom?” The Econ- omist, March 7, 2015. 7. Tangible resources are listed under “Prop- erty and Equipment” in the Consolidated Balance Sheet, see Alphabet / Google Annual Report, 2016, https://abc.xyz/investor/ index.html. 8. “Top 100 most valuable global brands 2016,” report by Millward Brown, WPP, http://www.millwardbrown.com/brandz/ top-global-brands/2016. 9. For a discussion on the benefits of being located in a technology cluster, see Rothaer- mel, F.T., and D. Ku (2008), “Intercluster innovation differentials: The role of research universities,” IEEE Transactions on Engineer- ing Management 55: 9–22; and Saxenian, A. L. (1994), Regional Advantage: Culture and Competition in Silicon Valley and Route 128 (Cambridge, MA: Harvard University Press). 10. Stuart, T., and O. Sorenson (2003), “The geography of opportunity: Spatial heterogene- ity in founding rates and the performance of biotechnology firms,” Research Policy 32: 229–253. 11. “Top 100 most valuable global brands 2016,” report by Millward Brown, WPP, http://www.millwardbrown.com/brandz/ top-global-brands/2016. 12. This discussion is based on: Amit, R., and P.J.H. Schoemaker (1993), “Strategic assets and organizational rent,” Strategic Manage- ment Journal 14: 33–46; Barney, J. (1991), “Firm resources and sustained competitive advantage,” Journal of Management 17: 99–120; Peteraf, M. (1993), “The corner- stones of competitive advantage,” Strategic Management Journal 14: 179–191; and Wer- nerfelt, B. (1984), “A resource-based view of the firm,” Strategic Management Journal 5: 171–180. 13. This discussion is based on: Barney, J., and W. Hesterly (2014), Strategic Manage- ment and Competitive Advantage, 5th ed. (Upper Saddle River, NJ: Pearson Prentice Hall); Amit, R., and P.J.H. Schoemaker (1993), “Strategic assets and organizational rent,” Strategic Management Journal 14: 33–46; Barney, J. (1991), “Firm resources and sustained competitive advantage,” Journal of Management 17: 99–120; Peteraf, M. (1993), “The cornerstones of competitive advantage,” Strategic Management Journal 14: 179–191; and Wernerfelt, B. (1984), “A resource-based view of the firm,” Strategic Management Journal 5: 171–180. 14. Barney, J., and W. Hesterly (2014), Stra- tegic Management and Competitive Advan- tage, 5th ed. (Upper Saddle River, NJ: Pearson Prentice Hall); and Barney, J. (1991), “Firm

resources and sustained competitive advan- tage,” Journal of Management 17: 99–120. 15. Crocs’ share price hit an all-time high of $74.75 on October 31, 2007. By November 20, 2008, the share price had fallen to $0.94. 16. For a detailed history of the creation and growth of Amazon.com, see Stone, B. (2013), The Everything Store: Jeff Bezos and the Age of Amazon (New York: Little, Brown and Co.). 17. “U.S. judge reduces Apple’s patent award in Samsung case,” The Wall Street Journal, March 1, 2013; and “Apple wins big in patent case,” The Wall Street Journal, August 24, 2012. 18. Chesbrough, H. (2006), Open Innovation: The New Imperative for Creating and Profit- ing from Technology (Boston, MA: Harvard Business School Press). 19. In 1968, Xerox moved its headquarters from Rochester, New York, to Norwalk, Connecticut. 20. Prahalad, C.K., and G. Hamel (1990), “The core competence of the corporation,” Harvard Business Review, May–June. 21. Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November– December: 61–78. 22. Groupon Annual Report, 2012; Groupon investor deck, March 2013; “Don’t weep for Groupon ex-CEO Andrew Mason,” The Wall Street Journal, March 1, 2013; “Groupon CEO fired as daily-deals biz bottoms out,” Wired, February 28, 2013; “Struggling Grou- pon ousts its quirky CEO,” The Wall Street Journal, February 28, 2013; “Why Groupon is over and Facebook and Twitter should fol- low,” Forbes, August 20, 2012; “Groupon: Deep discount,” The Economist, August 14, 2012; “The economics of Groupon,” The Economist, October 22, 2011; “In Groupon’s $6 billion wake, a fleet of startups,” The New York Times, March 9, 2011; and Godin, S. (2008), Tribes: We Need You to Lead Us (New York: Portfolio). 23. This discussion is based on: Mahoney, J.T., and J.R. Pandian (1992), “The resource- based view within the conversation of strategic management,” Strategic Management Jour- nal 13: 363–380; Barney, J. (1991), “Firm resources and sustained competitive advan- tage,” Journal of Management 17: 99–120; Dierickx, I., and K. Cool (1989), “Asset stock accumulation and sustainability of competitive advantage,” Management Science 35: 1504– 1513; and Barney, J. (1986), “Strategic factor markets: Expectations, luck, and business strat- egy,” Management Science 32: 1231–1241. 24. Lippman, S.A., and R. P. Rumelt (1982), “Uncertain imitability: An analysis

of interfirm differences in efficiency under competition,” The Bell Journal of Economics 13: 418–438. 25. Arthur, W.B. (1989), “Competing tech- nologies, increasing returns, and lock-in by historical events,” Economics Journal 99: 116–131; and Dierickx, I., and K. Cool (1989), “Asset stock accumulation and sus- tainability of competitive advantage,” Man- agement Science 35: 1504–1513. 26. Krugman, P. (1993), Geography and Trade (Cambridge, MA: MIT Press); and Patton, R.L. (2010), “A history of the U.S. carpet industry,” Economic History Associa- tion Encyclopedia, http://eh.net/encyclopedia/ article/patton.carpet. 27. Dierickx, I., and K. Cool (1989), “Asset stock accumulation and sustainability of com- petitive advantage,” Management Science 35: 1504–1513. 28. For a detailed discussion of how several stakeholders influenced the CARB to with- draw zero-emissions standard, see: Sony Pic- tures’ documentary “Who Killed the Electric Car?” www.whokilledtheelectriccar.com/ 29. Colias, M. (2016), “GM Says Chevy Bolt Electric Car to Get 238-Mile Range,” The Wall Street Journal, September 16; Sparks, D. (2017, Mar. 7), “Chevy Bolt U.S. deliveries decline in February,” The Motley Fool. 30. More formally, the number of relation- ships (r) in a group is a function of its group members (n), with r = n(n − 1)/2. The assumption is that two people, A and B, have only one relationship (A ← → B), rather than two relationships (A → B and A ← B). In the latter case, the number of relation- ships (r) in a group with n members doubles, where r = n(n − 1). 31. This discussion is based on: Hallenborg, L., M. Ceccagnoli, and M. Clendenin (2008), “Intellectual property protection in the global economy,” Advances in the Study of Entrepre- neurship, Innovation, and Economic Growth 18: 11–34; and Graham, S.J.H. (2008), “Beyond patents: The role of copyrights, trademarks, and trade secrets in technology commercialization,” Advances in the Study of Entrepreneurship, Innovation, and Economic Growth 18: 149–171. 32. “Cost to develop and win marketing approval for a new drug is $2.6 billion,” Tufts Center for the Study of Drug Development, November 2014. 33. “Lipitor becomes world’s top-selling drug,” Associated Press, December 28, 2011. 34. Sherr, I. (2013), “U.S. judge reduces Apple’s patent award in Samsung case,” The Wall Street Journal, March 1; and Vascellaro, J.E. (2012, Aug. 25), “Apple wins big in patent case,” The Wall Street Journal.

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

35. Loftus, P. (2014, Mar. 2), “Lipitor: Pfizer aims to sell over-the-counter version,” The Wall Street Journal. 36. “Drug prices to plummet in wave of expiring patents,” Drugs.com, www.drugs. com/news/prices-plummet-wave-expiring- patents-32684.html. 37. Leonard-Barton, D. (1992), “Core capa- bilities and core rigidities: A paradox in man- aging new product development,” Strategic Management Journal 13: 111–125. 38. Leonard-Barton, D. (1995), Wellsprings of Knowledge: Building and Sustaining the Sources of Innovation (Boston, MA: Harvard Business School Press). 39. This Strategy Highlight is based on: “Gillette, bleeding market share, cuts prices of razors,” The Wall Street Journal, April 4, 2017; “P&G names David Taylor as CEO,” The Wall Street Journal, July 29, 2015; “Razor sales move online, away from Gil- lette,” The Wall Street Journal, June 23, 2015; “Strong dollar squeezes U.S. firms,” The Wall Street Journal, January 27, 2014; “P&G to shed more than half its brands,” The Wall Street Journal, August 1, 2014; “P&G’s Billion-Dollar Brands: Trusted, Val- ued, Recognized,” Fact Sheet, www.pg.com; Lafley, A.G., and R.L. Martin (2013), Playing to Win: How Strategy Really Works (Bos- ton, MA: Harvard Business Review Press); “Embattled P&G chief replaced by old boss,” The Wall Street Journal, May 23, 2013; “At Procter & Gamble, the innovation well runs dry,” Bloomberg Businessweek, September

6, 2012; “P&G’s stumbles put CEO on hot seat for turnaround,” The Wall Street Journal, September 27, 2012; and “A David and Gil- lette story,” The Wall Street Journal, April 12, 2012. 40. This discussion is based on: Peteraf, M., G. Di Stefano, and G. Verona (2013), “The elephant in the room of dynamic capabili- ties: Bringing two diverging conversations together,” Strategic Management Journal 34: 1389–1410; Rothaermel, F.T., and A.M. Hess (2007), “Building dynamic capabilities: Innovation driven by individual-, firm-, and network-level effects,” Organization Science 18: 898–921; Eisenhardt, K.M., and Martin, J. (2000), “Dynamic capabilities: What are they?” Strategic Management Journal 21: 1105–1121; and Teece, D.J., G. Pisano, and A. Shuen (1997), “Dynamic capabilities and strategic management,” Strategic Management Journal 18: 509–533. 41. Dierickx, I., and K. Cool (1989), “Asset stock accumulation and sustainability of com- petitive advantage,” Management Science 35: 1504–1513. 42. Dierickx, I., and K. Cool (1989), “Asset stock accumulation and sustainability of com- petitive advantage,” Management Science 35: 1504–1513. 43. Eisenhardt, K.M., and J. Martin (2000), “Dynamic capabilities: What are they?” Stra- tegic Management Journal 21: 1105–1121. 44. This discussion is based on: Porter, M.E. (1985), Competitive Advantage: Creat- ing and Sustaining Superior Performance

(New York: Free Press); Porter, M.E. (1996), “What is strategy?”Harvard Business Review, November–December: 61–78; Siggelkow, N. (2001), “Change in the presence of fit: The rise, the fall, and the renaissance of Liz Claiborne,” Academy of Management Journal 44: 838–857; and Magretta, J. (2012), Under- standing Michael Porter. The Essential Guide to Competition and Strategy (Boston, MA: Harvard Business School Press). 45. This discussion draws on: Porter, M.E. (1996), “What is strategy?”Harvard Business Review, November–December: 61–78. 46. This discussion draws on: Porter, M.E. (1996), “What is strategy?”Harvard Busi- ness Review, November–December: 61–78; and Siggelkow, N. (2002), “Evolution toward fit,” Administrative Science Quarterly 47: 125–159. 47. https://careers.vanguard.com/vgcareers/ why_vgi/story/mission.shtml. 48. “Funds: How much you’re really paying,” Money, November 2005; and https://personal. vanguard.com/us/content/Home/WhyVan- guard/AboutVanguardWhoWeAreContent.jsp. 49. Krouse, S. (2017, Feb. 10), “Vanguard reaches $4 trillion for first time,” The Wall Street Journal. 50. “Special report: China and the internet,” The Economist, April 6, 2013; “How Baidu won China,” Bloomberg Businessweek, November 11, 2010; and “China search engine market update for Q4 2013,” China Internet Watch, March 11, 2014.

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CHAPTER Competitive Advantage, Firm Performance, and Business Models

Chapter Outline

5.1 Competitive Advantage and Firm Performance Accounting Profitability Shareholder Value Creation Economic Value Creation The Balanced Scorecard The Triple Bottom Line

5.2 Business Models: Putting Strategy into Action The Why, What, Who, and How of Business Models Framework Popular Business Models Dynamic Nature of Business Models

5.3 Implications for Strategic Leaders

Learning Objectives

LO 5-1 Conduct a firm profitability analysis using accounting data to assess and evaluate competitive advantage.

LO 5-2 Apply shareholder value creation to assess and evaluate competitive advantage.

LO 5-3 Explain economic value creation and differ- ent sources of competitive advantage.

LO 5-4 Apply a balanced scorecard to assess and evaluate competitive advantage.

LO 5-5 Apply a triple bottom line to assess and evaluate competitive advantage.

LO 5-6 Use the why, what, who, and how of business models framework to put strategy into action.

5

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The Quest for Competitive Advantage: Apple vs. Microsoft

APPLE AND MICROSOFT have been fierce rivals since their arrival in the mid-1970s. Although Apple has been dominat- ing more recently, in the early decades of the PC revolution, Microsoft was the undisputed leader. With its Windows oper- ating system, Microsoft set the standard in the world of per- sonal computers. Some 90 percent of all PCs run Windows. Once users are locked into Windows, which generally comes preloaded on the computer they purchased, they then want to buy appli- cations that run seamlessly with the operating system. The obvious choice for users is Microsoft’s Office Suite (containing Word, Excel, PowerPoint, Outlook, and other software pro- grams). Microsoft’s business model was to create a large installed base of users for its PC operating system and then make money selling application software such as its ubiquitous Office Suite.

Microsoft then went on to replicate with its corporate cus- tomers this hugely successful business model of setting the standard in operating systems combined with bundling dis- counted application suites. Once servers became ubiquitous in corporations, Microsoft offered IT departments e-mail systems, databases, and other business applications that were tightly integrated with Windows. As a consequence, some 80 percent of Microsoft’s revenues were either tied directly or indirectly to its Windows franchise. Microsoft’s strategy of focusing on setting the industry standard allowed it to cre- ate a strong strategic position and to extract high profits for many years. Microsoft’s bundling strategy with Office, com- bining different application services that run seamlessly in one discounted product offering, allowed Microsoft to over- take IBM, once the most valuable tech company. By 2000, Microsoft was the most valuable company globally with some $510 billion in market capitalization.

In contrast, at roughly the same time, Apple was strug- gling to survive with less than 5 percent market share in the PC market. Near bankruptcy in 1997, Apple’s revitalization took off in the fall of 2001 when it introduced the iPod, a portable digital music player. Eighteen months later, the Cupertino, California, company soared even higher when it opened the online store iTunes, quickly followed by its first retail stores. Apple’s stores earn the highest sales per square foot of any retail outlets, including luxury stores.

Apple didn’t stop there. In 2007, the company revolu- tionized the smartphone market with the introduction of the

iPhone. Just three years later, Apple introduced the iPad, reshaping the publishing and media industries. Further, for each of its iPod, iPhone, and iPad lines of business, Apple followed up with incremental product inno- vations extending each product category. By the fall of 2012, Apple had become the most valuable company in the world with some $620 billion market capitalization.

In 2015, the high- tech company introduced

Apple Watch, a wearable computer that is fully integrated with the iOS Apple operating system, running basically all the apps available for the iPhone. Not to be stopped, Apple introduced its 10th anniversary iPhone in 2017 to great fan- fare, with a curved screen and priced at about $1,000. In the same year, Apple’s market capitalization had further risen to more than $750 billion.

The comparison of Microsoft and Apple over time shows that competitive advantage is transitory. Given the rough- and-tumble competition combined with relentless technolog- ical progress and innovation, it is hard to gain a competitive advantage in the first place, and it is even harder to sustain it.1

You will learn more about Apple and Microsoft by reading this chapter; related questions appear in “ChapterCase 5 / Consider This . . . .”

NOTE: A financial ratio review related to this Chapter- Case is available in Connect.

CHAPTERCASE 5

One of the few photos depicting Steve Jobs (Apple co-founder and longtime CEO) and Bill Gates (Microsoft co-founder and longtime CEO) together shows the erstwhile archrivals apparently enjoying each other’s company. Taken at All Things Digital 5 in 2007. ©Reprinted by permission of WSJ, Copyright July 8, 2007, Dow Jones & Company, Inc.

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GAINING AND SUSTAINING competitive advantage is the defining goal of stra- tegic management. Competitive advantage leads to superior firm performance. To

explain differences in firm performance and to derive strategic implications—including new strategic initiatives—we must understand how to measure and assess competitive advantage. We devote this chapter to studying how to measure and assess firm perfor- mance. In particular, we introduce three frameworks to capture the multifaceted nature of competitive advantage. The three traditional frameworks to measure and assess firm performance are

■ Accounting profitability. ■ Shareholder value creation. ■ Economic value creation.

We then will introduce two integrative frameworks, combining quantitative data with qualitative assessments:

■ The balanced scorecard. ■ The triple bottom line.

Next, we take a closer look at business models to understand more deeply how firms put their strategy into action to make money. We conclude the chapter with practical Implica- tions for Strategic Leaders.

5.1 Competitive Advantage and Firm Performance It is easy to compare two firms and identify the better performer as having competi- tive advantage. But simple comparisons have their limitations. How can we understand how and why a firm has competitive advantage? How can we measure it? How can we understand that advantage within the bigger picture of an entire industry and the ever- changing external environment? And what strategic implications for managerial actions do we derive from our assessments? These apparently simple questions do not have simple answers. Strategic management researchers have debated them intensely for the past few decades.2

To address these key questions, we will develop a multidimensional perspective for assessing competitive advantage. Let’s begin by focusing on the three standard perfor- mance dimensions:3

1. What is the firm’s accounting profitability? 2. How much shareholder value does the firm create? 3. How much economic value does the firm generate?

These three performance dimensions tend to be correlated, particularly over time. Accounting profitability and economic value creation tend to be reflected in the firm’s stock price, which in turn determines in part the stock’s market valuation.

ACCOUNTING PROFITABILITY As we discussed in Chapter 1, strategy is a set of goal-directed actions a firm takes to gain and sustain competitive advantage. Using accounting data to assess competitive advantage and firm performance is standard managerial practice. When assessing competitive advan- tage by measuring accounting profitability, we use financial data and ratios derived from publicly available accounting data such as income statements and balance sheets.4 Since competitive advantage is defined as superior performance relative to other competitors in

LO 5-1

Conduct a firm profitability analysis using accounting data to assess and evaluate competitive advantage.

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the same industry or the industry average, a firm’s managers must be able to accomplish two critical tasks:

1. Accurately assess the performance of their firm. 2. Compare and benchmark their firm’s performance to other competitors in the same

industry or against the industry average.

Standardized financial metrics, derived from such publicly available accounting data as income statements and balance sheets, fulfill both these conditions. Public companies are required by law to release these data, in compliance with generally accepted accounting principles (GAAP) set by the Financial Accounting Standards Board (FASB), and as audited by certified public accountants. Publicly traded firms are required to file a Form 10-K (or 10-K report) annually with the U.S. Securities and Exchange Commission (SEC), a federal regulatory agency. The 10-K reports are the primary source of companies’ accounting data available to the public. The fairly stringent requirements applied to accounting data that are audited and released publicly enhance the data’s usefulness for comparative analysis.

Accounting data enable us to conduct direct performance comparisons between different companies. Some of the profitability ratios most commonly used in strategic management are return on invested capital (ROIC), return on equity (ROE), return on assets (ROA), and return on revenue (ROR). In the “How to Conduct a Case Analysis” module (at the end of Part 4, following the MiniCases), you will find a complete presentation of accounting mea- sures and financial ratios, how they are calculated, and a brief description of their strategic characteristics.

One of the most commonly used metrics in assessing firm financial performance is return on invested capital (ROIC), where ROIC = (Net profits / Invested capital).5 ROIC is a popular metric because it is a good proxy for firm profitability. In particular, the ratio measures how effectively a company uses its total invested capital, which consists of two components: (1) shareholders’ equity through the selling of shares to the public, and (2) interest-bearing debt through borrowing from financial institutions and bondholders.

As a rule of thumb, if a firm’s ROIC is greater than its cost of capital, it generates value; if it is less than the cost of capital, the firm destroys value. The cost of capital represents a firm’s cost of financing operations from both equity through issuing stock and debt through issuing bonds. To be more precise and to be able to derive strategic implications, however, managers must compare their ROIC to other competitors and the industry average.

APPLE VS. MICROSOFT. To demonstrate the usefulness of account- ing data in assessing competitive advantage and to derive strategic implications, let’s revisit the comparison between Apple and Micro- soft that we began in ChapterCase 5, and investigate the sources of performance differences in more detail.6 Exhibit 5.1 shows the ROIC for Apple and Microsoft as of fiscal year 2016.7 It further breaks down ROIC into its constituent components. This provides important clues for managers on which areas to focus when attempt- ing to improve firm performance relative to their competitors.

Apple’s ROIC is 18.3 percent, which is 4.6 percentage points higher than Microsoft’s (13.7 percent). This means that for every $1.00 invested in Apple, the company returned almost $1.18, while for every $1.00 invested in the company, Microsoft returned $1.13. Since Apple was 33 percent more efficient than Microsoft at gen- erating a return on invested capital, Apple had a clear competitive advantage over Microsoft. Although this is an important piece of

Tim Cook, Apple CEO.

©Scott Olson/Getty Images News/Getty Images

Satya Nadella, Microsoft CEO.

©Brian Smale/Microsoft/ Getty Images

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EXHIBIT 5.1 / Comparing Apple and Microsoft: Drivers of Firm Performance (2016)8

SOURCE: Analysis of publicly available data.

Return on Revenue (ROR) = (Net Profits /Revenue)

Microsoft: 21.5% Apple: 20.6%

Return on Invested Capital (ROIC) = NOPAT / (Total Stockholders’ Equity + Total Debt – Value of Preferred Stock)

Microsoft: 13.7% Apple: 18.3%

R&D/Revenue

Apple: 4.7% Microsoft: 14.1%

SG&A/Revenue

Apple: 6.6% Microsoft: 22.6%

Tax Rate

Apple: 7.3% Microsoft: 3.5%

Working Capital /Revenue

Apple: 12.9% Microsoft: 94.1%

PPE /Revenue

Apple: 12.5% Microsoft: 21.5%

Working Capital Turnover = (Revenue / Invested Capital)

Apple: 88.9% Microsoft: 63.5%

Intangibles /Revenue

Apple: 1.5% Microsoft: 4.4%

COGS/Revenue

Apple: 60.9% Microsoft: 38.4%

information, managers need to know the underlying factors driving differences in firm profitability. Why is the ROIC for these two companies different?

Much like detectives, managers look for clues to solve that mystery: They break down ROIC into its constituents (as shown in Exhibit 5.1)—return on revenue and working capital turnover—to discover the underlying drivers of the marked difference in firm profitability.

We start with the first component of ROIC. Return on revenue (ROR) indicates how much of the firm’s sales is converted into profits. Apple’s ROR was 20.6 percent, while Microsoft’s ROR was 21.5 percent. For every $100 in revenues, Apple earns $20.60 in profit, while Microsoft earns $21.50 in profit. On this metric, Microsoft had a slight edge over Apple. Keep in mind, however, that Apple’s 2016 revenues were $218 billion, while Microsoft’s were $86 billion. Thus, Apple is more than 2.5 times larger than Microsoft

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in terms of annual sales. As we investigate the differences in ROIC further, we will also discover that Microsoft has a higher cost structure than Apple, and that Apple is able to charge a much higher margin for its products and services than Microsoft.

To explore further drivers of this difference, we break down return on revenue into three additional financial ratios:

■ Cost of goods sold (COGS) / Revenue. ■ Research & development (R&D) expense / Revenue. ■ Selling, general, & administrative (SG&A) expense / Revenue.

The first of these three ratios, COGS / Revenue, indicates how efficiently a company can produce a good. On this metric, Microsoft turns out to be much more efficient than Apple, with a difference of 22.5 percentage points (see Exhibit 5.1). This is because Microsoft’s vast majority of revenues comes from software and online cloud services, with little cost attached to such digitally delivered products and services. In contrast, Apple’s revenues were mostly from mobile devices, combining both hardware and software. In particular, the iPhone made up some two-thirds (or over $145 billion) of Apple’s total revenues in 2016.

Even though Apple is more than two times as large as Microsoft in terms of revenues, it spends much less on research and development or on marketing and sales. Both of these help drive down Apple’s cost structure. In particular, the next ratio, R&D / Revenue, indi- cates how much of each dollar that the firm earns in sales is invested to conduct research and development. A higher percentage is generally an indicator of a stronger focus on inno- vation to improve current products and services, and to come up with new ones.

Interestingly, Apple is much less R&D intensive than Microsoft. Apple spent 4.7 percent on R&D for every dollar of revenue, while Microsoft spent almost three times as much (14.1 percent R&D). Even considering the fact that Microsoft’s revenues were $86 billion versus Apple’s $218 billion, Microsoft ($12 billion) spent more on R&D in absolute dollars than Apple ($10 billion). For every $100 earned in revenues Microsoft spent $14.10 on R&D, while Apple only spent $4.70. For more than a decade now, Microsoft generally spends the most on R&D in absolute terms among all technol- ogy firms.

In contrast, Apple has spent much less on research and development than other firms in the high-tech industry, in both absolute and relative terms. Apple’s co-founder and long- time CEO, the late Steve Jobs, defined Apple’s R&D philosophy as follows: “Innovation has nothing to do with how many R&D dollars you have. When Apple came up with the Mac, IBM was spending at least 100 times more on R&D. It’s not about money. It’s about the people you have, how you’re led, and how much you get it.”9

The third ratio in breaking down return on revenue, SG&A / Revenue, indicates how much of each dollar that the firm earns in sales is invested in sales, general, and adminis- trative (SG&A) expenses. Generally, this ratio is an indicator of the firm’s focus on mar- keting and sales to promote its products and services. For every $100 earned in revenues Microsoft spent $22.60 on sales and marketing, while Apple spent $6.60.

Again, Microsoft ($19.4 billion) not only outspent Apple ($14.4 billion) in absolute terms in marketing and sales expenses, but its SG&A intensity was more than 3.4 times as high as Apple’s. Microsoft is spending significantly more to rebuild its brand, espe- cially on Microsoft CEO Satya Nadella’s new strategic initiative of “mobile first, cloud first.”10 A focus on cloud computing on mobile devices marks a significant departure from Microsoft’s Windows-centric strategy for PCs under his predecessor, Steve Ballmer. Yet, by 2017, the Windows and Office combination still generates about 40 percent of Micro- soft’s total revenues and 75 percent of its profits. Microsoft is working hard to transition

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the Office business from the old business model of standalone software licenses ($150 for Office Home & Student) to repeat business via cloud-based subscriptions such as Office 365 Home & Student (which is $70 per year).

We also note, for completeness, that Apple’s effective tax rate in 2016 was 7.3 percent (with a net income of $45 billion), while that of Microsoft was 3.5 percent (with a net income of $17 billion).

The second component of ROIC is Working Capital Turnover (see Exhibit 5.1), which is a measure of how effectively capital is being used to generate revenue. In more general terms, working capital entails the amount of money a company can deploy in the short term, calculated as current assets minus current liabilities. This is where Apple outper- forms Microsoft by a fairly wide margin (88.9 percent vs. 63.5 percent). For every dollar that Apple puts to work, it realizes $89.90 of sales, while Microsoft realizes $63.50 of sales for every dollar invested; a difference of $26.40 in sales for every dollar invested. This implies that Apple is more than 40 percent more efficient than Microsoft in turning invested capital into revenues.

This significant difference provides an important clue for Microsoft’s managers to dig deeper to find the underlying drivers in working capital turnover. This enables managers to uncover which levers to pull in order to improve firm financial performance. In a next step, therefore, managers break down working capital turnover into other constituent finan- cial ratios, including Working Capital / Revenue; Plant, Property, and Equipment (PPE) / Revenue; and Intangibles / Revenue. Each of these metrics is a measure of how effective a particular item on the balance sheet is contributing to revenue.

The working capital to revenue ratio indicates how much of its working capital the firm has tied up in its operations. Apple (with a working capital to revenue ratio of 12.9 percent) operates much more efficiently than Microsoft (working capital to revenue ratio of 94.1 percent), because it has much less capital tied up in its operations. One reason is that Apple outsources its manufacturing. The vast majority of Apple’s manufacturing of its products is done in China by low-cost producer Foxconn, which employs over 1.3 million people. Moreover, Apple benefits from continued strong demand for its products (especially the iPhone), as well as an effective management of its global supply chain. Rather than out- sourcing manufacturing to Foxconn or other original equipment manufacturers (OEMs), Microsoft owns and operates some of its manufacturing facilities. They are also located in countries with a generally higher cost structure (e.g., Brazil and Mexico, among others) than China.

Although Apple’s installed base of iPhone users globally is more than 530 million, one significant area of future vulnerability for Apple is the fact that about 60 to 70 percent of its annual revenues is based on sales of a single product—the iPhone, depending on model year. Moreover, China accounts for more than 20 percent of Apple’s total revenues, a mar- ket that is becoming more and more volatile for the Cupertino-based tech company. These are pressing issues that Apple CEO Tim Cook needs to address in order to sustain Apple’s competitive advantage.

The PPE over revenue ratio indicates how much of a firm’s revenues are dedicated to cover plant, property, and equipment, which are critical assets to a firm’s operations but cannot be liquidated easily. One reason Microsoft’s PPE to revenue ratio (21.5 percent) is significant higher than that of Apple (12.5 percent) is the fact that Microsoft invests huge amounts of money to build its cloud business, Azure. To do so, it needs to build hundreds of data centers (large groups of networked computer servers used for the remote storage, processing, or distribution of large amounts of data) across the globe, a costly proposition reflected in high PPE expenditures on a much lower revenue base than Apple. On the upside, Azure is already reporting some $10 billion in sales, second

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only to Amazon’s AWS with $12 billion in sales as the world’s largest cloud-computing services provider.

One ratio that points toward possible stronger performance in the future is Micro- soft’s higher Intangibles / Revenue ratio when comparing it to Apple’s (see Exhibit 5.1). Intangible assets do not have physical attributes (see discussion of intangible resources in Chapter 4), and include a firm’s intellectual property (such as patents, copyrights, and trademarks), goodwill, and brand value. One way to think about this is that intangibles are the missing piece to be added to a firm’s physical resource base (that is plant, property, and equipment and current assets) to make up a company’s total asset base. With a higher Intangibles / Revenue ratio (albeit from a lower revenue base), Microsoft (4.4 percent) seems to be building a stronger intangible intensity (Intangibles / Revenue) compared with Apple (1.5 percent), which might position Microsoft stronger for innovation in future busi- ness areas such as cloud computing.

A second area of future growth for Microsoft is likely to be artificial intelligence (AI).  For example, algorithms combing through vast amounts of data on professionals and their networks might be able to tell sales staff on which leads to spend most of their time. This explains why Microsoft paid $26 billion in 2016 to acquire LinkedIn, a professional social network with some 100 million monthly active users.

A deeper understanding of the fundamental drivers for differences in firm profitability allows managers to develop strategic approaches. For example, CEO Satya Nadella could rework Microsoft’s cost structure, in particular, its fairly high R&D and SG&A spending. Perhaps, R&D dollars could be spent more effectively. Apple generates a much higher return on its R&D spending. Microsoft’s sales and marketing expenses also seem to be quite high, but may be needed to rebuild Microsoft’s brand image with a new focus on mobile and cloud computing.

LIMITATIONS OF ACCOUNTING DATA. Although accounting data tend to be readily avail- able and we can easily transform them into financial ratios to assess and evaluate competi- tive performance, they also exhibit some important limitations:

■ All accounting data are historical and thus backward-looking. Accounting profitabil- ity ratios show us only the outcomes from past decisions, and the past is no guarantee of future performance. There is also a significant time delay before accounting data become publicly available. Some strategists liken making decisions using accounting data to driving a car by looking in the rearview mirror.11 While financial strength cer- tainly helps, past performance is no guarantee that a company is prepared for market disruption.

■ Accounting data do not consider off–balance sheet items. Off–balance sheet items, such as pension obligations (quite large in some U.S. companies) or operating leases in the retail industry, can be significant factors. For example, one retailer may own all its stores, which would properly be included in the firm’s assets; a second retailer may lease all its stores, which would not be listed as assets. All else being equal, the second retailer’s return on assets (ROA) would be higher. Strategists address this shortcoming by adjusting accounting data to obtain an equivalent economic capital base, so that they can compare companies with different capital structures.

■ Accounting data focus mainly on tangible assets, which are no longer the most impor- tant.12 This limitation of accounting data is nicely captured in the adage: Not everything that can be counted counts. Not everything that counts can be counted.13 Although accounting data capture some intangible assets, such as the value of intellectual prop- erty (patents, trademarks, and so on) and customer goodwill, many key intangible assets

Satya Nadella, Microsoft CEO.

©Brian Smale/Microsoft/ Getty Images

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are not captured. Today, the most competitively important assets tend to be intangibles such as innovation, quality, and customer experience, which are not included in a firm’s balance sheets. For example, Apple’s core competency in designing beautiful and user- friendly mobile devices embedded within a large ecosystem of various services such as ApplePay is not a balance sheet item, but nonetheless a critical foundation in its quest for competitive advantage.

INTANGIBLES AND THE VALUE OF FIRMS. Intangible assets that are not captured in accounting data have become much more important in firms’ stock market valuations over the last few decades. Exhibit 5.2 shows the firm’s book value (accounting data capturing the firm’s actual costs of assets minus depreciation) as part of a firm’s total stock market valuation (number of outstanding shares times share price). The firm’s book value captures the historical cost of a firm’s assets, whereas market valuation is based on future expecta- tions for a firm’s growth potential and performance. For the firms in the S&P 500 (the 500 largest publicly traded companies by market capitalization in the U.S. stock market, as determined by Standard & Poor’s, a rating agency), the importance of a firm’s book value has declined dramatically over time. This decline mirrors a commensurate increase in the importance of intangibles that contribute to growth potential and yet are not captured in a firm’s accounting data.

In 1980, about 80 percent of a firm’s stock market valuation was based on its book value with 20 percent based on the market’s expectations concerning the firm’s future per- formance. This almost reversed by 2000 (at the height of the internet bubble), when firm valuations were based only 15 percent on assets captured by accounting data. The impor- tant take-away is that intangibles not captured in firms’ accounting data have become much more important to a firm’s competitive advantage. By 2015, about 75 percent of a firm’s market valuation was determined by its intangibles. This explains why in 2017 Alphabet, Google’s parent company ($580 billion), is valued over 10 times more

than GM ($50 billion), or why Facebook ($400 billion) is valued almost four times as much as Boeing ($110 billion).

So what have we learned about accounting profitability? Key financial ratios based on accounting data give us an important tool with which to assess competitive advantage. In particular, they help us measure relative profit- ability, which is useful when comparing firms of different sizes over time. While not perfect, these ratios are an impor- tant starting point when analyzing the competitive performance of firms (and thus are a critical tool for case analysis). Again, see the “How to Conduct a Case Analysis” module at the end of Part 4. We next turn to shareholder value cre- ation as a second traditional way to mea- sure and assess competitive advantage, attempting to overcome the shortcom- ings of a backward-looking internal focus on mostly tangible assets inherent in accounting profitability.

EXHIBIT 5.2 / The Declining Importance of Book Value in a Firm’s Stock Market Valuation, 1980–2015

90%

80%

70%

100%

20%

80%

55%

45%

85%

15% 25%

75% 60%

50%

40%

30%

20%

10%

0% 1980 1990 2000 2015

Not Captured in Book Value Book Value

SOURCE: Analysis and depiction of data from Compustat, 1980–2015.

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SHAREHOLDER VALUE CREATION Shareholders—individuals or organizations that own one or more shares of stock in a public company—are the legal owners of public companies. From the shareholders’ per- spective, the measure of competitive advantage that matters most is the return on their risk capital,14 which is the money they provide in return for an equity share, money that they cannot recover if the firm goes bankrupt. In September 2008, the shareholders of Lehman Brothers, a global financial services firm, lost their entire investment of about $40 billion when the firm declared bankruptcy.

Investors are primarily interested in a company’s total return to shareholders, which is the return on risk capital, including stock price appreciation plus dividends received over a specific period. Unlike accounting data, total return to shareholders is an external and forward- looking performance metric. It essentially indicates how the stock market views all available public information about a firm’s past, current state, and expected future performance, with most of the weight on future growth expectations. The idea that all available information about a firm’s past, current state, and expected future performance is embedded in the market price of the firm’s stock is called the efficient-market hypothesis.15 In this perspective, a firm’s share price provides an objective performance indicator. When assessing and evaluating competi- tive advantage, a comparison of rival firms’ share price development or market capitalization provides a helpful yardstick when used over the long term. Market capitalization (or market cap) captures the total dollar market value of a company’s total outstanding shares at any given point in time (Market cap = Number of outstanding shares × Share price). If a company has 50 million shares outstanding, and each share is traded at $200, the market capitalization is $10 billion (50,000,000 × $200 = $10,000,000,000, or $10 billion).16

All public companies in the United States are required to report total return to share- holders annually in the statements they file with the Securities and Exchange Commission (SEC). In addition, companies must also provide benchmarks, usually one comparison to the industry average and another to a broader market index that is relevant for more diversi- fied firms.17 Since competitive advantage is defined in relative terms, these benchmarks allow us to assess whether a firm has a competitive advantage. In its annual reports, Micro- soft, for example, compares its performance to two stock indices: the NASDAQ computer index and the S&P 500. The computer index includes over 400 high-tech companies traded on the NASDAQ, including Apple, Adobe, Google, Intel, and Oracle. It provides a com- parison of Microsoft to the computer industry—broadly defined. The S&P 500 offers a comparison to the wider stock market beyond the computer industry. In its 2016 annual report, Microsoft shows that it outperformed both the NASDAQ computer index and the S&P 500 over the last year, while performing roughly at the same levels in previous years.

Effective strategies to grow the business can increase a firm’s profitability and thus its stock price.18 Indeed, investors and Wall Street analysts expect continuous growth. A firm’s stock price generally increases only if the firm’s rate of growth exceeds investors’ expecta- tions. This is because investors discount into the present value of the firm’s stock price what- ever growth rate they foresee in the future. If a low-growth business like Comcast (in cable TV) is expected to grow 2 percent each year but realizes 4 percent growth, its stock price will appreciate. In contrast, if a fast-growing business like Apple in mobile computing is expected to grow by 10 percent annually but delivers “only” 8 percent growth, its stock price will fall.

Investors also adjust their expectations over time. Since the business in the slow-growth industry surprised them by delivering higher than expected growth, they adjust their expec- tations upward. The next year, they expect this firm to again deliver 4 percent growth. On the other hand, if the industry average is 10 percent a year in the high-tech business, the firm that delivered 8 percent growth will again be expected to deliver at least the industry average growth rate; otherwise, its stock will be further discounted.

LO 5-2

Apply shareholder value creation to assess and evaluate competitive advantage.

shareholders Individu- als or organizations that own one or more shares of stock in a public company.

risk capital The money provided by sharehold- ers in exchange for an equity share in a company; it cannot be recovered if the firm goes bankrupt.

total return to share- holders Return on risk capital that includes stock price appreciation plus dividends received over a specific period.

market capitalization A firm performance metric that captures the total dollar market value of a company’s total out- standing shares at any given point in time.

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In ChapterCase 5, we noted that Apple was the most valuable company on the planet. In 2017, Apple’s market cap was over $750 billion. Consistent with the notion that a firm’s market capitalization reflects its future growth expectations, the next four largest compa- nies are all tech companies: Alphabet ($580 billion), Microsoft ($500 billion), Amazon. com ($430 billion), and Facebook ($400 billion).

Considering stock market valuations (Share price × Number of outstanding shares) over the long term provides a useful metric to assess competitive advantage. Exhibit 5.3 shows the stock market valuations for Apple and Microsoft from 1990 until 2017. Micro- soft was once the most valuable company worldwide (in December 1999 with close to $600 billion in market cap), but its market valuation dropped in the following decade. The valuation declined because Microsoft struggled with the transition from desktop to mobile and cloud-based computing. CEO Satya Nadella vows to move Microsoft away from its Windows-only business model to compete more effectively in a “mobile first, cloud first world.”19 It appears that Nadella’s strategic initiative is bearing fruit as investors appear to be pleased with how well Microsoft is performing in future growth areas such as cloud computing. With its Azure offering, Microsoft holds a strong position just after Amazon’s AWS but way ahead of Google’s cloud, the number-three contender in this space. Since a low of about $220 billion in early 2013, Microsoft’s market cap more than doubled to over $500 billion by 2017. Nonetheless, Microsoft remains below Apple, as Exhibit 5.3 shows using market cap as its metric. But Microsoft is catching up—so stay tuned! This shows again that it is difficult to gain a competitive advantage and even harder to sustain it over a prolonged period of time. Competitive advantage is transitory!

LIMITATIONS OF SHAREHOLDER VALUE CREATION. Although measuring firm perfor- mance through total return to shareholders and firm market capitalization has many advan- tages, just as with accounting profitability, it has its shortcomings:

■ Stock prices can be highly volatile, making it difficult to assess firm performance, particularly in the short term. This volatility implies that total return to shareholders is a better measure of firm performance and competitive advantage over the long term

EXHIBIT 5.3 / Stock Market Valuations of Apple and Microsoft (in $ billion), 1990–2017

$750

M ar

ke t C

ap ita

liz at

io n

$650

$550

$450

$350

$250

$150

$50

20152010200520001995

AppleMicrosoft

Microsoft's competitive advantage over Apple

Apple's competitive advantage

over Microsoft

$752.04

$507.54

SOURCE: Depiction of publicly available data.

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(as shown in Exhibit 5.3), because of the “noise” introduced by market volatility, exter- nal factors, and investor sentiment.

■ Overall macroeconomic factors such as economic growth or contraction, the unem- ployment rate, and interest and exchange rates all have a direct bearing on stock prices. It can be difficult to ascertain the extent to which a stock price is influenced more by external macroeconomic factors (as discussed in Chapter 3) than by the firm’s strategy (see also Exhibit 3.2 highlighting firm, industry, and other effects in overall firm performance).

■ Stock prices frequently reflect the psychological mood of investors, which can at times be irrational. Stock prices can overshoot expectations based on economic fundamentals amid periods like the internet boom, during which former Federal Reserve Chairman Alan Greenspan famously described investors’ buoyant sentiments as “irrational exu- berance.”20 Similarly, stock prices can undershoot expectations during busts like the 2008–2009 global financial crisis, during which investors’ sentiment was described as “irrational gloom.”21

ECONOMIC VALUE CREATION The relationship between economic value creation and competitive advantage is funda- mental in strategic management. It provides the foundation upon which to formulate a firm’s competitive strategy for cost leadership or differentiation (discussed in detail in Chapter 6). For now, it is important to note that a firm has a competitive advantage when it creates more economic value than rival firms. What does that mean?

Economic value created is the difference between a buyer’s willingness to pay for a product or service and the firm’s total cost to produce it. Let’s assume you consider buy- ing a laptop computer and you have a budget of $1,200. You have narrowed your search to two models, one offered by Firm A, the other by Firm B. Your subjective assessment of the benefits derived from owning Firm A’s laptop is $1,000—this is the absolute maxi- mum you’d be willing to pay for it, or the reservation price. For example, this could be a more or less generic, run-of-the-mill Dell laptop. In contrast, you value Firm B’s laptop model at $1,200 because it has somewhat higher performance, is more user-friendly, and definitely has a higher “coolness factor.” Think of Apple’s MacBook Pro with Retina Dis- play. Given that you value Firm B’s laptop by $200 more than Firm A’s model, you will purchase a laptop from Firm B (and, in this case, end up paying as much as your reserva- tion price allows).

Let’s move now from your individual considerations to the overall market for laptop computers in order to derive implications for firm-level competitive advantage. To simplify this illustration, only Firm A and Firm B are competing in the market for laptops. Assum- ing that both Firm A and Firm B have the same total unit cost of producing the particular laptop models under consideration ($400) and the market at large has preferences similar to yours, then Firm B will have a competitive advantage. This is because Firm B creates more economic value than Firm A (by $200), but has the same total cost, depicted in Exhibit 5.4. The amount of total perceived consumer benefits equals the maximum willingness to pay, or the reservation price. This amount is then split into economic value creation and the firm’s total unit cost. Firm A and Firm B have identical total unit cost, $400 per laptop. However, Firm B’s laptop (e.g., Apple’s MacBook Pro) is perceived to provide more util- ity than Firm A’s laptop (e.g., Dell’s generic laptop), which implies that Firm B creates more economic value ($1,200 – $400 = $800) than Firm A ($1,000 – $400 = $600). Taken together, Firm B has a competitive advantage over Firm A because Firm B creates more economic value. This is because Firm B’s offering has greater total perceived consumer

LO 5-3

Explain economic value creation and different sources of competitive advantage.

economic value created Difference between value (V ) and cost (C), or (V − C).

reservation price The maximum price a consumer is willing to pay for a product or ser- vice based on the total perceived consumer benefits.

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EXHIBIT 5.4 / Firm B’s Competitive Advantage: Same Cost as Firm A but Firm B Creates More Economic Value

$1,000

Economic Value Created

$600

Total Perceived Consumer Benefits

=

=

=

Maximum Willingness

to Pay

Reservation Price

Reservation Price

$400 Cost $400

Firm A

$1,200

Total Perceived Consumer Benefits

$1,000 Economic

Value Created $800

=

=

=

Maximum Willingness

to Pay $400

Cost $400

$200

Firm B

Firm B

Competitive Advantage

$1,000 $1,200

EXHIBIT 5.5 / Firm C’s Competitive Advantage: Same Total Perceived Consumer Benefits as Firm D but Firm C Creates More Economic Value

$1,200

Economic Value Created

$600

$600

Cost $600

$300

Firm D

Firm C

Competitive Advantage

$1,200$1,200

Total Perceived Consumer Benefits

Economic Value Created

$900

=

=

=

Maximum Willingness

to Pay

Reservation Price

$1,200

Total Perceived Consumer Benefits

=

=

=

Maximum Willingness

to Pay

Reservation Price

$600

$300 Cost $300

Firm C

benefits than Firm A’s, while the firms have the same total cost. In short, Firm B’s advan- tage is based on superior differentiation leading to higher perceived value. Further, the competitive advantage can be quantified: It is $200 (or, $1,200 – $1,000) per laptop sold for Firm B over Firm A (see Exhibit 5.4).

Exhibit 5.4 shows that Firm B’s competitive advantage is based on greater economic value creation because of superior product differentiation. In addition, a firm can achieve competitive advantage through a second avenue. In particular, competitive advantage can also result from a relative cost advantage over rivals, assuming both firms can create the same total perceived consumer benefits.

As shown in Exhibit 5.5, two different laptop makers each offer a model that has the same perceived consumer benefits ($1,200). Firm C, however, creates greater economic

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value ($900, or $1,200 – $300) than that of Firm D ($600, or $1,200 – $600). This is because Firm C’s total unit cost ($300) is lower than Firm D’s ($600). Firm C has a relative cost advantage over Firm D, while both products provide identical total perceived con- sumer benefits ($1,200). In this example, Firm C could be Lenovo with lower cost struc- ture than Firm D, which could be HP, but both firms offer the same value. As Exhibit 5.5 shows, Firm C has a competitive advantage over Firm D because it has lower costs. Firm C’s competitive advantage over Firm D is in the amount of $300 for each laptop sold. Here, the source of the competitive advantage is a relative cost advantage over its rival.

So far we have looked at situations in which products are priced at the maximum a con- sumer might be willing to pay. But markets generally don’t work like that. More often, the economic value created is shared among the producer and the consumer. That is, most of the time consumers are able to purchase the product at a price point below the maximum they are willing to spend. Both the seller and the buyer benefit.

For ease in calculating competitive advantage, three components are needed. These will help us to further explain total perceived consumer benefits and economic value created in more detail:

1. Value (V) 2. Price (P) 3. Cost (C)

Value denotes the dollar amount (V) a consumer attaches to a good or service. Value captures a consumer’s willingness to pay and is determined by the perceived benefits a good or service provides to the buyer. The cost (C) to produce the good or service matters little to the consumer, but it matters a great deal to the producer (supplier) of the good or service since it has a direct bearing on the profit margin.

Let’s return to our laptop example from Exhibit 5.4, in which two firms sold their lap- tops at different prices ($1,000 for Firm A and $1,200 for Firm B), even though the costs were the same ($400). In each case, the price matched the consumer’s maximum willing- ness to pay for the particular offering. Subtracting the costs, we found that Firm A created an economic value of $600 while Firm B created an economic value of $800, thus achiev- ing a competitive advantage. In most market transactions, however, some of the economic value created benefits the consumer as well.

Again, let’s revisit the example depicted in Exhibit 5.4. The consumer’s preference was to buy the laptop from Firm B, which she would have done because it matched her reser- vation price. Let’s assume Firm B’s laptop is actually on sale for $1,000 (everything else remains constant). Assume the consumer again chose to purchase the laptop of Firm B rather than the one offered by Firm A (which she considered inferior). In this case, some of the economic value created by Firm B goes to the consumer. On a formula basis, total perceived value of Firm B’s laptop ($1,200) splits into economic value created (V – C = $800) plus total unit cost (C = $400), or: V = (V – C) + C.

The difference between the price charged (P) and the cost to produce (C) is the profit, or producer surplus. In the laptop example in Exhibit 5.6, if the price charged is $1,000, the profit is P − C = $1,000 − $400 = $600. The firm captures this amount as profit per unit sold. As the consumer, you capture the difference between what you would have been willing to pay (V) and what you paid (P), called consumer surplus. In our example, the consumer surplus is V − P = $1,200 − $1,000, or $200. Economic value creation there- fore equals consumer surplus plus firm profit, or (V − C) = (V − P) + (P − C). In the laptop example:

Economic value created ($1,200 − $400) = Consumer surplus ($1,200 − $1,000) + Producer surplus ($1,000 − $400) = $200 + $600 = $800.

value The dollar amount (V) a consumer attaches to a good or service; the consumer’s maximum willingness to pay; also called reservation price.

profit Difference between price charged (P) and the cost to pro- duce (C), or (P − C); also called producer surplus.

producer surplus Another term for profit, the difference between price charged (P) and the cost to produce (C), or (P − C); also called profit.

consumer surplus Difference between the value a consumer attaches to a good or service (V) and what he or she paid for it (P), or (V − P).

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The relationship between consumer and producer surplus is the reason trade happens: Both transacting parties capture some of the overall value created. Note, though, that the distribution of the value created between parties need not be equal to make trade worthwhile. In the exam- ple illustrated in Exhibit 5.6, the consumer surplus is $200, while profit per unit sold is $600.

In some cases, where firms offer highly innovative products or services, the relation- ship can be even more skewed. The entry-level model of the Apple Watch retailed for $349, when introduced in 2015. And it sold well, selling twice as many watches as iPhones in each device’s first year.22 An analysis by an independent engineering team, however, revealed that the firm’s total cost in terms of materials and labor for the Apple Watch is no more than $84.23 Thus, Apple’s profit for each watch sold is an estimated $265, with a profit margin of 315 percent.

The economic value creation framework shows that strategy is about

1. Creating economic value. 2. Capturing as much of it as possible.

In contrast to Apple, consider Amazon as a counterexample: It is creating a large amount of value for its customers, but it is not capturing much, if any, of it (at this point). Amazon has had several years of negative net income as it attempts to build a stronger position in a variety of businesses. With its online retail business, Amazon.com is creating significant value for its customers (especially its Prime members) as well as third-party sellers that use its platform, but Amazon is comfortable in taking minor or no profit in doing so. Its cloud-computing service, Amazon Web Services (AWS), moreover, is also creating tremendous value for the businesses that run their computing needs on AWS, businesses including Airbnb, Comcast, Foursquare, NASA, and even the CIA (and formerly WikiLeaks), but Amazon’s “profit” margin is a nega- tive 1 to 2 percent. In fact, Amazon’s comfort level appears to bear on its acquisition of Whole Foods. Even at the high end, the grocery industry has thin margins. Before Amazon acquired it, Whole Foods had been under stockholder pressure to increase margins by lowering costs for better shareholder returns. Now Whole Foods under Amazon becomes the grocery indus- try’s worst nightmare: It can deliver negative margins and still stockholders applaud. Even if Amazon had no plans to reap synergies between in-store and online tactics, now Whole Foods becomes supercompetitive with its potential ability to lower prices.24 Indeed, on its first day after closing the acquisition of Whole Foods, Amazon dropped prices at its new grocery chain by more than 30 percent on more than 100 grocery staples.

EXHIBIT 5.6 / The Role of Consumer Surplus and Producer Surplus (Profit) $1,200Consumer Surplus

$200

Producer Surplus or Profit

=$600

$1,000

$400

Price =$1,000

Firm B

$1,200

$1,000 Economic

Value Created $200 + $600

=$800

$400 Cost =$400

Cost =$400

Firm B

Total Perceived Consumer Benefits

=

=

=

Maximum Willingness

to Pay

Reservation Price

$1,200

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In this case, Amazon’s customers are capturing the value that Amazon is creating. Jeff Bezos, Amazon CEO, however, is focused on long-term performance rather than short- term profitability. Amazon’s investors don’t seem to mind Bezos’ long-term orientation, because Amazon’s some $430 billion in market cap makes it the fourth most valuable company on the planet.

Exhibit 5.7 illustrates how the components of economic value creation fit together con- ceptually. On the left side of the exhibit, V represents the total perceived consumer ben- efits, as captured in the consumer’s maximum willingness to pay. In the lower part of the center bar, C is the cost to produce the product or service (the unit cost). It follows that the difference between the consumers’ maximum willingness to pay and the firm’s cost (V − C) is the economic value created. The price of the product or service (P) is indicated in the dashed line. The economic value created (V − C), as shown in Exhibit 5.7, is split between producer and consumer: (V − P) is the value the consumer captures (consumer surplus), and (P − C) is the value the producer captures (producer surplus, or profit).

Competitive advantage goes to the firm that achieves the largest economic value cre- ated, which is the difference between V, the consumer’s willingness to pay, and C, the cost to produce the good or service. The reason is that a large difference between V and C gives the firm two distinct pricing options: (1) It can charge higher prices to reflect the higher value and thus increase its profitability, or (2) it can charge the same price as competitors and thus gain market share. Given this, the strategic objective is to maximize V − C, or the economic value created.

Applying the notion of economic value creation also has direct implications for firm financial performance. Revenues are a function of the value created for consumers and the price of the good or service, which together drive the volume of goods sold. In this per- spective, profit (Π) is defined as total revenues (TR) minus total costs (TC):

Π = TR − TC, where TR = P × Q, or price times quantity sold

Total costs include both fixed and variable costs. Fixed costs are independent of con- sumer demand—for example, the cost of capital to build computer manufacturing plants

EXHIBIT 5.7 / Competitive Advantage and Economic Value Created: The Role of Value, Cost, and Price

(V – P ) =

Consumer Surplus

(P – C ) =

Firm’s Profit=

V =

Total Perceived Consumer Benefits

Consumer’s Maximum

Willingness to Pay

=

Reservation Price

P = Price

(V – C ) =

Economic Value

Created

C

Firm’s Cost

= C

Firm’s Cost

=

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or an online retail presence to take direct orders. Variable costs change with the level of consumer demand—for instance, components such as different types of display screens, microprocessors, hard drives, and keyboards.

Rather than merely relying on historical costs, as done when taking the perspective of accounting profitability (introduced earlier), in the economic value creation perspective, all costs, including opportunity costs, must be considered. Opportunity costs capture the value of the best forgone alternative use of the resources employed.

An entrepreneur, for example, faces two types of opportunity costs: (1) forgone wages she could be earning if she was employed elsewhere and (2) the cost of capital she invested in her business, which could instead be invested in, say, the stock market or U.S. Trea- sury bonds. At the end of the year, the entrepreneur considers her business over the last 12 months. She made an accounting profit of $70,000, calculated as total revenues minus expenses, which include all historical costs but not opportunity costs. But she also real- izes she has forgone $60,000 in salary she could have earned as an employee at another firm. In addition, she knows she could have earned $15,000 in interest if she had bought U.S. Treasury bills with a 2 percent return instead of investing $750,000 in her business. The opportunity cost of being an entrepreneur was $75,000 ($60,000 + $15,000). There- fore, when considering all costs, including opportunity costs, she actually experienced an economic loss of $5,000 ($75,000 − $70,000). When considering her future options, she should stay in business only if she values her independence as an entrepreneur more than $5,000 per year, or thinks business will be better next year.

LIMITATIONS OF ECONOMIC VALUE CREATION. As with any tool to assess competitive advantage, the economic value creation framework also has some limitations:

■ Determining the value of a good in the eyes of consumers is not a simple task. One way to tackle this problem is to look at consumers’ purchasing habits for their revealed preferences, which indicate how much each consumer is willing to pay for a product or service. In the earlier example, the value (V) you placed on the laptop—the highest price you were willing to pay, or your reservation price—was $1,200. If the firm is able to charge the reservation price (P = $1,200), it cap- tures all the economic value created (V – C = $800) as producer surplus or profit (P – C = $800).

■ The value of a good in the eyes of consumers changes based on income, preferences, time, and other factors. If your income is high, you are likely to place a higher value on some goods (e.g., business-class air travel) and a lower value on other goods (e.g., Greyhound bus travel). In regard to preferences, you may place a higher value on a ticket for a Lady Gaga concert than on one for the New York Philharmonic (or vice versa). As an example of time value, you place a higher value on an airline ticket that will get you to an important business meeting tomorrow than on one for a planned trip to take place eight weeks from now.

■ To measure firm-level competitive advantage, we must estimate the economic value created for all products and services offered by the firm. This estimation may be a relatively easy task if the firm offers only a few products or services. However, it becomes much more complicated for diversified firms such as General Electric or the Tata Group that may offer hundreds or even thousands of different products and ser- vices across many industries and geographies. Although the performance of individual strategic business units (SBUs) can be assessed along the dimensions described here, it becomes more difficult to make this assessment at the corporate level (more on this in our discussion of diversification strategy in Chapter 8).

opportunity costs The value of the best forgone alternative use of the resources employed.

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The economic value creation perspective gives us one useful way to assess competi- tive advantage. This approach is conceptually quite powerful, and it lies at the center of many strategic management frameworks such as the generic business strategies (which we discuss in the next chapter). However, it falls somewhat short when managers are called upon to operationalize competitive advantage. When the need for “hard numbers” arises, managers and analysts frequently rely on firm financials such as accounting profitability or shareholder value creation to measure firm performance.

We’ve now completed our consideration of the three standard dimensions for measur- ing competitive advantage—accounting profitability, shareholder value, and economic value. Although each provides unique insights for assessing competitive advantage, one drawback is that they are more or less one-dimensional metrics. Focusing on just one per- formance metric when assessing competitive advantage, however, can lead to significant problems, because each metric has its shortcomings, as listed earlier. We now turn to two more conceptual and qualitative frameworks—the balanced scorecard and the triple bot- tom line—that attempt to provide a more holistic perspective on firm performance.

THE BALANCED SCORECARD Just as airplane pilots rely on a number of instruments to provide constant information about key variables—such as altitude, airspeed, fuel, position of other aircraft in the vicin- ity, and destination—to ensure a safe flight, so should managers rely on multiple yardsticks to more accurately assess company performance in an integrative way. The balanced scorecard is a framework to help managers achieve their strategic objectives more effec- tively.25 This approach harnesses multiple internal and external performance metrics in order to balance both financial and strategic goals.

Exhibit 5.8 depicts the balanced-scorecard framework. Managers using the balanced score- card develop appropriate metrics to assess strategic objectives by answering four key ques- tions.26 Brainstorming answers to these questions ideally results in measures that give managers a quick but also comprehensive view of the firm’s current state. The four key questions are: 1. How do customers view us? The customer’s perspective concerning the company’s

products and services links directly to its revenues and profits. Consumers decide their reservation price for a product or service based on how they view it. If the customer views the company’s offer- ing favorably, she is willing to pay more for it, enhancing its competitive advan- tage (assuming production costs are well below the asking price). Managers track customer perception to identify areas to improve, with a focus on speed, quality, service, and cost. In the air-express indus- try, for example, managers learned from their customers that many don’t really need next-day delivery for most of their documents and packages; rather what they really cared about was the ability to track the shipments. This discovery led to the development of steeply discounted second-day delivery by UPS and FedEx, combined with sophisticated real-time tracking tools online.

LO 5-4

Apply a balanced scorecard to assess and evaluate competitive advantage.

balanced scorecard Strategy implementa- tion tool that harnesses multiple internal and external performance metrics in order to balance financial and strategic goals.

EXHIBIT 5.8 / Balanced-Scorecard Approach to Creating and Sustaining Competitive Advantage

How do shareholders view us?

Ho w

do c

us to

me rs

vi ew

u s?

How do we create value?

COMPETITIVE ADVANTAGE

W ha

t c or

e co

mp et

en ci

es d

o we

n ee

d?

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2. How do we create value? Answering this question challenges managers to develop strategic objectives that ensure future competitiveness, innovation, and organizational learning. The answer focuses on the business processes and structures that allow a firm to create economic value. One useful metric is the percentage of revenues obtained from new-product introductions. For example, 3M requires that 30 percent of revenues must come from products introduced within the past four years.27 A second metric, aimed at assessing a firm’s external learning and collaboration capability, is to stipu- late that a certain percentage of new products must originate from outside the firm’s boundaries.28 Through its Connect + Develop program, the consumer products com- pany Procter & Gamble has raised the percentage of new products that originated (at least partly) from outside P&G, from 15 to 35 percent.29

3. What core competencies do we need? This question focuses managers internally, to identify the core competencies needed to achieve their objectives and the accompany- ing business processes that support, hone, and leverage those competencies. As men- tioned in Chapter 4, Honda’s core competency is to design and manufacture small but powerful and highly reliable engines. Its business model is to find places to put its engines. Beginning with motorcycles in 1948, Honda nurtured this core competency over many decades and is leveraging it to reach stretch goals in the design, develop- ment, and manufacture of small airplanes.

Today, consumers still value reliable, gas-powered engines made by Honda. If con- sumers start to value electric motors more because of zero emissions, lower mainte- nance costs, and higher performance metrics, among other possible reasons, the value of Honda’s engine competency will decrease. If this happens, then Tesla’s core com- petency in designing and building high-powered battery packs and electric drivetrains will become more valuable. In turn, Tesla (featured in ChapterCase 1) might then be able to leverage this core competency into a strong strategic position in the emerging all-electric car and mobility industry.

4. How do shareholders view us? The final perspective in the balanced scorecard is the shareholders’ view of financial performance (as discussed in the prior section). Some of the measures in this area rely on accounting data such as cash flow, operat- ing income, ROIC, ROE, and, of course, total returns to shareholders. Understand- ing the shareholders’ view of value creation leads managers to a more future-oriented evaluation.

By relying on both an internal and an external view of the firm, the balanced scorecard combines the strengths provided by the individual approaches to assessing competitive advantage discussed earlier: accounting profitability, shareholder value creation, and eco- nomic value creation.

ADVANTAGES OF THE BALANCED SCORECARD. The balanced-scorecard approach is popular in managerial practice because it has several advantages. In particular, the bal- anced scorecard allows managers to:

■ Communicate and link the strategic vision to responsible parties within the organization. ■ Translate the vision into measurable operational goals. ■ Design and plan business processes. ■ Implement feedback and organizational learning to modify and adapt strategic goals

when indicated.

The balanced scorecard can accommodate both short- and long-term performance met- rics. It provides a concise report that tracks chosen metrics and measures and compares them

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to target values. This approach allows managers to assess past performance, identify areas for improvement, and position the company for future growth. Including a broader perspec- tive than financials allows managers and executives a more balanced view of organizational performance—hence its name. In a sense, the balanced scorecard is a broad diagnostic tool. It complements the common financial metrics with operational measures on customer satis- faction, internal processes, and the company’s innovation and improvement activities.

As an example of how to implement the balanced-scorecard approach, let’s look at FMC Corp., a chemical manufacturer employing some 5,000 people in different SBUs and earn- ing over $3 billion in annual revenues.30 To achieve its vision of becoming “the customer’s most valued supplier,” FMC’s managers initially had focused solely on financial metrics such as return on invested capital (ROIC) as performance measures. FMC is a multibusi- ness corporation with several standalone profit-and-loss strategic business units; its overall performance was the result of both over- and underperforming units. FMC’s managers had tried several approaches to enhance performance, but they turned out to be ineffective. Per- haps even more significant, short-term thinking by general managers was a major obstacle in the attempt to implement an effective business strategy.

Searching for improved performance, FMC’s CEO decided to adopt a balanced- scorecard approach. It enabled the managers to view FMC’s challenges and shortcomings from a holistic, company perspective, which was especially helpful to the general manag- ers of different business units. In particular, the balanced scorecard allowed general man- agers to focus on market position, customer service, and product introductions that could generate long-term value. Using the framework depicted in Exhibit 5.7, general managers had to answer tough follow-up questions such as: How do we become the customer’s most valued supplier, and how can my division create this value for the customer? How do we become more externally focused? What are my division’s core competencies and contribu- tions to the company goals? What are my division’s weaknesses?

Implementing a balanced scorecard allowed FMC’s managers to align their different perspectives to create a more focused corporation overall. General managers now review progress along the chosen metrics every month, and corporate executives do so on a quarterly basis. Implementing a balanced-scorecard approach is not a onetime effort, but requires continuous tracking of metrics and updating of strategic objectives, if needed. It is a continuous process, feeding performance back into the strategy process to assess its effectiveness (see Chapter 2).

DISADVANTAGES OF THE BALANCED SCORECARD. Though widely implemented by many businesses, the balanced scorecard is not without its critics.31 It is important to note that the balanced scorecard is a tool for strategy implementation, not for strategy formula- tion. It is up to a firm’s managers to formulate a strategy that will enhance the chances of gaining and sustaining a competitive advantage. In addition, the balanced-scorecard approach provides only limited guidance about which metrics to choose. Different situ- ations call for different metrics. All of the three approaches to measuring competitive advantage—accounting profitability, shareholder value creation, and economic value creation—in addition to other quantitative and qualitative measures can be helpful when using a balanced-scorecard approach.

When implementing a balanced scorecard, managers need to be aware that a failure to achieve competitive advantage is not so much a reflection of a poor framework but of a strategic failure. The balanced scorecard is only as good as the skills of the managers who use it: They first must devise a strategy that enhances the odds of achieving competitive advantage. Second, they must accurately translate the strategy into objectives that they can measure and manage within the balanced-scorecard approach.32

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Once the metrics have been selected, the balanced scorecard tracks chosen metrics and measures and compares them to target values. It does not, however, provide much insight into how metrics that deviate from the set goals can be put back on track.33

THE TRIPLE BOTTOM LINE Today, managers are frequently asked to maintain and improve not only the firm’s eco- nomic performance but also its social and ecological performance. CEO Indra Nooyi responded by declaring PepsiCo’s vision to be Performance with Purpose defined by goals in the social dimension (human sustainability to combat obesity by making its prod- ucts healthier, and the whole person at work to achieve work/life balance) and ecological dimension (environmental sustainability in regard to clean water, energy, recycling, and so on), in addition to firm financial performance.

Being proactive along noneconomic dimensions can make good business sense. In anticipation of coming industry requirements for “extended producer responsibility,” which requires the seller of a product to take it back for recycling at the end of its life, the German carmaker BMW was proactive. It not only lined up the leading car-recycling companies but also started to redesign its cars using a modular approach. The modular parts allow for quick car disassembly and reuse of components in the after-sales market (so-called refurbished or rebuilt auto parts).34 Three dimensions—economic, social, and ecological—make up the triple bottom line, which is fundamental to a sustainable strat- egy. These three dimensions are also called the three Ps: profits, people, and planet:

■ Profits. The economic dimension captures the necessity of businesses to be profitable to survive.

■ People. The social dimension emphasizes the people aspect, such as PepsiCo’s initia- tive of the whole person at work.

■ Planet. The ecological dimension emphasizes the relationship between business and the natural environment.

As the intersection of the three ovals (profits, people, and planet) in Exhibit 5.9 suggests, achieving positive results in all three areas can lead to a sustainable strategy. Rather than emphasizing sustaining a competitive advantage over time, sustainable strategy means

a strategy that can be pursued over time without detri- mental effects on people or the planet. Using renewable energy sources such as wind or solar power, for example, is sustainable over time. It can also be good for profits, or simply put “green is green,” as Jeffrey Immelt was fond of saying before retiring in 2017 as CEO at GE. GE’s renewable energy business brought in more than $9 bil- lion in revenues in 2016 (up from $3 billion in 2006).35

Like the balanced scorecard, the triple bottom line takes a more integrative and holistic view in assessing a company’s performance.36 Using a triple-bottom-line approach, managers audit their company’s fulfillment of its social and ecological obligations to stakeholders such as employees, customers, suppliers, and communi- ties as conscientiously as they track its financial perfor- mance.37 In this sense, the triple-bottom-line framework is related to stakeholder theory, an approach to under- standing a firm as embedded in a network of internal and external constituencies that each make contributions and

LO 5-5

Apply a triple bottom line to assess and evaluate competitive advantage.

Planet Profits

People

SUSTAINABLE STRATEGY

EXHIBIT 5.9 / Sustainable Strategy: A Focus on the Triple Bottom Line

The simultaneous pursuit of performance along social, economic, and ecological dimensions provides a basis for a triple-bottom-line strategy.

triple bottom line Combination of eco- nomic, social, and ecological concerns— or profits, people, and planet—that can lead to a sustainable strategy.

sustainable strategy A strategy along the economic, social, and ecological dimensions that can be pursued over time without detri- mental effects on people or the planet.

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Interface: The World’s First Sustainable Company The Atlanta-based Interface Inc. is the world’s largest manu- facturer of modular carpet with annual sales of roughly $1 billion. What makes the company unique is its strategic intent to become the world’s first fully sustainable company. In 1994, founder Ray Anderson set a goal for the company to be “off oil” entirely by 2020. That included not using any petroleum-based raw materials or oil-related energy to fuel the manufacturing plants.

According to Collins and Porras in Built to Last, their classic study of high-performing companies over long peri- ods of time, this is an example of a “BHAG—a big hairy auda- cious goal.” BHAGs are bold missions declared by visionary companies and are a “powerful mechanism to stimulate prog- ress.”38 Weaning Interface off oil by 2020 is indeed a BHAG. Many see the carpet industry as an extension of the petro- chemical industry, given its heavy reliance on fossil fuels and chemicals in the manufacturing, shipping, and installation of its products.

Today, Interface is not only the global leader in modular carpet but also in sustainability. It offers innovative products such as its Cool Carpet, the world’s first carbon-neutral floor

covering. Interface’s customers reward it with a willingness to pay a higher price for its environmentally friendly prod- ucts. The company estimates that between 1996 and 2008, it saved over $400 million due to its energy efficiency and use of recycled materials. 

Interface’s business model is changing the carpet indus- try. Speaking of sustainability as a business model, Anderson concluded:

Sustainability has given my company a competitive edge in more ways than one. It has proven to be the most powerful marketplace differentiator I have known in my long career. Our costs are down, our profits are up, and our products are the best they have ever been. Sustainable design has provided an unexpected wellspring of innovation, people are galva- nized around a shared higher purpose, better people are applying, the best people are staying and working with a purpose, the goodwill in the marketplace gener- ated by our focus on sustainability far exceeds that which any amount of advertising or marketing expen- diture could have generated—this company believes it has found a better way to a bigger and more legiti- mate profit—a better business model.39

Strategy Highlight 5.1

expect consideration in return (see the discussion in Chapter 2). For an example of how Interface, a global leader in the carpet industry, uses a triple-bottom-line approach to gain and sustain a competitive advantage, read Strategy Highlight 5.1.

5.2 Business Models: Putting Strategy into Action Strategy is a set of goal-directed actions a firm takes to gain and sustain superior per- formance relative to competitors or the industry average. The translation of strategy into action takes place in the firm’s business model, which details the firm’s competitive tac- tics and initiatives. Simply put, the firm’s business model explains how the firm intends to make money. The business model stipulates how the firm conducts its business with its buyers, suppliers, and partners.40

How companies do business can sometimes be as important, if not more so, to gain- ing and sustaining competitive advantage as what they do. Indeed, a slight majority (54 percent) of senior executives responded to a recent survey stating that they consider business model innovation to be more important than process or product innovation.41 This is because product and process innovation is often more costly, is higher risk, and takes longer to come up with in the first place and to then implement. Moreover, business model innovation is often an area that is overlooked in a firm’s quest for competitive advantage,

LO 5-6

Use the why, what, who, and how of business models framework to put strategy into action.

business model Stipu- lates how the firm con- ducts its business with its buyers, suppliers, and partners in order to make money.

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Threadless: Leveraging Crowdsourcing to Design Cool T-Shirts

Threadless, an online design community and apparel store (www.threadless.com), was founded in 2000 by two students with $1,000 as start-up capital. Jake Nickell was then at the Illinois Institute of Art and Jacob DeHart at Purdue Univer- sity. After Nickell had won an online T-shirt design contest, the two entrepreneurs came up with a business model to leverage user-generated content. The idea is to let consum- ers “work for you” and turn consumers into prosumers, a hybrid between producers and consumers.

Members of the Threadless community, which is some 3 million strong, do most of the work, which they consider fun: They submit T-shirt designs online, and community mem- bers vote on which designs they like best. The designs receiv- ing the most votes are put in production, printed, and sold online. Each Monday, Threadless releases 10 new designs and reprints more T-shirts throughout the week as inventory

is cleared out. The cost of Threadless T-shirts is a bit higher than that of competitors, about $25.

Threadless leverages crowdsourcing, a process in which a group of people voluntarily perform tasks that were tradi- tionally completed by a firm’s employees. Rather than doing the work in-house, Threadless outsources its T-shirt design to its website community. The concept of leveraging a firm’s own customers via internet-enabled technology to help pro- duce better products is explicitly included in the Threadless business model. In particular, Threadless is leveraging the wisdom of the crowds, where the resulting decisions by many participants in the online forum are often better than deci- sions that could have been made by a single individual. To more effectively leverage this idea, the crowds need to be large and diverse.

At Threadless, the customers play a critical role across the entire value chain, from idea generation to design, mar- keting, sales forecasting, and distribution. The Threadless business model translates real-time market research and design contests into quick sales. Threadless produces only T-shirts that were approved by its community. Moreover, it has a good understanding of market demand because it knows the number of people who participated in each design contest. In addition, when scoring each T-shirt design in a contest, Threadless users have the option to check “I’d buy it.” These features give the Threadless community a voice in T-shirt design and also coax community members into mak- ing a purchasing commitment. Threadless does not make any significant investments until the design and market size are determined, minimizing its downside.

Not surprisingly, Threadless has sold every T-shirt that it has printed. Moreover, it has a cult-like following and is outper- forming established companies American Eagle, Old Navy, and Urban Outfitters with their more formulaic T-shirt designs.42

Strategy Highlight 5.2

Jacob DeHart, Jake Nickell, and Jeffrey Kalmikoff created Threadless, an

online company that sells millions of dollars’ worth of T-shirts annually.

©Rene Johnston/Getty Images

and thus much value can be unlocked by focusing on business model innovation. Strategy Highlight 5.2 takes a closer look at how the online startup Threadless uses business model innovation to gain a competitive advantage in the highly competitive apparel industry.

Perhaps most important, a firm’s competitive advantage based on product innovation, such as Apple’s iPhone, is less likely to be made obsolete if embedded within a business model innovation such as Apple’s ecosystem of services that make users less likely to leave Apple for a competing product, even if a competitor’s smartphone by itself is a better one. Indeed, Apple counts more than 530 million iPhone users embedded within its ecosys- tem made up of many different products and services including iTunes, iOS, App Store,

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iCloud, Apple Pay, and so on. Rather than a substitute, business model innovation com- plements product and service innovation, and with it, raises the barriers to imitation. This in turn allows a firm that successfully combines product and business model innovation to extend its competitive advantage, as Apple has done for over a decade since the intro- duction of the iPod and iTunes business model in 2001. This radical business innovation allowed Apple to link music producers to consumers, and benefit from each transaction. Apple extended its locus of innovation from mere product innovation to how it conducts its business. That is, Apple provided a two-sided platform for exchange between producers and consumers to take place (see discussion in Chapter 7 on platform strategy for more details).

THE WHY, WHAT, WHO, AND HOW OF BUSINESS MODELS FRAMEWORK To come up with an effective business model, a firm’s managers need to transform their strategy of how to compete into a blueprint of actions and initiatives that support the over- arching goals. Next, managers implement this blueprint through structures, processes, culture, and procedures. The framework shown in Exhibit 5.10 guides managers through the process of formulating and implementing a business model by asking the important questions of the why, what, who, and how. We illuminate these questions by focusing on Microsoft, also featured in ChapterCase 5.

The Microsoft example lets us see how a firm can readjust its business model respond- ing to business challenges.

1. Why does the business model create value? Microsoft’s new “mobile first, cloud first” business model creates value for both customers and stockholders. Customers always have the latest software, can access it anywhere, and can collaborate online with other

EXHIBIT 5.10 / The Why, What, Who, and How of Business Models Framework SOURCE: Adapted from R. Amit and C. Zott (2012), “Creating value through business model innovation,” MIT Sloan Management Review 53, no. 3, 41–49.

What activities need to be performed to create and

deliver the offerings to customers?

Why does the business model create value?

(revenue + cost models)

What?

Why?

How are the offerings to the customers created? (linking of activities)

How?Who? Who are the main

stakeholders performing the activities?

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users. Users no longer need to upgrade software or worry about “backward compatibil- ity,” meaning the ability to read old (Word) files with new (Word) software. Microsoft enjoys steady revenue that over time provides greater fees than the earlier “perpetual license” model, significantly reduces the problem of software piracy, and balances the cost of ongoing support with the ongoing flow of revenues.

2. What activities need to be performed to create and deliver the offerings to customers? To pivot to the new “mobile first, cloud first” business model, Microsoft is making huge investments to create and deliver new offerings to its customers. The Redmond, Washington-based company needed to rewrite much of its software to be functional in a cloud-based environment. CEO Satya Nadella also decided to open the Office suite of applications to competing operating systems including Google’s Android, Apple’s iOS, and Linux, an open-source operating system. In all these activities, Microsoft’s Azure, its cloud-computing service, plays a pivotal role in its new business model.

3. How are the offerings to the customers created? Microsoft shifted most of its resources, including R&D and customer support, to its cloud-based offerings to not only make them best in class, but also to provide a superior user experience.

4. Who are the main stakeholders performing the activities? Microsoft continues to focus on both the individual end consumer as well as on more profitable business clients. Microsoft’s Azure is particularly attractive to its business customers. For example, Walmart, still the largest retailer globally with some 12,000 stores staffed by over 2 million employees and revenues of some $500 billion, runs its cutting-edge IT logis- tics on Microsoft’s Azure servers, rather than Amazon’s AWS service, a major compet- itor to Walmart. Likewise, The Home Depot, one of the largest retailers in the United States, also uses Microsoft Azure for its computing needs.

To appreciate the value of this change in business model, we should consider for a moment the problems the change allows Microsoft to address.

■ Before, with the perpetual license model, Microsoft had revenue spikes on the sale but zero revenues thereafter to support users and produce necessary updates. Now, Micro- soft matches revenues to its costs and even comes out further ahead, in that after two years or so, Microsoft makes more money off a software subscription than a standalone software license.

■ Before, customers had a financial disincentive to keep their software current. Now, users always have the latest software, can access it anywhere, and can collaborate online with other users without worries about backward compatibility.

■ Perhaps most impressively, the new model deals effectively with software piracy. Before, Microsoft suffered tremendous losses through software piracy. This affects consumers too, as the cost of piracy is borne by legal consumers to a large degree. Now, pirating cloud-based software is much more difficult, because Microsoft can easily monitor how many users (based on unique internet protocol [IP] addresses) are using the same log-in information at different locations and perhaps even at the same time. Once the provider suspects piracy, it tends to disable the accounts as this goes against the terms of service agreed upon when purchasing the software, not to mention that copyright infringements are illegal. Indeed, the scope of the piracy problem is driven home by the survey-based claim that some 60 percent of computer users confess to pirating software.43

POPULAR BUSINESS MODELS Given their critical importance to achieving competitive advantage, business models are constantly evolving. Below we will discuss some of the more popular business models:44

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■ Razor–razor-blades ■ Subscription ■ Pay-as-you-go ■ Freemium ■ Wholesale ■ Agency ■ Bundling

Understanding the more popular business models today will increase the tools in your strategy toolkit.

■ Razor–razor-blades. The initial product is often sold at a loss or given away for free to drive demand for complementary goods. The company makes its money on the replace- ment part needed. As you might guess, it was invented by Gillette, which gave away its razors and sold the replacement cartridges for relatively high prices. The razor–razor- blade model is found in many business applications today. For example, HP charges little for its laser printers but imposes high prices for its replacement toner cartridges.

■ Subscription. The subscription model has been traditionally used for print magazines and newspapers. Users pay for access to a product or service whether they use the product or service during the payment term or not. Microsoft uses a subscription-based model for its new Office 365 suite of application software. Other industries that use this model presently are cable television, cellular service providers, satellite radio, internet service providers, and health clubs. Netflix also uses a subscription model.

■ Pay-as-you-go. In the pay-as-you-go business model, users pay for only the services they consume. The pay-as-you-go model is most widely used by utilities providing power and water and cell phone service plans, but it is gaining momentum in other areas such as rental cars and cloud computing such as Microsoft’s Azure. News provid- ers such as The New York Times and The Wall Street Journal have created “pay walls” as a pay-as-you-go option.

■ Freemium. The freemium (free + premium) business model provides the basic features of a product or service free of charge, but charges the user for premium services such as advanced features or add-ons.45 For example, companies may provide a minimally supported version of their software as a trial (e.g., business application or video game) to give users the chance to try the product. Users later have the option of purchasing a supported version of software, which includes a full set of product features and product support. An ultra low-cost business model is quite similar to freemium: a model in which basic service is provided at a low cost and extra items are sold at a premium. The business pursuing this model has the goal of driving down costs. Examples include Spirit Airlines (in the United States), Ryanair (in Europe), or AirAsia, which provide minimal flight services but allow customers to pay for additional services and upgrades à la carte, often at a premium.

■ Wholesale. The traditional model in retail is called a wholesale model. Let’s look at the book publishing industry as an example. Under the wholesale model, book publish- ers would sell books to retailers at a fixed price (usually 50 percent below the recom- mended retail price). Retailers, however, were free to set their own price on any book and profit from the difference between their selling price and the cost to buy the book from the publisher (or wholesaler).

■ Agency. In this model the producer relies on an agent or retailer to sell the product, at a predetermined percentage commission. Sometimes the producer will also control the retail price. The agency model was long used in the entertainment industry, where

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agents place artists or artistic properties and then take their commission. More recently we see this approach at work in a number of online sales venues, as in Apple’s pricing of book products or its app sales. (See further discussion following.)

■ Bundling. The bundling business model sells products or services for which demand is negatively correlated at a discount. Demand for two products is negatively correlated if a user values one product more than another. In the Microsoft Office Suite, a user might value Word more than Excel and vice versa. Instead of selling both products for $120 each, Microsoft bundles them in a suite and sells them combined at a discount, say $150. This bundling strategy allowed Microsoft to become the number-one pro- vider of all major application software packages such as word processing, spreadsheets, slide show presentation, and so on. Before its bundling strategy, Microsoft faced strong competition in each segment. Indeed, Word Perfect was outselling Word, Lotus 1-2-3 was outselling Excel, and Harvard Graphics was outselling PowerPoint. The problem for Microsoft’s competitors was that they did not control the operating system (Win- dows), which made their programs less seamless on this operating system. In addition, the competitor products to Microsoft were offered by three independent companies, so they lacked the option to bundle them at a discount.

DYNAMIC NATURE OF BUSINESS MODELS Business models evolve dynamically, and we can see many combinations and permutations. Sometimes business models are tweaked to respond to disruptions in the market, efforts that can conflict with fair trade practices and may even prompt government intervention.

COMBINATION. Telecommunications companies such as AT&T or Verizon, to take one industry, combine the razor–razor-blade model with the subscription model. They fre- quently provide a basic cell phone at no charge, or significantly subsidize a high-end smartphone, when you sign up for a two-year wireless service plan. Telecom providers recoup the subsidy provided for the smartphone by requiring customers to sign up for lengthy service plans. This is why it is so critical for telecom providers to keep their churn rate—the proportion of subscribers that leave, especially before the end of the contractual term—as low as possible.

EVOLUTION. The freemium business model can be seen as an evolutionary variation on the razor–razor-blade model. The base product is provided free, and the producer finds other ways to monetize the usage. The freemium model is used extensively by open-source soft- ware companies (e.g., Red Hat), mobile app companies, and other internet businesses. Many of the free versions of applications include advertisements to make up for the cost of sup- porting nonpaying users. In addition, the paying premium users subsidize the free users. The freemium model is often used to build a consumer base when the marginal cost of add- ing another user is low or even zero (such as in software sales). Many online video games, including massive multiplayer online games and app-based mobile games, follow a variation of this model, allowing basic access to the game for free, but charging for power-ups, cus- tomizations, special objects, and similar things that enhance the game experience for users.

DISRUPTION. When introducing the agency model, we mentioned Apple and book pub- lishing, and you may already know how severely Amazon disrupted the traditional whole- sale model for publishers. Amazon took advantage of the pricing flexibility inherent in the wholesale model and offered many books (especially e-books) below the cost that other retailers had to pay to publishers. In particular, Amazon would offer newly released best- sellers, such as Dan Brown’s novels, for $9.99 to promote its Kindle e-reader. Publishers

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and other retailers strongly objected because Amazon’s retail price was lower than the wholesale price paid by retailers competing with Amazon. Moreover, the $9.99 e-book offer by Amazon made it untenable for other retailers to continue to charge $28.95 for newly released hardcover books (for which they had to pay $14 to $15 to the publish- ers). With its aggressive pricing, Amazon not only devalued the printed book, but also lost money on every book it sold. It did this to increase the number of users of its Kindle e-readers and tablets.

RESPONSE TO DISRUPTION. The market is dynamic, and in the above example, book publishers looked for another model. Many book publishers worked with Apple on an agency approach, in which the publishers would set the price for Apple and receive 70 percent of the revenue, while Apple received 30 percent. The approach is similar to the Apple App Store pricing model for iOS applications in which developers set a price for applications and Apple retains a percentage of the revenue.

Use of the agency model was intended to give publishers the leverage to raise e-book prices for retailers. Under the agency model, publishers could increase their e-book profits and price e-books more closely to prices of printed books. Publishers inked their deals with Apple, but how could they get Amazon to play ball? For leverage, publishers withheld new releases from Amazon. This forced Amazon to raise prices on newly released e-books in line with the agency model to around $14.95.

LEGAL CONFLICTS. The rapid development of business models, especially in response to disruption, can lead producers to breach existing rules of commerce. In the above example, the publishers’ response prompted an antitrust investigation. In 2012 the Depart- ment of Justice determined that Apple and major publishers had conspired to raise prices of e-books. To settle the legal action, each publisher involved negotiated new deals with retailers, including Amazon. A year later, Apple was found guilty of colluding with several major book publishers to fix prices on e-books and had to change its agency model.46

5.3 Implications for Strategic Leaders In this chapter, we discussed how to measure and assess competitive advantage using three traditional approaches: accounting profitability, shareholder value creation, and economic value creation. We then introduced two conceptual frameworks to help us understand com- petitive advantage in a more holistic fashion: the balanced scorecard and the triple bottom line. Exhibit 5.11 summarizes the concepts discussed.

Competitive advantage is reflected in superior firm performance.

• We always assess competitive advantage relative to a benchmark, either using competitors or the industry average.

• Competitive advantage is a multifaceted concept.

• We can assess competitive advantage by measuring accounting profit, shareholder value, or economic value.

• The balanced-scorecard approach harnesses multiple internal and external performance dimensions to balance a firm’s financial and strategic goals.

• More recently, competitive advantage has been linked to a firm’s triple bottom line, the ability to maintain performance in the economic, social, and ecological contexts (profits, people, planet) to achieve a sustainable strategy.

EXHIBIT 5.11 / How to Measure and Assess Competitive Advantage

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Several managerial implications emerged from our discussion of competitive advantage and firm performance:

■ No best strategy exists—only better ones (better in comparison with others). We must interpret any performance metric relative to those of competitors and the industry aver- age. True performance can be judged only in comparison to other contenders in the field or the industry average, not on an absolute basis.

■ The goal of strategic management is to integrate and align each business function and activity to obtain superior performance at the business unit and corporate levels. There- fore, competitive advantage is best measured by criteria that reflect overall business unit performance rather than the performance of specific departments. For example, although the functional managers in the marketing department may (and should) care greatly about the success or failure of their recent ad campaign, the general manager cares most about the performance implications of the ad campaign at the business-unit level for which she has profit-and-loss responsibility. Metrics that aggregate upward and reflect overall firm and corporate performance are most useful to assess the effec- tiveness of a firm’s competitive strategy.

■ Both quantitative and qualitative performance dimensions matter in judging the effectiveness of a firm’s strategy. Those who focus on only one metric will risk being blindsided by poor performance on another. Rather, managers need to rely on a more holistic perspective when assessing firm performance, measuring different dimensions over different time periods.

■ A firm’s business model is critical to achieving a competitive advantage. How a firm does business is as important as what it does.

This concludes our discussion of competitive advantage, firm performance, and busi- ness models, and completes Part 1—strategy analysis—of the AFI framework. In Part 2, we turn our attention to the next steps in the AFI framework—strategy formulation. In Chapters 6 and 7, we focus on business strategy: How should the firm compete (cost lead- ership, differentiation, or value innovation)? In Chapters 8 and 9, we study corporate strat- egy: Where should the firm compete (industry, markets, and geography)? Chapter 10 looks at global strategy: How and where (local, regional, national, and international) should the firm compete around the world?

GIVEN MICROSOFT’S LACKLUSTER performance since 2000, the once dominant company is now in turnaround mode. Over time, its competitive advantage turned into a competi- tive disadvantage, lagging behind Apple by a wide margin. Satya Nadella’s strategic focus is to move Microsoft away from its Windows-only business model to compete more effectively in a “mobile first, cloud first world,” the mantra he used in his appointment e-mail as CEO. Under his lead- ership, Microsoft made the Office Suite available on Apple iOS and Android mobile devices. Office 365, its cloud-based

CHAPTERCASE 5  Consider This . . .

software offering, is now avail- able as a subscription service starting at $6.99 per month for personal use and $69.99 for business use. Software applications can be accessed on any device, any time, with online storage, combined with Skype’s global calling feature. Yet, Nadella needs to work

Satya Nadella, Microsoft CEO.

©Brian Smale/Microsoft/ Getty Images

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CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 173

hard to ensure Microsoft’s future viability because Win- dows and Office were cash cows for so long. They are still generating 40 percent of revenues and some 75 percent of profits, but both continue to decline. The problem he faces is that the gross margin of “classic” PC-based Office is 90 percent (due to Microsoft’s “monopoly” position), while the gross margin for Office 365 is only around 50 per- cent. The cloud computing space with Amazon, Alphabet (Google), Apple, IBM, and others is fiercely competitive.47

Questions

1. Why is it so hard to gain a competitive advantage? Why is it even harder to sustain a competitive advantage?

2. Looking at the different ways to assess competitive advantage discussed in this chapter, does Microsoft

have a competitive advantage over Apple using any of the approaches? Why or why not? In which approach is Microsoft looking “the best”? Explain.

3. Microsoft CEO Satya Nadella has made drastic changes to Microsoft’s strategy. What was Microsoft’s strategy before Nadella was appointed CEO in 2014? What is it now under his leadership? Do you agree that Nadella has formulated a promising business model? Why or why not?

4. How much longer do you think Apple can sustain its competitive advantage (not just over Microsoft, but in general)? Explain.

NOTE: A financial ratio review related to this ChapterCase is avail- able in Connect.

This chapter demonstrated three traditional approaches for assessing and measuring firm performance and competitive advantage, as well as two conceptual frameworks designed to provide a more holistic, albeit more qualitative, perspective on firm performance. We also discussed the role of business models in translating a firm’s strategy into actions.

LO 5-1 / Conduct a firm profitability analysis using accounting data to assess and evaluate competitive advantage. ■ To measure competitive advantage, we must be

able to (1) accurately assess firm performance, and (2) compare and benchmark the focal firm’s performance to other competitors in the same industry or the industry average.

■ To measure accounting profitability, we use standard metrics derived from publicly available accounting data.

■ Commonly used profitability metrics in strategic management are return on assets (ROA), return on equity (ROE), return on invested capital (ROIC), and return on revenue (ROR). See the key financial ratios in five tables in the “How to Conduct a Case Analysis” guide.

■ All accounting data are historical and thus backward-looking. They focus mainly on tangible assets and do not consider intangibles that are hard or impossible to measure and quantify, such as an innovation competency.

LO 5-2 / Apply shareholder value creation to assess and evaluate competitive advantage. ■ Investors are primarily interested in total return to

shareholders, which includes stock price apprecia- tion plus dividends received over a specific period.

■ Total return to shareholders is an external perfor- mance metric; it indicates how the market views all publicly available information about a firm’s past, current state, and expected future performance.

■ Applying a shareholders’ perspective, key met- rics to measure and assess competitive advan- tage are the return on (risk) capital and market capitalization.

■ Stock prices can be highly volatile, which makes it difficult to assess firm performance. Overall macroeconomic factors have a direct bearing on stock prices. Also, stock prices frequently reflect the psychological mood of the investors, which can at times be irrational.

TAKE-AWAY CONCEPTS

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

■ Shareholder value creation is a better measure of competitive advantage over the long term due to the “noise” introduced by market volatility, exter- nal factors, and investor sentiment.

LO 5-3 / Explain economic value creation and different sources of competitive advantage. ■ The relationship between economic value creation

and competitive advantage is fundamental in strategic management. It provides the foundation upon which to formulate a firm’s competitive strategy of cost leadership or differentiation.

■ Three components are critical to evaluating any good or service: value (V), price (P), and cost (C). In this perspective, cost includes opportunity costs.

■ Economic value created is the difference between a buyer’s willingness to pay for a good or service and the firm’s cost to produce it (V − C).

■ A firm has a competitive advantage when it is able to create more economic value than its rivals. The source of competitive advantage can stem from higher perceived value creation (assuming equal cost) or lower cost (assuming equal value creation).

LO 5-4 / Apply a balanced scorecard to assess and evaluate competitive advantage. ■ The balanced-scorecard approach attempts to

provide a more integrative view of competitive advantage.

■ Its goal is to harness multiple internal and exter- nal performance dimensions to balance financial and strategic goals.

■ Managers develop strategic objectives for the bal- anced scorecard by answering four key questions: (1) How do customers view us? (2) How do we create value? (3) What core competencies do we need? (4) How do shareholders view us?

LO 5-5 / Apply a triple bottom line to assess and evaluate competitive advantage. ■ Noneconomic factors can have a significant

impact on a firm’s financial performance,

not to mention its reputation and customer goodwill.

■ Managers are frequently asked to maintain and improve not only the firm’s economic performance but also its social and ecological performance.

■ Three dimensions—economic, social, and ecologi- cal, also known as profits, people, and planet— make up the triple bottom line. Achieving positive results in all three areas can lead to a sustainable strategy—a strategy that can endure over time.

■ A sustainable strategy produces not only positive financial results, but also positive results along the social and ecological dimensions.

■ Using a triple-bottom-line approach, managers audit their company’s fulfillment of its social and ecological obligations to stakeholders such as employees, customers, suppliers, and communi- ties in as serious a way as they track its financial performance.

■ The triple-bottom-line framework is related to stakeholder theory, an approach to understanding a firm as embedded in a network of internal and external constituencies that each make contribu- tions and expect consideration in return.

LO 5-6 / Use the why, what, who, and how of business models framework to put strategy into action. ■ The translation of a firm’s strategy (where and

how to compete for competitive advantage) into action takes place in the firm’s business model (how to make money).

■ A business model details how the firm con- ducts its business with its buyers, suppliers, and partners.

■ How companies do business is as important to gaining and sustaining competitive advantage as what they do.

■ The why, what, who, and how framework guides managers through the process of formulating and implementing a business model.

Balanced scorecard (p. 161) Business model (p. 165)

Consumer surplus (p. 157) Economic value created (p. 155)

Market capitalization (p. 153) Opportunity costs (p. 160)

KEY TERMS

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CHAPTER 5 Competitive Advantage, Firm Performance, and Business Models 175

Producer surplus (p. 157) Profit (p. 157) Reservation price (p. 155)

Risk capital (p. 153) Shareholders (p. 153) Sustainable strategy (p. 164)

Total return to shareholders (p. 153) Triple bottom line (p. 164) Value (p. 157)

DISCUSSION QUESTIONS

1. Domino’s Pizza has been in business more than 50 years and claims to be “#1 Worldwide in Pizza Delivery” with over 13,000 locations. Visit the company’s business-related website (www.biz. dominos.com) and read the “our strengths” sec- tion under the “Investors/Profile” tab. Does the firm focus on the accounting, shareholder, or eco- nomic perspective in describing its competitive advantage?

2. For many people, the shareholder perspective is perhaps the most familiar measure of competitive

advantage for publicly traded firms. What are some of the disadvantages of using shareholder value as the sole point of view for defining com- petitive advantage?

3. Interface, Inc., is discussed in Strategy Highlight 5.1. It may seem unusual for a business-to-business carpet company to be using a triple-bottom-line approach for its strategy. What other industries do you think could productively use this approach? How would it change customers’ perceptions if it did?

ETHICAL/SOCIAL ISSUES

1. You work as a supervisor in a manufacturing firm. The company has implemented a balanced- scorecard performance-appraisal system and a financial bonus for exceeding goals. A major customer order for 1,000 units needs to ship to a destination across the country by the end of the quarter, which is two days away from its close. This shipment, if it goes well, will have a major impact on both your customer-satisfaction goals and your financial goals.

With 990 units built, a machine breaks. It will take two days to get the parts and repair the machine. You realize there is an opportunity to load the finished units on a truck tomorrow with paperwork for the completed order of 1,000 units. You can have an employee fly out with the 10

remaining parts and meet the truck at the destina- tion city once the machinery has been repaired. The 10 units can be added to the pallet and deliv- ered as a complete shipment of 1,000 pieces, matching the customer’s order and your paper- work. What do you do?

2. How do the perspectives on competitive advan- tage differ when comparing brick-and-mortar stores to online businesses (e.g., Best Buy ver- sus Amazon, Barnes & Noble versus Amazon, Old Navy versus Threadless [noted in Strategy Highlight 5.2], Nordstrom versus Zappos, and so on)? Make recommendations to brick-and-mortar stores as to how they can compete more effec- tively with online firms. What conclusions do you draw?

SMALL GROUP EXERCISES

//// Small Group Exercise 1 As discussed in the chapter, a balanced scorecard views the performance of an organization through four lenses: customer, innovation and learning, internal

business, and financial. According to surveys from consulting firm Bain & Co., about 60 percent of firms in both public and private sectors have used a bal- anced scorecard for performance measures.48

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

With your group, create a balanced scorecard for the business school at your university. You might start by looking at your school’s web page for a mission or vision statement. Then divide up the four perspectives among the team members to develop key elements for each one. It may be helpful to remember the four key balanced-scorecard questions from the chapter:

1. How do customers view us? (Hint: First discuss the following: Who are the customers? The stu- dents? The companies that hire students? Others?)

2. How do we create value? 3. What core competencies do we need? 4. How do shareholders view us? (For public uni-

versities, the shareholders are the taxpayers who invest their taxes in the university. For private uni- versities, the shareholders are the people or orga- nizations that endow the university.)

1. For an in-depth discussion of Apple, see: Rothaermel, F.T., (2017), “Apple Inc.,” Case MHE-FTR-051-1259927628, http://create.mheducation.com/; “Microsoft at middle age: Opening Windows,” The Economist, April 4, 2015; “What Satya Nadella did at Microsoft,” The Economist, March 16, 2017; and Mochhizuki, T. (2017, Feb. 28), “Apple’s next iPhone will have a curved screen,” The Wall Street Journal.

2. This debate takes place in the following discourses, 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, corporate, and business unit effects,” Strategic Manage- ment Journal 27: 571–590; McNamara, G., F. Aime, and P. Vaaler (2005), “Is performance driven by industry- or firm-specific factors? A reply to Hawawini, Subramanian, and Verdin,” Strategic Management Journal 26:

1075–1081; Hawawini, G., V. Subramanian, and P. Verdin (2005), “Is performance driven by industry- or firm-specific factors? A new look at the evidence: A response to McNamara, Aime, and Vaaler,” Strategic Management Journal 26: 1083–1086; Rumelt, R.P. (2003), “What in the world is competitive advantage?” Policy Working Paper 2003-105; McGahan, A.M., and M.E. Porter (2002), “What do we know about variance in account- ing profitability?” Management Science 48:

ENDNOTES

//// Small Group Exercise 2 At the next big family gathering, you want to impress your grandparents with the innovative ideas you have learned in business school. They have decades of expe- rience in investing in the stock market and, from their college days, believe that economic profitability is a busi- ness’s primary responsibility. You would like to convince them that a triple-bottom-line approach is the modern path to stronger economic performance. With your group members, prepare a casual yet informative pitch you can use to persuade them. They probably will not listen for more than two minutes, so you know you have to be clear and concise with interesting examples. You may want to reinforce your argument by consulting “The Bottom Line of Corporate Good,” published in Forbes.49 Present your speech in whatever way your instructor requests— to your group, to the entire class, or in an online video.

How Much Is an MBA Worth to You?

T he myStrategy box at the end of Chapter 1  asked how much you would be willing to pay for the job you want—for a job that reflects your values. Here, we look at a dif- ferent issue relating to worth: How much is an MBA worth over the course of your career?

Alongside the traditional two-year full-time MBA program, many business schools also offer evening MBAs and executive MBAs. Let’s assume you know you want to pursue an advanced degree, and you need to decide which program format is better

for you (or you want to evaluate the choice you already made). You’ve narrowed your options to either (1) a two-year full-time MBA program, or (2) an executive MBA program at the same institution that is 18 months long with classes every other week- end. Let’s also assume the price for tuition, books, and fees is $30,000 for the full-time program and $90,000 for the execu- tive MBA program.

Which MBA program should you choose? Consider in your analysis the value, price, and cost concepts discussed in this chapter. Pay special attention to opportunity costs attached to different MBA program options.

mySTRATEGY

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834–851; 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 mat- ter, really?” Strategic Management Journal 18: 15–30; Rumelt, R.P. (1991), “How much does industry matter?” Strategic Management Journal 12: 167–185; Porter, M.E. (1985), Competitive Advantage: Creating and Sustain- ing Superior Performance (New York: Free Press); and Schmalensee, R. (1985), “Do markets differ much?” American Economic Review 75: 341–351; 3. Rumelt, R.P. (2003), “What in the world is competitive advantage?” Policy Working Paper 2003-105.

4. For discussion see: McGahan, A.M., and M. E. Porter (2002), “What do we know about variance in accounting profitability?” Man- agement Science, 48: 834–851. 5. (Net profits / Invested capital) is short- hand for (Net operating profit after taxes [NOPAT]/Total stockholders’ equity + Total debt – Value of preferred stock). See dis- cussion of profitability ratios in Table 1, “When and How to Use Financial Measures to Assess Firm Performance,” of the “How to Conduct a Case Analysis” the guide to con- ducting a case analysis that concludes Part 4 of the text. 6. The data for this section are drawn from Apple and Microsoft annual reports (various years) and a number of news articles, includ- ing: Dou, E. (2017, Feb. 1), “Cheaper rivals eat away at Apple sales in China,” The Wall Street Journal; “What Satya Nadella did at Microsoft,” The Economist, March 16, 2016; and “iPhone, therefore I am,” The Economist, January 30, 2016. 7. This example is based on the 2016 SEC 10-K reports for Apple and Microsoft. Con- nect provides the financial analysis conducted here as an exercise for a five-year time period, 2012–2016. This allows for more dynamic considerations. 8. The complete equation for Return on Invested Capital (ROIC) is: ROIC = (Net Profit / Revenue) × (Revenue / Invested Capital) =  [1- ((COGS / Revenue) + (R&D / Revenue) + (S&GA / Revenue) + (Tax / Rev- enue))] * [1 / ((Working Capital / Revenue) + (PPE / Revenue) + (Intangible Assets / Revenue) + (Long-term Marketable Securities /   Revenue) + (Goodwill / Revenue) + (Other Assets / Revenue))].  The calculation of work- ing capital turnover also demands “Long-term Assets /  Revenue,” “Goodwill /  Revenue,” and “Other Assets /  Revenue.”  This chart does not provide these values because they are not closely related to firm competitive

advantage. They are included, however, in the Teacher’s Resource Manual. 9. “The second coming of Apple through a magical fusion of man—Steve Jobs—and company, Apple is becoming itself again: The little anticompany that could,” Fortune, November 9, 1998. 10. “Satya Nadella: Mobile first, cloud first press briefing,” Microsoft press release, March 27, 2014. 11. Prahalad, C.K., and G. Hamel (1990), “The core competence of the corporation,” Harvard Business Review, May–June. 12. Baruch, L. (2001), Intangibles: Man- agement, Measurement, and Reporting ( Washington, DC: Brookings Institution Press). 13. Cameron, W.B. (1967), Informal Sociol- ogy: A Casual Introduction to Sociological Thinking (New York: Random House). 14. Friedman, M. (2002), Capitalism and Freedom, 40th anniversary edition (Chicago, IL: University of Chicago Press). 15. Beechy, M., D. Gruen, and J. Vickrey (2000), “The efficient market hypothesis: A survey,” Research Discussion Paper, Federal Reserve Bank of Australia; and Fama, E. (1970), “Efficient capital markets: A review of theory and empirical work,” Journal of Finance 25: 383–417. 16. The three broad categories of companies by market cap are large cap (over $10 billion), mid cap ($2 billion to $10 billion), and small cap (less than $2 billion). 17. Alexander, J. (2007), Performance Dashboards and Analysis for Value Creation (Hoboken, NJ: Wiley-Interscience). 18. This section draws on: Christensen, C.M., and M.E. Raynor (2003), The Innovator’s Solution: Creating and Sustaining Success- ful Growth (Boston, MA: Harvard Business School Press). 19. “Satya Nadella: Mobile first, cloud first press briefing,” Microsoft press release, March 27, 2014. 20. Speech given by Alan Greenspan on December 5, 1996, at the American Enterprise Institute. 21. “Irrational gloom,” The Economist, October 11, 2002. 22. Wakabayashi D. (2016, Apr. 24), “Apple’s watch outpaced the iPhone in first year,” The Wall Street Journal. 23. Olivarez-Giles, N., “What makes the Apple Watch tick,” The Wall Street Journal, April 30, 2015. 24. “Microsoft at middle age: Opening Win- dows,” The Economist, April 4, 2015; and Amazon.com, various annual reports. For Amazon’s acquisition of Whole Foods, see Stevens, L., and A. Gasparro (2017, June 16),

“Amazon to buy Whole Foods for $13.7 bil- lion: Whole Foods would continue to operate stores under its brand,” The Wall Street Jour- nal, https://www.wsj.com/articles/amazon-to- buy-whole-foods-for-13-7-billion-1497618446. For industry response, see La Monica, P.R., and C. Isidore (2017, June 16), “Grocery stocks are getting clobbered after Amazon- Whole Foods deal,” CNN Money, http:// money.cnn.com/2017/06/16/investing/amazon- buying-whole-foods/index.html. 25. Kaplan, R.S., and D.P. Norton (1992), “The balanced scorecard: Measures that drive performance,” Harvard Business Review, January–February: 71–79. 26. Kaplan, R.S., and D.P. Norton (1992), “The balanced scorecard: Measures that drive performance,” Harvard Business Review, January–February: 71–79. 27. Govindarajan, V., and J.B. Lang (2002), 3M Corporation, case study, Tuck School of Business at Dartmouth. 28. Rothaermel, F.T., and A.M. Hess (2010), “Innovation strategies combined,” MIT Sloan Management Review, Spring: 12–15. 29. Huston, L., and N. Sakkab (2006), “Con- nect & Develop: Inside Procter & Gamble’s new model for innovation,” Harvard Business Review, March: 58–66. 30. Kaplan, R.S. (1993), “Implementing the balanced scorecard at FMC Corporation: An interview with Larry D. Brady,” Har- vard Business Review, September–October: 143–147. 31. Norreklit, H. (2000), “The balance on the balanced scorecard—A critical analysis of some of its assumptions,” Management Accounting Research 11: 65–88; Jensen, M.C. (2002), “Value maximization, stakeholder theory, and the corporate objective func- tion,” in Unfolding Stakeholder Thinking, ed. J. Andriof, et al. (Sheffield, UK: Greenleaf Publishing). 32. Kaplan, R.S., and D.P. Norton (2007), “Using the balanced scorecard as a strategic management system,” Harvard Business Review, July–August; and Kaplan, R.S., and D.P. Norton (1992), “The balanced scorecard: Measures that drive performance,” Harvard Business Review, January–February: 71–79. 33. Lawrie, G., and I. Cobbold (2002), “Development of the 3rd generation bal- anced scorecard: Evolution of the balanced scorecard into an effective strategic perfor- mance management tool,” 2GC Working Paper (Berkshire, UK: 2GC Limited). 34. Senge, P.M., B. Bryan Smith, N. Kruschwitz, J. Laur, and S. Schley (2010), The Necessary Revolution: How Individuals and Organizations Are Working Together to Create a Sustainable World (New York: Crown).

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

35. GE 2016 Annual Report, http://www. ge.com/ar2016; Gryta T.,  J. Lubin, and D. Benoit (2017, June 12), “Jeff Immelt to step down as CEO of GE; John Flannery tales role,” The Wall Street Journal. 36. Anderson, R.C. (2009), Confessions of a Radical Industrialist: Profits, People, Purpose—Doing Business by Respecting the Earth (New York: St. Martin’s Press). 37. Norman, W., and C. MacDonald (2004), “Getting to the bottom of ‘triple bottom line,’” Business Ethics Quarterly 14: 243–262. 38. Collins, J.C., and J.I. Porras (1994), Built to Last: Successful Habits of Visionary Com- panies (New York: HarperBusiness), 93. 39. Anderson, R.C. (2009), Confessions of a Radical Industrialist: Profits, People, Purpose—Doing Business by Respecting the Earth (New York: St. Martin’s Press), 5; TED talk, “Ray Anderson on the busi- ness logic of sustainability,” www.ted.com; and Perkins, J. (2009), Hoodwinked: An Economic Hit Man Reveals Why the World Financial Markets Imploded—and What We

Need to Do to Remake Them (New York: Crown Business), 107. 40. This discussion is based on: Adner, R. (2012), The Wide Lens. A New Strategy for Innovation (New York: Portfolio/Penguin); and Amit, R., and C. Zott (2012), “Creat- ing value through business model innova- tion,” MIT Sloan Management Review, Spring: 41–49; see also Gassmann, O., K. Frankenberger, and M. Csik (2015), The Busi- ness Model Navigator: 55 Models That Will Revolutionise Your Business (Harlow, UK: FT Press). 41. Amit, R., and C. Zott (2012), “Creating value through business model innovation,” MIT Sloan Management Review, Spring: 41–49. 42. Nickell, J. (2010), Threadless: Ten Years of T-shirts from the World’s Most Inspir- ing Online Design Community (New York: Abrams); Howe, J. (2008), Crowdsourcing: Why the Power of the Crowd Is Driving the Future of Business (New York: Crown Busi- ness); and Surowiecki, J. (2004), The Wisdom of Crowds (New York: Anchor Books). 

43. Fitzgerald, B. (2012, June 1), “Software piracy: Study claims 57 percent of the world pirates software,” The Huffington Post. 44. For a fully dedicated and more in-depth treatment of business models, see Gassmann, O., K. Frankenberger, and M. Csik (2015), The Business Model Navigator: 55 Mod- els That Will Revolutionise Your Business (Harlow, UK: FT Press). 45. Anderson, C. (2009), Free: The Future of a Radical Price (New York: Hyperion). 46. Bray, C., J. Palazzolo, and I. Sherr (2013, Jul. 13), “U.S. judge rules Apple colluded on e-books,” The Wall Street Journal. 47. “Microsoft at middle age: Opening Win- dows,” The Economist, April 4, 2015; “What Satya Nadella did at Microsoft,” The Econo- mist, March 16, 2017. 48. See: www.thepalladiumgroup.com for exam. 49. Scott, Ryan (2012, Sept. 14), “The bot- tom line of corporate good,” Forbes; www. forbes.com/sites/causeintegration/2012/09/14/ the-bottom-line-of-corporate-good/.

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PART

Formulation

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

CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms

CHAPTER 8 Corporate Strategy: Vertical Integration and Diversification

CHAPTER 9 Corporate Strategy: Strategic Alliances, Mergers and Acquisitions

CHAPTER 10 Global Strategy: Competing Around the World

2

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The AFI Strategy Framework

Part 1: Analysis

Part 1: Analysis

Part 2: Formulation

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 3: Implementation

Part 2: Formulation

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

Chapter Outline

6.1 Business-Level Strategy: How to Compete for Advantage Strategic Position Generic Business Strategies

6.2 Differentiation Strategy: Understanding Value Drivers Product Features Customer Service Complements

6.3 Cost-Leadership Strategy: Understanding Cost Drivers Cost of Input Factors Economies of Scale Learning Curve Experience Curve

6.4 Business-Level Strategy and the Five Forces: Benefits and Risks Differentiation Strategy: Benefits and Risks Cost-Leadership Strategy: Benefits and Risks

6.5 Blue Ocean Strategy: Combining Differentiation and Cost Leadership Value Innovation Blue Ocean Strategy Gone Bad: “Stuck in the Middle”

6.6 Implications for Strategic Leaders

Learning Objectives

LO 6-1 Define business-level strategy and describe how it determines a firm’s strategic position.

LO 6-2 Examine the relationship between value drivers and differentiation strategy.

LO 6-3 Examine the relationship between cost driv- ers and cost-leadership strategy.

LO 6-4 Assess the benefits and risks of differentia- tion and cost-leadership strategies vis-à-vis the five forces that shape competition.

LO 6-5 Evaluate value and cost drivers that may allow a firm to pursue a blue ocean strategy.

LO 6-6 Assess the risks of a blue ocean strategy, and explain why it is difficult to succeed at value innovation.

6

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JetBlue Airways: Finding a New Blue Ocean?

WHEN JETBLUE AIRWAYS took to the skies, founder David Neeleman set out to pursue a blue ocean strategy. This type of competitive strategy combines differentiation and cost-leadership activities using value innovation to recon- cile the inherent trade-offs in those two distinct strategic positions. How is this done, and where did Neeleman’s ideas come from?

At the age of 25, the young entrepreneur co-founded Morris Air, a charter air service that in 1993 was pur- chased by Southwest Airlines (SWA). Mor- ris Air  was a low-fare airline that pioneered many cost-saving prac- tices that later became standard in the indus- try, such as e-ticketing. After working as an airline executive for SWA, Neeleman went on to launch JetBlue in 2000. When Neeleman established JetBlue, his strategy was to provide air travel at even lower costs than SWA. At the same time, he wanted to offer better service and more amenities than the legacy carriers such as American, Delta, or United. To sum it up, JetBlue’s Customer Bill of Rights declares its dedication to bringing humanity back to air travel.

To implement a blue ocean strategy, JetBlue focused on lowering operating costs while driving up perceived customer value in its service offerings. In particular, JetBlue copied and improved upon many of SWA’s cost- reducing activities. It initially used just one type of air- plane (the Airbus A-320) to lower the costs of aircraft maintenance and pilot and crew training. It also chose to fly point to point, directly connecting highly trafficked city pairs. JetBlue specialized in transcontinental flights

connecting the East Coast (e.g., from its home base in New York) to the West Coast (e.g., Los Angeles). In contrast, legacy airlines such as American, Delta, or United use a hub-and-spoke system. This type of operating model con- nects many different locations via layovers at airport hubs. The point-to-point model focuses on directly connecting fewer but more highly trafficked city pairs. This model lowers costs by not offering baggage transfers and sched- ule coordination with other airlines. In addition, JetBlue flies longer distances and transports more passengers per flight than SWA, further driving down its costs. Initially, JetBlue enjoyed the lowest cost per available seat-mile (an

important performance metric in the airline industry) in the United States.

At the same time, JetBlue also enhanced its differential appeal by driving up its perceived value. Its mantra was to combine high-touch— to enhance the customer experience—and high- tech—to drive down costs. Because roughly one-third of custom- ers prefer speaking to a live reservation agent, despite a highly functional website for reservations and other

travel-related services, JetBlue decided to use work-from- home employees in the United States instead of follow- ing industry best practice by outsourcing its reservation system. Some of JetBlue’s other value-enhancing features include high-end 100-seat Embraer regional jets with leather seats, free movie and television programming via DirecTV, XM Satellite Radio, along with friendly and attentive on-board service. Other amenities include its recently added Mint class, which is a luxury version of first-class travel. The Mint service features small private suites with a lie-flat bed up to 6 feet 8 inches long, a high- resolution personal screen, and free in-flight high-speed Wi-Fi (“Fly-Fi”). It also features other amenities such as personal check-in and early boarding, free bag checking

CHAPTERCASE 6

JetBlue offers its Mint luxury experience, which includes a lie-flat bed up to 6 feet 8 inches long, a high-resolution personal screen, and free in-flight high- speed Wi-Fi, on many domestic U.S. routes. Other U.S. competitors offer such amenities only on very few routes. ©Carlos Yudica/123RF

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and priority bag retrieval after flight, and complimentary gourmet food and alcoholic beverages in flight.

For JetBlue, pursuing a blue ocean strategy by combin- ing a cost-leadership position with a differentiation strat- egy resulted in a competitive advantage in its early years. Although the idea of combining different business strat- egies seems appealing, it is quite difficult to execute a cost-leadership and differentiation position at the same time. This is because cost leadership and differentiation are distinct strategic positions. Pursuing them simultaneously results in trade-offs that work against each other. For instance, higher perceived customer value (e.g., providing leather seats throughout the entire aircraft and free Wi-Fi) comes with higher costs. These trade-offs caught up with JetBlue. Between 2007 and 2015, the airline upstart faced severe tur- bulence after several high-profile mishaps (e.g., passengers stranded on the tarmac for hours after a snowstorm, emer- gency landings, erratic pilot and crew behaviors). These public relations disasters compounded the fundamental dif- ficulty of resolving the need to limit costs while providing superior customer service and in-flight amenities. 

This fundamental conflict was not apparent at first. In its early days, JetBlue could use value innovation to drive up perceived customer value even while lowering operat- ing costs. The approach can work when an airline is small and connecting a few highly profitable city routes. But as the airline grew, its blue ocean strategy started to fray. As a consequence of such factors, JetBlue experienced a sus- tained competitive disadvantage for a number of years. The airline removed founder Neeleman as CEO in 2007. He left to found Azul, a Brazilian airline, in 2008. (In 2017 Azul was a publicly listed company on both the NYSE and the Sao Paulo exchanges with positive results; Azul is currently the third-largest airline in Brazil.)

Meanwhile, unable to overcome challenges in its profit and market share, the JetBlue board of directors in 2015 accepted the resignation of then CEO David Barger and appointed Robin Hayes to replace him. Formerly with British Airways for almost 20 years, Hayes wasted no time in sharp- ening JetBlue’s strategic profile, doubling down on its blue ocean strategy as he attempted to lower operating costs while increasing perceived value creation. To drive down costs, he decided to add more seats to each plane, reducing legroom in coach (now on par with the legacy carriers). Other areas of cost savings included mainly aircraft maintenance and crew scheduling. At the same time, Hayes also expanded the Mint class offerings to many more flights, providing a product that customers love and that some other airlines lack.

JetBlue is also considering adding a new airplane (Air- bus A-321) to its fleet, which scores significantly higher in customer satisfaction surveys than the older A-320. Although JetBlue already flies internationally by serving destinations in Central and South America as well as the Caribbean, Hayes is considering adding selected flights to Europe in the future. Flying non-stop to cities in Europe is now possible with new Airbus A-321. Flying longer, non- stop routes drives down costs. International routes, more- over, tend to be much more profitable than domestic routes because of less competition, for the time being.

JetBlue is now the sixth-largest airline in the United States, right after the “big four” (Delta,  SWA, American, and United) and Alaska Airlines, which beat out JetBlue in acquiring Virgin America in 2016. Noteworthy is also that the “big four” airlines control more than 80 percent of the U.S. domestic market, so the industry is fairly concentrated.1

You will learn more about JetBlue by reading this chapter; related questions appear in “ChapterCase 6 / Consider This . . . .”

THE CHAPTERCASE illustrates how JetBlue ran into trouble by pursuing two dif- ferent business strategies at the same time—a cost-leadership strategy, focused on

low cost, and a differentiation strategy, focused on delivering unique features and service. Although the idea of combining different business strategies seems appealing, it is quite difficult to execute a cost-leadership and differentiation position at the same time. This is because cost leadership and differentiation are distinct strategic positions. Pursuing them simultaneously results in trade-offs that work against each other. For instance, higher per- ceived customer value (e.g., providing leather seats throughout the entire aircraft and free Wi-Fi) comes with higher costs.

Many firms that attempt to combine cost-leadership and differentiation strategies end up being stuck in the middle. In this situation, strategic leaders have failed to carve out a clear strategic position. In their attempt to be everything to everybody, these firms end up being neither a low-cost leader nor a differentiator (thus the phrase stuck in the middle between

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the two distinct strategic positions). This common strategic failure contributed to JetBlue’s sustained competitive disadvantage during the 2007 to 2015 time period. Strategic leaders need to be aware to not end up being stuck in the middle between distinct business strategies. A clear strategic position—either as differentiator or low-cost leader—is more likely to form the basis for competitive advantage. Although quite attractive at first glance, a blue ocean strategy is difficult to implement because of the trade-offs between the two distinct strategic positions (low-cost leadership and differentiation), unless the firm is successful in value innovation that allows a reconciliation of these inherent trade-offs (discussed in detail later).

This chapter, the first in Part 2 on strategy formulation, takes a close look at busi- ness-level strategy, frequently also referred to as competitive strategy. It deals with how to compete for advantage. Based on the analysis of the external and internal environments (presented in Part 1), the second step in the AFI Strategy Framework is to formulate a busi- ness strategy that enhances the firm’s chances of achieving a competitive advantage.

We begin our discussion of strategy formulation by defining business-level strategy, strategic position, and generic business strategies. We then look at two key generic busi- ness strategies: differentiation and cost leadership. We pay special attention to value and cost drivers that managers can use to carve out a clear strategic profile. Next, we relate the two business-level strategies to the external environment, in particular, to the five forces, to highlight their respective benefits and risks. We then introduce the notion of blue ocean strategy—using value innovation to combine a differentiation and cost-leadership strategic position. We also look at changes in competitive positioning over time before concluding with practical Implications for Strategic Leaders.

6.1 Business-Level Strategy: How to Compete for Advantage

Business-level strategy details the goal-directed actions managers take in their quest for competitive advantage when competing in a single product market.2 It may involve a single product or a group of similar products that use the same distribution channel. It concerns the broad question, “How should we compete?” To formulate an appropriate business-level strategy, managers must answer the who, what, why, and how questions of competition:

■ Who—which customer segments will we serve? ■ What customer needs, wishes, and desires will we satisfy? ■ Why do we want to satisfy them? ■ How will we satisfy our customers’ needs?3

To formulate an effective business strategy, managers need to keep in mind that compet- itive advantage is determined jointly by industry and firm effects. As shown in Exhibit 6.1, one route to competitive advantage is shaped by industry effects, while a second route is determined by firm effects. As discussed in Chapter 3, an industry’s profit potential can be assessed using the five forces framework plus the availability of complements. Managers need to be certain that the business strategy is aligned with the five forces that shape com- petition. They can evaluate performance differences among clusters of firms in the same industry by conducting a strategic-group analysis. The concepts introduced in Chapter 4 are key in understanding firm effects because they allow us to look inside firms and explain why they differ based on their resources, capabilities, and competencies. It is also impor- tant to note that industry and firm effects are not independent, but rather they are interde- pendent, as shown by the two-pointed arrow connecting industry effects and firm effects in Exhibit 6.1. At the firm level, performance is determined by value and cost positions relative to competitors. This is the firm’s strategic position, to which we turn next.

LO 6-1

Define business-level strategy and describe how it determines a firm’s strategic position.

business-level strategy The goal- directed actions managers take in their quest for competitive advantage when competing in a single product market.

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STRATEGIC POSITION We noted in Chapter 5 that competitive advantage is based on the difference between the perceived value a firm is able to create for consumers (V), captured by how much con- sumers are willing to pay for a product or service, and the total cost (C) the firm incurs to create that value. The greater the economic value created (V − C), the greater is a firm’s potential for competitive advantage. To answer the business-level strategy question of how to compete, managers have two primary competitive levers at their disposal: value (V) and cost (C).

A firm’s business-level strategy determines its strategic position—its strategic profile based on value creation and cost—in a specific product market. A firm attempts to stake out a valuable and unique position that meets customer needs while simultaneously creat- ing as large a gap as possible between the value the firm’s product creates and the cost required to produce it. Higher value creation tends to require higher cost. To achieve a desired strategic position, managers must make strategic trade-offs—choices between a cost or value position. Managers must address the tension between value creation and the pressure to keep cost in check so as not to erode the firm’s economic value creation and profit margin. As shown in the ChapterCase, JetBlue experienced a competitive disad- vantage for a number of years because it was unable to effectively address the strategic trade-offs inherent in pursuing a cost-leadership and differentiation strategy at the same time. A business strategy is more likely to lead to a competitive advantage if a firm has a clear strategic profile, either as differentiator or a low-cost leader. A blue ocean strategy is only successful, in contrast, if the firm can implement some type of value innovation that reconciles the inherent trade-off between value creation and underlying costs.

GENERIC BUSINESS STRATEGIES There are two fundamentally different generic business strategies—differentiation and cost leadership. A differentiation strategy seeks to create higher value for customers than the value that competitors create, by delivering products or services with unique features while

EXHIBIT 6.1 / Industry and Firm Effects Jointly Determine Competitive Advantage

COMPETITIVE ADVANTAGE

BUSINESS STRATEGY

• Cost Leadership • Differentiation • Blue OceanCOST POSITION

Relative to Competitors

VALUE POSITION Relative to Competitors

WITHIN INDUSTRY • Strategic Groups

INDUSTRY ATTRACTIVENESS

• 5 Forces Model • Complements

INDUSTRY EFFECTS

FIRM EFFECTS

strategic trade- offs Choices between a cost or value position. Such choices are necessary because higher value creation tends to generate higher cost.

differentiation strategy Generic business strategy that seeks to create higher value for customers than the value that competitors create, while containing costs.

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keeping costs at the same or similar levels, allowing the firm to charge higher prices to its customers. A cost-leadership strategy, in contrast, seeks to create the same or similar value for customers by delivering products or services at a lower cost than competitors, enabling the firm to offer lower prices to its customers.

These two business strategies are called generic strategies because they can be used by any organization—manufacturing or service, large or small, for-profit or nonprofit, public or private, domestic or foreign—in the quest for competitive advantage, independent of industry context. Differentiation and cost leadership require distinct strategic positions, and in turn increase a firm’s chances to gain and sustain a competitive advantage.4 Because value creation and cost tend to be positively correlated, however, important trade-offs exist between value creation and low cost. A business strategy, therefore, is more likely to lead to a competitive advantage if it allows firms to either perform similar activities differently or perform different activities than their rivals that result in creating more value or offering similar products or services at lower cost.5

When considering different business strategies, managers also must define the scope of competition—whether to pursue a specific, narrow part of the market or go after the broader market.6 The automobile industry provides an example of the scope of competi- tion. Alfred P. Sloan, longtime president and CEO of GM, defined the carmaker’s mission as providing a car for every purse and purpose. GM was one of the first to implement a multidivisional structure in order to separate the brands into strategic business units, allowing each brand to create its unique strategic position (with its own profit and loss responsibility) within the broad automotive market. For example, GM’s product lineup ranges from the low-cost-positioned Chevy brand to the differentiated Cadillac brand. In this case, Chevy is pursuing a broad cost-leadership strategy, while Cadillac is pursu- ing a broad differentiation strategy. The two different business strategies are integrated at the corporate level at GM (more on corporate strategy in Chapters 8 and 9). On the other hand, Tesla, the maker of all-electric cars (featured in ChapterCase 1), offers a highly differentiated product and pursues only a small market segment. At this point, it uses a focused differentiation strategy. In particular, Tesla focuses on environmentally conscious consumers who are willing to pay a premium price. Going forward, Tesla is hop- ing to broaden its competitive scope with its new Model 3, priced at roughly half of the existing models (Model S sedan and Model X sport utility crossover). Taken together, GM’s competitive scope is broad—with a focus on the mass automotive market—while Tesla’s competitive scope is narrow—with a focus on all-electric luxury cars.

Now we can combine the dimensions describing a firm’s strategic position (differ- entiation versus cost) with the scope of com- petition (narrow versus broad). As shown in Exhibit 6.2, by doing so we get the two major broad business strategies (cost leadership and differentiation), shown as the top two boxes in the matrix, and the focused version of each, shown as the bottom two boxes in the matrix. The focused versions of the two

cost-leadership strategy Generic business strategy that seeks to create the same or similar value for customers at a lower cost.

scope of competition The size—narrow or broad—of the market in which a firm chooses to compete.

SOURCE: Adapted from M.E. Porter (1980), Competitive Strategy. Techniques for Analyzing Industries and Competitors (New York: Free Press).

Cost Leadership Differentiation

Focused Differentiation

Focused Cost Leadership

Cost

Na rr

ow Br

oa d

Differentiation

STRATEGIC POSITION

CO M

PE TI

TI VE

S CO

PE

EXHIBIT 6.2 / Strategic Position and Competitive Scope: Generic Business Strategies

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business strategies—focused cost-leadership strategy and focused differentiation strategy—are essentially the same as the broad generic strategies except that the com- petitive scope is narrower. For example, the manufacturing company BIC pursues a focused cost-leadership strategy, designing and producing disposable pens and ciga- rette lighters at a low cost, while Mont Blanc pursues a focused differentiation strategy, offering exquisite pens—what it calls “writing instruments”—frequently priced at sev- eral hundred dollars.

As discussed in ChapterCase 6, JetBlue attempts to combine a focused cost-leadership position with a focused differentiation position. Although initially successful, JetBlue has been consistently outperformed for several years by airlines that do not attempt to straddle different strategic positions, but rather have a clear strategic profile as either a differentia- tor or a low-cost leader. For example, Southwest Airlines competes clearly as a broad cost leader (and would be placed squarely in the upper-left quadrant of Exhibit 6.2). The legacy carriers—Delta, American, and United—all compete as broad differentiators (and would be placed in the upper-right quadrant of Exhibit 6.2). Regionally, we find smaller airlines that are ultra low cost, such as Allegiant Air, Frontier Airlines, or Spirit Airlines, with a very clear strategic position. These smaller airlines would be placed in the lower-left quad- rant of Exhibit 6.2 because they are pursuing a focused cost-leadership strategy. Based on a clear strategic position, these airlines have outperformed JetBlue over many years. The reason is that JetBlue appears to be stuck between different strategic positions, trying to combine a focused cost-leadership position with focused differentiation. As JetBlue grew, the problems inherent in an attempt to straddle different strategic positions grew more severe because JetBlue now attempts to also straddle the (broad) cost-leadership position with the (broad) differentiation position, thus trying to be everything to everybody. Being stuck in the middle of different strategic positions is a recipe for inferior performance and competitive disadvantage—and this is exactly what JetBlue has experienced between 2007 and 2015. Over the past few years, JetBlue has performed roughly on par with the industry average, as determined by the Dow Jones Airlines Index, including the big four airlines (American, Delta, SWA, and United) as well as smaller airlines such as Alaska Airlines, Allegiant Air, and Spirit. Part of JetBlue’s ability to close its performance gap is the highly successful rollout of the Mint experience, which offers first-class travel at a discount. Indeed, on routes where JetBlue offers its Mint experience (such as flying coast to coast), the legacy airlines have dropped their first-class prices significantly to be competitive with JetBlue. Many customers, however, feel that the Mint travel experience is superior to first- class travel on traditional airlines.7

6.2 Differentiation Strategy: Understanding Value Drivers

The goal of a differentiation strategy is to add unique features that will increase the perceived value of goods and services in the minds of consumers so they are willing to pay a higher price. Ideally, a firm following a differentiation strategy aims to achieve in the minds of consumers a level of value creation that its competitors cannot easily match. The focus of competition in a differentiation strategy tends to be on unique prod- uct features, service, and new-product launches, or on marketing and promotion rather than price.

Several competitors in the bottled-water industry provide a prime example of pursuing a successful differentiation strategy.8 As more and more consumers shift from carbon- ated soft drinks to healthier choices, the industry for bottled water is booming—growing

LO 6-2

Examine the relationship between value drivers and differentiation strategy.

focused cost- leadership strategy Same as the cost- leadership strategy except with a narrow focus on a niche market.

focused differentiation strategy Same as the differentiation strategy except with a narrow focus on a niche market.

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about 10 percent per year. In the United States, the per person consumption of bottled water surpassed that of carbonated soft drinks for the first time in 2016. Such a fast-growing industry provides ample opportunity for differentiation. In particu- lar, the industry is split into two broad segments depending on the sales price. Bottled water with a sticker price of $1.30 or less per 32 ounces (close to one liter) is considered low-end, while those with a higher price tag are seen as luxury items. For example, PepsiCo’s Aquafina and Coca- Cola’s Dasani are considered low-end products, selling purified tap water at low prices, often in bulk at big-box retailers such as Walmart. On the premium end, PepsiCo introduced Lifewtr with a splashy ad during Super Bowl LI in 2017, while Jennifer Aniston markets Smartwater, Coca-Cola’s premium water.

The idea of selling premium water is not new, however. Evian (owned by Danone, a French consumer products company) and Pellegrino (owned by Nestlé of Switzerland) have long focused on differentiating their products by emphasizing the uniqueness of their respective natural sources (Evian hails from the French Alps while Pellegrino comes from San Pellegrino Terme in Italy’s Lombardy region). Recent entrants into the luxury seg- ment for bottled water have taken the differentiation of their products to new heights. Some purveyors, such as Svalbardi, are able to charge super premium prices. At upscale retailer Harrods in London, a bottle of Svalbardi costs about $100 for 25 ounces; the water, sold in a heavy glass bottle, hails from Norwegian icebergs some 4,000 years old. Ordering premium bottled water in the United States to accompany lunch has become a status sym- bol. Indeed, many restaurants now feature water lists besides the more traditional wine selection. “Energy waters” enhanced with minerals and vitamins are the fastest-growing segment. Although flavored waters make up less than 5 percent of the overall market for bottled water, they rack up 15 percent of total revenues. And this is nothing to be snuffed at: The market for bottled water globally reached some $150 billion, and continues to grow fast. Although a free substitute can be had from most taps in industrialized countries, the success of many luxury brands in the bottled-water industry shows the power of differen- tiation strategy.

A company that uses a differentiation strategy can achieve a competitive advantage as long as its economic value created (V − C) is greater than that of its competitors. Firm A in Exhibit 6.3 produces a generic commodity. Firm B and Firm C represent two efforts at differentiation. Firm B not only offers greater value than Firm A, but also maintains cost parity, meaning it has the same costs as Firm A. However, even if a firm fails to achieve cost parity (which is often the case because higher value creation tends to go along with higher costs in terms of higher-quality raw materials, research and development, employee training to provide superior customer service, and so on), it can still gain a competitive advantage if its economic value creation exceeds that of its competitors. Firm C represents just such a competitive advantage. For the approach shown either in Firm B or Firm C, economic value creation, (V − C)B or (V − C)C, is greater than that of Firm A (V − C)A. Either Firm B or C, therefore, achieves a competitive advantage because it has a higher value gap over Firm A [(V − C)B > (V − C)A, or (V − C)C > (V − C)A], which allows it to charge a premium price, reflecting its higher value creation. To complete the relative

©anythings/Shutterstock .com RF

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comparison, although both companies pursue a differentiation strategy, Firm B also has a competitive advantage over Firm C because although both offer identical value, Firm B has lower cost, thus (V − C)B > (V − C)C.

Although increased value creation is a defining feature of a differentiation strategy, managers must also control costs. Rising costs reduce economic value created and erode profit margins. Indeed, if cost rises too much as the firm attempts to create more perceived value for customers, its value gap shrinks, negating any differentiation advantage. One reason JetBlue could not maintain an initial competitive advantage was because it was unable to keep its costs down sufficiently. JetBlue’s new management team immediately put measures in place to lower the airline’s cost structure such as charging fees for checked bags and reducing leg space to increase passenger capacity on each of its planes. These cost-saving initiatives should increase its economic value creation.

Although a differentiation strategy is generally associated with premium pricing, man- agers have an important second pricing option. When a firm is able to offer a differentiated product or service and can control its costs at the same time, it is able to gain market share from other firms in the industry by charging a similar price but offering more perceived value. By leveraging its differentiated appeal of superior customer service and quality, for example, Marriott offers a line of different hotels: its flagship Marriott full-service business hotel equipped to host large conferences; Residence Inn for extended stay; Mar- riott Courtyard for business travelers; and Marriott Fairfield Inn for inexpensive leisure and family travel.9 Although these hotels are roughly comparable to competitors in price, they generally offer a higher perceived value. With this line of different hotels, Marriott can benefit from economies of scale and scope, and thus keep its cost structure in check. Economies of scale denote decreases in cost per unit as output increases (more in the next section when we discuss cost-leadership strategy). Economies of scope describe the sav- ings that come from producing two (or more) outputs at less cost than producing each output individually, even though using the same resources and technology. This larger dif- ference between cost and value allows Marriott to achieve greater economic value than its competitors, and thus to gain market share and post superior performance.

economies of scope Savings that come from producing two (or more) outputs at less cost than producing each output individually, despite using the same resources and technology.

Firm A

Disadvantage

Va lu

e

C B

(V–C )A

(V–C )B (V–C )C

C A C C

Co st

Firm B: Differentiator

Firm C: Differentiator

Advantage

Competitive PositionEXHIBIT 6.3 / Differentiation Strategy: Achieving Competitive Advantage Under a differentiation strategy, firms that suc- cessfully differentiate their products enjoy a com- petitive advantage. Firm A’s product is seen as a generic commodity with no unique brand value. Firm B has the same cost structure as Firm A but creates more economic value, and thus has a competitive advantage over both Firm A and Firm C because (V − C )B > (V − C )C > (V − C )A. Although, Firm C has higher costs than Firm A and B, it still generates a significantly higher eco- nomic value than Firm A.

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Managers can adjust a number of different levers to improve a firm’s strategic position. These levers either increase perceived value or decrease costs. Here, we will study the most salient value drivers that managers have at their disposal (we look at cost drivers in the next section).10 They are:

■ Product features ■ Customer service ■ Complements

These value drivers are related to a firm’s expertise in, and organization of, different internal value chain activities. Although these are the most important value drivers, no such list can be complete. Applying the concepts introduced in this chapter should allow strategic leaders to identify other important value and cost drivers unique to their business.

When attempting to increase the perceived value of the firm’s product or service offer- ings, managers must remember that the different value drivers contribute to competitive advantage only if their increase in value creation (ΔV) exceeds the increase in costs (ΔC). The condition of ΔV > ΔC must be fulfilled if a differentiation strategy is to strengthen a firm’s strategic position and thus enhance its competitive advantage.

PRODUCT FEATURES One of the obvious but most important levers that strategic leaders can adjust is product features, thereby increasing the perceived value of the product or service offering. Adding unique product attributes allows firms to turn commodity products into differentiated prod- ucts commanding a premium price. Strong R&D capabilities are often needed to create superior product features. In the kitchen-utensil industry, OXO follows a differentiation strategy, highlight- ing product features. By adhering to its philoso- phy of making products that are easy to use for the largest variety of possible users,11 OXO dif- ferentiates its kitchen utensils through its patent- protected ergonomically designed soft black rubber grips.

CUSTOMER SERVICE Managers can increase the perceived value of their firms’ product or service offerings by focusing on customer service. For example, the online retailer Zappos earned a reputation for superior customer service by offering free shipping both ways: to the customer and for returns.12 Zappos’s strategic leaders didn’t view this as an additional expense but rather as part of their marketing budget. Moreover, Zappos does not outsource its customer service, and its associates do not use predetermined scripts. They are instead encouraged to build a relationship of trust with each individual customer. There seemed to be a good return on investment as word spread through the online shopping community. Competitors took notice, too; Amazon bought Zappos for over $1 billion.13

COMPLEMENTS When studying industry analysis in Chapter 3, we identified the availability of complements as an important force determining the profit potential of an industry. Complements add value

Trader Joe’s is a chain of more than 400 stores, half of which are in California and the rest in another 38 states plus Washington, D.C. The chain is known for good products, value for money, clerks in Hawaiian shirts—and great customer service. As just one example, stores happily stock local products as requested by their communities.14

©Karsten Moran/Aurora Photos/Alamy Stock Photo

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to a product or service when they are consumed in tandem. Finding complements, therefore, is an important task for managers in their quest to enhance the value of their offerings.

A prime example of complements is smartphones and cellular services. A smartphone without a service plan is much less useful than one with a data plan. Traditionally, the provid- ers of phones such as Apple, Samsung, and others did not provide wireless services. AT&T and Verizon are by far the two largest service providers in the United States, jointly holding some 70 percent of market share. To enhance the attractiveness of their phone and service bundles, phone makers and service providers frequently sign exclusive deals. When first released, for instance, service for the iPhone was exclusively offered by AT&T. Thus, if you wanted an iPhone, you had to sign up for a two-year service contract with AT&T.

Google, a division of Alphabet, decided to offer the important complements of smart- phones and wireless services in-house to attract more customers.15 Google offers high-end phones such as the Pixel 2 with cutting-edge artificial intelligence built in (via its Google Assistant) at competitive prices. It combines this with discounted high-speed wireless ser- vices in its Project Fi, a complementary offering. Working in conjunction with smaller wireless service providers such as Sprint and T-Mobile, Google provides seamless wire- less services by stitching together a nationwide network of services based on available free Wi-Fi hotspots (such as at Starbucks) and cellular networks offered by Sprint or T-Mobile. This not only enables wide coverage, but also reduces data usage significantly because Google phones automatically switch to free Wi-Fi networks wherever available.

Project Fi is intended to drive more demand for Google’s phone; sales have been lack- luster thus far. Stronger demand for Google’s phones locks more users into the Google ecosystem as its wireless services are available only with its own phones. This provides an example where complementary product and service offerings not only reinforce demand for one another, but also create a situation where network externalities can arise. As more users sign up for Project Fi, Google is able to offer faster and more reliable services (through investing more into the latest technology, such as 5G), making its network and with it its Google phones more attractive to more users, and so forth.

As you have just seen, the differentiation strategy covers a great deal of ground, so let’s summarize what we have learned. By choosing the differentiation strategy as the strate- gic position for a product, managers focus their attention on adding value to the product through its unique features that respond to customer preferences, customer service during and after the sale, or effective marketing that communicates the value of the product’s features. Although this positioning involves increased costs (for example, higher-quality inputs or innovative research and development activities), customers will be willing to pay a premium price for the product or service that satisfies their needs and preferences. In the next section, we will discuss how managers formulate a cost-leadership strategy.

6.3 Cost-Leadership Strategy: Understanding Cost Drivers

The goal of a cost-leadership strategy is to reduce the firm’s cost below that of its competitors while offering adequate value. The cost leader, as the name implies, focuses its attention and resources on reducing the cost to manufacture a product or on lowering the operating cost to deliver a service in order to offer lower prices to its customers. The cost leader attempts to optimize all of its value chain activities to achieve a low-cost position. Although staking out the lowest-cost position in the industry is the overriding strategic objective, a cost leader still needs to offer products and services of acceptable value. As an example, GM and Korean car manufacturer Kia offer some models that compete directly with one another, yet Kia’s cars tend to be produced at lower cost, while providing a similar value proposition.

LO 6-3

Examine the relationship between cost drivers and cost-leadership strategy.

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A cost leader can achieve a competitive advantage as long as its economic value cre- ated (V − C) is greater than that of its competitors. Firm A in Exhibit 6.4 produces a product with a cost structure vulnerable to competition. Firms B and C show two differ- ent approaches to cost leadership. Firm B achieves a competitive advantage over Firm A because Firm B not only has lower cost than Firm A, but also achieves differentiation parity (meaning it creates the same value as Firm A). As a result, Firm B’s economic value creation, (V − C)B, is greater than that of Firm A, (V − C)A. For example, as the low-cost leader, Walmart took market share from Kmart, which subsequently filed for bankruptcy.

What if a firm fails to create differentiation parity? Such parity is often hard to achieve because value creation tends to go along with higher costs, and Firm B’s strategy is aimed at lower costs. A firm can still gain a competitive advantage as long as its economic value creation exceeds that of its competitors. Firm C represents this approach to cost leadership. Even with lower value (no differentiation parity) but lower cost, Firm C’s economic value creation, (V − C)C, still is greater than that of Firm A, (V − C)A.

In both approaches to cost leadership in Exhibit 6.4, Firm B’s economic value creation is greater than that of Firm A and Firm C. Yet, both firms B and C achieve a competitive advantage over Firm A. Either one can charge prices similar to its competitors and benefit from a greater profit margin per unit, or it can charge lower prices than its competition and gain higher profits from higher volume. Both variations of a cost-leadership strategy can result in competitive advantage. Although Firm B has a competitive advantage over both firms A and C, Firm C has a competitive advantage in comparison to Firm A.

Although companies successful at cost leadership must excel at controlling costs, this doesn’t mean that they can neglect value creation. Kia signals the quality of its cars with a five-year, 60,000-mile warranty, one of the more generous warranties in the industry. Walmart offers products of acceptable quality, including many brand-name products.

The most important cost drivers that managers can manipulate to keep their costs low are:

■ Cost of input factors. ■ Economies of scale. ■ Learning-curve effects. ■ Experience-curve effects.

EXHIBIT 6.4 / Cost-Leadership Strategy: Achieving Competitive Advantage Under a cost-leadership strategy, firms that can keep their cost at the low- est point in the industry while offering acceptable value are able to gain a competitive advantage. Firm A has not managed to take advantage of possi- ble cost savings, and thus experiences a competitive disadvantage. The offering from Firm B has the same perceived value as Firm A but through more effective cost containment creates more economic value (over both Firm A and Firm C because (V − C)B > (V − C)C > (V − C)A. The offering from Firm C has a lower perceived value than that of Firm A or B and has the same reduced product cost as with Firm B; as a result, Firm C still generates higher eco- nomic value than Firm A.

Firm A

Disadvantage

Competitive Position

Advantage Va

lu e

C B

(V –C )B

(V –C )A (V –C )C

C A C C

Co st

Firm B: Cost Leader

Firm C: Cost Leader

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However, this list is only a starting point; managers may consider other cost drivers, depending on the situation.

COST OF INPUT FACTORS One of the most basic advantages a firm can have over its rivals is access to lower-cost input factors such as raw materials, capital, labor, and IT services. In the market for international long-distance travel, the greatest competitive threat facing U.S. legacy carriers— American, Delta, and United—comes from three fast-growing airlines located in the Persian Gulf states—Emirates, Etihad, and Qatar. These airlines achieve a competitive advantage over their U.S. counterparts thanks to lower-cost inputs—raw materials (access to cheaper fuel), capital (interest-free government loans), labor—and fewer regulations (for example, regarding nighttime takeoffs and landings, or in adding new runways and building luxury airports with swimming pools, among other amenities).16 To benefit from lower-cost IT services, the Gulf carriers also outsource some value chain activities such as booking and online customer service to India. Together, these distinct cost advantages across several key input factors add up to create a greater economic value creation for the Gulf carriers vis-à-vis U.S. competitors, leading to a competitive advantage (more on the Gulf carriers in Strategy Highlight 10.1).

ECONOMIES OF SCALE Firms with greater market share might be in a position to reap economies of scale, decreases in cost per unit as output increases. This relationship between unit cost and out- put is depicted in the first (left-hand) part of Exhibit 6.5: Cost per unit falls as output increases up to point Q1. A firm whose output is closer to Q1 has a cost advantage over other firms with less output. In this sense, bigger is better.

In the airframe-manufacturing industry, for example, reaping economies of scale and learning is critical for cost-competitiveness. The market for commercial airplanes is often not large enough to allow more than one competitor to reach sufficient scale to drive down unit cost. Boeing chose not to compete with Airbus in the market for superjumbo jets; rather, it decided to focus on a smaller, fuel-efficient airplane (the 787 Dreamliner, priced at roughly $250 million) that allows for long-distance, point-to-point connections.

economies of scale Decreases in cost per unit as output increases.

EXHIBIT 6.5 / Economies of Scale, Minimum Efficient Scale, and Diseconomies of Scale

Pe r-U

ni t C

os t (

$)

Output (Q )

Economies of Scale Constant Returns

to Scale Diseconomies of Scale

Q 1 Q 2

Minimum Efficient Scale

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By 2017, it had built over 530 Dreamliners with more than 1,200 orders for the new air- plane.17  Boeing can expect to reap significant economies of scale and learning, which will lower per-unit cost. At the same time, Airbus had delivered 210 A-380 superjumbos (sticker price: $430 million) with more than 100 orders on its books.18 If both companies would have chosen to compete head-on in each market segment, the resulting per-unit cost for each airplane would have been much higher because neither could have achieved sig- nificant economies of scale (overall their market share split is roughly 50–50).

What causes per-unit cost to drop as output increases (up to point Q1)? Economies of scale allow firms to:

■ Spread their fixed costs over a larger output. ■ Employ specialized systems and equipment. ■ Take advantage of certain physical properties.

SPREADING FIXED COSTS OVER LARGER OUTPUT. Larger output allows firms to spread their fixed costs over more units. That is why gains in market share are often critical to drive down per-unit cost. This relationship is even more pronounced in many high-tech industries because most of the cost occurs before a single product or service is sold. Take operating systems software as an example. Microsoft spends over $10 billion a year on research and development (R&D).19 Between 2011 and 2015, a good part of this was spent on developing Windows 10, its newest operating system software. This R&D expense was a fixed cost Microsoft had to incur before a single copy of Windows 10 was sold. How- ever, once the initial version of the new software was completed, the marginal cost of each additional copy was basically zero, especially for copies sold in digital form online. Given that Microsoft dominates the operating system market for personal computers (PCs) with more than 90 percent market share, it expects to sell several hundred million copies of Windows 10, thereby spreading its huge fixed cost of development over a large out- put. Microsoft’s huge installed base of Windows operating systems throughout the world allowed it to capture a large profit margin for each copy of Windows sold, after recouping its initial investment. Microsoft has high hopes for its newest operating system with the goal of bringing together not only PCs and mobile devices but also the Xbox One and other Windows devices. Microsoft’s Windows 10 also drives sales for complementary products such as the ubiquitous Microsoft Office Suite made up of Word, Excel, PowerPoint, and Outlook, among other programs (as discussed in ChapterCase 5).

EMPLOYING SPECIALIZED SYSTEMS AND EQUIPMENT. Larger output also allows firms to invest in more specialized systems and equipment, such as enterprise resource planning (ERP) software or manufacturing robots. Tesla’s strong demand for its new Model 3 sedan allows it to employ cutting-edge robotics in its Fremont, California, manufacturing plant to produce cars of the highest quality at large scale, and thus driving down costs.

TAKING ADVANTAGE OF CERTAIN PHYSICAL PROPERTIES. Economies of scale also occur because of certain physical properties. One such property is known as the cube- square rule: The volume of a body such as a pipe or a tank increases disproportionately more than its surface. This same principle makes big-box retail stores such as Walmart or The Home Depot cheaper to build and run. They can also stock much more merchandise and handle inventory more efficiently. Their huge size makes it difficult for department stores or small retailers to compete on cost and selection.

Look again at Exhibit 6.5. The output range between Q1 and Q2 in the figure is consid- ered the minimum efficient scale (MES) to be cost-competitive. Between Q1 and Q2, the returns to scale are constant. It is the output range needed to bring the cost per unit down as

minimum efficient scale (MES) Output range needed to bring down the cost per unit as much as possible, allowing a firm to stake out the lowest- cost position that is achievable through economies of scale.

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much as possible, allowing a firm to stake out the lowest-cost position achievable through economies of scale. With more than 10 million Prius cars sold since its introduction in 1997, Toyota has been able to reach the minimum efficient scale part of the per-unit cost curve. This allows the company to offer the car at a relatively low price and still make a profit.

The concept of minimum efficient scale applies not only to manufacturing processes but also to managerial tasks such as how to organize work. Due to investments in special- ized technology and equipment (e.g., electric arc furnaces), Nucor is able to reach MES with much smaller batches of steel than larger, fully vertically integrated steel companies using older technology. Nucor’s optimal plant size is about 500 people, which is much smaller than at larger integrated steelmakers such as U.S. Steel which often employ thou- sands of workers per plant.20 Of course, minimum efficient scale depends on the specific industry: The average per-unit cost curve, depicted conceptually in Exhibit 6.5, is a reflec- tion of the underlying production function, which is determined by technology and other input factors.

Benefits to scale cannot go on indefinitely, though. Bigger is not always better; in fact, sometimes bigger is worse. Beyond Q2 in Exhibit 6.5, firms experience diseconomies of scale—increases in cost as output increases. As firms get too big, the complexity of managing and coordinating the production process raises the cost, negating any benefits to scale. Large firms also tend to become overly bureaucratic, with too many layers of hierar- chy. They grow inflexible and slow in decision making. To avoid problems associated with diseconomies of scale, Gore Associates, maker of GORE-TEX fabric, Glide dental floss, and many other innovative products, breaks up its company into smaller units. Gore Asso- ciates found that employing about 150 people per plant allows it to avoid diseconomies of scale. It uses a simple decision rule:21 “We put 150 parking spaces in the lot, and when people start parking on the grass, we know it’s time to build a new plant.”22

Finally, there are also physical limits to scale. Airbus is pushing the envelope with its A-380 aircraft, which can hold more than 850 passengers and fly up to 8,200 miles (enough to travel nonstop from Boston to Hong Kong at about 600 mph). The goal, of course, is to drive down the cost of the average seat-mile flown (CASM, a standard cost metric in the airline industry). It remains to be seen whether the A-380 superjumbo will enable airlines to reach minimum efficient scale or will simply be too large to be efficient. For example, boarding and embarking procedures must be streamlined to accommodate more than 850 people in a timely and safe manner. Many airports around the world need to be retrofitted with longer and wider runways to allow the superjumbo to take off and land.

Scale economies are critical to driving down a firm’s cost and strengthening a cost- leadership position. Although managers need to increase output to operate at a minimum efficient scale (between Q1 and Q2 in Exhibit 6.5), they also need to be watchful not to drive scale beyond Q2, where they would encounter diseconomies. In sum, if the firm’s output range is less than Q1 or more than Q2, the firm is at a cost disadvantage; reaching an output level between Q1 and Q2 is optimal in regards to driving down costs. Monitoring the firm’s cost structure closely over different output ranges allows managers to fine-tune operations and benefit from economies of scale.

LEARNING CURVE Do learning curves go up or down? Looking at the challenge of learning, many people tend to see it as an uphill battle, and assume the learning curve goes up. But if we con- sider our productivity, learning curves go down, as it takes less and less time to produce the same output as we learn how to be more efficient—learning by doing drives down cost. As individuals and teams engage repeatedly in an activity, whether writing computer code, developing new medicines, or building submarines, they learn from their cumulative

diseconomies of scale Increases in cost per unit when output increases.

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experience.23  Learning curves were first documented in aircraft manufacturing as the United States ramped up production in the 1930s, before its entry into World War II.24 Every time production was doubled, the per-unit cost dropped by a predictable and con- stant rate (approximately 20 percent).25

It is not surprising that a learning curve was first observed in aircraft manufacturing. Highly complex, a modern commercial aircraft can contain more than 5 million parts, compared with a few thousand for a car. The more complex the underlying process to manufacture a product or deliver a service, the more learning effects we can expect. As cumulative output increases, managers learn how to optimize the process, and workers improve their performance through repetition.

TESLA’S LEARNING CURVE. Tesla’s production of its Model S vehicle provides a more recent example, depicted in Exhibit 6.6, with the horizontal axis showing cumulative out- put in units and the vertical axis showing per-unit cost in thousands of dollars.26

The California-based designer and manufacturer of all-electric cars made headlines in 2017 when its market capitalization overtook both GM and Ford. This was the first time in U.S. history that the most valuable U.S. car company is not based in Detroit, Michigan, but in Silicon Valley. In 2016, Tesla sold some 80,000 vehicles, while GM sold some 10 million. How can a start-up company that makes less than 1 percent as many vehicles as GM have a higher market valuation? The answer: Future expected growth. Investors bidding up Tesla’s share price count on the maker of all-electric cars to sell millions of its new Model 3. When the Model 3 was announced in 2016, Tesla garnered some 400,000 preorders from future owners for a car that was not yet produced, let alone test-driven by any potential buyer.

Tesla’s learning curve is critical in justifying such lofty stock market valuations, because as production volume increases, production cost per car falls, and the company becomes profitable. Based on a careful analysis of production reports for the Model S between 2012 and 201427, Exhibit 6.6 shows how Tesla was able to drive down the unit cost for each car as production volume ramped up. Initially, Tesla lost a significant amount of money on each Model S sold because of high upfront R&D spending to develop the futuristic

EXHIBIT 6.6 / Tesla’s Learning Curve Producing the Model S SOURCE: Depiction of functional relationship estimated in J. Dyer and H. Gregersen (2016), “Tesla’s innovations are transforming the auto industry,” Forbes, August 24.

$350,000

$300,000

$250,000

$200,000

$150,000

$100,000

$50,000

$0 0 2,000 4,000 6,000 8,000 10,000 12,000

Cumulative Output (Units)

Model S $ average sales

price: $90,000

Pe r-

Un it

C os

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self-driving car. When producing only 1,000 vehicles, unit cost was $140,000. As produc- tion volume of the Model S reached some 12,000 units per year (in 2014), unit cost fell to about $57,000. Although still high, Tesla was able start making money on each car, because the average selling price for a Model S was about $90,000.

The relationship between production volume and per-unit cost for Tesla (depicted in Exhibit 6.6) suggests that it is an 80 percent learning curve. In an 80 percent learning curve, per-unit cost drops 20 percent every time output is doubled. Assuming a similar relationship holds for the Model 3 production, then per-unit cost would fall to $16,000 per Model 3 with a cumulative production volume of 400,000 (which is the number of preor- ders Tesla received within one week of announcing this new vehicle). Although the Model 3 base price is pegged at $35,000, the estimated average selling price is more like $50,000 given additional features and eventual expiration of a $7,500 federal tax credit for electric vehicles (when a manufacturer hits 200,000 units). Riding down an 80 percent learning curve, Tesla could make a profit of an estimated $34,000 per Model 3. This would translate to a cumulative profit for Tesla of more than $13.5 billion for the Model 3 preorders alone. This back-of-the-envelope calculation shows some of the rationale behind Tesla’s market capitalization exceeding that of GM and Ford.

Taken together, this example highlights not only the power of the learning curve in driv- ing down per-unit costs, but also how critical cost containment is in gaining a competitive advantage when pursuing a differentiation strategy as Tesla does.

DIFFERENCES IN LEARNING CURVES. Let’s now compare different learning curves, and explore their implications for competitive advantage. The steeper the learning curve, the more learning has occurred. As cumulative output increases, firms move down the learn- ing curve, reaching lower per-unit costs. Exhibit 6.7 depicts two different learning curves: a 90 percent and an 80 percent learning curve. In a 90 percent learning curve, per-unit cost drops 10 percent every time output is doubled. The steeper 80 percent learning curve

EXHIBIT 6.7 / Gaining Competitive Advantage through Leveraging Learning- and Experience-Curve Effects

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indicates a 20 percent drop every time output is doubled (this was the case in the Tesla example above). It is important to note that the learning-curve effect is driven by increasing cumulative output within the existing technology over time. That implies that the only dif- ference between two points on the same learning curve is the size of the cumulative output. The underlying technology remains the same. The speed of learning determines the slope of the learning curve, or how steep the learning curve is (e.g., 80 percent is steeper than a 90 percent learning curve because costs decrease by 20 percent versus a mere 10 percent each time output doubles). In this perspective, economies of learning allow movement down a given learning curve based on current production technology.

By moving further down a given learning curve than competitors, a firm can gain a competitive advantage. Exhibit 6.7 shows that Firm B is further down the 90 percent learn- ing curve than Firm A. Firm B leverages economies of learning due to larger cumulative output to gain an advantage over Firm A. The only variable that has changed is cumulative output; the technology underlying the 90 percent learning curve remained the same. 

Let’s continue with the example of manufacturing airframes. To be more precise, as shown in Exhibit 6.7, Firm A produces eight aircraft and reaches a per-unit cost of $73 million per aircraft.28 Firm B produces 128 aircraft using the same technology as Firm A (because both firms are on the same [90 percent] learning curve), but given a much larger cumulative out- put, its per unit-cost falls to only $48 million. Thus, Firm B has a clear competitive advantage over Firm A, assuming similar or identical quality in output. We will discuss Firm C when we formally introduce the impact of changes in technology and process innovation.

Learning curves are a robust phenomenon observed in many industries, not only in man- ufacturing processes but also in alliance management, franchising, and health care.29 For example, physicians who perform only a small number of cardiac surgeries per year can have a patient mortality rate five times higher than physicians who perform the same surgery more frequently.30 Strategy Highlight 6.1 features Dr. Devi Shetty of India who reaped huge benefits by applying learning-curve principles to open-heart surgery, driving down cost while improving quality at the same time!

Learning effects differ from economies of scale (discussed earlier) as shown:

■ Differences in timing. Learning effects occur over time as output accumulates, while economies of scale are captured at one point in time when output increases. The improvements in Tesla’s production costs, featured earlier, resulted from some 12,000 units in cumulative output, but it took two years to reach this volume (see Exhibit 6.6). Although learning can decline or flatten (see Exhibit 6.7), there are no diseconomies to learning (unlike diseconomies to scale in Exhibit 6.5).

■ Differences in complexity. In some production processes (e.g., the manufacture of steel rods), effects from economies of scale can be quite significant, while learning effects are minimal. In contrast, in some professions (brain surgery or the practice of estate law), learning effects can be substantial, while economies of scale are minimal.

Managers need to understand such differences to calibrate their business-level strategy. If a firm’s cost advantage is due to economies of scale, a manager should worry less about employee turnover (and a potential loss in learning) and more about drops in production runs. In contrast, if the firm’s low-cost position is based on complex learning, a manager should be much more concerned if a key employee (e.g., a star engineer) was to leave.

EXPERIENCE CURVE In the learning curve just discussed, we assumed the underlying technology remained con- stant, while only cumulative output increased. In the experience curve, in contrast, we now change the underlying technology while holding cumulative output constant.31

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Dr. Shetty: “The Henry Ford of Heart Surgery” days a week. The difference adds up. Some of Dr. Shetty’s sur- geons perform more specialized procedures by the time they are in their 30s than their U.S. counterparts will perform throughout their entire careers. This volume of experience allows the cardiac surgeons to move down the learning curve quickly, because the more heart surgeries they perform, the more their skills improve. With this skill level, surgical teams develop robust standard oper- ating procedures and processes, where team members become experts at their specific tasks.

This expertise improves outcomes while the learning- curve effects of performing the same procedures over time also save money (see Exhibit 6.7). Other factors provide addi- tional cost savings. At the same time, Dr. Shetty pays his car- diac surgeons the going rate in India, between $110,000 and $250,000 a year, depending on experience. Their U.S. coun- terparts earn two to three times the average Indian salary.

Dr. Shetty’s health group also reduces costs through econo- mies of scale. By performing thousands of heart surgeries a year, high fixed costs such as the purchase of expensive medical equip- ment can be spread over a much larger volume. The Narayana hospital in Bangalore has 1,000 beds (many times larger than the average U.S. hospital with 160 beds) and some 20 operating rooms that stay busy pretty much around the clock. This scale allows the Narayana heart clinic to cost-effectively employ special- ized high-tech equipment. Given the large size of Dr. Shetty’s hos- pital, he also has significant buying power, driving down the costs of the latest high-tech equipment from top-notch vendors such as GE. Wherever possible, Dr. Shetty sources lower-cost inputs such as sutures locally, rather than from the more expensive companies such as Johnson & Johnson. Further, the Narayana heart clinic shares common services, such as laboratories and blood bank and more mundane services such as catering, with the 1,400-bed cancer clinic next door. Taken together, all of these small changes result in significant cost savings, and so create a reinforcing sys- tem of low-cost value chain activities.

While many worry that high volume compromises quality, the data suggest the opposite: Narayana Health’s medical outcomes in terms of mortality rate are equal to or even lower than the best hospitals in the United States. The American College of Cardiol- ogy frequently sends surgeons and administrators to visit the Narayana heart clinic. The college concluded that the clinic pro- vides high-tech and high-quality care at low cost. Dr. Shetty now brings top-notch care at low cost to the masses in India. Narayana Health runs a chain of over 30 hospitals in 20 locations through- out India and performs some 100,000 heart surgeries a year.32

Strategy Highlight 6.1

©Namas Bhojani

Open-heart surgeries are complex medical procedures and loaded with risk. While well-trained surgeons using high-tech equipment are able to reduce mortality rates, costs for cardiac surgeries in the United States have climbed. Difficult heart surgeries can cost $100,000 or more. A heart surgeon in India has driven the costs down to an average of $2,000 per heart surgery, while delivering equal or better outcomes in terms of quality.

Dr. Devi Shetty’s goal is to be “the Henry Ford of heart sur- gery.” Just like the great American industrialist who applied the learning curve to drive down the cost of an automobile to make it affordable, so Dr. Shetty is reducing the costs of health care and making some of the most complex medical procedures affordable to the world’s poorest. A native of Mangalore, India, Dr. Shetty was trained as a heart surgeon at Guy’s Hospital in London, one of Europe’s best medical facilities. He first came to fame in the 1990s when he successfully conducted an open-heart bypass sur- gery on Mother Teresa, after she suffered a heart attack.

Dr. Shetty believes that the key to driving down costs in health care is not product innovation, but process innovation. He is able to drive down the cost of complex medical procedures from $100,000 to $2,000 not by doing one big thing, but rather by focusing on doing a thousand small things. Dr. Shetty is apply- ing the concept of the learning curve to make a complex proce- dure routine and comparatively inexpensive. Part of the Narayana Health group, Dr. Shetty’s hospital in Bangalore, India, performs so many cardiac procedures per year that doctors are able to get a great deal of experience quickly, which allows them to specialize in one or two complex procedures. The Narayana surgeons per- form two or three procedures a day for six days a week, compared to U.S. surgeons who perform one or two procedures a day for five

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In general, technology and production processes do not stay constant. Process innovation—a new method or technology to produce an existing product—may initiate a new and steeper curve. Assume that Firm C, on the same learning curve as Firm B, imple- ments a new production process (such as lean manufacturing). In doing so, Firm C initi- ates an entirely new and steeper learning curve. Exhibit 6.7 shows this experience-curve effect based on a process innovation. Firm C jumps down to the 80 percent learning curve, reflecting the new and lower-cost production process. Although Firm B and Firm C pro- duce the same cumulative output (each making 128 aircraft), the per-unit cost differs. Firm B’s per-unit cost for each airplane, being positioned on the less-steep 90 percent learning curve is $48 million.33 In contrast, Firm C’s per-unit cost, being positioned on the steeper 80 percent learning curve because of process innovation, is only $21 million per aircraft, and thus less than half of that of Firm B. Clearly, Firm C has a competitive advantage over Firm B based on lower cost per unit (assuming similar quality).

Learning by doing allows a firm to lower its per-unit costs by moving down a given learning curve, while experience-curve effects based on process innovation allow a firm to leapfrog to a steeper learning curve, thereby driving down its per-unit costs.

In Strategy Highlight 6.1, we saw how Dr. Shetty leveraged learning-curve effects to save lives while driving down costs. One could argue that his Narayana Health group not only moved down a given learning curve using best industry practice, but it also jumped down to a new and steeper learning curve through process innovation. Dr. Shetty sums up his business strategy based on cost leadership: “Japanese companies reinvented the process of making cars (by introducing lean manufacturing). That’s what we’re doing in health care. What health care needs is process innovation, not product innovation.”34

In a cost-leadership strategy, managers must focus on lowering the costs of production while maintaining a level of quality acceptable to the customer. If firms can share the ben- efits of lower costs with consumers, cost leaders appeal to the bargain-conscious buyer, whose main criterion is price. By looking to reduce costs in each value chain activity, managers aim for the lowest-cost position in the industry. They strive to offer lower prices than competitors and thus to increase sales. Cost leaders such as Walmart (“Every Day Low Prices”) can profit from this strategic position over time.

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

The business-level strategies introduced in this chapter allow firms to carve out strong stra- tegic positions that enhance the likelihood of gaining and sustaining competitive advantage. The five forces model introduced in Chapter 3 helps managers assess the forces—threat of entry, power of suppliers, power of buyers, threat of substitutes, and rivalry among existing competitors—that make some industries more attractive than others. With this understanding of industry dynamics, managers use one of the generic business-level strategies to protect themselves against the forces that drive down profitability.35 Exhibit 6.8 details the relation- ship between competitive positioning and the five forces. In particular, it highlights the bene- fits and risks of differentiation and cost-leadership business strategies, which we discuss next.

DIFFERENTIATION STRATEGY: BENEFITS AND RISKS A differentiation strategy is defined by establishing a strategic position that creates higher perceived value while controlling costs. The successful differentiator stakes out a unique strategic position, where it can benefit from imperfect competition (as discussed in Chapter 3) and command a premium price. A well-executed differentiation strategy reduces rivalry among competitors.

LO 6-4

Assess the benefits and risks of differentiation and cost-leadership strategies vis-à-vis the five forces that shape competition.

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Competitive Force Differentiation Cost Leadership

Benefits Risks Benefits Risks

Threat of entry • Protection against entry due to intangible resources such as a reputation for innovation, quality, or customer service

• Erosion of margins

• Replacement

• Protection against entry due to economies of scale

• Erosion of margins

• Replacement

Power of suppliers • Protection against increase in input prices, which can be passed on to customers

• Erosion of margins • Protection against increase in input prices, which can be absorbed

• Erosion of margins

Power of buyers • Protection against decrease in sales prices, because well- differentiated products or services are not perfect imitations

• Erosion of margins • Protection against decrease in sales prices, which can be absorbed

• Erosion of margins

Threat of substitutes

• Protection against substitute products due to differential appeal

• Replacement, especially when faced with innovation

• Protection against substitute products through further lowering of prices

• Replacement, especially when faced with innovation

Rivalry among existing competitors

• Protection against competitors if product or service has enough differential appeal to command premium price

• Focus of competition shifts to price

• Increasing differentiation of product features that do not create value but raise costs

• Increasing differentiation to raise costs above acceptable threshold

• Protection against price wars because lowest- cost firm will win

• Focus of competition shifts to non-price attributes

• Lowering costs to drive value creation below acceptable threshold

EXHIBIT 6.8 / Competitive Positioning and the Five Forces: Benefits and Risks of Differentiation and Cost-Leadership Business Strategies

SOURCES: Based on M.E. Porter (2008), “The Five Competitive Forces That Shape Strategy,” Harvard Business Review, January; and M.E. Porter (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press).

A successful differentiation strategy is likely to be based on unique or specialized fea- tures of the product, on an effective marketing campaign, or on intangible resources such as a reputation for innovation, quality, and customer service. A rival would need to improve the product features as well as build a similar or more effective reputation in order to gain market share. The threat of entry is reduced: Competitors will find such intangible advan- tages time-consuming and costly, and maybe impossible, to imitate. If the source of the differential appeal is intangible rather than tangible (e.g., reputation rather than observable product and service features), a differentiator is even more likely to sustain its advantage.

Moreover, if the differentiator is able to create a significant difference between per- ceived value and current market prices, the differentiator will not be so threatened by

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increases in input prices due to powerful suppliers. Although an increase in input factors could erode margins, a differentiator is likely able to pass on price increases to its custom- ers as long as its value creation exceeds the price charged. Since a successful differentiator creates perceived value in the minds of consumers and builds customer loyalty, powerful buyers demanding price decreases are unlikely to emerge. A strong differentiated position also reduces the threat of substitutes, because the unique features of the product have been created to appeal to customer preferences, keeping them loyal to the product. By providing superior quality beverages and other food items combined with a great customer experi- ence and a global presence, Starbucks has built a strong differentiated appeal. It has culti- vated a loyal following of customers who reward it with repeat business.

The viability of a differentiation strategy is severely undermined when the focus of competition shifts to price rather than value-creating features. This can happen when differentiated products become commoditized and an acceptable standard of quality has emerged across rival firms. Although the iPhone was a highly differentiated product when introduced in 2007, touch-based screens and other once-innovative features are now stan- dard in smartphones. Indeed, Android-based smartphones hold some 82 percent market share, while Apple’s iOS phones hold about 18 percent.36 Several companies including Google; Samsung and LG, both of South Korea; and low-cost leader Huawei of China are attempting to challenge Apple’s ability to extract significant profits from the smartphone industry based on its iPhone franchise. A differentiator also needs to be careful not to over- shoot its differentiated appeal by adding product features that raise costs but not perceived value in the minds of consumers. For example, any additional increase in screen resolution beyond Apple’s retina display cannot be detected by the human eye at a normal viewing distance. Finally, a differentiator needs to be vigilant that its costs of providing uniqueness do not rise above the customer’s willingness to pay.

COST-LEADERSHIP STRATEGY: BENEFITS AND RISKS A cost-leadership strategy is defined by obtaining the lowest-cost position in the industry while offering acceptable value. The cost leader, therefore, is protected from other com- petitors because of having the lowest cost. If a price war ensues, the low-cost leader will be the last firm standing; all other firms will be driven out as margins evaporate. Since reap- ing economies of scale is critical to reaching a low-cost position, the cost leader is likely to have a large market share, which in turn reduces the threat of entry.

A cost leader is also fairly well isolated from threats of powerful suppliers to increase input prices, because it is more able to absorb price increases through accepting lower profit margins. Likewise, a cost leader can absorb price reductions more easily when demanded by powerful buyers. Should substitutes emerge, the low-cost leader can try to fend them off by further lowering its prices to reinstall relative value with the substitute. For example, Walmart tends to be fairly isolated from these threats. Walmart’s cost struc- ture combined with its large volume allows it to work with suppliers in keeping prices low, to the extent that suppliers are often the party that experiences a profit-margin squeeze.

Although a cost-leadership strategy provides some protection against the five forces, it also carries some risks. If a new entrant with new and relevant expertise enters the market, the low-cost leader’s margins may erode due to loss in market share while it attempts to learn new capabilities. For example, Walmart faces challenges to its cost leadership. Dollar General stores, and other smaller low-cost retail chains, have drawn customers who prefer a smaller format than the big box of Walmart. The risk of replacement is particularly per- tinent if a potent substitute emerges due to an innovation. Leveraging ecommerce, Amazon has become a potent substitute and thus a powerful threat to many brick-and-mortar retail outlets including Barnes & Noble, Best Buy, The Home Depot, and even Walmart. Powerful

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suppliers and buyers may be able to reduce margins so much that the low-cost leader could have difficulty covering the cost of capital and lose the potential for a competitive advantage.

The low-cost leader also needs to stay vigilant to keep its cost the lowest in the industry. Over time, competitors can beat the cost leader by implementing the same business strategy, but more effectively. Although keeping its cost the lowest in the industry is imperative, the cost leader must not forget that it needs to create an acceptable level of value. If continuously lowering costs leads to a value proposition that falls below an acceptable threshold, the low- cost leader’s market share will evaporate. Finally, the low-cost leader faces significant dif- ficulties when the focus of competition shifts from price to non-price attributes.

We have seen how useful the five forces model can be in industry analysis. None of the business-level strategies depicted in Exhibit 6.2 (cost leadership, differentiation, and focused variations thereof) is inherently superior. The success of each depends on context and relies on two factors:

■ How well the strategy leverages the firm’s internal strengths while mitigating its weaknesses. ■ How well it helps the firm exploit external opportunities while avoiding external threats.

There is no single correct business strategy for a specific industry. The deciding factor is that the chosen business strategy provides a strong position that attempts to maximize economic value creation and is effectively implemented.

6.5 Blue Ocean Strategy: Combining Differentiation and Cost Leadership

So far we’ve seen that firms can create more economic value and the likelihood of gaining and sustaining competitive advantage in one of two ways—either increasing perceived con- sumer value (while containing costs) or lowering costs (while offering acceptable value).

Should managers try to do both at the same time? To accomplish this, they would need to integrate two different strategic positions: differentiation and low cost.37 In general the answer is no. Managers should not pursue this complex strategy because of the inher- ent trade-offs in different strategic positions, unless they are able to reconcile the conflict- ing requirements of each generic strategy.

To meet this challenge, the strategy schol- ars Kim and Mauborgne advance the notion of a blue ocean strategy, which is a business- level strategy that successfully combines dif- ferentiation and cost-leadership activities using value innovation to reconcile the inher- ent trade-offs in those two distinct strategic

positions.38 They use the metaphor of an ocean to denote market spaces. Blue oceans rep- resent untapped market space, the creation of additional demand, and the resulting oppor- tunities for highly profitable growth. In contrast, red oceans are the known market space of existing industries. In red oceans the rivalry among existing firms is cut-throat because the market space is crowded and competition is a zero-sum game. Products become com- modities, and competition is focused mainly on price. Any market share gain comes at the expense of other competitors in the same industry, turning the oceans bloody red.

A blue ocean strategy allows a firm to offer a differentiated product or service at low cost. As one example of a blue ocean strategy, consider Trader Joe’s, the grocer introduced

blue ocean strategy Business- level strategy that successfully combines differentiation and cost- leadership activities using value innovation to reconcile the inherent trade-offs.

Canny managers may use value innovation to move to blue oceans, that is, to new and uncontested market spaces. Shown here is the famous “blue hole” just off Belize.

©Mlenny/Getty Images RF

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earlier in the chapter. Trader Joe’s had (prior to its 2017 acquisition by Amazon) much lower costs than Whole Foods for the same market of patrons desiring high value and health-conscious foods, and the chain scores exceptionally well in customer service and other areas. When a blue ocean strategy is successfully formulated and implemented, investments in differentiation and low cost are not substitutes but are complements, providing important positive spill-over effects. A successfully implemented blue ocean strategy allows firms two pricing options: First, the firm can charge a higher price than the cost leader, reflecting its higher value creation and thus generating greater profit margins. Second, the firm can lower its price below that of the differentiator because of its lower- cost structure. If the firm offers lower prices than the differentiator, it can gain market share and make up the loss in margin through increased sales.

VALUE INNOVATION For a blue ocean strategy to succeed, managers must resolve trade-offs between the two generic strategic positions—low cost and differentiation.39 This is done through value innovation, aligning innovation with total perceived consumer benefits, price, and cost (also see the discussion in Chapter 5 on economic value creation). Instead of attempting to out-compete your rivals by offering better features or lower costs, successful value innova- tion makes competition irrelevant by providing a leap in value creation, thereby opening new and uncontested market spaces.

Successful value innovation requires that a firm’s strategic moves lower its costs and also increase the perceived value for buyers (see Exhibit 6.9). Lowering a firm’s costs is primarily achieved by eliminating and reducing the taken-for-granted factors that the firm’s industry rivals compete on. Perceived buyer value is increased by raising existing key success factors and by creating new elements that the industry has not offered previ- ously. To initiate a strategic move that allows a firm to open a new and uncontested market space through value innovation, managers must answer the four key questions below when formulating a blue ocean business strategy.40 In terms of achieving successful value inno- vation, note that the first two questions focus on lowering costs, while the other two ques- tions focus on increasing perceived consumer benefits.

Value Innovation—Lower Costs

1. Eliminate. Which of the factors that the industry takes for granted should be eliminated?

2. Reduce. Which of the factors should be reduced well below the industry’s standard?

Value Innovation—Increase Perceived Consumer Benefits

3. Raise. Which of the factors should be raised well above the industry’s standard?

4. Create. Which factors should be created that the industry has never offered?

The international furniture retailer IKEA, for example, has used value innovation based on the eliminate-reduce-raise-create frame- work to initiate its own blue ocean and to achieve a sustainable competitive advantage.41

LO 6-5

Evaluate value and cost drivers that may allow a firm to pursue a blue ocean strategy.

EXHIBIT 6.9 / Value Innovation Accomplished through Simultaneously Pursuing Differentiation (V ↑) and Low Cost (C ↓)

Cost (C )

Value Innovation

Total Perceived Consumer Benefits (V )

SOURCE: Adapted from C.W. Kim and R. Mauborgne (2005), Blue Ocean Strategy: How to Create Uncontested Market Space and Make Competition Irrelevant (Boston, MA: Harvard Business School Publishing).

value innovation The simultaneous pursuit of differentiation and low cost in a way that creates a leap in value for both the firm and the consumers; considered a cornerstone of blue ocean strategy.

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ELIMINATE. IKEA eliminated several taken-for-granted competitive elements: salespeo- ple, expensive but small retail outlets in prime urban locations and shopping malls, long wait after ordering furniture, after-sales service, and other factors. In contrast, IKEA dis- plays its products in a warehouse-like setting, thus reducing inventory cost. Customers serve themselves and then transport the furniture to their homes in IKEA’s signature flat- packs for assembly. IKEA also uses the big-box concept of locating supersized stores near major metropolitan areas (please refer to the discussion of “Taking Advantage of Certain Physical Properties” under “Economies of Scale” in Section 6.3).

REDUCE. Because of its do-it-yourself business model regarding furniture selection, deliv- ery, and assembly, IKEA drastically reduced the need for staff in its mega-stores. Strolling through an IKEA store, you encounter few employees. IKEA also reduced several other taken-for-granted competitive elements: 25-year warranties on high-end custom furniture, high degree of customization in selection of options such as different fabrics and patterns, and use of expensive materials such as leather or hardwoods, among other elements.

RAISE. IKEA raised several competitive elements: It offers tens of thousands of home fur- nishing items in each of its big-box stores (some 300,000 square feet, roughly five football fields), versus a few hundred at best in traditional furniture stores; it also offers more than furniture, including a range of accessories such as place mats, laptop stands, and much more; each store has hundreds of rooms fully decorated with all sorts of IKEA items, each with a detailed tag explaining the item. Moreover, rather than sourcing its furniture from wholesalers or other furniture makers, IKEA manufactures all of its furniture at fully dedicated suppliers, thus tightly controlling the design, quality, functionality, and cost of each product.

IKEA also raised the customer experience by laying out its stores in such a way that customers see and can touch basically all of IKEA’s products, from wineglasses (six for $2.99) to bookshelves (for less than $100).

CREATE. IKEA created a new way for people to shop for furniture. Customers stroll along a predetermined path winding through the fully furnished showrooms. They can compare, test, and touch all the things in the showroom. The price tag on each item con-

tains other important information: type of material, weight, and so on. Once an item is selected, the customer notes the item num- ber (the store provides a pencil and paper). The tag also indicates the location in the warehouse where the customer can pick up the item in IKEA’s signature flat-packs. After paying, the customer transports the products and assembles the furniture. The customer has 90 days to return items for a full refund.

In traditional furniture shopping, custom- ers visit a small retail outlet where sales- people swarm them. After a purchase, the customer has to wait generally a few weeks before the furniture is shipped because many furniture makers do not produce items, such

as expensive leather sofas, unless they are paid for in advance. Finely crafted couches and chairs cost thousands of dollars (while IKEA’s fabric couches retail for $399). When shop- ping at a traditional furniture store, the customer also pays for delivery of the furniture.

Each IKEA store has a large self-service warehouse section.

©Alex Segre/Alamy Stock Photo

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IKEA also created a new approach to pricing its products. Rather than using a “cost plus margin approach” like traditional furniture stores when pricing items, IKEA begins with the retail price first. For example, it sets the price for an office chair at $150, and IKEA’s designers figure out how to meet this goal, which includes a profit margin. They need to consider the chair from start to finish, including not only design but also raw materials and the way the product will be displayed and transported. Only then will products go into production.

IKEA also created several other new competitive elements that allow it to offer more value to its customers: Stores provide on-site child care, include a cafeteria serving deli- cious food options including Swedish delicatessen such as smoked salmon at low prices, and offer convenient and ample parking, often in garages under the store, where escalators bring customers directly into the showrooms.

Taken together, with all these steps to eliminate, reduce, raise, and create, IKEA orches- trates different internal value chain activities to reconcile the tension between differentia- tion and cost leadership to create a unique market space. IKEA uses innovation in multiple dimensions—in furniture design, engineering, and store design—to solve the trade-offs between value creation and production cost. An IKEA executive highlights the difficulty of achieving value innovation as follows: “Designing beautiful-but-expensive products is easy. Designing beautiful products that are inexpensive and functional is a huge chal- lenge.”42 IKEA leverages its deep design and engineering expertise to offer furniture that is stylish and functional and that can be easily assembled by the consumer. In this way, IKEA can pursue a blue ocean strategy based on value innovation to increase the perceived value of its products, while simultaneously lowering its cost and offering competitive prices. It opened a new market serving a younger demographic than traditional furniture stores. When young people the world over move into their own apartment or house, they fre- quently furnish it from IKEA.

BLUE OCEAN STRATEGY GONE BAD: “STUCK IN THE MIDDLE” Although appealing in a theoretical sense, a blue ocean strategy can be quite difficult to translate into reality. Differentiation and cost leadership are distinct strategic positions that require important trade-offs.43 A blue ocean strategy is difficult to implement because it requires the reconciliation of fundamentally different strategic positions—differentiation and low cost—which in turn require distinct internal value chain activities (see Chapter 4) so the firm can increase value and lower cost at the same time.

Exhibit 6.10 suggests how a successfully formulated blue ocean strategy based on value innovation combines both a differentiation and low-cost position. It also shows the con- sequence of a blue ocean strategy gone bad— the firm ends up being stuck in the middle, meaning the firm has neither a clear differ- entiation nor a clear cost- leadership profile. Being stuck in the middle leads to inferior performance and a resulting competitive dis- advantage. Strategy Highlight 6.2 illustrates how JCPenney failed at a blue ocean strategy and ended up in the red ocean of cut-throat competition.

LO 6-6

Assess the risks of a blue ocean strategy, and explain why it is difficult to succeed at value innovation.

EXHIBIT 6.10 / Value Innovation vs. Stuck in the Middle

Cost Leadership Differentiation

Focused Differentiation

Focused Cost Leadership

Cost

Na rr

ow Br

oa d

Differentiation

STRATEGIC POSITION

CO M

PE TI

TI VE

S CO

PE

Blue Ocean Strategy vs.

Stuck in the Middle

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How JCPenney Sailed Deeper into the Red Ocean JCPenney under former CEO Ron Johnson learned the hard way how difficult it is to change a strategic position. When hired as JCPenney’s CEO in 2011, Johnson was hailed as a star executive. He was poached from Apple, where he had created and led Apple’s retail stores since 2000. Apple’s stores are the most successful retail outlets globally in terms of sales per square foot. No other retail outlet, not even luxury jewelers, achieves more.

Once on board with JCPenney, Johnson immediately began to change the company’s strategic position from a cost-leadership to a blue ocean strategy, attempting to com- bine the cost-leadership position with a differentiation posi- tion. In particular, he tried to reposition the department store more toward the high end by providing an improved customer experience and more exclusive merchandise through in-store boutiques. Johnson ordered all clearance racks with steeply discounted merchandise, common in JCPenney stores, to be removed. He also did away with JCPenney’s long- standing practice of mailing discount coupons to its customers. Rather than following industry best practice by testing the more drastic strategic moves in a small number of selected stores, Johnson implemented them in all 1,800 stores at once. When one executive raised the issue of pretesting, Johnson bristled and responded: “We didn’t test at Apple.” Under his leadership, JCPenney also got embroiled in a legal battle with Macy’s because of Johnson’s attempt to lure away homemaking maven Martha Stewart and her exclusive mer- chandise collection.

The envisioned blue ocean strategy failed badly, and JCPenney ended up being stuck in the middle. Within 12 months with Johnson at the helm, JCPenney’s sales dropped by 25 percent. In a hypercompetitive industry such as retail- ing where every single percent of market share counts, this was a landslide. In 2013, JCPenney’s stock performed so poorly it was dropped from the S&P 500 index. Less than 18 months into his new job, Johnson was fired. Myron Ullman, his predecessor, was brought out of retirement as a temporary replacement.

JCPenney failed at its attempted blue ocean strategy and instead sailed deeper into the red ocean of bloody compe- tition. This highlights the perils of attempting a blue ocean

strategy because of the inherent trade-offs in the underly- ing generic business strategies of cost leadership and dif- ferentiation. As a result, JCPenney continues to experience a sustained competitive disadvantage as of this writing. In the decade preceding 2015, JCPenney underperformed the wider stock market (measured in the S&P 500 index) by almost 150 percentage points, with the gap widening over time. To turn around the 115-year-old company, the board appointed Marvin Ellison as CEO in 2015. Ellison came to JCPenney from The Home Depot, where he excelled as a strong leader focused on effective operations. In an attempt to stem losses, JCPenney closed some 140 retail stores across the United States out of a total of 1,000 outlets in 2017.44

Strategy Highlight 6.2

JCPenney’s new CEO, Marvin Ellison, is charged with turning the 115-year-old

industry icon around. With a strong background in operations management and

leadership skills honed at The Home Depot, he is focusing on lowering JCPen-

ney’s cost structure while increasing perceived value offered to its customers.

©MediaPunch Inc/Alamy Stock Photo

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THE STRATEGY CANVAS The value curve is the basic component of the strategy canvas. It graphically depicts a company’s relative performance across its industry’s factors of competition. A strong value curve has focus and divergence, and it can even provide a kind of tagline as to what strategy is being undertaken or should be undertaken.

Exhibit 6.11 plots the strategic profiles or value curves for three kinds of competitors in the U.S. airline industry. On the left-hand side, descending in price, are the legacy carri- ers (for example, Delta), JetBlue, and finally low-cost airlines such as Southwest Airlines (SWA). We also show the different strategic positions (differentiator, stuck in the middle, and low-cost leader) and trace the value curves as they rank high or low on a variety of parameters. JetBlue is stuck in the middle (as discussed in the ChapterCase). Low-cost airlines follow a cost-leadership strategy. The value curve, therefore, is simply a graphic representation of a firm’s relative performance across different competitive factors in an industry.

Legacy carriers tend to score highly among most competitive elements in the airline industry, including different seating class choices (such as first class, business class, econ- omy comfort, basic economy, and so on), a high level of in-flight amenities such as Wi-Fi, personal video console to view movies or play games, complimentary drinks and meals, coast-to-coast coverage via connecting hubs, plush airport lounges, international routes and global coverage, high customer service, and high reliability in terms of safety and on-time departures and arrivals. As is expected when pursuing a generic differentiation strategy, all these scores along the different competitive elements in an industry go along with a relative higher cost structure.

In contrast, the low-cost airlines tend to hover near the bottom of the strategy can- vas, indicating low scores along a number of competitive factors in the industry, with no assigned seating, no in-flight amenities, no drinks or meals, no airport lounges, few if any international routes, low to intermediate level of customer service. A relatively lower cost structure goes along with a generic low-cost leadership strategy.

This strategy canvas also reveals key strategic insights. Look at the few competi- tive elements where the value curves of the differentiator and low-cost leader diverge.

EXHIBIT 6.11 / Strategy Canvas of JetBlue vs. Low-Cost Airlines and Legacy Carriers High

Low Price Seating Class In-flight

Amenities Meals Connections

(via hub) Lounges International

Routes Customer Service

Reliability Convenience

JetBlue Stuck in the Middle

Differentiation Strategy Pursued by Legacy Carriers

Low-Cost Leadership Strategy Pursued by Low-Cost Airlines

value curve Horizontal connection of the points of each value on the strategy canvas that helps strategic leaders diagnose and determine courses of action.

strategy canvas Graphical depiction of a company’s relative performance vis-à-vis its competitors across the industry’s key success factors.

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Interestingly, some cost leaders (e.g., SWA) score much higher than some differentiators (e.g., Delta) in terms of reliability and convenience, offering frequent point-to-point con- nections to conveniently located airports, often in or near city centers. This key divergence between the two strategies explains why generic cost leaders have frequently outperformed generic differentiators in the U.S. airline industry. Overall, both value curves show a con- sistent pattern representative of a more or less clear strategic profile as either differentia- tion or low-cost leader.

Now look at JetBlue’s value curve. Rather than being consistent such as the differ- entation or low-cost value curves, the JetBlue value curve follows a zigzag pattern. Jet- Blue attempts to achieve parity or even out-compete differentiators in the U.S. airline industry along the competitive factors such as different seating classes (e.g., the high- end Mint offering discussed in the ChapterCase), higher level of in-flight amenities, higher-quality beverages and meals, plush airport lounges, and a large number of inter- national routes (mainly with global partner airlines). JetBlue, however, looks more like a low-cost leader in terms of the ability to provide only a few connections via hubs domestically, and it recently has had a poor record of customer service, mainly because of some high-profile missteps as documented in the ChapterCase. JetBlue’s reliability is somewhat mediocre, but it does provide a larger number of convenient point-to-point flights than a differentiator such as Delta, but fewer than a low-cost leader such as SWA.

A value curve that zigzags across the strategy canvas indicates a lack of effectiveness in its strategic profile. The curve visually represents how JetBlue is stuck in the middle and as a consequence experienced inferior performance and thus a sustained competitive disadvantage vis-à-vis airlines with a stronger strategy profile such as SWA and Delta, among others.

6.6 Implications for Strategic Leaders Strategy is never easy, even when, as in achieving competitive advantage, only a hand- ful of strategic options are available (i.e., low cost or differentiation, broad or narrow, or blue ocean). The best managers work hard to make sure they understand their firm and industry effects, and the opportunities they reveal. They work even harder to fine-tune strategy formulation and execution. When well-formulated and implemented, a firm’s business strategy enhances a firm’s chances of obtaining superior performance. Strategic positioning requires making important trade-offs (think Walmart versus J. Crew in clothing).

In rare instances, a few exceptional firms might be able to change the competitive landscape by opening previously unknown areas of competition. To do so requires the firm reconcile the significant trade-offs between increasing value and lowering costs by pursuing both business strategies (differentiation and low cost) simultane- ously. Such a blue ocean strategy tends to be successful only if a firm is able to rely on a value innovation that allows it to reconcile the trade-offs mentioned. Toyota, for example, initiated a new market space with its introduction of lean manufactur- ing, delivering cars of higher quality and value at lower cost. This value innovation allowed Toyota a competitive advantage for a decade or more, until this new process technology diffused widely. JCPenney, on the other hand, stumbled and found itself failing on most fronts, resulting in a sustained competitive disadvantage (see Strategy Highlight 6.2).

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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 211

Early in its history JetBlue Airways achieved a competitive advantage based on value innovation. In particular, JetBlue was able to drive up perceived customer value while lowering costs. This allowed it to carve out a strong strategic position and move to a non-contested market space. This implies that no other com- petitors in the U.S. domestic airline industry were able to provide such value innovation at that point in time. Rather than directly competing with other airlines, JetBlue created a blue ocean.

Although JetBlue was able to create an initial competitive advantage, the airline was unable to sustain it. Because JetBlue failed in reconciling the strategic trade-offs inherent in com- bining differentiation and cost leadership, it was unable to con- tinue its blue ocean strategy, despite initial success. Between 2007 and 2015, JetBlue experienced a sustained competitive disadvantage, at one point lagging the Dow Jones U.S. Airlines Index by more than 180 percentage points in 2015.

A new leadership team CEO Robin Hayes put in place in early 2015 is attempting to reverse this trend. The new team made quick changes to improve the airline’s flagging profit- ability. It is putting strategic initiatives in place to lower costs, while also trying to further increase its value offering. To lower operating costs, JetBlue decided to start charging $50 per checked bag instead of offering it as a free service. It also removed the additional legroom JetBlue was famous for in the industry. To drive up perceived customer value, JetBlue is adding to its fleet a new airplane (Airbus A-321), which scores significantly higher in customer satisfaction surveys than the older A-320. Although JetBlue already flies internationally by serving destinations in Central and South America as well as the Caribbean, Hayes is considering adding selected flights to Europe. Flying non-stop to cities in Europe such as London is now possible with the new Airbus A-321. Flying longer, non-stop routes drives down costs. International routes, more- over, tend to be much more profitable than domestic routes because of less competition, for the time being.

CHAPTERCASE 6  Consider This . . .

Questions

1. Despite its initial success, why was JetBlue unable to sustain a blue ocean strategy?

2. JetBlue’s chief marketing officer, Marty St. George, was asked by The Wall Street Journal, “What is the biggest marketing challenge JetBlue faces?” His response: “We are flying in a space where our competitors are moving toward commoditization. We have taken a position that air travel is not a commodity but a services business. We want to stand out, but it’s hard to break through to customers with that message.”45

a. Given St. George’s statement, which strategic posi- tion is JetBlue trying to accomplish: differentiator, cost leader, or blue ocean strategy? Explain why.

b. Which strategic moves has the new CEO put in place, and why? Explain whether they focus on value creation, operating costs, or both simultane- ously. Do these moves correspond to St. George’s understanding of JetBlue’s strategic position? Why or why not? Explain.

3. Consider JetBlue’s value curve in Exhibit 6.11. Why is JetBlue experiencing a competitive disadvantage? What recommendations would you offer to JetBlue to strengthen its strategic profile? Be specific.

4. JetBlue CEO Robin Hayes is contemplating adding international routes, connecting the U.S. East Coast to Europe. Would this additional international expan- sion put more pressure on JetBlue’s current business strategy? Or would this international expansion require a shift in JetBlue’s strategic profile? Why or why not? And if a strategic repositioning is needed, in which direction should JetBlue pivot? Explain.

©Carlos Yudica/123RF

This chapter discussed two generic business-level strat- egies: differentiation and cost leadership. Companies can use various tactics to drive one or the other of those strategies, either narrowly or broadly. A blue ocean

strategy attempts to find a competitive advantage by cre- ating a new competitive area, which it does (when suc- cessful) by value innovation, reconciling the trade-offs between the two generic business strategies discussed.

TAKE-AWAY CONCEPTS

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

These concepts are summarized by the following learn- ing objectives and related take-away concepts.

LO 6-1 / Define business-level strategy and describe how it determines a firm’s strategic position. ■ Business-level strategy determines a firm’s strategic

position in its quest for competitive advantage when competing in a single industry or product market.

■ Strategic positioning requires that managers address strategic trade-offs that arise between value and cost, because higher value tends to go along with higher cost.

■ Differentiation and cost leadership are distinct strategic positions.

■ Besides selecting an appropriate strategic posi- tion, managers must also define the scope of competition—whether to pursue a specific market niche or go after the broader market.

LO 6-2 / Examine the relationship between value drivers and differentiation strategy. ■ The goal of a differentiation strategy is to increase

the perceived value of goods and services so that customers will pay a higher price for additional features.

■ In a differentiation strategy, the focus of competi- tion is on value-enhancing attributes and features, while controlling costs.

■ Some of the unique value drivers managers can manipulate are product features, customer service, customization, and complements.

■ Value drivers contribute to competitive advan- tage only if their increase in value creation (ΔV) exceeds the increase in costs, that is: (ΔV) > (ΔC).

LO 6-3 / Examine the relationship between cost drivers and cost-leadership strategy. ■ The goal of a cost-leadership strategy is to reduce

the firm’s cost below that of its competitors. ■ In a cost-leadership strategy, the focus of competi-

tion is achieving the lowest possible cost position, which allows the firm to offer a lower price than competitors while maintaining acceptable value.

■ Some of the unique cost drivers that managers can manipulate are the cost of input factors, economies of scale, and learning- and experience-curve effects.

■ No matter how low the price, if there is no acceptable value proposition, the product or service will not sell.

LO 6-4 / Assess the benefits and risks of dif- ferentiation and cost-leadership strategies vis- à-vis the five forces that shape competition. ■ The five forces model helps managers use generic

business strategies to protect themselves against the industry forces that drive down profitability.

■ Differentiation and cost-leadership strategies allow firms to carve out strong strategic positions, not only to protect themselves against the five forces, but also to benefit from them in their quest for competitive advantage.

■ Exhibit 6.8 details the benefits and risks of each business strategy.

LO 6-5 / Evaluate value and cost drivers that may allow a firm to pursue a blue ocean strategy. ■ To address the trade-offs between differentiation and

cost leadership at the business level, managers must employ value innovation, a process that will lead them to align the proposed business strategy with total perceived consumer benefits, price, and cost.

■ Lowering a firm’s costs is primarily achieved by eliminating and reducing the taken-for-granted fac- tors on which the firm’s industry rivals compete.

■ Increasing perceived buyer value is primarily achieved by raising existing key success factors and by creating new elements that the industry has not yet offered.

■ Strategic leaders track their opportunities and risks for lowering a firm’s costs and increasing perceived value vis-à-vis their competitors by use of a strategy canvas, which plots industry factors among competitors (see Exhibit 6.11).

LO 6-6 / Assess the risks of a blue ocean strategy, and explain why it is difficult to suc- ceed at value innovation. ■ A successful blue ocean strategy requires that

trade-offs between differentiation and low cost be reconciled.

■ A blue ocean strategy often is difficult because the two distinct strategic positions require internal value chain activities that are fundamentally dif- ferent from one another.

■ When firms fail to resolve strategic trade-offs between differentiation and cost, they end up being “stuck in the middle.” They then succeed at neither business strategy, leading to a competitive disadvantage.

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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 213

Blue ocean strategy (p. 204) Business-level strategy (p. 185) Cost-leadership strategy (p. 187) Differentiation strategy (p. 186) Diseconomies of scale (p. 196) Economies of scale (p. 194) Economies of scope (p. 190)

Focused cost-leadership strategy (p. 188)

Focused differentiation s trategy (p. 188)

Minimum efficient scale (MES) (p. 195)

Scope of competition (p. 187)

Strategic trade-offs (p. 186) Strategy canvas (p. 209) Value curve (p. 209) Value innovation (p. 205)

KEY TERMS

DISCUSSION QUESTIONS

1. What are some drawbacks and risks to a broad generic business strategy? To a focused strategy?

2. In Chapter 4, we discussed the internal value chain activities a firm can perform (see Exhibit 4.7). The value chain priorities can be quite different for firms taking different business strategies. Create examples of value chains for three firms: one using cost leadership, another using differentiation, and a third using value inno- vation business-level strategy.

3. The chapter notes there are key differences between economies of scale and learning effects. Let us put that into practice with a brief example.

A company such as Intel has a complex design and manufacturing process. For instance,

one fabrication line for semiconductors typically costs more than $1.5 billion to build. Yet the industry also has high human costs for research and development (R&D) departments. Semicon- ductor firms spend an average of 17 percent of revenues on R&D. For comparison the automo- bile industry spends a mere 3 percent of sales on R&D.46 Thus Intel’s management must be con- cerned with both scale of production and learn- ing curves. When do you think managers should be more concerned with large-scale production runs, and when do you think they should be most concerned with practices that would foster or hinder the hiring, training, and retention of key employees?

ETHICAL/SOCIAL ISSUES

1. Suppose Procter & Gamble (P&G) learns that the relatively new start-up company Method (www.methodhome.com) is gaining market share with a new laundry detergent in West Coast markets. In response, P&G lowers the price of its Tide detergent from $18 to $9 for a 150-ounce bottle only in markets where Method’s product is for sale. The goal of this “loss leader” price drop is to encourage Method

to leave the laundry detergent market. Is this an ethical business practice? Why or why not?

2. In the chapter discussion on value innovation, IKEA is noted as a firm that has successfully applied these techniques. What roles, if any, do sustainability and triple-bottom-line factors have in the success of IKEA as a leader in the furniture industry? (See Chapter 5.)

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

SMALL GROUP EXERCISES

//// SMALL GROUP EXERCISE 1 Ryanair based in Dublin, Ireland, has been renowned in Europe as a firm that can make a profit on a $20 ticket by imposing numerous fees and surcharges. The airline has sought to be the lowest of the low-cost providers in the EU with a “no frills get you from point A to B model.” Ryanair is on record as saying it wants to be the “Ama- zon.com of travel in Europe” by bringing in competi- tors’ price comparison, hotel discounts, and even concert tickets.47 Check out the company website (www.ryanair .com) and consider the questions that follow.

1. If you were a competitor in the European market, such as British Airways or Lufthansa, how would you compete against Ryanair, knowing your cost structure would not allow price parity? If you were a low-cost leader like EasyJet, how would you compete against Ryanair?

2. What similarities and differences do you find about RyanAir compared to Jet Blue from ChapterCase 6?

//// SMALL GROUP EXERCISE 2 This chapter discusses several firms in the retailing envi- ronment. Strategy Highlight 6.2 for example covers the struggles JCPenney has had in recent years and the clos- ing of 140 stores across the United States. JC Penney

is far from alone in having performance challenges. By March 2017, 21 retailers (including Macy’s, Sears, and The Limited) had announced the closure of over 3,500 stores affecting more than 50,000 jobs just in 2017. Several factors are impacting the retailing industry. For example, consumer behavior in developed countries is shifting from shopping trips to social experiences. In 2016 the amount of money spent in restaurants and bars for the first time surpassed that spent in grocery stores across the United States. Complicating matters for stores such as JCPenney, Macy’s, and Nordstrom, which are largely based in malls, is a 2017 report that showed the United States had 1,200 malls and probably needs less than 900. On a per capita basis, the United States has 40 percent more shopping space than Canada and a remarkable 1,000 percent more than Germany.48

1. The retail department store is clearly a red ocean space right now. Your team has been asked to con- sult for Simon Property Group (SPG in NYSE), one of the largest U.S. operators of shopping malls. The company wants to know how its mall space could be repurposed. What blue ocean ideas can your team develop to present to the executives at Simon? Consider the positives and negatives of typical mall sizes and locations in your answer. Stretch beyond traditional retailing for ideas to consider.

Low-Cost and Differentiated Workplaces

W e have studied the differences in business-level strategies closely in this chapter, but how might these differences relate directly to you? As you’ve learned, firms using a differentiation strategy will focus on driv- ers such as product features and customer service, while firms using a cost-leadership strategy will prioritize cost of inputs and economies of scale. These strategic decisions can have an impact on an employee’s experience with the firm’s work envi- ronment and culture.

Nordstrom, Whole Foods Market (before its 2017 acquisi- tion by Amazon), and Wegmans Food Markets are companies

that routinely end up on Fortune’s list of “100 Best Places to Work.” These companies use a differentiation business strategy. In contrast, Amazon and Walmart use the cost-leadership strat- egy; and as low-cost leaders, they do not rate nearly as well. According to inputs from the employee review site Glassdoor. com, only 50 percent of the employees working at Walmart would recommend the firm to a friend. Compare this to the 72 percent who would recommend both Nordstrom and Whole Foods, and the 80 percent who would recommend Wegmans Food Markets. As for Whole Foods, some industry watchers believe Amazon will enact the same tactics in dealing with work- ers at Whole Foods as it has applied to its own warehouse work- ers, leading to a low rating of employee satisfaction.

As you seek options for starting or growing your career, carefully consider the strategy the firm takes in the marketplace. By no means

mySTRATEGY

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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 215

should you avoid low-cost leaders in lieu of strong differentiators (nor should you deem all differentiators as great places to work). Fast-paced organizations that focus on driving tangible results for the organization offer much to learn. For example, Amazon has been a very successful company for the past decade, and many employ- ees have had multiple opportunities to learn enormous amounts in a short period. The firm has also made HR and cultural changes after a scathing New York Times article about its “bruising workplace.” Amazon has reportedly eliminated the practice of forcing employee rankings to follow a normal curve with only a small percentage get- ting top scores.

Amazon employees are encouraged to criticize each other’s ideas openly in meetings; they work long days and on week- ends; and they strive to meet “unreasonably high” standards. “When you’re shooting for the moon, the nature of the work is really challenging. For some people it doesn’t work,” says Susan Harker, a top recruiter for Amazon. The high standards and relentless pace are a draw for many employees who are moti- vated to push themselves to learn, grow, and create— perhaps beyond their perceived limits. Many former employees say the nimble and productive environment is great for learning and

the Amazon experience has really helped their careers expand. Now consider the following questions.

1. Employees and consultants say the Amazon workplace is the epitome of a “do more for less cost” environment. We recognize this is a hallmark goal of a cost-leadership business strategy. But ask yourself this key question, Is it the type of high-pressure work environment in which YOU would thrive?

2. Amazon has surpassed 350,000 employees, adding more than 100,000 employees in 2016 alone! The company will be offer- ing bold new ideas and moving Amazon toward being the first trillion-dollar retailer under an intense pressure to deliver on its goals. The allure from this type of success is compelling and offers tremendous rewards to many employees, shareholders, and customers. What aspects of success are you seeking in your professional career?

3. Before you launch into a new project, job, or firm, or even before you make a change in industry in the effort to move forward in your career, always consider the trade-offs that you would and would not be willing to make.49

1. This ChapterCase is based on: McCartney, S. (2017, Mar. 8), “Discount business class? Thank JetBlue,” The Wall Street Journal; Leahy, J. (2017, Apr. 17), “Azul float raises hopes for Brazil’s stalled IPO market,” Financial Times; Lovelace Jr., B. (2017, Apr. 11), “Brazilian airline Azul begins trading at the NYSE, shoots 8% higher,” CNBC; Carey, S. (2016, Dec. 16), “JetBlue unveils cost-cutting plan worth up to $300 million by 2020,” The Wall Street Journal; Carey, S. (2016, Jul. 26), “JetBlue considers foray into Europe,” The Wall Street Journal; Carey, S. (2016, Apr. 12), “JetBlue to expand its high-end service, dubbed Mint, to more routes,” The Wall Street Journal; Nicas, J. (2015, Mar. 27), “Pilot sues JetBlue for allegedly letting him fly while mentally unfit,” The Wall Street Jour- nal; Mayerowitz, S. (2015, Feb. 16), “JetBlue’s CEO vies to please passengers, stocks,” The Associated Press; Vranica, S. (2015, Feb. 22), “JetBlue’s plan to repair its brand,” The Wall Street Journal; Harris, R.L. (2015, Feb. 11), “On JetBlue, passengers can use ApplePay,” The New York Times; Rosenbloom, S. (2015, Jan. 22), “Flying deluxe domestic coast-to- coast for around $1,000,” The New York Times; Nicas, J. (2014, Nov. 19), “JetBlue to add bag fees, reduce legroom,” The Wall Street Journal; Gardiner, S. (2010, Aug. 10), “Flight attendant

grabs two beers, slides down the emergency chute,” The Wall Street Journal; “Can JetBlue weather the storm?” Time, February 21, 2007; “Held hostage on the tarmac: Time for a pas- senger bill of rights?” The New York Times, February 16, 2007; Bryce, D.J., and J.H. Dyer (2007), “Strategies to crack well-guarded mar- kets,” Harvard Business Review, May; Kim, C.W., and R. Mauborgne (2005), Blue Ocean Strategy: How to Create Uncontested Market Space and Make Competition Irrelevant (Bos- ton, MA: Harvard Business School Publish- ing); Friedman, T. (2005), The World Is Flat: A Brief History of the Twenty-First Century (New York: Farrar, Strauss and Giroux); and Neeleman, D. (2003, Apr. 30), “Entrepreneurial thought leaders lecture,” Stanford Technology Ventures Program. 2. This discussion is based on: Porter, M.E. (2008, Jan.), “The five competitive forces that shape strategy,” Harvard Business Review; Porter, M.E. (1996), “What is strategy?” Har- vard Business Review, November–December; Porter, M.E. (1985), Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press); and Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press).

3. These questions are based on: Priem, R. (2007), “A consumer perspective on value creation,” Academy of Management Review 32: 219–235; Abell, D.F. (1980), Defining the Busi- ness: The Starting Point of Strategic Planning (Englewood Cliffs, NJ: PrenticeHall); and Por- ter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December. 4. The discussion of generic business strategies is based on: Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press); Porter, M.E. (1985), Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press); Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December; and Porter, M.E. (2008, Jan.), “The five competitive forces that shape strategy,” Harvard Business Review. 5. Porter, M.E. (1996), “What is strat- egy?” Harvard Business Review, November–December. 6. To decide if and how to divide the market, you can apply the market segmentation tech- niques you have acquired in your marketing and microeconomics classes. 7. For sources on JetBlue, see: McCartney, S. (2017, Mar. 8), “Discount business class?

ENDNOTES

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

Thank JetBlue,” The Wall Street Journal; Leahy, J. (2017, Apr. 17), “Azul float raises hopes for Brazil’s stalled IPO market,” Financial Times; Lovelace Jr., B. (2017, Apr. 11), “Brazilian airline Azul begins trading at the NYSE, shoots 8% higher,” CNBC; Carey, S. (2016, Dec. 16), “JetBlue unveils cost-cutting plan worth up to $300 million by 2020,” The Wall Street Journal; Carey, S. (2016, Jul. 26), “JetBlue considers foray into Europe,” The Wall Street Journal; Carey, S. (2016, Apr. 12), “JetBlue to expand its high-end service, dubbed Mint, to more routes,” The Wall Street Journal; Nicas, J. (2015, Mar. 27), “Pilot sues JetBlue for alleg- edly letting him fly while mentally unfit,” The Wall Street Journal; Mayerowitz, S. (2015, Feb. 16), “JetBlue’s CEO vies to please pas- sengers, stocks,” The Associated Press; Vranica, S. (2015, Feb. 22), “JetBlue’s plan to repair its brand,” The Wall Street Journal; Harris, R.L. (2015, Feb. 11), “On JetBlue, passengers can use ApplePay,” The New York Times; Rosenbloom, S. (2015, Jan. 23), “Flying deluxe domestic coast-to-coast for around $1,000,” The New York Times; Nicas, J. (2014, Nov. 19), “JetBlue to add bag fees, reduce legroom,” The Wall Street Journal; Gardiner, S. (2010, Aug. 10), “Flight attendant grabs two beers, slides down the emer- gency chute,” The Wall Street Journal; “Can JetBlue weather the storm?” Time, February 21, 2007; “Held hostage on the tarmac: Time for a passenger bill of rights?” The New York Times, February 16, 2007; Bryce, D.J., and J.H. Dyer (2007, May), “Strategies to crack well-guarded markets,” Harvard Business Review; Friedman, T. (2005), The World Is Flat: A Brief History of the Twenty-First Century (New York: Farrar, Strauss and Giroux); and Neeleman, D. (2003, Apr. 30), “Entrepreneurial thought leaders lecture,” Stanford Technology Ventures Program. 8. This example is drawn from “Companies are racing to add value to water,” The Econo- mist, March 25, 2017. 9. Christensen, C.M., and M.E. Raynor (2003), The Innovator’s Solution: Creating and Sustain-

ing Successful Growth (Boston, MA: Harvard Business School Press). 10. The interested reader is referred to the strategy, marketing, and economics literatures. A good start in the strategy literature is the clas- sic work of M.E. Porter: Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing

Industries and Competitors (New York: Free Press); Porter, M.E. (1985), Competitive Advan- tage: Creating and Sustaining Superior Perfor- mance (New York: Free Press); and Porter, M.E. (2008, Jan.), “The five competitive forces that shape strategy,” Harvard Business Review. 11. www.oxo.com/about.jsp. 12. Hsieh, T. (2010), Delivering Happiness: A Path to Profits, Passion, and Purpose (New York: Business Plus).

13. “Amazon opens wallet, buys Zappos,” The Wall Street Journal, July 23, 2009. 14. “Where in the Dickens can you find a Trader Joe’s,” store listing at www.traderjoes. com/pdf/locations/all-llocations.pdf; “Ten companies with excellent customer service,” Huffington Post, August 15, 2014, http://www. huffingtonpost.com/2013/08/15/ best-customer- service_n_3720052.html. 15. Olivarez-Giles, N. (2015, Jul. 7), “Project Fi review: Google masters Wi-Fi calling, but needs better phones,” The Wall Street Journal; Duran M. (2015, Jul. 7), “Google’s Project Fi wireless service is crazy cheap. But should you switch?” Wired. 16. “Flights of hypocrisy,” The Economist, April 25, 2015. 17. “Boeing 787: Orders and Deliveries (updated monthly),” The Boeing Co., March 2015, www.boeing.com. 18. www.airbus.com/en/aircraftfamilies/a380/ home/. 19. Microsoft Annual Report (various years). 20. “Nucor’s new plant project still on hold,” The Associated Press, July 23, 2009; www.nucor.com. 21. On strategy as simple rules, see: Sull, D., and K.M. Eisenhardt (2015), Simple Rules: How to Thrive in a Complex World (New York: Houghton Mifflin Harcourt). 22. Gladwell, M. (2002), The Tipping Point: How Little Things Can Make a Big Difference (New York: Back Bay Books), 185. 23. Levitt, B., and J.G. March (1988), “Organi- zational learning,”Annual Review of Sociology 14: 319–340. 24. For insightful reviews and syntheses on the learning-curve literature, see: Argote, L., and G. Todorova (2007), “Organizational learning: Review and future directions,” International Review of Industrial and Organizational Psy- chology 22: 193–234; and Yelle, L.E. (1979), “The learning curve: Historical review and comprehensive survey,” Decision Sciences 10: 302–308. 25. Wright, T.P. (1936), “Factors affecting the cost of airplanes,” Journal of Aeronautical Sci- ences 3: 122–128. 26. The Tesla example draws on: Dyer, J., and H. Gregersen (2016, Aug. 24),“Tesla’s innova- tions are transforming the auto industry,”  Forbes; Higgins T. (2017, Apr. 10), “How Tesla topped GM as most valuable U.S. auto- maker,” The Wall Street Journal Tech Talk; “Tesla increases deliveries of electric cars,” The Economist, April 6, 2017; Tesla Annual Reports (various years); and GM Annual Reports (vari- ous years). 27. Dyer, J., and H. Gregersen (2016, Aug. 24), “Tesla’s innovations are transforming the auto industry,” Forbes. The authors (in conjunction

with David Kryscynski of Brigham Young Uni- versity) estimate that the functional relationship between production volume and production cost for Tesla’s Model S between 2012 and 2014 is Y=1726.5* (X^−0.363) Data underlying Exhibit 6.6:

Units Per-Unit Cost ($) 100 $324,464

500 $180,901

1,000 $140,659

1,500 $121,407

2,000 $109,369

2,500 $100,859

3,000 $94,400

3,500 $89,263

4,000 $85,039

4,500 $81,480

5,000 $78,422

5,500 $75,756

6,000 $73,400

6,500 $71,298

7,000 $69,406

7,500 $67,689

8,000 $66,122

8,500 $64,683

9,000 $63,354

9,500 $62,123

10,000 $60,977

10,500 $59,907

11,000 $58,903

11,500 $57,961

12,000 $57,072

28. The exact data for learning curves depicted in Exhibit 6.7 are depicted below. A simplify- ing assumption is that the manufacturing of one aircraft costs $100 million, from there the two different learning curves set in. Notewor- thy, that while making only one aircraft costs $100 million, when manufacturing over 4,000 aircraft the expected per-unit cost falls to only $28 million (assuming a 90 percent learning curve) and only $7 million (assuming an 80 per- cent learning curve). Data underlying Exhibit 6.7

Learning Curves Per-Unit Cost*

Units 90% 80% 1 $100 $100

2     90     80

4     81     64

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CHAPTER 6 Business Strategy: Differentiation, Cost Leadership, and Blue Oceans 217

8     73     51

16     66     41

32     59     33

64     53     26

128     48     21

256     43     17

512     39     13

1,024     35     11

2,048     31       9

4,096     28       7

* Rounded to full dollar value in millions.

29. This discussion is based on: Gulati, R., D. Lavie, and H. Singh (2009), “The nature of partnering experience and the gain from alliances,” Strategic Management Journal 30: 1213–1233; Thompson, P. (2001), “How much did the liberty shipbuilders learn? New evidence from an old case study,” Journal of Political Economy 109: 103–137; Edmond- son, A.C., R.M. Bohmer, and G.P. Pisano (2001), “Disrupted routines: Team learning and new technology implementation in hos- pitals,” Administrative Science Quarterly 46: 685–716; Pisano, G.P., R.M. Bohmer, and A.C. Edmondson (2001), “Organizational differences in rates of learning: Evidence from the adoption of minimally invasive cardiac surgery,” Management Science 47: 752–768; Rothaermel, F.T., and D.L. Deeds (2006), “Alliance type, alliance experience, and alliance management capability in high- technology ventures,” Journal of Business Venturing 21: 429–460; Hoang, H., and F.T. Rothaermel (2005), “The effect of general and partner-specific alliance experience on joint R&D project performance,” Academy of Management Journal 48: 332–345; Zollo, M., J.J. Reuer, and H. Singh (2002), “Interorgani- zational routines and performance in strategic alliances,” Organization Science 13: 701–713; King, A.W., and A.L. Ranft (2001), “Captur- ing knowledge and knowing through impro- visation: What managers can learn from the thoracic surgery board certification process,” Journal of Management 27: 255–277; and Darr, E.D., L. Argote, and D. Epple (1995), “The acquisition, transfer and depreciation of knowledge in service organizations: Produc- tivity in franchises,” Management Science 42: 1750–1762.

30. Ramanarayanan, S. (2008), “Does prac- tice make perfect: An empirical analysis of learning-by-doing in cardiac surgery.” Available at SSRN: http://ssrn.com/ abstract=1129350.

31. Boston Consulting Group (1972), Perspec- tives on Experience (Boston, MA: Boston Con- sulting Group).

32. “Coronary artery bypass grafting,” (2015), healthcarebluebook.com, doi:10.1016/ B978- 1-84569-800-3.50011-5; Gokhale, K. (2013), “Heart surgery in India for $1,583 Costs $106,385 in U.S., Bloomberg Businessweek, July 29; and Anand, G. (2009), “The Henry Ford of heart surgery,” The Wall Street Journal, November 25. See also: “Cardiac Surgeon Salary (United States),” Payscale.com, survey updated July 18, 2015. 33. See data presented in Endnote 28. 34. Anand, G. (2009, Nov. 25), “The Henry Ford of heart surgery,” The Wall Street Journal. 35. This discussion is based on: Porter, M.E. (1979), “How competitive forces shape strat- egy,” Harvard Business Review, March–April: 137–145; Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press); and Porter, M.E. (2008, Jan.), “The five competitive forces that shape strategy,” Harvard Business Review. 36. Vincent, J. (2017), “99.6 percent of new smartphones run Android or iOS,” The Verge, February 16. Data drawn from Gartner, a firm tracking the information technology indus- try.  As of Q4 2016, the exact market share for Google’s Android was 81.7 percent and for Apple’s iOS was 17.9 percent, thus together they hold 99.6 percent of the entire market, which rounds up to 100 percent. 37. This discussion is based on: Kim, C.W., and R. Mauborgne (2017), Blue Ocean Shift: Beyond Competing - Proven Steps to Inspire Confidence and Seize New Growth (New York, NY: Hachette); Kim, C.W., and R. Mauborgne (2005), Blue Ocean Strategy: How to Create Uncontested Market Space and Make Competi- tion Irrelevant (Boston, MA: Harvard Business School Publishing); Miller, A., and G.G. Dess (1993), “Assessing Porter’s model in terms of its generalizability, accuracy, and simplicity,” Journal of Management Studies 30: 553–585; and Hill, C.W.L. (1988), “Differentiation versus low cost or differentiation and low cost: A con- tingency framework,” Academy of Management Review 13: 401–412. 38. Kim, C.W., and R. Mauborgne (2005), Blue Ocean Strategy: How to Create Uncontested Market Space and Make Competition Irrel- evant (Boston, MA: Harvard Business School Publishing); Miller, A., and G.G. Dess (1993), “Assessing Porter’s model in terms of its gen- eralizability, accuracy, and simplicity,” Journal of Management Studies 30: 553–585; and Hill, C.W.L. (1988), “Differentiation versus low cost or differentiation and low cost: A contingency framework,” Academy of Management Review 13: 401–412 39. Kim, C.W., and R. Mauborgne (2005), Blue Ocean Strategy: How to Create Uncontested Market Space and Make Competition Irrelevant

(Boston, MA: Harvard Business School Publish- ing); Miller, A., and G.G. Dess (1993), “Assessing Porter’s model in terms of its generalizability, accuracy, and simplicity,” Journal of Management Studies 30: 553–585; and Hill, C.W.L. (1988), “Differentiation versus low cost or differentiation and low cost: A contingency framework,” Acad- emy of Management Review 13: 401–412. 40. Kim, C.W., and R. Mauborgne (2005), Blue Ocean Strategy: How to Create Uncon- tested Market Space and Make Competition Irrelevant (Boston, MA: Harvard Business School Publishing); Miller, A., and G.G. Dess (1993), “Assessing Porter’s model in terms of its generalizability, accuracy, and simplicity,” Journal of Management Studies 30: 553–585; and Hill, C.W.L. (1988), “Differentiation ver- sus low cost or differentiation and low cost: A contingency framework,” Academy of Man- agement Review 13: 401–412 41. The IKEA example is drawn from: “IKEA: How the Swedish retailer became a global cult brand,” Bloomberg Businessweek, November 14, 2005; Edmonds, M., “How Ikea works” (accessed May 6, 2015), http://money. howstuffworks.com/; and www.ikea.com. 42. “IKEA: How the Swedish retailer became a global cult brand,” Bloomberg Businessweek, November 14, 2005. 43. This discussion is based on: Porter, M.E. (1980), Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press); and Porter, M.E. (1996), “What is strategy?” Harvard Business Review, November–December: 61–78. 44. Mattioli, D. (2013), “For Penney’s heralded boss, the shine is off the apple,” The Wall Street Journal, February 24; Bray, C. (2013, Feb. 25), “Macy’s CEO: Penney, Martha Stewart deal made me ‘sick,’” The Wall Street Journal; and Lublin, S., and D. Mattioli (2013, Apr. 8), “Penney CEO out, old boss back in,” The Wall Street Journal. 45. Vranica S. (2015, Feb. 22), “JetBlue’s plan to repair its brand,” The Wall Street Journal. 46. “McKinsey on Semiconductors,” McKinsey & Co., Autumn 2011. 47. Whyte, P., “Ryanair plans to become ‘Ama- zon’ of European travel,” TTGDigital, August 14, 2015. 48. This small group exercise is drawn from the following sources: Loeb, W. (2017), “These 21 retailers are closing 3,591 stores—who is next?” Forbes.com, March 20; and Thompson, D. (2017, Apr. 10), “What in the world is causing the retail meltdown of 2017?” The Atlantic. 49. Sources for this myStrategy include: Kan- tor, J., and D. Streitfeld (2015, Aug. 15), “Inside Amazon: Wrestling big ideas in a bruising workplace,” The New York Times; “100 best companies to work for,” Fortune, 2014, 2015; and www.glassdoor.com.

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CHAPTER Business Strategy: Innovation, Entrepreneurship, and Platforms

Chapter Outline

7.1 Competition Driven by Innovation The Innovation Process

7.2 Strategic and Social Entrepreneurship

7.3 Innovation and the Industry Life Cycle Introduction Stage Growth Stage Shakeout Stage Maturity Stage Decline Stage Crossing the Chasm

7.4 Types of Innovation Incremental vs. Radical Innovation Architectural vs. Disruptive Innovation

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

7.6 Implications for Strategic Leaders

Learning Objectives

LO 7-1 Outline the four-step innovation process from idea to imitation.

LO 7-2 Apply strategic management concepts to entrepreneurship and innovation.

LO 7-3 Describe the competitive implications of dif- ferent stages in the industry life cycle.

LO 7-4 Derive strategic implications of the crossing-the-chasm framework.

LO 7-5 Categorize different types of innovations in the markets-and-technology framework.

LO 7-6 Explain why and how platform businesses can outperform pipeline businesses.

7

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Netflix: Disrupting the TV Industry

JUST LIKE CABLE content providers disrupted the broadcast model of television, companies streaming video on demand are now disrupting the television industry once again.

The disruption by cable content providers played out in the 1980s and 1990s, upsetting a handful of broadcast networks with cable’s dozens and then hundreds of channels. The cur- rent wave of disruption started in the 2000s, bypassing old-line cable content providers for direct online streaming. Now a multitude of devices— TV, PC, laptop, tablet, smartphone—provides a screen for online streaming. Netflix, rid- ing atop the crest of this wave to industry lead- ership and competitive advantage, accounts for more than one-third of all downstream internet traffic in the United States during peak hours!

How did Netflix get here? It started as an obscure online shop renting DVDs delivered through U.S. mail. After being annoyed at having to pay more than $40 in late fees for a Block- buster video, Reed Hastings started Net- flix in 1997 to offer online rentals of DVDs. At the time, the commercial internet was in its infancy; Amazon had just made its IPO in the same year. Streaming content may have been only a distant dream in the era of dial-up internet, but Netflix got a head start by turning from the dwindling VHS format and dealing with DVDs, which were cheaper and easier to mail. An improved business model helped too.

In 1999 Netflix rolled out a monthly subscription model, with unlimited rentals for a single monthly rate (and no late fees!). Rental DVDs were sent in distinctive red envelopes, with preprinted return envelopes. New rentals would not be sent until the current rental was returned.

Even with an innovative business model, Netflix got off to a slow start. By 2000, it had only about 300,000 subscribers and was losing money. Hastings approached Blockbuster, at the time the largest brick-and-mortar video rental chain with almost 8,000 stores in the United

States. He proposed selling Blockbuster 49 percent of Netf- lix and rebranding it as Blockbuster.com. Basically the idea was that Netflix would become the online presence for the huge national chain. The dot-com bubble had just burst, and Block- buster turned Netflix down cold. Netflix, however, survived the dot-com bust, and by 2002, the company was profitable and went public. Block- buster began online rentals in 2004, but by this time, Netflix already had a sub- scriber base of almost 4 million and a strong brand identity. Block- buster lost 75 percent of its market value

between 2003 and 2005. From there it went from bad to worse. In 2010, the once mighty Blockbuster filed for bankruptcy.

Netflix was at the forefront of the current wave of dis- ruption in the TV industry as it began streaming content over the internet in 2007. And it stayed at the forefront. It

CHAPTERCASE 7

House of Cards, a Netflix original series, stars Kevin Spacey and Robin Wright. ©A-Pix Entertainment/Photofest

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INNOVATION  the successful introduction of a new product, process, or business model—is a powerful driver in the competitive process. The ChapterCase provides

an example of how innovations in technology and business models can make existing com- petitors obsolete, and how they allowed Netflix to gain a competitive advantage.

Continued innovation forms the bedrock of Netflix’s business strategy. Using big data analytics, in particular, Netflix introduced a number of early innovations in the video rental business. One of the more ingenious moves by Netflix was to have each user build a queue of movies he or she wanted to watch next. This allowed Netflix to predict future demand for specific movies fairly accurately. Another innovation was to create a “personalized rec- ommendation engine” for each user that would predict what each subscriber might want to watch next based not only on a quick rating survey and the subscriber’s viewing history, but also what movies users with a similar profile had watched and enjoyed. Based on Netflix’s proprietary learning algorithm, the recommendations would improve over time as the user’s preferences become more clear. This also allowed Netflix to steer users away from hit mov- ies (where wait times for DVD rentals were long because the company only had a limited number in its library) to lesser-known titles in its catalog. The ability to bring in the long tail3 of demand delighted not only viewers, as they enjoyed lesser-known, but often criti- cally acclaimed films, but also movie studios, which could now make additional money on movies that would otherwise not be in demand. Moreover, in contrast to other players in the media industry, Netflix was fast to catch the wave of content streaming via the internet.

Innovation allows firms to redefine the marketplace in their favor and achieve a competi- tive advantage.4 That’s why we focus on innovation and the related topic of entrepreneur- ship in this chapter—to celebrate innovation as a powerful competitive weapon for business strategy formulation. We begin this chapter by detailing how competition is a process driven by continuous innovation. Next we discuss strategic and social entrepreneurship. We then

adjusted quickly to the new options consumers had to receive content, making streaming available on a large number of devices including mobile phones, tablets, game consoles, and new devices dedicated to internet content streaming such as Roku, Apple TV, and Google Chromecast. At the same time, more and more Americans were signing up for high-speed broadband internet connections, making streaming content a much more enjoyable experience. The market for internet- connected, large, high-definition flat-screen TVs also began to take off. Within just two years, Netflix subscriptions (then priced at $7.99 per month) jumped to 12 million.

Old-line media executives continued to dismiss Net- flix as a threat. In 2010, Time Warner CEO Jeff Bewkes snubbed Netflix, saying, “It’s a little bit like, is the Alba- nian army going to take over the world? I don’t think so.”1

Even Reed Hastings called what Netflix provided “rerun TV.” But behind their bravado, the broadcast networks were waking up to the Netflix threat. They stopped distributing content to Netflix and instead made it available through Hulu.com, an online content website jointly owned by sev- eral major networks. In 2011, Hulu began offering original content that was not available on broadcast or cable televi- sion. With its lower-cost structure, the networks saw Hulu’s

streaming model as a way to test new series ideas with mini- mal financial risk. In response, Netflix announced a move to create and stream original content online.

But not on the cheap. Since content streaming was Netflix’s main business, it devoted significant resources to produce high-quality content. In 2013, Netflix released the political drama House of Cards, followed, among oth- ers, by the comedy-drama Orange Is the New Black and The Crown, a  biographical series about Queen Elizabeth II. These shows proved tremendous hits and have received many Emmys and Golden Globes.

In 2017, Netflix had 100 million subscribers worldwide, 51 million in the United States. Its revenues were $9 billion, and its market cap was more than $60 billion. Over the past decade, Netflix’s stock appreciated by more than 4,200 per- centage points, while the tech-heavy NASDAQ-100 index grew by “only” 192 percentage points in the same period. By innovating on many dimensions, Netflix was able to not only disrupt the TV industry, but also to gain a competitive advantage.2

You will learn more about Netflix by reading this chapter; related questions appear in “ChapterCase 7 / Consider This. . . .”

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take a deep dive into the industry life cycle. This helps us to formulate a more dynamic busi- ness strategy as the industry changes over time. We also introduce the crossing-the-chasm framework, highlighting the difficulties in transitioning through different stages of the industry life cycle. We then move into a detailed discussion of different types of innovation using the markets-and-technology framework. We next present insights on how to compete in two-sided markets when discussing platform strategy. As with every chapter, we con- clude with practice-oriented Implications for Strategic Leaders.

7.1 Competition Driven by Innovation Competition is a process driven by the “perennial gale of creative destruction,” in the words of famed economist Joseph Schumpeter.5 The continuous waves of market leader- ship changes in the TV industry, detailed in the ChapterCase, demonstrate the potency of innovation as a competitive weapon: It can simultaneously create and destroy value. Firms must be able to innovate while also fending off competitors’ imitation attempts. A success- ful strategy requires both an effective offense and a hard-to-crack defense.

Many firms have dominated an early wave of innovation only to be challenged and often destroyed by the next wave. As highlighted in the ChapterCase, traditional television networks (ABC, CBS, and NBC) have been struggling to maintain viewers and advertis- ing revenues as cable and satellite providers offered innovative programming. Those same cable and satellite providers now are trying hard to hold on to viewers as more and more people gravitate toward customized content online. To exploit such opportunities, Google acquired YouTube, while Comcast, the largest U.S. cable operator, purchased NBC- Universal.6 Comcast’s acquisition helps it integrate delivery services and content, with the goal of establishing itself as a new player in the media industry. In turn, both traditional TV and cable networks are currently under threat from content providers that stream via the internet, such as Netflix, YouTube, and Amazon.

As the adage goes, change is the only constant—and the rate of technological change has accelerated dramatically over the past hundred years. Changing technologies spawn new industries, while others die. This makes innovation a powerful strategic weapon to gain and sustain competitive advantage. Exhibit 7.1 shows how many years it took for dif- ferent technological innovations to reach 50 percent of the U.S. population (either through ownership or usage). As an example, it took 84 years for half of the U.S. population to own a car, but only 28 years for half the population to own a TV. The pace of the adoption rate of recent innovations continues to accelerate. It took 19 years for the PC to reach 50  percent ownership, but only 6 years for MP3 players to accomplish the same diffusion rate.

What factors explain increasingly rapid technological diffusion and adoption? One determinant is that initial innovations such as the car, airplane, telephone, and the use of electricity provided the necessary infrastructure for newer innovations to diffuse more rap- idly. Another reason is the emergence of new business models that make innovations more accessible. For example, Dell’s direct-to-consumer distribution system improved access to low-cost PCs, and Walmart’s low-price, high-volume model used its sophisticated IT logistics system to fuel explosive growth. In addition, satellite and cable distribution sys- tems facilitated the ability of mass media such as radio and TV to deliver advertising and information to a wider audience. The speed of technology diffusion has accelerated further with the emergence of the internet, social networking sites, and viral messaging. Amazon continues to drive increased convenience, higher efficiency and lower costs in retailing. The accelerating speed of technological changes has significant implications for the com- petitive process and firm strategy. We will now take a close look at the innovation process unleashed by technological changes.

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THE INNOVATION PROCESS Broadly viewed, innovation describes the discovery, development, and transformation of new knowledge in a four-step process captured in the four I’s: idea, invention, innovation, and imitation (see Exhibit 7.2).7

The innovation process begins with an idea. The idea is often presented in terms of abstract concepts or as findings derived from basic research. Basic research is conducted to discover new knowledge and is often published in academic journals. This may be done to enhance the fundamental understanding of nature, without any commercial application or benefit in mind. In the long run, however, basic research is often transformed into applied research with commercial applications. For example, wireless communication technology today is built upon the fundamental science breakthroughs Albert Einstein accomplished over 100 years ago in his research on the nature of light.8

In a next step, invention describes the transformation of an idea into a new product or process, or the modification and recombination of existing ones. The practical application of basic knowledge in a particular area frequently results in new technology. If an invention is useful, novel, and non-obvious as assessed by the U.S. Patent and Trademark Office, it

LO 7-1

Outline the four-step innovation process from idea to imitation.

invention The transformation of an idea into a new product or process, or the modification and recombination of existing ones.

EXHIBIT 7.1 / Accelerating Speed of Technological Change

Years

Car Airplane

TelephoneElectricity VCRMicrowave

RadioTV

8475715237353328

MP3 Internet

6 10 14

Cell Phone PC

19

50 %

O wn

er sh

ip /

Us e

(U .S

.)

SOURCE: Depiction of data from the U.S. Census Bureau, the Consumer Electronics Association, Forbes, and the National Cable and Telecommunications Association.

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can be patented.9 A patent is a form of intellectual property, and gives the inventor exclu- sive rights to benefit from commercializing a technology for a specified time period in exchange for public disclosure of the underlying idea (see also the discussion on isolating mechanisms in Chapter 4). In the United States, the time period for the right to exclude others from the use of the technology is 20 years from the filing date of a patent applica- tion. Exclusive rights often translate into a temporary monopoly position until the patent expires. For instance, many pharmaceutical drugs are patent protected.

Strategically, however, patents are a double-edged sword. On the one hand, patents pro- vide a temporary monopoly as they bestow exclusive rights on the patent owner to use a novel technology for a specific time period. Thus, patents may form the basis for a com- petitive advantage. Because patents require full disclosure of the underlying technology and know-how so that others can use it freely once the patent protection has expired, many firms find it strategically beneficial not to patent their technology. Instead they use trade secrets, defined as valuable proprietary information that is not in the public domain and where the firm makes every effort to maintain its secrecy. The most famous example of a trade secret is the Coca-Cola recipe, which has been protected for over a century.10 The same goes for Ferrero’s Nutella, whose secret recipe is said to be known by even fewer than the handful of people who have access to the Coca-Cola recipe.11

Avoiding public disclosure and thus making its underlying technology widely known is precisely the reason Netflix does not patent its recommendation algorithm or Google its PageRank algorithm. Netflix has an advantage over competitors because its recommen- dation algorithm works best; the same goes for Google—its search algorithm is the best available. Disclosing how exactly these algorithms work would nullify their advantage.

Innovation concerns the commercialization of an invention.12 The successful commer- cialization of a new product or service allows a firm to extract temporary monopoly profits. As detailed in the ChapterCase, Netflix began its life with a business model innovation, offer- ing unlimited DVD rentals via the internet, without any late fees. However, Netflix gained its early lead by applying big data analytics to its user preferences to not only predict future demand but also to provide highly personalized viewing recommendations. The success of the latter is evident by the fact that movies that were recommended to viewers scored higher than they were scored previously. To sustain a competitive advantage, however, a firm must continuously innovate—that is, it must produce a string of successful new products or ser- vices over time. In this spirit, Netflix further developed its business model innovation, moving from online DVD rentals to directly streaming content via the internet. Moreover, it innovated further in creating proprietary content such as House of Cards and Orange Is the New Black.

EXHIBIT 7.2 / The Four I’s: Idea, Inven- tion, Innovation, and Imitation

Idea

Invention

Innovation

Imitation

patent A form of intellectual property that gives the inventor exclusive rights to benefit from commercializing a technology for a specified time period in exchange for public disclosure of the underlying idea.

trade secret Valuable proprietary information that is not in the public domain and where the firm makes every effort to maintain its secrecy.

innovation The commercialization of any new product or process, or the modification and recombination of existing ones.

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Successful innovators can benefit from a number of first-mover advantages,13 includ- ing economies of scale as well as experience and learning-curve effects (as discussed in Chapter 6). First movers may also benefit from network effects (see the discussion of Apple and Uber later in this chapter). Moreover, first movers may hold important intellectual property such as critical patents. They may also be able to lock in key suppliers as well as customers through increasing switching costs. For example, users of Microsoft Word might find the switching costs entailed in moving to a different word-processing software prohibitive. Not only would they need to spend many hours learning the new software, but collaborators would also need to have compatible software installed and be familiar with the program to open and revise shared documents.

Google—by offering a free web-based suite of application software such as word-processing (Google Docs), spreadsheet (Google Sheets), and presentation pro- grams (Google Slides)—is attempting to minimize switching costs by leveraging cloud computing—a real-time network of shared computing resources via the internet (Google Drive). Rather than requiring each user to have the appropriate software installed on his or her personal computer, the software is maintained and updated in the cloud. Files are also saved in the cloud, which allows collaboration in real time globally wherever one can access an internet connection.

Innovation need not be high-tech to be a potent competitive weapon, as P&G’s history of innovative product launches such as the Swiffer line of cleaning products shows. P&G uses the razor–razor-blade business model (introduced in Chapter 5), where the consumer purchases the handle at a low price, but must pay a premium for replacement refills and pads over time. As shown in Exhibit 7.3, an innovation needs to be novel, useful, and suc- cessfully implemented to help firms gain and sustain a competitive advantage.

The innovation process ends with imitation. If an innovation is successful in the mar- ketplace, competitors will attempt to imitate it. Although Netflix has some 50 million U.S. subscribers, imitators are set to compete its advantage away. Amazon offers its Instant Video service to its estimated 65 million Prime subscribers ($99 a year or $8.25 a month), with selected titles free. In addition, Prime members receive free two-day shipping on Ama-

zon purchases. Hulu Plus ($7.99 a month), a video-on- demand service, has some 9 million subscribers. One advantage Hulu Plus has over Netflix and Amazon is that it typically makes the latest episodes of popular TV shows available the day following broadcast, on Hulu; the shows are often delayed by several months before being offered by Netflix or Amazon. A joint venture of NBCUniversal Television Group (Comcast), Fox Broad- casting (21st Century Fox), and Disney/ABC Television Group (The Walt Disney Co.), Hulu Plus uses advertise- ments along with its subscription fees as revenue sources. Finally, Google’s YouTube with its more than 1 billion users is evolving into a TV ecosystem, benefiting not only from free content uploaded by its users but also creating original programming. As of 2017, the most subscribed channels were by PewDiePie (57 million) and YouTube Spotlight, its official channel (26 million) used to high- light videos and events such as YouTube Music Awards and YouTube Comedy Week14. Google’s business is, of course, ad supported. Only time will tell whether Netflix will be able to sustain its competitive advantage given the imitation attempts by a number of potent competitors.

first-mover advantages Competitive benefits that accrue to the successful innovator.

EXHIBIT 7.3 / Innovation: A Novel and Useful Idea That Is Successfully Implemented

Novel

INNOVATION

Useful

Implemented

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7.2 Strategic and Social Entrepreneurship Entrepreneurship describes the process by which change agents (entrepreneurs) under- take economic risk to innovate—to create new products, processes, and sometimes new organizations.15 Entrepreneurs innovate by commercializing ideas and inventions.16 They seek out or create new business opportunities and then assemble the resources necessary to exploit them.17 Indeed, innovation is the competitive weapon entrepreneurs use to exploit opportunities created by change, or to create change themselves, in order to commercial- ize new products, services, or business models.18 If successful, entrepreneurship not only drives the competitive process, but it also creates value for the individual entrepreneurs and society at large.

Although many new ventures fail, some achieve spectacular success. Examples of suc- cessful entrepreneurs are:

■ Reed Hastings, founder of Netflix featured in the ChapterCase. Hastings grew up in Cambridge, Massachusetts. He obtained an undergraduate degree in math and then volunteered for the Peace Corps for two years, teaching high school math in Swaziland (Africa). Next, he pursued a master’s degree in computer science, which brought him to Silicon Valley. Hastings declared his love affair with writing computer code, but emphasized, “The big thing that Stanford did for me was to turn me on to the entrepre- neurial model.”19 His net worth today is an estimated $1 billion.

■ Dr. Dre, featured in ChapterCase 4,  a successful rapper, music and movie producer, and serial entrepreneur. Born in Compton, California, Dr. Dre focused on music and entertainment early on during high school, working his first job as a DJ. Dr. Dre’s major breakthrough as a rapper came with the group N.W.A. One of his first business successes as an entrepreneur was Death Row Records, which he founded in 1991. A year later, Dr. Dre’s first solo album, The Chronic, was a huge hit. In 1996, Dr. Dre founded Aftermath Entertainment and signed famed rappers such as 50 Cent and Emi- nem. Dr. Dre, known for his strong work ethic and attention to detail, expects nothing less than perfection from the people with whom he works. Stories abound that Dr. Dre made famous rappers rerecord songs hundreds of times if he was not satisfied with the outcome. In 2014, Dr. Dre appeared to become the first hip-hop billionaire after Apple acquired Beats Electronics for $3 billion.  In 2015, N.W.A’s early success was depicted in the biographical movie Straight Outta Compton, focusing on group members Eazy- E, Ice Cube, and Dr. Dre, who coproduced the film, grossing over $200 million at the box office, with a budget of $45 million.20

■ Jeff Bezos, the founder of Amazon.com (featured in ChapterCase 8), the world’s larg- est online retailer. The stepson of a Cuban immigrant, Bezos graduated with a degree in computer science and electrical engineering, before working as a financial analyst on Wall Street. In 1994, after reading that the internet was growing by 2,000 percent a month, he set out to leverage the internet as a new distribution channel. Listing prod- ucts that could be sold online, he finally settled on books because that retail market was fairly fragmented, with huge inefficiencies in its distribution system. Perhaps even more important, books are a perfect commodity because they are identical regardless of where a consumer buys them. This reduced uncertainty when introducing online shopping to consumers. In 2017 his personal wealth exceeded $80 billion.21

■ Elon Musk, an engineer and serial entrepreneur with a deep passion to “solve envi- ronmental, social, and economic challenges.”22 We featured him in his role as leader of Tesla in ChapterCase 1. Musk left his native South Africa at age 17. He went to Canada and then to the United States, where he completed a bachelor’s degree in economics and physics at the University of Pennsylvania. After only two days in a PhD program in

LO 7-2

Apply strategic management concepts to entrepreneurship and innovation.

entrepreneurship The process by which people undertake economic risk to innovate—to create new products, processes, and sometimes new organizations.

Dr. Dre, rapper, music and movie producer, as well as highly successful serial entrepreneur.

©JC Olivera/Getty Images Entertainment/Getty Images

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applied physics and material sciences at Stanford University, Musk left graduate school to found Zip2, an online provider of content publishing software for news organizations. Four years later, in 1999, computer maker Compaq acquired Zip2 for $341 million (and was in turn acquired by HP in 2002). Musk moved on to co-found PayPal, an online payment processor. When eBay acquired PayPal for $1.5 billion in 2002, Musk had the financial resources to pursue his passion to use science and engineering to solve social and economic challenges. He is leading three new ventures simultaneously: electric cars with Tesla, renewable energy with SolarCity, and space exploration with SpaceX.23 (In 2016, Tesla Motors acquired SolarCity, renaming itself simply Tesla).

Entrepreneurs are the agents who introduce change into the competitive system. They do this not only by figuring out how to use inventions, but also by introducing new prod- ucts or services, new production processes, and new forms of organization. Entrepreneurs can introduce change by starting new ventures, such as Reed Hastings with Netflix or Mark Zuckerberg with Facebook. Or they can be found within existing firms, such as A.G. Lafley at Procter & Gamble (P&G), who implemented an open-innovation model (which we’ll discuss in Chapter 11). When innovating within existing companies, change agents are often called intrapreneurs: those pursuing corporate entrepreneurship.24

Entrepreneurs who drive innovation need just as much skill, commitment, and daring as the inventors who are responsible for the process of invention.25 As an example, the engi- neer Nikola Tesla invented the alternating-current (AC) electric motor and was granted a patent in 1888 by the U.S. Patent and Trademark Office.26 Because this breakthrough tech- nology was neglected for much of the 20th century and Nikola Tesla did not receive the recognition he deserved in his lifetime, the entrepreneur Elon Musk is not just commercial- izing Tesla’s invention but also honoring Tesla with the name of his company, Tesla, which was formed to design and manufacture all-electric automobiles. Tesla launched several all-electric vehicles based on Tesla’s original invention (see ChapterCase 1).

Strategic entrepreneurship describes the pursuit of innovation using tools and con- cepts from strategic management.27 We can leverage innovation for competitive advantage by applying a strategic management lens to entrepreneurship. The fundamental question of strategic entrepreneurship, therefore, is how to combine entrepreneurial actions, creating new opportunities or exploiting existing ones with strategic actions taken in the pursuit of competitive advantage.28 This can take place within new ventures such as Tesla or within established firms such as Apple. Apple’s continued innovation in mobile devices is an example of strategic entrepreneurship: Apple’s managers use strategic analysis, formula- tion, and implementation when deciding which new type of mobile device to research and develop, when to launch it, and how to implement the necessary organizational changes to support the product launch. Each new release is an innovation; each is therefore an act of entrepreneurship—planned and executed using strategic management concepts. In 2015, for example, Apple entered the market for computer wearables by introducing the Apple Watch. In 2017, Apple released the 10th-year anniversary model of its original iPhone, introduced in 2007.

Social entrepreneurship describes the pursuit of social goals while creating profitable businesses. Social entrepreneurs evaluate the performance of their ventures not only by finan- cial metrics but also by ecological and social contribution (profits, planet, and people). They use a triple-bottom-line approach to assess performance (discussed in Chapter 5). Examples of social entrepreneurship ventures include Teach For America, TOMS Shoes (which gives a pair of shoes to an economically disadvantaged child for every pair of shoes it sells), Better World Books (an online bookstore that uses capitalism to alleviate illiteracy around the word),29 and Wikipedia, whose mission is to collect and develop educational information, and make it freely available to any person in the world (see following and MiniCase 14).

entrepreneurs The agents that introduce change into the competitive system.

strategic entrepreneurship The pursuit of innovation using tools and concepts from strategic management.

social entrepreneurship The pursuit of social goals while creating a profitable business.

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The founder of Wikipedia, Jimmy Wales, typifies social entrepreneurship.30 Raised in Alabama, Wales was educated by his mother and grandmother who ran a nontraditional school. In 1994, he dropped out of a doctoral program in economics at Indiana University to take a job at a stock brokerage firm in Chicago. In the evenings he wrote computer code for fun and built a web browser. During the late 1990s internet boom, Wales was one of the first to grasp the power of an open-source method to provide knowledge on a very large scale. What differentiates Wales from other web entrepreneurs is his idealism: Wikipedia is free for the end user and supports itself solely by donations and not, for example, by online advertising. Wikipedia has 35 million articles in 288 languages, including some 5 million items in English. About 500 million people use Wikipedia each month. Wales’ idealism is a form of social entrepreneurship: His vision is to make the entire repository of human knowledge available to anyone anywhere for free.

Since entrepreneurs and the innovations they unleash frequently create entire new industries, we now turn to a discussion of the industry life cycle to derive implications for competitive strategy.

7.3 Innovation and the Industry Life Cycle Innovations frequently lead to the birth of new industries. Innovative advances in IT and logistics facilitated the creation of the overnight express delivery industry by FedEx and that of big-box retailing by Walmart. The internet set online retailing in motion, with new companies such as Amazon and eBay taking the lead, and it revolutionized the advertising industry first through Yahoo, and later Google and Facebook. Advances in nanotechnol- ogy are revolutionizing many different industries, ranging from medical diagnostics and surgery to lighter and stronger airplane components.31

Industries tend to follow a predictable industry life cycle: As an industry evolves over time, we can identify five distinct stages: introduction, growth, shakeout, maturity, and decline.32 We will illustrate how the type of innovation and resulting strategic implications change at each stage of the life cycle as well as how innovation can initiate and drive a new life cycle.

The number and size of competitors change as the industry life cycle unfolds, and dif- ferent types of consumers enter the market at each stage. That is, both the supply and demand sides of the market change as the industry ages. Each stage of the industry life cycle requires different competencies for the firm to perform well and to satisfy that stage’s unique customer group. We first introduce the life cycle model before discussing different customer groups in more depth when introducing the crossing-the-chasm concept later in this chapter.33

Exhibit 7.4 depicts a typical industry life cycle, focusing on the smartphone industry in emerging and developed economies. In a stylized industry life cycle model, the horizontal axis shows time (in years) and the vertical axis market size. In Exhibit 7.4, however, we are taking a snapshot of the global smartphone industry in the year 2018. This implies that we are joining two different life cycles (one for emerging economies and one for developed economies) in the same exhibit at one point in time.

The development of most industries follows an S-curve. Initial demand for a new prod- uct or service is often slow to take off, then accelerates, before decelerating, and eventually turning to zero, and even becoming negative as a market contracts.

As shown in Exhibit 7.4, in emerging economies such as Argentina, Brazil, China, India, Indonesia, Mexico, and Russia, the smartphone industry is in the growth stage. The market for smartphones in these countries is expected to grow rapidly over the next few years. More and more of the consumers in these countries with very large populations

LO 7-3

Describe the competitive implications of different stages in the industry life cycle.

industry life cycle The five different stages—introduction, growth, shakeout, maturity, and decline— that occur in the evolution of an industry over time.

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are expected to upgrade from a simple mobile phone to a smartphone such as the Apple iPhone, Samsung Galaxy, or Xiaomi’s popular Mi6.

In contrast, the market for smartphones is in the maturity stage in 2018 in developed economies such as Australia, Canada, Germany, Japan, South Korea, the United Kingdom, and the United States. This implies that developed economies moved through the prior three stages of the industry life cycle (introductory, growth, and shakeout) some years earlier. Because the smartphone industry is mature in these markets, little or no growth in market size is expected over the next few years because most consumers own smartphones. This implies that any market share gain by one firm comes at the expense of others, as users replace older smartphones with newer models. Competitive intensity is expected to be high.

Each stage of the industry life cycle—introduction, growth, shakeout, maturity, and decline—has different strategic implications for competing firms. We now discuss each stage in detail.

INTRODUCTION STAGE When an individual inventor or company launches a successful innovation, a new industry may emerge. In this introductory stage, the innovator’s core competency is R&D, which is necessary to creating a product category that will attract customers. This is a capital- intensive process, in which the innovator is investing in designing a unique product, trying new ideas to attract customers, and producing small quantities—all of which contribute to a high price when the product is launched. The initial market size is small, and growth is slow.

In this introductory stage, when barriers to entry tend to be high, generally only a few firms are active in the market. In their competitive struggle for market share, they empha- size unique product features and performance rather than price.

Although there are some benefits to being early in the market (as previously discussed), innovators also may encounter first-mover disadvantages. They must educate potential

EXHIBIT 7.4 / Industry Life Cycle: The Smartphone Industry in Emerging and Developed Economies M

ar ke

t S ize

MaturityGrowthIntroduction DeclineShakeout

Smartphones– Emerging

Economies in 2018

Smartphones– Developed Economies

in 2018

Time

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customers about the product’s intended benefits, find distribution channels and comple- mentary assets, and continue to perfect the fledgling product. Although a core competency in R&D is necessary to create or enter an industry in the introductory stage, some com- petency in marketing also is helpful in achieving a successful product launch and market acceptance. Competition can be intense, and early winners are well-positioned to stake out a strong position for the future. As one of the main innovators in software for mobile devices, Google’s Android operating system for smartphones is enjoying a strong market position and substantial lead over competitors.

The strategic objective during the introductory stage is to achieve market acceptance and seed future growth. One way to accomplish these objectives is to initiate and lever- age network effects,34 the positive effect that one user of a product or service has on the value of that product for other users. Network effects occur when the value of a product or service increases, often exponentially, with the number of users. If successful, network effects propel the industry to the next stage of the life cycle, the growth stage (which we discuss next).

Apple effectively leveraged the network effects generated by numerous complementary software applications (apps) available via iTunes to create a tightly integrated ecosystem of hardware, software, and services, which competitors find hard to crack. The consequence has been a competitive advantage for over a decade, beginning with the introduction of the iPod in 2001 and iTunes in 2003. Apple launched its enormously successful iPhone in the summer of 2007. A year later, it followed up with the Apple App Store, which boasts, for almost anything you might need, “there’s an app for that.” Popular apps allow iPhone users to access their business contacts via LinkedIn, hail a ride via Uber, call colleagues overseas via Skype, check delivery of their Zappos packages shipped via UPS, get the latest news on Twitter, and engage in customer relationship management using Salesforce.com. You can stream music via Pandora, post photos using Instagram, watch Netflix, access Facebook to check on your friends, or video message using Snap.

Even more important is the effect that apps have on the value of an iPhone. Arguably, the explosive growth of the iPhone is due to the fact that the Apple App Store offers the largest selection of apps to its users. By 2017, the App Store offered more than 2 million apps, which had been downloaded more than 130 billion times, earning Apple some $50 billion in revenues. Moreover, Apple argues that users have a better experience because the apps take advantage of the tight integration of hardware and software provided by the iPhone. The availability of apps, in turn, leads to network effects that increase the value of the iPhone for its users. Exhibit 7.5 shows how. Increased value creation, as we know from Chapter 6, is positively related to demand, which in turn increases the installed base, meaning the number of people using an iPhone. As of the spring of 2017, Apple had sold some 80 million iPhone 7 models in just six months. The average selling price of an iPhone was $700; with the latest model (iPhone X) priced at $1,000. As the installed base of iPhone users further increases, this incentivizes software developers to write even more apps. Making apps widely available strengthened Apple’s position in the smartphone industry. Based on positive feedback loops, a virtuous cycle emerges where one fac- tor positively reinforces another. Apple’s ecosystem based on integrated hardware, software, and services providing a superior user experience is hard to crack for competitors.

network effects The positive effect (externality) that one user of a product or service has on the value of that product for other users.

EXHIBIT 7.5 / Leveraging Network Effects to Drive Demand: Apple’s iPhone

Apple iPhone Installed Base

Value of iPhone

Demand for iPhone

iPhone Apps

(+)

(+) (+)

(+)

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GROWTH STAGE Market growth accelerates in the growth stage of the industry life cycle (see Exhibit 7.4). After the initial innovation has gained some market acceptance, demand increases rapidly as first-time buyers rush to enter the market, convinced by the proof of concept demon- strated in the introductory stage.

As the size of the market expands, a standard signals the market’s agreement on a common set of engineering features and design choices.35 Standards can emerge from the bottom up through competition in the marketplace or be imposed from the top down by government or other standard-setting agencies such as the Institute of Electrical and Electronics Engineers (IEEE) that develops and sets industrial standards in a broad range of industries, including energy, electric power, biomedical and health care technology, IT, telecommunications, consumer electronics, aerospace, and nanotechnology. Strategy Highlight 7.1 discusses the unfolding standards battle in the automotive industry.

standard An agreed-upon solution about a common set of engineering features and design choices.

Standards Battle: Which Automotive Technology Will Win? In the envisioned future transition away from gasoline-powered cars, Nissan Chairman Carlos Ghosn firmly believes the next technological paradigm will be electric motors. Ghosn calls hybrids a “halfway technology” and suggests they will be a tem- porary phenomenon at best. A number of start-up companies, including Tesla in the United States and BYD Auto in China, share Ghosn’s belief in this particular future scenario.

One of the biggest impediments to large-scale adoption of electric vehicles, however, remains the lack of appropri- ate infrastructure: There are few stations where drivers can recharge their car’s battery when necessary. With the range of electric vehicles currently limited to some 200 miles, many consider a lack of recharging stations a serious prob- lem, so called “range anxiety.” High-end Tesla vehicles can achieve 250 miles per charge, while a lower priced Nissan Leaf’s maximum is range is roughly 85 miles. Tesla, Nissan, and other independent charging providers such as Charge- Point, however, are working hard to develop a network of charging stations. By early 2017, Tesla claimed a network of some 800 supercharger stations throughout the United States and was building more stalls at many stations. It also enabled the in-car map to identify how many stalls were open at each station in real time.

Nissan’s Ghosn believes electric cars will account for up to 10 percent of global auto sales over the next decade. The

Swedish car maker Volvo has gone even further by announc- ing that beginning in 2019 it will no longer produce any cars with internal combustion engines. Rather, all its new vehicles will be fully electric or hybrid. This is a strong strategic com- mitment by one of the traditional car manufacturers. It is also the first of its kind.

In contrast, Toyota is convinced gasoline-electric hybrids will become the next dominant technology. These different predictions have significant influence on how much money Nissan and Toyota invest in technology and where. Nissan builds one of its fully electric vehicles, the Leaf (an acro- nym for Leading, Environmentally friendly, Affordable, Fam- ily car) at a plant in Smyrna, Tennessee. Toyota is expanding

Strategy Highlight 7.1

The Nissan Leaf, the world’s best-selling electric vehicle. ©VDWI Automotive/Alamy Stock Photo RF

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Since demand is strong during the growth phase, both efficient and inefficient firms thrive; the rising tide lifts all boats. Moreover, prices begin to fall, often rapidly, as stan- dard business processes are put in place and firms begin to reap economies of scale and learning. Distribution channels are expanded, and complementary assets in the form of products and services become widely available.37

After a standard is established in an industry, the basis of competition tends to move away from product innovations toward process innovations.38 Product innovations, as the name suggests, are new or recombined knowledge embodied in new products—the jet air- plane, electric vehicle, smartphones, and wearable computers. Process innovations are new ways to produce existing products or to deliver existing services. Process innovations are made possible through advances such as the internet, lean manufacturing, Six Sigma, biotechnology, nanotechnology, and so on.

product innovation New or recombined knowledge embodied in new products.

process innovation New ways to produce existing products or deliver existing services.

its R&D investments in hybrid technology. Nissan put its money where its mouth is and has spent millions developing its electric-car program since the late 1990s. Since it was introduced in December 2010, the Nissan Leaf has become the best-selling electric vehicle, with more than 250,000 units sold. The most recent Nissan Leaf model has a range of more than 100 miles per charge. In 2017, GM introduced the all-electric Chevy Bolt, with a range of over 200 miles per charge, similar to Tesla’s Model 3.

Toyota, on the other hand, has already sold 10 million of its popular Prius cars since they were introduced in 1997. By 2020, Toyota plans to offer hybrid technology in all its

vehicles. Eventually, the investments made by Nissan and Toyota will yield different returns, depending on which pre- dictions prove more accurate.

An alternative outcome is that neither hybrids nor elec- tric cars will become the next paradigm. To add even more uncertainty to the mix, Honda and BMW are betting on cars powered by hydrogen fuel cells. In sum, many alternative technologies are competing to become the winner in setting a new standard for propelling cars. This situation is depicted in Exhibit 7.6, where the new technologies represent a swarm of new entries vying for dominance. Only time will tell which technology will win this standards battle.36

EXHIBIT 7.6 / Automotive Technologies Compete for Industry Dominance

Gasoline-Powered Combustion Engine

Old Technology

Ra te

o f T

ec hn

ol og

ica l P

ro gr

es s

• Electric • Hybrid • Hydrogen • Solar • Others . . .

Next Dominant Technology

Time

Competing Technologies

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Process innovation must not be high-tech to be impactful, however. The invention of the standardized shipping container, for instance, has transformed global trade. By load- ing goods into uniform containers that could easily be moved between trucks, rail, and ships, significant savings in cost and time were accomplished. Before containerization was invented some 60 years ago, it cost almost $6 to load a ton of (loose) cargo, and theft was rampant. After containerization, the cost for loading a ton of cargo had plummeted to $0.16 and theft all but disappeared (because containers are sealed at the departing factory). Efficiency gains in terms of labor and time were even more impressive. Before container- ization, dock labor could move 1.7 tons per hour onto a cargo ship. After containerization, this had jumped to 30 tons per hour. Ports are now able to accommodate much larger ships, and travel time across the oceans has fallen in half. As a consequence, costs for shipping goods across the globe have fallen rapidly. Moreover, containerization enabled optimiza- tion of global supply chains and set the stage for subsequent process innovations such as just-in-time (JIT) operations management. Taken together, a set of research studies esti- mated that containerization alone more than tripled international trade within five years of adopting this critical process innovation.39

Exhibit 7.7 shows the level of product and process innovation throughout the entire life cycle.40 In the introductory stage, the level of product innovation is at a maximum because new features increasing perceived consumer value are critical to gaining traction in the market. In contrast, process innovation is at a minimum in the introductory stage because companies produce only a small number of products, often just prototypes or beta versions. The main concern is to commercialize the invention—that is, to demonstrate that the prod- uct works and that a market exists.

The relative importance, however, reverses over time. Frequently, a standard emerges during the growth stage of the industry life cycle (see the second column, “Growth,” in Exhibit 7.7). At that point, most of the technological and commercial uncertainties about the new product are gone. After the market accepts a new product, and a standard for the new technology has emerged, process innovation rapidly becomes more important than product innovation. As market demand increases, economies of scale kick in: Firms estab- lish and optimize standard business processes through applications of lean manufacturing,

EXHIBIT 7.7 / Product and Process Innovation throughout an Industry Life Cycle

Le ve

l o f I

nn ov

at io

n

Time

Introduction Growth Shakeout Maturity Decline

Process Innovation

Product Innovation

Product Innovation

Process Innovation

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Six Sigma, and so on. As a consequence, product improvements become incremental, while the level of process innovation rises rapidly.

During the growth stage, process innovation ramps up (at increasing marginal returns) as firms attempt to keep up with rapidly rising demand while attempting to bring down costs at the same time. The core competencies for competitive advantage in the growth stage tend to shift toward manufacturing and marketing capabilities. At the same time, the R&D emphasis tends to shift to process innovation for improved efficiency. Competitive rivalry is somewhat muted because the market is growing fast.

Since market demand is robust in this stage and more competitors have entered the mar- ket, there tends to be more strategic variety: Some competitors will continue to follow a differentiation strategy, emphasizing unique features, product functionality, and reliability. Other firms employ a cost-leadership strategy in order to offer an acceptable level of value but lower prices to consumers. They realize that lower cost is likely a key success factor in the future, because this will allow the firm to lower prices and attract more consumers into the market. When introduced in the spring of 2010, for example, Apple’s first-generation iPad was priced at $829 for 64GB with a 3G Wi-Fi connection.41  Just three years later, in spring 2013, the same model was priced at only one-third of the original price, or $275.42 Access to efficient and large-scale manufacturing operations (such as those offered by Foxconn in China, the company that assembles most of Apple’s products) and effective supply chain capabilities are key success factors when market demand increases rapidly. By 2017, Gazelle, an ecommerce company that allows people to sell their electronic devices and to buy pre-certified used ones, offered a mere $15 for a “flawless” first-generation iPad.

The key objective for firms during the growth phase is to stake out a strong strate- gic position not easily imitated by rivals. In the fast-growing shapewear industry, start-up company Spanx has staked out a strong position. In 1998, Florida State University gradu- ate Sara Blakely decided to cut the feet off her pantyhose to enhance her looks when wear- ing pants.43  Soon after she obtained a patent for her body-shaping undergarments, and Spanx began production and retailing of its shapewear in 2000. Sales grew exponentially after Blakely appeared on The Oprah Winfrey Show. By 2017, Spanx had grown to more than 250 employees and sold millions of Spanx “power panties,” with estimated revenues of some $500 million. To stake out a strong position and to preempt competitors, Spanx now offers over 200 products ranging from slimming apparel and swimsuits to bras and activewear. Moreover, it now designs and manufactures body-shaping undergarments for men (“Spanx for Men—Manx”). Spanx products are now available in over 50 countries globally via the internet. Moreover, to strengthen its strategic position and brand image in the United States, Spanx is opening retail stores across the country.

The shapewear industry’s explosive growth—it is expected to reach $6 billion in annual sales by 2022—has attracted several other players: Flexees by Maidenform, BodyWrap, and Miraclesuit, to name a few. They are all attempting to carve out positions in the new industry. Given Spanx’s ability to stake out a strong position during the growth stage of the industry life cycle and the fact that it continues to be a moving target, it might be difficult for competitors to dislodge the company.

Taking the risk paid off for Spanx’s founder: After investing an initial $5,000 into her startup, Blakely became the world’s youngest self-made female billionaire. Blakely was also listed in the Time 100, the annual list of the most influential people in the world.

SHAKEOUT STAGE Rapid industry growth and expansion cannot go on indefinitely. As the industry moves into the next stage of the industry life cycle, the rate of growth declines (see Exhibit 7.4). Firms begin to compete directly against one another for market share, rather than trying

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to capture a share of an increasing pie. As competitive intensity increases, the weaker firms are forced out of the industry. This is the reason this phase of the industry life cycle is called the shakeout stage: Only the strongest competitors survive increasing rivalry as firms begin to cut prices and offer more services, all in an attempt to gain more of a mar- ket that grows slowly, if at all. This type of cutthroat competition erodes profitability of all but the most efficient firms in the industry. As a consequence, the industry often con- solidates, as the weakest competitors either are acquired by stronger firms or exit through bankruptcy.

The winners in this increasingly competitive environment are often firms that stake out a strong position as cost leaders. Key success factors at this stage are the manufacturing and process engineering capabilities that can be used to drive costs down. The importance of process innovation further increases (albeit at diminishing marginal returns), while the importance of product innovation further declines.

Assuming an acceptable value proposition, price becomes a more important competi- tive weapon in the shakeout stage, because product features and performance requirements tend to be well-established. A few firms may be able to implement a blue ocean strat- egy, combining differentiation and low cost, but given the intensity of competition, many weaker firms are forced to exit. Any firm that does not have a clear strategic profile is likely to not survive the shakeout phase.

MATURITY STAGE After the shakeout is completed and a few firms remain, the industry enters the maturity stage. During the fourth stage of the industry life cycle, the industry structure morphs into an oligopoly with only a few large firms. Most of the demand was largely satisfied in the shakeout stage. Any additional market demand in the maturity stage is limited. Demand now consists of replacement or repeat purchases. The market has reached its maximum size, and industry growth is likely to be zero or even negative going forward. This decrease in market demand increases competitive intensity within the industry. In the maturity stage, the level of process innovation reaches its maximum as firms attempt to lower cost as much as possible, while the level of incremental product innovation sinks to its minimum (see Exhibit 7.7).

Generally, the firms that survive the shakeout stage tend to be larger and enjoy econ- omies of scale, as the industry consolidated and most excess capacity was removed. The domestic airline industry has been in the maturity stage for a long time. The large number of bankruptcies as well as the wave of mega-mergers, such as those of Delta and Northwest, United and Continental, and American Airlines and US Airways, are a consequence of low or zero growth in a mature market characterized by significant excess capacity.

DECLINE STAGE Changes in the external environment (such as those discussed in Chapter 3 when present- ing the PESTEL framework) often take industries from maturity to decline. In this final stage of the industry life cycle, the size of the market contracts further as demand falls, often rapidly. At this final phase of the industry life cycle, innovation efforts along both product and process dimensions cease (see Exhibit 7.7). If a technological or business model breakthrough emerges that opens up a new industry, however, then this dynamic interplay between product and process innovation starts anew.

If there is any remaining excess industry capacity in the decline stage, this puts strong pressure on prices and can further increase competitive intensity, especially if the industry

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has high exit barriers. At this final stage of the industry life cycle, managers generally have four strategic options: exit, harvest, maintain, or consolidate:44

■ Exit. Some firms are forced to exit the industry by bankruptcy or liquidation. The U.S. textile industry has experienced a large number of exits over the last few decades, mainly due to low-cost foreign competition.

■ Harvest. In pursuing a harvest strategy, the firm reduces investments in product sup- port and allocates only a minimum of human and other resources. While several com- panies such as IBM, Brother, Olivetti, and Nakajima still offer typewriters, they don’t invest much in future innovation. Instead, they are maximizing cash flow from their existing typewriter product line.

■ Maintain. Philip Morris, on the other hand, is following a maintain strategy with its Marlboro brand, continuing to support marketing efforts at a given level despite the fact that U.S. cigarette consumption has been declining.

■ Consolidate. Although market size shrinks in a declining industry, some firms may choose to consolidate the industry by buying rivals. This allows the consolidating firm to stake out a strong position—possibly approaching monopolistic market power, albeit in a declining industry.

Although chewing tobacco is a declining industry, Swedish Match has pursued a number of acquisitions to consolidate its strategic position in the industry. It acquired, among other firms, the Pinkerton Tobacco Co. of Owensboro, Kentucky, maker of the Red Man brand. Red Man is the leading chewing tobacco brand in the United States. Red Man has carved out a strong strategic position built on a superior reputation for a quality product and by past endorsements of Major League Baseball players since 1904. Despite gory product warnings detailing the health risk of chewing tobacco and a federally mandated prohibition on marketing, the Red Man brand has remained not only popular, but also profitable.

The industry life cycle model assumes a more or less smooth transition from one stage to another. This holds true for most continuous innovations that require little or no change in consumer behavior. But not all innovations enjoy such continuity.

CROSSING THE CHASM In the influential bestseller Crossing the Chasm45 Geoffrey Moore documented that many innovators were unable to successfully transition from one stage of the industry life cycle to the next. Based on empirical observations, Moore’s core argument is that each stage of the industry life cycle is dominated by a different customer group. Different customer groups with distinctly different preferences enter the industry at each stage of the industry life cycle. Each customer group responds differently to a technological innovation. This is due to differences in the psychological, demographic, and social attributes observed in each unique customer segment. Moore’s main contribution is that the significant differ- ences between the early customer groups—who enter during the introductory stage of the industry life cycle—and later customers—who enter during the growth stage—can make for a difficult transition between the different parts of the industry life cycle. Such differ- ences between customer groups lead to a big gulf or chasm into which companies and their innovations frequently fall. Only companies that recognize these differences and are able to apply the appropriate competencies at each stage of the industry life cycle will have a chance to transition successfully from stage to stage.

Exhibit 7.8 shows the crossing-the-chasm framework and the different customer seg- ments. The industry life cycle model (shown in Exhibit 7.4) follows an S-curve leading

LO 7-4

Derive strategic implications of the crossing-the-chasm framework.

crossing-the-chasm framework Conceptual model that shows how each stage of the industry life cycle is dominated by a different customer group.

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up to 100 percent total market potential that can be reached during the maturity stage. In contrast, the chasm framework breaks down the 100 percent market potential into differ- ent customer segments, highlighting the incremental contribution each specific segment can bring into the market. This results in the familiar bell curve. Note the big gulf, or chasm, separating the early adopters from the early and late majority that make up the mass market. Social network sites have followed a pattern similar to that illustrated in Exhibit 7.8. Friendster was unable to cross the big chasm. Myspace was successful with the early majority, but only Facebook went on to succeed with the late majority and lag- gards. Each stage customer segment, moreover, is also separated by smaller chasms. Both the large competitive chasm and the smaller ones have strategic implications.

Both new technology ventures and innovations introduced by established firms have a high failure rate. This can be explained as a failure to successfully cross the chasm from the early users to the mass market because the firm does not recognize that the business strategy needs to be fine-tuned for each customer segment. Formulating a business strategy for each segment guided by the who, what, why, and how questions of competition (Who to serve? What needs to satisfy? Why and how to satisfy them?), introduced in Chapter 6, the firm will find that the core competencies to satisfy each of the different customer seg- ments are quite different. If not recognized and addressed, this will lead to the demise of the innovation as it crashes into the chasm between life cycle stages.

We first introduce each customer group and map it to the respective stage of the indus- try life cycle. To illustrate, we then apply the chasm framework to an analysis of the mobile phone industry.

TECHNOLOGY ENTHUSIASTS. The customer segment in the introductory stage of the industry life cycle is called technology enthusiasts.46  The smallest market segment, it makes up some 2.5 percent of total market potential. Technology enthusiasts often have an engineering mind-set and pursue new technology proactively. They frequently seek out new products before the products are officially introduced into the market. Technology enthusiasts enjoy using beta versions of products, tinkering with the product’s imperfec- tions and providing (free) feedback and suggestions to companies. For example, many software companies such as Google and Microsoft launch beta versions to accumulate customer feedback to work out bugs before the official launch. Moreover, technology enthusiasts will often pay a premium price to have the latest gadget. The endorsement by technology enthusiasts validates the fact that the new product does in fact work.

A recent example of an innovation that appeals to technology enthusiasts is Google Glass, a mobile computer that is worn like a pair of regular glasses. Instead of a lens,

EXHIBIT 7.8 / The Crossing-the-Chasm Framework SOURCE: Adapted from G.A. Moore (1991), Crossing the Chasm: Marketing and Selling Disruptive Products to Mainstream Customers (New York: HarperCollins), 17.

Technology Enthusiasts

2.5%

Late Majority

34%

Early Majority

34%

Early Adopters

13.5%

Laggards 16%

THE CHASM

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however, one side displays a small, high- definition computer screen. Google Glass was developed as part of Google’s wild-card program. Technology enthusiasts were eager to get ahold of Google Glass when made available in a beta testing program in 2013.

Those interested had to compose a Google+ or Twitter message of 50 words or less explaining why they would be a good choice to test the device and include the hashtag #ifihadglass. Some 150,000 people applied and 8,000 winners were chosen. They were required to attend a Google Glass event and pay $1,500 for the developer ver- sion of Google Glass.

Although many industry leaders, includ- ing Apple CEO Tim Cook, agree that wear- able computers such as the Apple Watch or the Fitbit (a physical activity tracker that is worn on the wrist; data are integrated into an online community and phone app) are impor- tant mobile devices, they suggest that there is a large chasm between the current technol- ogy for computerized eyeglasses and a successful product for early adopters let alone the mass market.47 They seem to be correct, because Google was until now unable to cross the chasm between technology enthusiasts and early adopters, even after spending $10 billion on R&D per year.48

EARLY ADOPTERS. The customers entering the market in the growth stage are early adopters. They make up roughly 13.5 percent of the total market potential. Early adopt- ers, as the name suggests, are eager to buy early into a new technology or product con- cept. Unlike technology enthusiasts, however, their demand is driven by their imagination and creativity rather than by the technology per se. They recognize and appreciate the possibilities the new technology can afford them in their professional and personal lives. Early adopters’ demand is fueled more by intuition and vision rather than technology concerns. These are the people that lined up at Apple Stores in the spring of 2015 when it introduced Apple Watch. Since early adopters are not influenced by standard techno- logical performance metrics but by intuition and imagination (What can this new prod- uct do for me or my business?), the firm needs to communicate the product’s potential applications in a more direct way than when it attracted the initial technology enthusiasts. Attracting the early adopters to the new offering is critical to opening any new high-tech market segment.

EARLY MAJORITY. The customers coming into the market in the shakeout stage are called early majority. Their main consideration in deciding whether or not to adopt a new tech- nological innovation is a strong sense of practicality. They are pragmatists and are most concerned with the question of what the new technology can do for them. Before adopting a new product or service, they weigh the benefits and costs carefully. Customers in the early majority are aware that many hyped product introductions will fade away, so they prefer to wait and see how things shake out. They like to observe how early adopters are using the product. Early majority customers rely on endorsements by others. They seek out reputable references such as reviews in prominent trade journals or in magazines such as Consumer Reports.

Google Glass allows the wearer to use the internet and smartphone-like applica- tions via voice commands (e.g., conduct online search, stream video, and so on).

©AP Images/Google/REX

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Because the early majority makes up roughly one-third of the entire market potential, winning them over is critical to the commercial success of the innovation. They are on the cusp of the mass market. Bringing the early majority on board is the key to catching the growth wave of the industry life cycle. Once they decide to enter the market, a herding effect is frequently observed: The early majority enters in large numbers.49

The significant differences in the attitudes toward technology of the early majority when compared to the early adopters signify the wide competitive gulf—the chasm—between these two consumer segments (see Exhibit 7.8). Without adequate demand from the early majority, most innovative products wither away.

Fisker Automotive, a California-based designer and manufacturer of premium plug-in hybrid vehicles, fell into the chasm because it was unable to transition to early adopters, let alone the mass market. Between its founding in 2007 and 2012, Fisker sold some 1,800 of its Karma model, a $100,000 sports car, to technology enthusiasts. It was unable, how- ever, to follow up with a lower-cost model to attract the early adopters into the market. In addition, technology and reliability issues for the Karma could not be overcome. By 2013, Fisker had crashed into the first chasm (between technology enthusiasts and early adopt- ers), filing for bankruptcy. The assets of Fisker Automotive were purchased by Wanxiang, a Chinese auto parts maker.50

In contrast, Tesla, the maker of all-electric vehicles introduced in ChapterCase 1 and a fierce rival of Fisker at one time, was able to overcome some of the early chasms. The Tesla Roadster was a proof-of-concept car that demonstrated that electric vehicles could achieve an equal or better performance than the very best gasoline-engine sports cars. The 2,400 Roadsters that Tesla built between 2008 and 2012 were purchased by technol- ogy enthusiasts. Next, Tesla successfully launched the Model S, a family sedan, sold to early adopters. The Tesla Model S received a strong endorsement as the 2013 Motor Trend Car of the Year and the highest test scores ever awarded by Consumer Reports. This may help in crossing the chasm to the early majority, because consumers would now feel more comfortable in considering and purchasing a Tesla vehicle. Tesla is hoping to cross the large competitive chasm between early adopters and early majority with its new, lower-priced Model 3.

LATE MAJORITY The next wave of growth comes from buyers in the late majority enter- ing the market in the maturity stage. Like the early majority, they are a large customer

Tesla Motors CEO Elon Musk (left) in front of a Tesla Road- ster; Fisker Automotive CEO Henrik Fisker (right) in front of a Fisker Karma.

©Misha Gravenor

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segment, making up approximately 34 percent of the total market potential. Combined, the early majority and late majority make up the lion’s share of the market potential. Demand coming from just two groups—early and late majority—drives most industry growth and firm profitability.

Members of the early and late majority are also quite similar in their attitudes toward new technology. The late majority shares all the concerns of the early majority. But there are also important differences. Although members of the early majority are confident in their ability to master the new technology, the late majority is not. They prefer to wait until standards have emerged and are firmly entrenched, so that uncertainty is much reduced. The late majority also prefers to buy from well-established firms with a strong brand image rather than from unknown new ventures.

LAGGARDS. Finally, laggards are the last consumer segment to come into the market, entering in the declining stage of the industry life cycle. These are customers who adopt a new product only if it is absolutely necessary, such as first-time cell phone adopters in the United States today. These customers generally don’t want new technology, either for personal or economic reasons. Given their reluctance to adopt new technology, they are generally not considered worth pursuing. Laggards make up no more than 16 percent of the total market potential. Their demand is far too small to compensate for reduced demand from the early and late majority (jointly almost 70 percent of total market demand), who are moving on to different products and services.

CROSSING THE CHASM: APPLICATION TO THE MOBILE PHONE INDUSTRY. Let’s apply the crossing-the-chasm framework to one specific industry. In this model, the tran- sition from stage to stage in the industry life cycle is characterized by different com- petitive chasms that open up because of important differences between customer groups. Although the large chasm between early adopters and the early majority is the main cause of demise for technological innovations, other smaller mini-chasms open between each stage.

Exhibit 7.9 shows the application of the chasm model to the mobile phone indus- try. The first victim was Motorola’s Iridium, an ill-fated satellite-based telephone sys- tem.51 Development began in 1992 after the spouse of a Motorola engineer complained about being unable to get any data or voice access to check on clients while vacationing

EXHIBIT 7.9 / Crossing the Chasm: The Mobile Phone Industry

Galaxy

iPhone

Tre o

Bla ckB

err y

Technology Enthusiasts

2.5%

Late Majority

34%

Early Majority

34%

Early Adopters

13.5%

Laggards 16%

THE CHASMIrid

ium

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on a remote island. Motorola’s solution was to launch 66 satellites into low orbit to pro- vide global voice and data coverage. In late 1998, Motorola began offering its satellite phone service, charging $5,000 per handset (which was almost too heavy to carry around) and up to $14 per minute for calls.52  Problems in consumer adoption beyond the few technology enthusiasts became rapidly apparent. The Iridium phone could not be used inside buildings or in cars. Rather, to receive a satellite signal, the phone needed an unob- structed line of sight to a satellite. Iridium crashed into the first chasm, never moving beyond technology enthusiasts (see Exhibit 7.9). For Motorola, it was a billion-dollar blunder. Iridium was soon displaced by cell phones that relied on Earth-based networks of radio towers. The global satellite telephone industry never moved beyond the introduc- tory stage of the industry life cycle.

The first Treo, a fully functioning smartphone combining voice and data capabilities, was released in 2002 by Handspring. The Treo fell into the main chasm that arises between early adopters and the early majority (see Exhibit 7.9). Technical problems, combined with a lack of apps and an overly rigid contract with Sprint as its sole service provider, prevented the Treo from gaining traction in the market beyond early adopters. For these reasons, the Treo was not an attractive product for the early majority, who rejected it. This caused the Treo to plunge into the chasm. Just a year later, Handspring was folded into Palm, which in turn was acquired by HP for $1 billion in 2010.53 HP shut down Palm in 2011 and wrote off the acquisition.54

BlackBerry (formerly known as Research in Motion or RIM)55 introduced its first fully functioning smartphone in 2000. It was a huge success—especially with two key con- sumer segments. First, corporate IT managers were early adopters. They became product champions for the BlackBerry smartphone because of its encrypted security software and its reliability in always staying connected to a company’s network. This allowed users to receive e-mail and other data in real time, anywhere in the world where wireless service was provided. Second, corporate executives were the early majority pulling the BlackBerry smartphone over the chasm because it allowed 24/7 access to data and voice. BlackBerry was able to create a beachhead to cross the chasm between the technology enthusiasts and early adopters on one side and the early majority on the other.56 BlackBerry’s managers identified the needs of not only early adopters (e.g., IT managers) but also the early major- ity (e.g., executives), who pulled the BlackBerry over the chasm. By 2005, the BlackBerry had become a corporate executive status symbol. As a consequence of capturing the first three stages of the industry life cycle, between 2002 and 2007, BlackBerry enjoyed no less than 30 percent year-over-year revenue growth as well as double-digit growth in other financial performance metrics such as return on equity. BlackBerry enjoyed a temporary competitive advantage.

In 2007, BlackBerry’s dominance over the smartphone market began to erode quickly. The main reason was Apple’s introduction of the iPhone. Although technology enthu- siasts and early adopters argue that the iPhone is an inferior product to the BlackBerry based on technological criteria, the iPhone enticed not only the early majority, but also the late majority to enter the market. For the late majority, encrypted software security was much less important than having fun with a device that allowed users to surf the web, take pictures, play games, and send and receive e-mail. Moreover, the Apple iTunes Store soon provided thousands of apps for basically any kind of service. While the BlackBerry couldn’t cross the gulf between the early and the late majority, Apple’s iPhone captured the mass market rapidly. Moreover, consumers began to bring their personal iPhone to work, which forced corporate IT departments to expand their services beyond the BlackBerry. Apple rode the wave of this success to capture each market segment. Likewise, Sam- sung with its Galaxy line of phones, having successfully imitated the look-and-feel of an

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iPhone (as discussed in Chapter 4), is enjoying similar success across the different market segments.

This brief application of the chasm framework to the mobile phone industry shows its usefulness. It provides insightful explanations of why some companies failed, while others succeeded—and thus goes at the core of strategy management.

In summary, Exhibit 7.10 details the features and strategic implications of the entire industry life cycle at each stage.

A word of caution is in order, however: Although the industry life cycle is a useful frame- work to guide strategic choice, industries do not necessarily evolve through these stages. Moreover, innovations can emerge at any stage of the industry life cycle, which in turn can initiate a new cycle. Industries can also be rejuvenated, often in the declining stage.

Although the industry life cycle is a useful tool, it does not explain everything about changes in industries. Some industries may never go through the entire life cycle, while others are continually renewed through innovation. Be aware, too, that other external fac- tors that can be captured in the PESTEL framework (introduced in Chapter 3) such as fads

Life Cycle Stages

Introduction Growth Shakeout Maturity Decline

Core Competency R&D, some marketing

R&D, some manufacturing, marketing

Manufacturing, process engineering

Manufacturing, process engineering, marketing

Manufacturing, process engineering, marketing, service

Type and Level of Innovation

Product innovation at a maximum; process innovation at a minimum

Product innovation decreasing; process innovation increasing

After emergence of standard: product innovation decreasing rapidly; process innovation increasing rapidly

Product innovation low; process innovation high

Product innovation at a minimum; process innovation at a maximum

Market Growth Slow High Moderate and slowing down

None to moderate Negative

Market Size Small Moderate Large Largest Small to moderate

Price High Falling Moderate Low Low to high

Number of Competitors

Few, if any Many Fewer Moderate, but large Few, if any

Mode of Competition

Non-price competition

Non-price competition

Shifting from non-price to price competition

Price Price or non-price competition

Type of Buyers Technology enthusiasts

Early adopters Early majority Late majority Laggards

Business-Level Strategy

Differentiation Differentiation Differentiation, or integration strategy

Cost-leadership or integration strategy

Cost-leadership, differentiation, or integration strategy

Strategic Objective Achieving market acceptance

Staking out a strong strategic position; generating “deep pockets”

Surviving by drawing on “deep pockets”

Maintaining strong strategic position

Exit, harvest, maintain, or consolidate

EXHIBIT 7.10 / Features and Strategic Implications of the Industry Life Cycle

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in fashion, changes in demographics, or deregulation can affect the dynamics of industry life cycles at any stage.

It is also important to note that innovations that failed initially can sometimes get a second chance in a new industry or for a new application. When introduced in the early 1990s as an early wireless telephone system, Iridium’s use never went beyond that by technology enthusiasts. After Motorola’s failure, the technology was spun out as a standalone venture called Iridium Communications. As of 2017, it looks like Iridium’s satellite-based communications system will get another chance of becoming a true break- through innovation.57  Rather than in an application in the end-consumer market, this time Iridium is considered for global deployment by airspace authorities to allow real- time tracking of airplanes wherever they may be. The issue of being able to track air- planes around the globe at all times came to the fore in 2014, when Malaysia Airlines Flight 370 with 239 people on board disappeared without a trace, and authorities were unable to locate the airplane.

For the last few decades, air controllers had to rely on ground-based radar to direct planes and to triangulate their positions. A major problem with any ground-based system is that it only works over land or near the shore, but not over oceans, which cover more than 70 percent of the Earth’s surface. Moreover, radar does not work in mountain ranges. Oceans and mountain terrain, therefore, are currently dead zones where air traffic control- lers are unable to track airplanes.

Iridium’s technology is now used as a space-based flight tracking system.  In 2017, Elon Musk’s SpaceX launched the first set of 10 satellites (out of a total of 66 needed) into space to begin constructing a space-based air traffic control system. Such a system affords air traffic controllers full visibility of and real-time flight information from any airplane over both water and land. It also allows pilots more flexibility in changing routes to avoid bad weather and turbulence, thus increasing passenger convenience, saving fuel, and reducing greenhouse-gas emissions. In addition, the new technology, called Aireon, would allow planes to fly closer together (15 miles apart instead of the now customary 80 miles), allowing for more air traffic on efficient routes. A research study by an inde- pendent body predicts that global deployment of Aireon would also lead to a substantial improvement in air safety.

Providing the next-generation air traffic control technology and services is a huge busi- ness opportunity for Iridium Communications. National air traffic control agencies will be the main customers to deploy the new Aireon technology. This goes to show that a second chance of success for an innovation may arise, even after the timing and application of an initial technology were off.

7.4 Types of Innovation Because of the importance of innovation in shaping competitive dynamics and as a critical component in formulating business strategy, we now turn to a discussion of different types of innovation and the strategic implications of each. We need to know, in particular, along which dimensions we should assess innovations. This will allow us to formulate a business strategy that can leverage innovation for competitive advantage.

One insightful way to categorize innovations is to measure their degree of newness in terms of technology and markets.58 Here, technology refers to the methods and mate- rials used to achieve a commercial objective.59  For example, Amazon integrates dif- ferent types of technologies (hardware, software, big data analytics, cloud computing, logistics, and so on) to provide not only the largest selection of retail goods online, but also an array of services and mobile devices (e.g., Alexa, a digital personal assistant;

LO 7-5

Categorize different types of innovations in the markets-and-technology framework.

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Kindle tablets; Prime; cloud-computing ser- vices; and so on). We also want to understand the market for an innovation—e.g., whether an innovation is introduced into a new or an existing market—because an invention turns into an innovation only when it is suc- cessfully commercialized.60  Measuring an innovation along these dimensions gives us the markets-and-technology framework depicted in Exhibit 7.11. Along the horizon- tal axis, we ask whether the innovation builds on existing technologies or creates a new one. On the vertical axis, we ask whether the innovation is targeted toward existing or new markets. Four types of innovations emerge: incremental, radical, architectural, and dis- ruptive innovations. As indicated by the color coding in Exhibit 7.11, each diagonal forms a pair: incremental versus radical innovation and architectural versus disruptive innovation.

INCREMENTAL VS. RADICAL INNOVATION Although radical breakthroughs such as smartphones and magnetic resonance imaging (MRI) radiology capture most of our attention, the vast majority of innovations are actually incremental ones. An incremental innovation squarely builds on an established knowl- edge base and steadily improves an existing product or service offering.61 It targets existing markets using existing technology.

On the other hand, radical innovation draws on novel methods or materials, is derived either from an entirely different knowledge base or from a recombination of existing knowledge bases with a new stream of knowledge. It targets new markets by using new technologies.62 Well-known examples of radical innovations include the introduction of the mass-produced automobile (the Ford Model T), the X-ray, the airplane, and more recently biotechnology breakthroughs such as genetic engineering and the decoding of the human genome.

Many firms get their start by successfully commercializing radical innovations, some of which, such as the jet-powered airplane, even give birth to new industries. Although the British firm de Havilland first commercialized the jet-powered passenger airplane, Boeing was the company that rode this radical innovation to industry dominance. More recently, Boeing’s leadership has been contested by Airbus; each company has approximately half the market. This stalemate is now being challenged by aircraft manufacturers such as Bom- bardier of Canada and Embraer of Brazil, which are moving up-market by building larger luxury jets that are competing with some of the smaller airplane models offered by Boeing and Airbus.

EXHIBIT 7.11 / Types of Innovation: Combining Markets and Technologies

Architectural Innovation

Radical Innovation

Disruptive Innovation

Incremental Innovation

Existing

Ex is

tin g

Ne w

New

TECHNOLOGIES

M AR

KE TS

markets-and-technology framework A conceptual model to categorize innovations along the market (existing/ new) and technology (existing/new) dimensions.

incremental innovation An innovation that squarely builds on an established knowledge base and steadily improves an existing product or service.

radical innovation An innovation that draws on novel methods or materials, is derived either from an entirely different knowledge base or from a recombination of the existing knowledge bases with a new stream of knowledge.

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A predictable pattern of innovation is that firms (often new ventures) use radical inno- vation to create a temporary competitive advantage. They then follow up with a string of incremental innovations to sustain that initial lead. Gillette is a prime example for this pat- tern of strategic innovation. In 1903, entrepreneur King C. Gillette invented and began sell- ing the safety razor with a disposable blade. This radical innovation launched the Gillette Co. (now a brand of Procter & Gamble). To sustain its competitive advantage, Gillette not only made sure that its razors were inexpensive and widely available by introducing the “razor and razor blade” business model, but also continually improved its blades. In a clas- sic example of a string of incremental innovations, Gillette kept adding an additional blade with each new version of its razor until the number had gone from one to six! Though this innovation strategy seems predictable, it worked. Gillette’s newest razor, the Fusion ProGlide with Flexball technology, a razor handle that features a swiveling ball hinge, costs $11.49 (and $12.59 for a battery-operated one) per razor! 63 Dollar Shave Club is dis- rupting Gillette’s business model based on incremental innovation. As a result, Gillette’s market share in the $15 billion wet shaving industry has declined from some 70 percent (in 2010) to below 60 percent (by 2017).64

The Gillette example, nonetheless, shows how radical innovation created a competi- tive advantage that the company can sustain through follow-up incremental innovation. Such an outcome is not a foregone conclusion, though. In some instances, the innovator is outcompeted by second movers that quickly introduce a similar incremental innova- tion to continuously improve their own offering. For example, although CNN was the pioneer in 24-hour cable news, today Fox News is the most watched cable news network in the United States (although the entire industry is in decline as viewers now stream much more content directly via mobile devices, as discussed in ChapterCase 7 about Netflix). Once firms have achieved market acceptance of a breakthrough innovation, they tend to follow up with incremental rather than radical innovations. Over time, these companies morph into industry incumbents. Future radical innovations are generally introduced by new entrepreneurial ventures. Why is this so? The reasons concern eco- nomic incentives, organizational inertia, and the firm’s embeddedness in an innovation ecosystem.65

ECONOMIC INCENTIVES. Economists highlight the role of incentives in strategic choice. Once an innovator has become an established incumbent firm (such as Google has today), it has strong incentives to defend its strategic position and market power. An emphasis on incremental innovations strengthens the incumbent firm’s position and thus maintains high entry barriers. A focus on incremental innovation is particularly attractive once an indus- try standard has emerged and technological uncertainty is reduced. Moreover, many mar- kets where network effects are important (such as online search), turn into winner-take-all markets, where the market leader captures almost all of the market share. As a near monop- olist, the winner in these types of markets is able to extract a significant amount of the value created. In the United States, Google handles some 65 percent of all online queries, while it handles more than 90 percent in Europe. As a result, the incumbent firm uses incremental innovation to extend the time it can extract profits based on a favorable industry structure (see the discussion in Chapter 3). Any potential radical innovation threatens the incumbent firm’s dominant position.

The incentives for entrepreneurial ventures, however, are just the opposite. Successfully commercializing a radical innovation is frequently the only option to enter an industry protected by high entry barriers. One of the first biotech firms, Amgen, used newly discov- ered drugs based on genetic engineering to overcome entry barriers to the pharmaceutical

winner-take-all markets Markets where the market leader captures almost all of the market share and is able to extract a significant amount of the value created.

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industry, in which incumbents had enjoyed notoriously high profits for several decades. Because of differential economic incentives, incumbents often push forward with incre- mental innovations, while new entrants focus on radical innovations.

ORGANIZATIONAL INERTIA. From an organizational perspective, as firms become estab- lished and grow, they rely more heavily on formalized business processes and structures. In some cases, the firm may experience organizational inertia—resistance to changes in the status quo. Incumbent firms, therefore, tend to favor incremental innovations that rein- force the existing organizational structure and power distribution while avoiding radical innovation that could disturb the existing power distribution. Take, for instance, power distribution between different functional areas, such as R&D and marketing. New entrants, however, do not have formal organizational structures and processes, giving them more freedom to launch an initial breakthrough. We discuss the link between organizational structure and firm strategy in depth in Chapter 11.

INNOVATION ECOSYSTEM. A final reason incumbent firms tend to be a source of incre- mental rather than radical innovations is that they become embedded in an innovation ecosystem: a network of suppliers, buyers, complementors, and so on.66 They no longer make independent decisions but must consider the ramifications on other parties in their innovation ecosystem. Continuous incremental innovations reinforce this network and keep all its members happy, while radical innovations disrupt it. Again, new entrants don’t have to worry about preexisting innovation ecosystems, since they will be building theirs around the radical innovation they are bringing to a new market.

ARCHITECTURAL VS. DISRUPTIVE INNOVATION Firms can also innovate by leveraging existing technologies into new markets. Doing so generally requires them to reconfigure the components of a technology, meaning they alter the overall architecture of the product.67 An architectural innovation, therefore, is a new product in which known components, based on existing technologies, are reconfigured in a novel way to create new markets.

As a radical innovator commercializing the xerography invention, Xerox was long the most dominant copier company worldwide.68 It produced high-volume, high-quality, and high-priced copying machines that it leased to its customers through a service agreement. Although these machines were ideal for the high end of the market such as Fortune 100 companies, Xerox ignored small and medium-sized businesses. By apply- ing an architectural innovation, the Japanese entry Canon was able to redesign the copier so that it didn’t need professional service—reliability was built directly into the machine, and the user could replace parts such as the cartridge. This allowed Canon to apply the razor–razor-blade business model (introduced in Chapter 5), charging relatively low prices for its copiers but adding a steep markup to its cartridges. Xerox had not envisioned the possibility that the components of the copying machine could be put together in an altogether different way that was more user-friendly. More impor- tantly, Canon addressed a need in a specific consumer segment—small and medium- sized businesses and individual departments or offices in large companies—that Xerox neglected.

Finally, a disruptive innovation leverages new technologies to attack existing markets. It invades an existing market from the bottom up, as shown in Exhibit 7.12.69 The dashed lines represent different market segments, from Segment 1 at the low end to Segment 4 at the high end. Low-end market segments are generally associated with low profit margins,

innovation ecosystem A firm’s embeddedness in a complex network of suppliers, buyers, and complementors, which requires interdependent strategic decision making.

architectural innovation A new product in which known components, based on existing technologies, are reconfigured in a novel way to attack new markets.

disruptive innovation An innovation that leverages new technologies to attack existing markets from the bottom up.

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while high-end market segments often have high profit margins. As first demonstrated by Clayton Christensen, the dynamic process of disruptive innovation begins when a firm, fre- quently a startup, introduces a new product or process based on a new technology to meet existing customer needs. To be a disruptive force, however, this new technology has to have additional characteristics:

1. It begins as a low-cost solution to an existing problem. 2. Initially, its performance is inferior to the existing technology, but its rate of techno-

logical improvement over time is faster than the rate of performance increases required by different market segments. In Exhibit 7.12, the solid upward curved line captures the new technology’s trajectory, or rate of improvement over time.

The following examples illustrate disruptive innovations:

■ Japanese carmakers successfully followed a strategy of disruptive innovation by first introducing small fuel-efficient cars and then leveraging their low-cost and high- quality advantages into high-end luxury segments, captured by brands such as Lexus, Infiniti, and Acura. More recently, the South Korean carmakers Kia and Hyundai have followed a similar strategy.

■ Digital photography improved enough over time to provide higher-definition pictures. As a result, it has been able to replace film photography, even in most professional applications.

■ Laptop computers disrupted desktop computers; now tablets and larger-screen smart- phones are disrupting laptops.

■ Educational organizations such as Coursera and Udacity are disrupting traditional uni- versities by offering massive open online courses (MOOCs), using the web to provide large-scale, interactive online courses with open access.

One factor favoring the success of disruptive innovation is that it relies on a stealth attack: It invades the market from the bottom up, by first capturing the low end. Many times, incumbent firms fail to defend (and sometimes are even happy to cede) the low end of the market, because it is frequently a low-margin business. Google, for example, is using its mobile operating system, Android, as a beachhead to challenge Microsoft’s dominance in the personal computer industry, where 90 percent of machines run Windows.70 Google’s

EXHIBIT 7.12 / Disruptive Innovation: Rid- ing the Technology Trajec- tory to Invade Different Market Segments from the Bottom Up

Segment 1

Segment 2

Segment 3

Segment 4

Pe rfo

rm an

ce

Time

Technology trajectory (curved line) – used by disruptive innovator to invade market segments from the bottom up

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Android, in contrast, is optimized to run on mobile devices, the fastest-growing segment in computing. To appeal to users who spend most of their time on the web accessing e-mail and other online applications, for instance, it is designed to start in a few seconds. More- over, Google provides Android free of charge.71 In contrast to Microsoft’s proprietary Windows operating system, Android is open-source software, accessible to anyone for fur- ther development and refinement. Google’s Android holds an 85 percent market share in mobile operating systems, while Apple’s iOS has 12 percent, and the remaining 3 percent is held by Microsoft’s Windows.72

Another factor favoring the success of disruptive innovation is that incumbent firms often are slow to change. Incumbent firms tend to listen closely to their current customers and respond by continuing to invest in the existing technology and in incremental changes to the existing products. When a newer technology matures and proves to be a better solu- tion, those same customers will switch. At that time, however, the incumbent firm does not yet have a competitive product ready that is based on the disruptive technology. Although customer-oriented visions are more likely to guard against firm obsolescence than product- oriented ones (see Chapter 2), they are no guarantee that a firm can hold out in the face of disruptive innovation. One of the counterintuitive findings that Clayton Christensen unearthed in his studies is that it can hurt incumbents to listen too closely to their exist- ing customers. Apple is famous for not soliciting customer feedback because it believes it knows what customers need before they even realize it.

Netflix, featured in the ChapterCase, disrupted the television industry from the bottom up (as shown in Exhibit 7.12) with its online streaming video-on-demand service. Netflix’s streaming service differentiated itself from cable television by making strategic trade-offs. By initially focusing on older “rerun TV” (such as Breaking Bad) and not including local content or exorbitant expensive live sport events, Netflix was able to price its subscription service considerably lower than cable bundles. Netflix improved the viewing experience by allowing users to watch shows and movies without commercial breaks and on-demand, thus enhancing perceived consumer value. By switching quickly from sending DVDs via postal mail to online streaming, Netflix was able to ride the upward-sloping technology trajectory (shown in Exhibit 7.12) to invade the media industry from the bottom up, all the way to providing premium original content such as House of Cards. Netflix’s pivot to online streaming was aided by increased technology diffusion (see Exhibit 7.1) as more and more Americans adopted broadband internet connections in the early 2000s.

HOW TO RESPOND TO DISRUPTIVE INNOVATION? Many incumbents tend to dismiss the threat by startups that rely on disruptive innovation because initially their product or ser- vice offerings are considered low end and too niche-focused. As late as 2010 (the year Blockbuster filed for bankruptcy), the CEO of Time Warner, one of the incumbent media companies to be disrupted by Netflix, did not take it seriously. When asked about the online streaming service as a potential competitor, he ridiculed the threat as equivalent to the likelihood of the Albanian army taking over the entire world.73 It is critical to have an effective response to disruptive innovation.

Although the examples in the previous section show that disruptive innovations are a serious threat for incumbent firms, some have devised strategic initiatives to counter them:

1. Continue to innovate in order to stay ahead of the competition. A moving target is much harder to hit than one that is standing still and resting on existing (innovation) laurels. Amazon is an example of a company that has continuously morphed through innovation,74  from a simple online book retailer to the largest ecommerce company, and now to include stores on the ground in the grocery sector. It also offers a personal- ized digital assistant (Alexa), consumer electronics (Kindle tablets), cloud computing,

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and content streaming, among other many other offerings (see ChapterCase 8). Netflix continued to innovate by pivoting to online streaming and away from sending DVDs through the mail.

2. Guard against disruptive innovation by protecting the low end of the market (Seg- ment 1 in Exhibit 7.12) by introducing low-cost innovations to preempt stealth com- petitors. Intel introduced the Celeron chip, a stripped-down, budget version of its Pentium chip, to prevent low-cost entry into its market space. More recently, Intel fol- lowed up with the Atom chip, a new processor that is inexpensive and consumes little battery power, to power low-cost mobile devices.75 Nonetheless, Intel also listened too closely to its existing personal computer customers such as Dell, HP, Lenovo, and so on, and allowed ARM Holdings, a British semiconductor design company (that supplies its technology to Apple, Samsung, HTC, and others) to take the lead in providing high-performing, low-power-consuming processors for smartphones and other mobile devices.

3. Disrupt yourself, rather than wait for others to disrupt you. A firm may develop prod- ucts specifically for emerging markets such as China and India, and then introduce these innovations into developed markets such as the United States, Japan, or the Euro- pean Union. This process is called reverse innovation,76 and allows a firm to disrupt itself. Strategy Highlight 7.2 describes how GE Healthcare invented and commercial- ized a disruptive innovation in China that is now entering the U.S. market, riding the steep technology trajectory of disruptive innovation shown in Exhibit 7.12.

GE’s Innovation Mantra: Disrupt Yourself! GE Healthcare is a leader in diagnostic devices. Realizing that the likelihood of disruptive innovation increases over time, GE decided to disrupt itself. A high-end ultrasound machine found in cutting-edge research hospitals in the United States or Europe costs $250,000. There is not a large market for these high-end, high-price products in developing countries. Given their large populations, however, these countries have a strong medical need for ultrasound devices.

In 2002, a GE team in China, through a bottom-up strate- gic initiative, developed an inexpensive, portable ultrasound device, combining laptop technology with a probe and sophis- ticated imaging software. This lightweight device (11 pounds) was first used in rural China. In spring 2009, GE unveiled the new medical device under the name Venue 40 in the United States, at a price of less than $30,000. There was also high demand from many American general practitioners, who could not otherwise afford the $250,000 needed to pro- cure a high-end machine (that weighed about 400 pounds). In the fall of 2009, then GE Chairman and CEO Jeff Immelt

unveiled the Vscan, an even smaller device that looks like a cross between an early iPod and a flip phone. This wire- less ultrasound device is priced around $5,000. GE views the Vscan as the “stethoscope of the 21st century,” which a primary care doctor can hang around her neck when visiting with patients.77

Strategy Highlight 7.2

GE’s Vscan is a wireless ultrasound device priced around $5,000. ©VCG/Getty Images News/ Getty Images

reverse innovation An innovation that was developed for emerging economies before being introduced in developed economies. Sometimes also called frugal innovation.

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7.5 Platform Strategy Up to this point in our discussion of strategy and competitive advantage, we focused mainly on businesses that operate at one or more stages of the linear value chain (introduced in Chapter 4).

A firm’s value chain captures the internal activities a firm engages in, beginning with raw materials and ending with retailing and after-sales service and support. The value chain represents a linear view of a firm’s business activities. As such, this traditional system of horizontal business organization has been described as a pipeline, because it captures a linear transformation with producers at one end and consumers at the other. Take BlackBerry as an example of a business using a linear pipeline approach based on a step-by-step arrangement for creating and transferring value. This Canadian ex-leader in smartphones conducted internal R&D, designed the phones, then manufactured them (often in company-owned plants), and finally retailed them in partner stores such as AT&T or Verizon, which offered wireless services and after-sales support.

THE PLATFORM VS. PIPELINE BUSINESS MODELS Read the examples below, and try to figure out how these businesses’ operations differ from the traditional pipeline structure described earlier.78

■ Valued at $70 billion in 2017, the ride-hailing service Uber was launched less than 10 years earlier in a single city, San Francisco. Uber is not only disrupting the traditional taxi and limousine business in hundreds of cities around the globe, but also reshaping the transportation and logistics industries, without owning a single car. In the future, Uber might deploy a fleet of driverless cars; it is currently testing autonomous vehicles.

■ Reaching close to 2 billion people (out of a total of 7 billion on Earth), Facebook is where people get their news, watch videos, listen to music, and share photos. Garnering some $30 billion in annual advertising revenues in 2016, Facebook has become one of the largest media companies in the world, without producing a single piece of content.

•■ China-based ecommerce firm Alibaba is the largest web portal that offers online retailing as well as business-to-business services on a scale that dwarfs Amazon. com and eBay combined. On its Taobao site (similar to eBay), Alibaba offers more than 1 billion products, making it the world’s largest retailer without owning a sin- gle item of inventory. When going public in 2014 by listing on the New York Stock Exchange (NYSE), Alibaba was the world’s largest initial public offering (IPO), valued at $25 billion. Not even three years later, by early 2017, Alibaba was valued at some $260 billion, making it one of the most valuable technology companies in the world.

What do Uber, Facebook, and Alibaba have in common? They are not organized as traditional linear pipelines, but instead as a platform businesses. The five most valuable companies globally (Apple, Alphabet, Microsoft, Amazon, and Facebook) all run plat- form business models. ExxonMobil, running a traditional linear business model from raw materials (fossil fuels) to distribution (of refined petroleum products) and long the most valuable company in the world, had fallen to number six by 2016.79  Based on the 2016 book Platform Revolution by Parker, Van Alstyne, and Choudary, platforms can be defined along three dimensions:

1. A platform is a business that enables value-creating interactions between external pro- ducers and consumers.

LO 7-6

Explain why and how platform businesses can outperform pipeline businesses.

platform business An enterprise that creates value by matching external producers and consumers in a way that creates value for all participants, and that depends on the infrastructure or platform that the enterprise manages.

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2. The platform’s overarching purpose is to consummate matches among users and facili- tate the exchange of goods, services, or social currency, thereby enabling value cre- ation for all participants.

3. The platform provides an infrastructure for these interactions and sets governance con- ditions for them.

The business phenomenon of platforms, however, is not a new one. Platforms, often also called multi-sided markets, have been around for millennia. The town squares in ancient cities were marketplaces where sellers and buyers would meet under a set of governing rules determined by the owner or operator (such as what type of wares could be offered, when the marketplace was open for business, which vendor would get what stand on the square, etc.). The credit card, often hailed has the most important innovation in the finan- cial sector over the last few decades,80 provides a more recent example of a multi-sided market. Credit cards facilitate more frictionless transactions between vendors and custom- ers because the vendor is guaranteed payment by the bank that issues the credit card, and customers using credit cards can easily transact online without the need to carry cash in the physical world. In addition, credit card users can buy goods or services on credit based on their promise of repaying the bank.

In the digital age, platforms are business model innovations that use technology (such as the internet, cloud computing, etc.) to connect organizations, resources, information, and people in an interactive ecosystem where value-generating transactions (such as hail- ing a ride on Uber, catching up on news on Facebook, or connecting a Chinese supplier to a U.S. retailer via Alibaba) can be created and exchanged. Effective use of technology allows platform firms to drastically reduce the barriers of time and space: Information is avail- able in real time across the globe, and market exchanges can take place effectively across vast distances (i.e., China to the United States) or even in small geographic spaces (such as Tinder, a location-based dating service).

THE PLATFORM ECOSYSTEM To formulate an effective platform strategy, a first step is to understand the roles of the players within any platform ecosystem (see Exhibit 7.13).  From a value chain perspec- tive, producers  create or make available a product or service that consumers  use. The owner of the platform controls the platform IP address and controls who may participate and in what ways. The providers offer the interfaces for the platform, enabling its acces- sibility online.

The players in the ecosystem typically fill one or more of the four roles but may rapidly shift from one role to another. For example, a producer may decide to purchase the platform to become an owner, or an owner may use the platform as a producer. Producer and consumer can also switch, for example, as when a passenger (consumer) who uses Uber for transportation decides to become an Uber driver (producer). This is an example of so-called side switching.

ADVANTAGES OF THE PLATFORM BUSINESS MODEL. Platform businesses tend to fre- quently outperform pipeline businesses, because of the following advantages:81

1. Platforms scale more efficiently than pipelines by eliminating gatekeepers. Platform businesses leveraging digital technology can also grow much faster—that is, they scale efficiently—because platforms create value by orchestrating resources that reside in the ecosystem. The platform business does not own or control these resources, facilitating rapid and often exponential growth.

In contrast, pipelines tend to be inefficient in managing the flow of information from producer to consumer. When hiring a professional services firm such as consultants or

platform ecosystem The market environment in which all players participate relative to the platform.

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lawyers, the buyer has to purchase a bundle of services offered by the firm, for example, retaining a consulting team for a specific engagement. This team of consultants contains both senior and junior consultants, as well as administrative support staff. The client is unable to access the services of only one or two senior partners but not the rest of the team, where inexperienced junior associates are also billed at a high rate to the client. Platforms such as Upwork unbundle professional services by making available precisely defined individual services while eliminating the need to purchase a bundle of services as required by gatekeepers in old-line pipelines.

2. Platforms unlock new sources of value creation and supply. Consider how upstart Airbnb (featured in ChapterCase 3) disrupted the hotel industry. To grow, traditional com- petitors such as Marriott or Hilton would need to add additional rooms to their existing stock. To add new hotel room inventory to their chains, they would need to find suitable real estate, develop and build a new hotel, furnish all the rooms, and hire and train staff to run the new hotel. This often takes years, not to mention the multimillion-dollar upfront investments required and the risks involved.

In contrast, Airbnb faces no such constraints because it does not own any real estate, nor does it manage any hotels. Just like Marriott or Hilton, however, it uses sophisticated pricing and booking systems to allow guests to find a large variety of rooms pretty much anywhere in the world to suit their needs. As a digital platform, Airbnb allows any person to offer rooms directly to pretty much any consumer that is looking for accommodation online. Airbnb makes money by taking a cut on every rental through its platform. Given that Airbnb is a mere digital platform, it can grow much faster than old-line pipeline busi- nesses such as Marriott. Airbnb’s inventory is basically unlimited as long as it can sign up new users with spare rooms to rent, combined with very little if any cost to adding inven- tory to its existing online offerings. Unlike traditional hotel chains, Airbnb’s growth is not limited by capital, hotel staff, or ownership of real estate. In 2017, Airbnb offered over 2 million listings worldwide for rent.

3. Platforms benefit from community feedback. Feedback loops from consumers back to the producers allow platforms to fine-tune their offerings and to benefit from big data

SOURCE: Adapted from Van Alystyn, M., Parker. G. G., and Choudary, S. P. (2016, Apr.) “Pipelines, Platforms, and the New Rules of Strategy,” Harvard Business Review.

EXHIBIT 7.13 / The Players in a Platform Ecosystem PLATFORM

CONSUMERSPRODUCERS Value and data exchange and

feedback

Controller of platform IP and arbiter of who may participate and in what ways

Interfaces for the platform

Creators of the platform’s offerings

Buyers or users of the offerings

PROVIDERS

OWNER

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analytics. TripAdvisor, a travel website, derives significant value from the large amount of quality reviews (including pictures) by its users of hotels, restaurants, and so on. This enables TripAdvisor to consummate more effective matches between hotels and guests via its website, thus creating more value for all participants. It also allows TripAdvisor to capture a percentage of each successful transaction in the process.

Netflix also collects large amounts of data about users’ viewing habits and preferences across the world. This allows Netflix to not only make effective recommendations on what to watch next, but also affords a more effective resource allocation process when mak- ing content investments. Before even producing a single episode of House of Cards, for example, Netflix knew that its audience would watch this series. Netflix has continued following the data, which allows the market to shape new content.

NETWORK EFFECTS For platform businesses to succeed, however, it is critical to benefit from positive network effects. We provided a brief introduction of network effects earlier when discussing how to gain a foothold for an innovation in a newly emerging industry during the introduction stage of the industry life cycle. We now take a closer look at the role of network effects in platforms, including feedback loops that can initiate virtuous growth cycles leading to platform leadership.

Netflix. Consider how the video-streaming service Netflix (featured in the ChapterCase) leverages network effects for competitive advantage. Netflix’s business model is to grow its global user base as large as possible and then to monetize it via monthly subscription fees. It does not offer any ads. The established customer base in the old-line DVD rental business gave Netflix a head start when entering into the new business of online stream- ing. Moreover, the cost to Netflix of establishing a large library of streaming content is more or less fixed, but the per unit cost falls drastically as more users join. Moreover, the marginal cost of streaming content to additional users is also extremely low (it is not quite zero because Netflix pays for some delivery of content either by establishing servers host- ing content in geographic proximity of users, or paying online service providers for faster content streaming).

As Netflix acquires additional streaming content, it increases the value of its subscrip- tion service to customers, resulting in more people signing up. With more customers, Net-

flix could then afford to provide more and higher-quality content, further increasing the value of the subscription to its users. This created a virtuous cycle that increased the value of a Netflix subscription as more subscribers signed up (see Exhibit 7.14).

Growing its user base is critical for Netflix to sus- tain its competitive advantage. Netflix has been hugely successful in attracting new users: In 2017 it had some 100 million subscribers worldwide. Yet, while providing a large selection of high-quality streaming content is a necessity of the Netflix business model, this element can and has been easily duplicated by others such as Ama- zon, Hulu, and premium services on Google’s YouTube. To lock in its large installed base of users, however, Net- flix has begun producing and distributing original con- tent such as the hugely popular shows House of Cards and Orange Is the New Black. To sustain its competitive advantage going forward, Netflix needs to rely on its core competencies, including its proprietary recommendation

EXHIBIT 7.14 / Netflix Business Model: Leveraging Network Effects to Drive Demand

More Netflix Subscribers

Value of Netflix Subscription

Demand for Netflix Services

More Content

(+)

(+) (+)

(+)

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engine, data-driven content investments, and network infra- structure management.

Uber. The feedback loop in network effects becomes even more apparent when taking a closer look at Uber’s busi- ness model. Like many platforms, Uber performs a classic matching service. In this case, it allows riders to find driv- ers and drivers to find riders. Uber’s deep pockets, thanks to successful rounds of fund-raising, allow the startup to lose money on each ride in order to initiate a positive feed- back loop. Uber provides incentives for drivers to sign up (such as extending credit so that potential drivers can pur- chase vehicles) and also charges lower than market rates for its rides. As more and more drivers sign up in each city and thus coverage density rises accordingly, the service becomes more convenient. This drives more demand for its services as more riders choose Uber, which in turn brings in more drivers. This positive feedback loop is shown in Exhibit 7.15.

With more and more drivers on the Uber platform, both wait time for rides as well as driver downtime falls. Less downtime implies that a driver can complete more rides in a given time while making the same amount of money, even if Uber should lower its fares. Lower fares and less wait time, in turn, bring in more riders on the platform, and so on. This additional feedback loop is shown in Exhibit 7.16.

This feedback loop also explains the much hated “surge pricing” that Uber employs. It is based on dynamic pricing for its services depending on demand. For example, dur- ing the early hours of each New Year, demand for rides far outstrips supply. To entice more drivers to work during this time, Uber has to pay them more. Higher pay will bring more drivers onto the platform. Some users complain about surge pricing, but it allows Uber to match supply and demand in a dynamic fashion. As surge pricing kicks in, fewer people will demand rides, eventually bringing supply and demand back into an equilibrium (see Exhibit 7.16).

The ability of a platform to evince and manage positive network effects is critical to producing value for each participant, and it allows it to gain and sustain a competitive advantage. In contrast, neg- ative network effects describe the situa- tion where more and more users exit a platform and the value that each remain- ing user receives from the platform declines. The social network Myspace experienced negative network effects as more and more users abandoned it for Facebook. One reason was that Myspace attempted to maximize ad rev- enues per user too early in its existence, while Facebook first focused on build- ing a social media platform that allowed for the best possible user experience before starting to monetize its user base through selling ads.

EXHIBIT 7.15 / Uber’s Business Model: Leveraging Network Effects to Increase Demand

More Demand

More Geographic Coverage

Faster Pickups

More Drivers

(+)

(+) (+)

(+)

EXHIBIT 7.16 / Uber’s Network Effects with Feedback Loop More Demand

More Geographic Coverage

Faster Pickups

Less Driver Downtime

Lower Prices

More Drivers

(+)

(+)

(+)

(+)

(+) (+)

(+)

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7.6 Implications for Strategic Leaders Innovation drives the competitive process. An effective innovation strategy is critical in for- mulating a business strategy that provides the firm with a competitive advantage. Successful innovation affords firms a temporary monopoly, with corresponding monopoly pricing power. Fast Company named Amazon, Google, Uber, Apple, and Snap as the top five of its 2017 Most Innovative Companies.82 Continuous innovation fuels the success of these companies.

Entrepreneurs are the agents that introduce change into the competitive system. They do this not only by figuring out how to use inventions, but also by introducing new products or services, new production processes, and new forms of organization. Entrepreneurs fre- quently start new ventures, but they may also be found in existing firms.

The industry life cycle model and the crossing-the-chasm framework have critical implications for how you manage innovation. To overcome the chasm, you need to formu- late a business strategy guided by the who, what, why, and how questions of competition (Chapter 6) to ensure you meet the distinctly different customer needs inherent along the industry life cycle. You also must be mindful that to do so, you need to bring different competencies and capabilities to bear at different stages of the industry life cycle.

It is also useful to categorize innovations along their degree of newness in terms of technology and markets. Each diagonal pair—incremental versus radical innovation and architectural versus disruptive innovation—has different strategic implications.

Moving from the traditional pipeline business to a platform business model implies three important shifts in strategy focus:83

1. From resource control to resource orchestration. 2. From internal optimization to external interactions. 3. From customer value to ecosystem value.

The focus in platform strategy, therefore, shifts from traditional concepts of resource control, industry structure, and firm strategic position to creating and facilitating more or less frictionless market exchanges.

In conclusion, in this and the previous chapter, we discussed how firms can use business- level strategy—differentiation, cost leadership, blue ocean, and innovation—to gain and sus- tain competitive advantage. We now turn our attention to corporate-level strategy to help us understand how executives make decisions about where to compete (in terms of products and services offered, integration along the value chain, and geography) and how to execute it through strategic alliances as well as mergers and acquisitions. A thorough understanding of business and corporate strategy is necessary to formulate and sustain a winning strategy.

THE IMPACT OF NETFLIX’S mega-success House of Cards in reshaping the TV industry cannot be underestimated. The American political TV drama starring Kevin Spacey and Robin Wright was an innovation that fundamentally changed the existing business model of TV viewing on three fronts.

1. Delivery. House of Cards was the first time that a major original TV drama was streamed online and thus

CHAPTERCASE 7  Consider This. . .

bypassed the established ecosystem of networks and cable operators.

2. Access. House of Cards created the phenomenon of binge watching because it allowed Netflix subscribers ©A-Pix Entertainment/

Photofest

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to view many or all episodes in one sitting, without any advertising interruptions. As of 2017, spending an esti- mated $200 million, Netflix produced five seasons for a total of 65 episodes each roughly 45 to 60 minutes long.

3. Management. House of Cards was the first time original programming had been developed based on Netflix’s proprietary data algorithms and not by more traditional methods. When executive producer David Fincher and actor Kevin Spacey brought the proposed show to Netflix, the company approved the project without a pilot or any test-marketing. “Netflix was the only network that said, ‘We believe in you,’” recalls Spacey. “‘We’ve run our data and it tells us that our audience would watch this series. We don’t need you to do a pilot. How many [episodes] do you wanna do?’”84

The success of House of Cards created a huge buzz, attracted millions of new subscribers to Netflix, and helped its stock climb to new highs.

Despite riding high, there are some serious challenges for CEO Reed Hastings and Netflix on the horizon. First is the issue of how to ensure that Netflix users have a seamless, uninterrupted viewing experience, without buffering (and seeing the “spinning wheels”). Recall that Netflix is respon- sible for more than one-third of all downstream internet traf- fic in the United States during peak hours. For a long time, Netflix has been a strong supporter of net neutrality, with the goal of preventing internet service providers (ISPs) such as Comcast from slowing content or blocking access to certain websites. Conceivably, Comcast may have an incentive to slow Netflix’s content and favor its own NBC content.

To work around the net neutrality rules, ISPs have begun imposing “data caps” on their customers. Once users exceed their data cap, additional data usage incurs added fees. Another ISP practice that concerns Hastings is “zero-rating,” an arrangement where the ISP does not count traffic from preferred data providers such as their own content toward customers’ data caps. These are the reasons Netflix—after refusing to do so for a long time—has begun to pay ISPs directly to ensure a smoother streaming experience for its users. Rather than going through the public internet, in exchange for payment, Netflix is able to hook its servers directly to Comcast’s broadband network. Given its prece- dent, Netflix is likely to strike similar deals with other ISPs, such as AT&T and Verizon, that control access to Netflix customers.

The second issue for Hastings is how to create sustained future growth. The domestic market seems to be maturing, so growth has to come from international expansion. Some

49 million (or about half of) Netflix subscribers reside outside the United States. To drive future growth, Netflix is rapidly expanding its services internationally from 60  countries in 2016 to 190 countries. Netflix is still noticeably absent from China, a market where Hastings commented that Netflix is still, “in the relationship building phase.”85 One of the issues Netflix will face is potential censoring of its content; House of Cards has not only explicit content in terms of nudity and violence, but also features a corrupt Chinese businessman meddling in U.S. politics. Moreover, problems with a lack of available titles and few places with broadband internet con- nections hamper Netflix’s international growth.

Questions

1. Netflix started to pay ISPs to ensure fast and seamless access to its end users.

a. Does this violate net neutrality (the rule that inter- net service providers should treat all data equally, and not charge differentially by user, content, site, etc.)? Why or why not?

b. Do you favor net neutrality? Explain why or why not?

c. How do ISPs use “zero-rating” of data to circum- vent net neutrality rules? Is this legal? Is this ethi- cal? Explain.

d. As ISPs will extract more fees from Netflix, the company continues to invest heavily in its proprie- tary “Open Connect” network, which allows Netflix to connect its servers directly to those of ISPs (via peering). Since most users upgrade their internet connections to faster broadband in order to watch video, are the incentives of broadband providers aligned with Netflix, or will the broadband provid- ers continue to extract significant value from this industry? Apply a five forces analysis.

2. Netflix growth in the United States seems to be matur- ing. What other services can Netflix offer that might increase demand in the United States?

3. International expansion appears to be a major growth opportunity for Netflix. Elaborate on the challenges Netflix faces going beyond the U.S. market.

a. Do you think it is a good idea to rapidly expand to 190 countries in one fell swoop, or should Netflix follow a more gradual international expansion?

b. What are some of the challenges Netflix is likely to encounter internationally? What can Netflix do to address these? Explain.

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

This chapter discussed various aspects of innovation and entrepreneurship as a business-level strategy, as summarized by the following learning objectives and related take-away concepts.

LO 7-1 / Outline the four-step innovation process from idea to imitation. ■ Innovation describes the discovery and develop-

ment of new knowledge in a four-step process captured in the four I’s: idea, invention, innova- tion, and imitation.

■ The innovation process begins with an idea. ■ An invention describes the transformation of an

idea into a new product or process, or the modifi- cation and recombination of existing ones.

■ Innovation concerns the commercialization of an invention by entrepreneurs (within existing com- panies or new ventures).

■ If an innovation is successful in the marketplace, competitors will attempt to imitate it.

LO 7-2 / Apply strategic management concepts to entrepreneurship and innovation. ■ Entrepreneurship describes the process by

which change agents undertake economic risk to innovate—to create new products, processes, and sometimes new organizations.

■ Strategic entrepreneurship describes the pursuit of innovation using tools and concepts from strategic management.

■ Social entrepreneurship describes the pursuit of social goals by using entrepreneurship. Social entrepreneurs use a triple-bottom-line approach to assess performance.

LO 7-3 / Describe the competitive implications of different stages in the industry life cycle. ■ Innovations frequently lead to the birth of new

industries. ■ Industries generally follow a predictable industry

life cycle, with five distinct stages: introduction, growth, shakeout, maturity, and decline.

■ Exhibit 7.10 details features and strategic implica- tions of the industry life cycle

LO 7-4 / Derive strategic implications of the crossing-the-chasm framework. ■ The core argument of the crossing-the-chasm

framework is that each stage of the industry life cycle is dominated by a different customer group, which responds differently to a new technological innovation.

■ There exists a significant difference between the customer groups that enter early during the introductory stage of the industry life cycle and customers that enter later during the growth stage.

■ This distinct difference between customer groups leads to a big gulf or chasm, which companies and their innovations frequently fall into.

■ To overcome the chasm, managers need to formu- late a business strategy guided by the who, what, why, and how questions of competition.

LO 7-5 / Categorize different types of innovations in the markets-and-technology framework. ■ Four types of innovation emerge when applying

the existing versus new dimensions of technology and markets: incremental, radical, architectural, and disruptive innovations (see Exhibit 7.11).

■ An incremental innovation squarely builds on an established knowledge base and steadily improves an existing product or service offering (existing market/existing technology).

■ A radical innovation draws on novel methods or materials and is derived either from an entirely different knowledge base or from the recom- bination of the existing knowledge base with a new stream of knowledge (new market/new technology).

■ An architectural innovation is an embodied new product in which known components, based on existing technologies, are reconfigured in a novel way to attack new markets (new market/existing technology).

■ A disruptive innovation is an innovation that leverages new technologies to attack existing markets from the bottom up (existing market/new technology).

TAKE-AWAY CONCEPTS

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CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 257

LO 7-6 / Explain why and how platform businesses can outperform pipeline businesses. ■ Platform businesses scale more efficiently than

pipeline businesses by eliminating gatekeepers and leveraging digital technology. Pipeline busi- nesses rely on gatekeepers to manage the flow of value from end to end of the pipeline. Platform businesses leverage technology to provide real- time feedback.

■ Platforms unlock new sources of value creation and supply. Thus they escape the limits faced by a pipeline company working within an existing industry based on physical assets.

■ Platforms benefit from community feedback. Feedback loops from consumers back to the pro- ducers allow platforms to fine-tune their offerings and to benefit from big data analytics.

Architectural innovation (p. 245) Crossing-the-chasm

framework (p. 235) Disruptive innovation (p. 245) Entrepreneurs (p. 226) Entrepreneurship (p. 225) First-mover advantages (p. 224) Incremental innovation (p. 243) Industry life cycle (p. 227)

Innovation (p. 223) Innovation ecosystem (p. 245) Invention (p. 222) Markets-and-technology frame-

work (p. 243) Network effects (p. 229) Patent (p. 223) Platform business (p. 249) Platform ecosystem (p. 250)

Process innovation (p. 231) Product innovation (p. 231) Radical innovation (p. 243) Reverse innovation (p. 248) Social entrepreneurship (p. 226) Standard (p. 230) Strategic entrepreneurship (p. 226) Trade secret (p. 223) Winner-take-all markets (p. 244)

KEY TERMS

DISCUSSION QUESTIONS

1. Patents are discussed as part of the invention phase of the innovation process in Exhibit 7.2. Describe the trade-offs that are made when a firm decides to patent its business processes or soft- ware. Is this same trade-off applicable to tangible hardware products made by a firm?

2. Select an industry and consider how the indus- try life cycle has affected business strategy for the firms in that industry over time. Detail your answer based on each stage: introduction, growth, shakeout, maturity, and decline.

3. Describe a firm you think has been highly innova- tive. Which of the four types of innovation—radical, incremental, disruptive, or architectural—did it use? Did the firm use different types over time?

4. The chapter discussed the internet as a disruptive innovation that has facilitated online retailing. It also has presented challenges to brick-and-mortar retailers. How might retailers such as Nordstrom, Neiman Marcus, or Macy’s need to change their in-store experience to continue to attract a flow of customers into their stores to expand sales using direct selling and store displays of the actual mer- chandise? If the internet continues to grow and sales of brick-and-mortar retailers decline, how might the retailers attract, train, and retain high- quality employees if the industry is perceived as in decline?

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

ETHICAL/SOCIAL ISSUES

1. You are a co-founder of a start-up firm making electronic sensors. After a year of sales, your business is not growing rapidly, but you have some steady customers keeping the business afloat. A major supplier has informed you it can no longer supply your firm because it is moving to serve large customers only, and your volume does not qualify. Though you have no current orders to support an increased commitment to this supplier, you do have a new version of your sensor coming out that you hope will increase the purchase volume by over 75 percent and qualify you for continued supply. This supplier is impor- tant to your plans. What do you do?

2. GE’s development of the Vscan provides many benefits as a lower-cost and portable ultrasound device (see Strategy Highlight 7.2). Cardiologists, obstetricians, and veterinarians will be able to use the device in rural areas and developing countries. One of the criticisms of the device, however, is that it also facilitates the use of the technology for

gender-selective abortion. In India, for example, there is a cultural preference for males, and the Vscan has been used to identify gender in order to abort an unwanted female fetus. Some argue that gender selection is also used for economic reasons—specifically, to alleviate the financial strain of the common dowry practice. A daughter would require the family to pay a dowry of cash and gifts to the bridegroom’s family in order to arrange a suitable marriage, while a son would bring in a dowry of cash, jewelry, gifts, and house- hold items to help the couple start their home.86

To what extent is GE ethically responsible for how—and why—the Vscan is used? (To what extent is any company ethically responsible for how—and why—its product is used?) Note that GE’s website states that it is an “Agent of Good.” Consider ways that GE might become involved in communities in India to show the company’s con- cern for the underlying problems by improving conditions for women. What other ways might GE influence how its equipment is used?

SMALL GROUP EXERCISES

//// Small Group Exercise 1 Your group works for Warner Music Group (www .wmg.com), a large music record label whose sales are declining largely due to digital piracy and online sales overall. Your supervisor assigns you the task of devel- oping a strategy for improving this situation.

1. What are the key issues you must grapple with to improve the position of Warner Music Group (WMG)?

2. In what phase of the life cycle is the record-label industry?

3. How does this life cycle phase affect the types of innovation that should be considered to help WMG be successful?

//// Small Group Exercise 2 The text discusses the pros and cons of pipeline busi- nesses and platform businesses. Several examples

of new platform businesses are mentioned (Uber, Airbnb, Facebook, and Alibaba, for example). Yet it is noted that these multi-sided markets have actually been around much longer.

1. What are some of the biggest differences in the historical way to view platform markets and the more modern business incarnation?

2. In your group, discuss a company that could be moving toward a platform business or a new firm that is developing as a platform. Sketch out a busi- ness model for this firm and the network loop it could be utilizing to drive demand.

3. Can you identify a pipeline business that is likely to be disrupted by the firm you discussed in ques- tion 2 above? What could this pipeline business do to improve its long-term viability?

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CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 259

Do You Want to Be an Entrepreneur?

R ecent years have seen a sometimes public debate around the question of whether entrepreneurs are better off skipping college. For reasons noted below, we think this is a false debate, and we’ll explain why. But before we’re done, we will identify an unexpected way in which a higher education can legitimately be seen as limiting one’s ability to innovate and start a new business.87

Let’s start by acknowledging there are complex links between education and entrepreneurship and by explicitly stating our point of view: The right person can become an entrepreneur without the benefit of a college degree. But having a college degree is no impediment to becoming an entrepreneur and can further provide the benefit of formally studying the dynamics of business—just as we are doing in this class.

One volley in the debate was a provocative article in Forbes, titled “The Secret to Entrepreneurial Success: Forget College.” Another article listed 100 impressive entrepreneurs, none with a college degree and some with only an elementary school edu- cation. And while some famous entrepreneurs neglected higher education (Mark Zuckerberg dropped out of Harvard; Steve Jobs dropped out of Reed College), entrepreneurs are more likely to be better educated than most business owners. Just over half of business owners have a college degree.

And while the very different entrepreneurs in this chapter were chosen for their business success and innovations, and not their education, they—Jeff Bezos, Sara Blakely, Reed Hast- ings, Elon Musk, and Jimmy Wales—all have college degrees.

On the student side, business majors are drawn to the entrepreneurial role. Over the past 20 years, there has been an explosion of entrepreneurial programs at business schools, all in response to demand. Some 50 to 75 percent of MBA stu- dents from the leading programs are becoming entrepreneurs within 15 years of graduation.

But there is a more likely way in which higher education could be the enemy of entrepreneurship: the impact of large student loans. According to a new report, the higher the student loan debt in an area, the lower the net creation of very small businesses. The correlation of those two factors comes with some caveats:

• These effects tend to affect only the smallest businesses, which are more likely to take on debt that’s secured by the founder’s own personal credit.

• The authors of the report stop short of claiming that heavy debt burdens hamper an individual’s attempt.

• An alternate view of the data would be that students with high debt load go directly to higher paying corporate jobs.

1. Thinking about today’s business climate, would you say that now is a good time to start a business? Why or why not?

2. Do you see higher education as a benefit or detriment to becoming a successful entrepreneur? Why or why not?

3. Identify both the up and down sides of taking on personal debt to finance a higher education.

4. Explain how you would apply the strategic management framework to enhance your startup’s chances to gain and sustain a competitive advantage.

mySTRATEGY

1. Auletta, K. (2014, Feb. 3), “Outside the box: Netflix and the future of television,” The New Yorker. 2. Ramachandran, S., and T. Stynes (2016, Oct. 26), “Netflix CEO Reed Hastings talks with WSJ Financial Editor Dennis K. Ber- man at the 2016 WSJDlive Conference in Laguna Beach, CA,” https://www.youtube. com/watch?v=pBg3q2vHCLg [25:04 min]; “Netflix steps up foreign expansion,” The Wall Street Journal, January 20, 2015;

Ramachandran, S., and S. Sharma (2015, Mar. 3), “NBCU plans subscription comedy video service,” The Wall Street Journal; Vranica, S. (2015, Mar. 10), “Streaming services hammer cable-TV ratings,” The Wall Street Journal; Lin, L. (2015, May 15), “Netflix in talks to take content to China,” The Wall Street Jour- nal; Jenkins, H.W. (2015, Mar. 2017), “Netflix is the culprit,” The Wall Street Journal; Jakab, S. (2015, Apr. 14), “Don’t overlook Netflix’s bigger picture,” The Wall Street Journal;

Armental, M., and S. Ramachandran (2015, Apr. 15), “Netflix gains more users than pro- jected,” The Wall Street Journal; Auletta, K. (2014, Feb. 3), “Outside the box: Netflix and the future of television” The New Yorker; “A brief history of the company that revolution- ized watching of movies and TV shows,” http://netflix.com; “A brief history of Netflix” (2014), CNN.com, www.cnn.com/2014/07/21/ showbiz/gallery/netflix-history/; Ramach- andran, S. (2014, Feb. 23), “Netflix to pay

ENDNOTES

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

Comcast for smoother streaming,” The Wall Street Journal; and Darlin, D. (2005, Aug. 20), “Falling costs of big-screen TVs to keep falling,” The New York Times. 3. The long tail is a business model in which companies can obtain a large part of their revenues by selling a small number of units from among almost unlimited choices. See Anderson, C. (2006), The Long Tail. Why the Future of Business Is Selling Less of More (New York: Hachette). 4. Rothaermel, F.T., and A. Hess (2010), “Innovation strategies combined,” MIT Sloan Management Review, Spring: 12–15. 5. Schumpeter, J.A. (1942), Capitalism, Socialism, and Democracy (New York: Harper & Row); Foster, R., and S. Kaplan (2001), Creative Destruction: Why Compa- nies That Are Built to Last Underperform the Market—and How to Successfully Transform Them (New York: Currency). 6. “Comcast, GE strike deal; Vivendi to sell NBC stake,” The Wall Street Journal, December 4, 2009. 7. Rothaermel, F.T., and D.L. Deeds (2004), “Exploration and exploitation alliances in biotechnology: A system of new product development,” Strategic Management Journal 25: 201–221; Madhavan, R., and R. Grover (1998), “From embedded knowledge to embodied knowledge: New product develop- ment as knowledge management,” Journal of Marketing 62: 1–12; and Stokes, D.E. (1997), Pasteur’s Quadrant: Basic Science and Technological Innovation (Washington, DC: Brookings Institute Press). 8. Isaacson, W. (2007), Einstein: His Life and Universe (New York: Simon & Schuster). 9. A detailed description of patents can be found at the U.S. Patent and Trademark Office’s website at www.uspto.gov/. 10. Hallenborg, L., M. Ceccagnoli, and M. Clendenin (2008), “Intellectual property pro- tection in the global economy,” Advances in the Study of Entrepreneurship, Innovation, and Economic Growth 18: 11–34; and Graham, S.J.H. (2008), “Beyond patents: The role of copyrights, trademarks, and trade secrets in technology commercialization,” Advances in the Study of Entrepreneurship, Innovation, and Economic Growth 18: 149–171. 11. “Sweet secrets—obituary: Michele Fer- rero,” The Economist, February 21, 2015. 12. Schumpeter, J.A. (1942), Capitalism, Social- ism, and Democracy (New York: Harper & Row). For an updated and insightful discussion, see Foster, R., and S. Kaplan (2001), Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them (New York: Currency). For a very accessible discussion, see McCraw, T. (2007), Prophet of Innovation:

Joseph Schumpeter and Creative Destruction (Boston: Harvard University Press). 13. Lieberman, M.B., and D.B. Montgomery (1988), “First-mover advantages,” Strategic Management Journal 9: 41–58. 14. Winkler, R., J. Nicas, and B. Fritz (2017, Feb. 14), “Disney severs ties with YouTube star PewDiePie after anti-Semitic posts,” The Wall Street Journal; “Top 100 YouTubers by Subscribed,” Social Blade, http://socialblade. com/youtube/top/100/mostsubscribed accessed February 21, 2017. 15. Schramm, C.J. (2006), The Entrepreneur- ial Imperative (New York: HarperCollins). Dr. Carl Schramm is president of the Kauffman Foundation, the world’s leading foundation for entrepreneurship. 16. Schumpeter, J.A. (1942), Capitalism, Socialism, and Democracy (New York: Harper & Row); Foster, R., and S. Kaplan (2001), Creative Destruction: Why Compa- nies That Are Built to Last Underperform the Market—and How to Successfully Transform Them (New York: Currency). 17. Shane, S., and S. Venkataraman (2000), “The promise of entrepreneur- ship as a field of research,” Academy of Management Review 25: 217–226; Alvarez, S., and J.B. Barney (2007), “Discovery and creation: Alternative theories of entrepre- neurial action,” Strategic Entrepreneurship Journal 1: 11–26. 18. Drucker, P. (1985), Innovation and Entre- preneurship (New York: HarperBusiness), 20. 19. Auletta, K. (2014, Feb. 3), “Outside the box: Netflix and the future of television,” The New Yorker. 20. Greenburg, Z. O’Malley (2015), “Why Dr. Dre isn’t a billionaire yet,” Forbes, May 5; and “Dr. Dre net worth: $710 million in 2016,” Forbes, May 5, 2016. 21. Vinton, K. (2016), “Jeff Bezos becomes second richest person on the Forbes 400,” Forbes, October 4. 22. http://elonmusk.com/. 23. Vance, A. (2015), Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic Future (New York: Ecco). 24. Burgelman, R.A. (1983), “Corporate entrepreneurship and strategic management: Insights from a process study,” Management Science 29: 1349–1364; Zahra, S.A., and J.G. Covin (1995), “Contextual influences on the corporate entrepreneurship-performance rela- tionship: A longitudinal analysis,” Journal of Business Venturing 10: 43–58. 25. Schumpeter, J.A. (1942), Capitalism, Socialism, and Democracy (New York: Harper & Row). 26. U.S. Patent 381968, see www.google. com/patents/US381968.

27. Hitt, M.A., R.D. Ireland, S.M. Camp, and D.L. Sexton (2002), “Strategic entrepreneur- ship: Integrating entrepreneurial and strategic management perspectives,” in Strategic Entre- preneurship: Creating a New Mindset, ed. M.A. Hitt, R.D. Ireland, S.M. Camp, and D.L. Sexton (Oxford, UK: Blackwell Publishing); Rothaermel, F.T. (2008, Oct. 12), “Strategic management and strategic entrepreneurship,” Presentation at the Strategic Management Society Annual International Conference, Cologne, Germany. 28. Hitt, M.A., R.D. Ireland, S.M. Camp, and D.L. Sexton (2002), “Strategic entrepreneur- ship: Integrating entrepreneurial and strategic management perspectives,” in Strategic Entre- preneurship: Creating a New Mindset, ed. M.A. Hitt, R.D. Ireland, S.M. Camp, and D.L. Sexton (Oxford, UK: Blackwell Publishing); Rothaermel, F.T. (2008), “Strategic manage- ment and strategic entrepreneurship,” Presen- tation at the Strategic Management Society Annual International Conference, Cologne, Germany, October 12; Bingham, C.B., K.M. Eisenhardt, and N.R. Furr (2007), “What makes a process a capability? Heuristics, strat- egy, and effective capture of opportunities,” Strategic Entrepreneurship Journal 1: 27–47. 29. www.betterworldbooks.com/info. aspx?f=corevalues. 30. This discussion is based on: “How Jimmy Wales’ Wikipedia harnessed the web as a force for good,” Wired, March 19, 2013. 31. Rothaermel, F.T., and M. Thursby (2007), “The nanotech vs. the biotech revolu- tion: Sources of incumbent productivity in research,” Research Policy 36: 832–849; and Woolley, J. (2010), “Technology emergence through entrepreneurship across multiple industries,” Strategic Entrepreneurship Jour- nal 4: 1–21. 32. This discussion is built on the seminal work by Rogers, E. (1962), Diffusion of Inno- vations (New York: Free Press). For a more recent treatise, see: Baum, J.A.C., and A.M. McGahan (2004), Business Strategy over the Industry Lifecycle, Advances in Strategic Management, Vol. 21 (Bingley, United King- dom: Emerald). 33. Moore, G.A. (1991), Crossing the Chasm. Marketing and Selling Disruptive Prod- ucts to Mainstream Customers (New York: HarperCollins). 34. This discussion is based on: Schilling, M.A. (2002), “Technology success and failure in winner-take-all markets: Testing a model of technological lockout,” Academy of Man- agement Journal 45: 387–398; Shapiro, C., and H.R. Varian (1998), Information Rules. A Strategic Guide to the Network Economy (Boston, MA: Harvard Business School Press); Hill, C.W.L. (1997), “Establishing a

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CHAPTER 7 Business Strategy: Innovation, Entrepreneurship, and Platforms 261

standard: Competitive strategy and winner- take-all industries,” Academy of Management Executive 11: 7–25; and Arthur, W.B. (1989), “Competing technologies, increasing returns, and lock-in by historical events,” Economics Journal 99: 116–131. 35. This discussion is based on: Schilling, M.A. (1998), “Technological lockout: An integrative model of the economic and stra- tegic factors driving technology success and failure,” Academy of Management Review 23: 267–284; Utterback, J.M. (1994), Master- ing the Dynamics of Innovation (Boston, MA: Harvard Business School Press); and Anderson, P., and M. Tushman (1990), “Technological discontinuities and dominant designs: A cyclical model of technological change,” Administrative Science Quarterly 35: 604–634. 36. This Strategy Highlight is based on: Boston, W. (2017), “Volvo plans to go elec- tric, to abandon conventional car engine by 2019,” The Wall Street Journal, July 5. (Note: Since 2010, Volvo Cars is owned by the Geely Holding Group, a Chinese car manufac- turer.) “Tesla unlocks real-time Supercharger occupancy data on vehicle map,” Teslarati, February 8, 2017, http://www.teslarati. com/tesla-unlocks-real-time-supercharger- occupancy-data-vehicle-map/; “Tesla is now adding new stalls to existing Supercharger stations as a ‘top priority,’ says CEO Elon Musk,” Electrek, January 11, 2017, https:// electrek.co/2017/01/11/tesla-supercharger- stations-adding-stall-top-priority-elon-musk/; “Propulsion systems: The great powertrain race,” The Economist, April 20, 2013; “Tesla recharges the battery-car market,” The Econo- mist, May 10, 2013; www.teslamotors.com/ supercharger; “Renault-Nissan alliance sells its 250,000th electric vehicle,” www .media.blog.alliance-renault-nissan.com/ news/24-juin-10-am/#sthash.lwx1fRYG.dpuf; “Bright sparks,” The Economist, January 15, 2009; “The electric-fuel-trade acid test,” The Economist, September 3, 2009; “At Tokyo auto show, hybrids and electrics dominate,” The New York Times, October 21, 2009; and “Risky business at Nissan,” BusinessWeek, November 2, 2009. 37. This discussion is based on: Ceccagnoli, M., and F.T. Rothaermel (2008), “Appropriat- ing the returns to innovation,” Advances in Study of Entrepreneurship, Innovation, and Economic Growth 18: 11–34; and Teece, D.J. (1986), “Profiting from technological innova- tion: Implications for integration, collabora- tion, licensing and public policy,” Research Policy 15: 285–305. 38. Benner, M., and M.A. Tushman (2003), “Exploitation, exploration, and process management: The productivity dilemma revisited,” Academy of Management Review

28: 238–256; and Abernathy, W.J., and J.M. Utterback (1978), “Patterns of innovation in technology,” Technology Review 80: 40–47. 39. “Containers have been more important for globalization than freer trade,” The Economist, May 18, 2013, presents findings from the fol- lowing research studies: Hummels, D. (2007), “Transportation costs and international trade in the second era of globalization,” Journal of Economic Perspectives 21: 131–154; Baldwin, R. (2011), “Trade and industrialization after globalization’s 2nd unbundling: How building and joining a supply chain are different and why it matters,” NBER Working Paper 17716; and Bernhofen, D., Z. El-Sahli, and R. Keller (2013), “Estimating the Effects of the Con- tainer Revolution on World Trade,” Working Paper, Lund University. 40. This discussion is based on: Benner, M., and M.A. Tushman (2003), “Exploitation, exploration, and process management: The productivity dilemma revisited,” Academy of Management Review 28: 238–256; and Aber- nathy, W.J., and J.M. Utterback (1978), “Pat- terns of innovation in technology,” Technology Review 80: 40–47. 41. www.apple.com/ipad/pricing/. 42. www.geeks.com. 43. O’Connor, C. (2012), “How Sara Blakely of Spanx turned $5,000 into $1 billion,” Forbes, March 14. The history of Spanx is documented at www.spanx.com. 44. Harrigan, K.R. (1980), Strategies for Declining Businesses (Lexington, MA: Heath). 45. Moore, G.A. (1991), Crossing the Chasm. Marketing and Selling Disruptive Prod- ucts to Mainstream Customers (New York: HarperCollins). 46. We follow the customer type category originally introduced by Rogers, E.M. (1962), Diffusion of Innovations (New York: Free Press) and also used by Moore, G.A. (1991), Crossing the Chasm. Marketing and Selling Disruptive Products to Mainstream Custom- ers (New York: HarperCollins): technology enthusiasts (∼2.5%), early adopters (∼13.5%), early majority (∼34%), late majority (∼34%), and laggards (∼16%). Rogers’ book originally used the term innovators rather than technology enthusiasts for the first segment. Given the spe- cific definition of innovation as commercial- ized invention in this chapter, we follow Moore (p. 30) and use the term technology enthusiasts. 47. “For wearable computers, future looks blurry,” The Wall Street Journal, May 30, 2013. 48. Barr, A. (2015, Mar. 31), “Google Lab puts a time limit on innovations,” The Wall Street Journal. 49. Shiller, R. (1995), “Conversation, infor- mation, and herd behavior,” American Eco- nomic Review 85: 181–185.

50. Brickley, P. (2014, June 3), “Creditors agree on Chapter 11 plan with former Fisker Automotive,” The Wall Street Journal; “How the wheels came off for Fisker,” The Wall Street Journal, April 24, 2013; and “A year of few dull moments,” The New York Times, December 21, 2012. 51. The Iridium example is drawn from: Finkelstein, S. (2003), Why Smart Executives Fail: And What You Can Learn from Their Mistakes (New York: Portfolio). 52. In inflation-adjusted 2012 U.S. dollars. The original price in 1998 was $3,000 and the cost per minute up to $8. 53. “HP gambles on ailing Palm,” The Wall Street Journal, April 29, 2010. 54. “What’s gone wrong with HP?” The Wall Street Journal, November 6, 2012. 55. In 2013, RIM adopted BlackBerry as its company name. 56. Moore, G.A. (1991), Crossing the Chasm. Marketing and Selling Disruptive Prod- ucts to Mainstream Customers (New York: HarperCollins). 57. Pasztor, A. and S. Carey (2017, Jan. 15), “Space-based flight tracking comes closer with launch of satellites,” The Wall Street Journal. 58. Shuen, A. (2008), Web 2.0: A Strategy Guide (Sebastopol, CA: O’Reilly Media); Thursby, J., and M. Thursby (2006), Here or There? A Survey in Factors of Multinational R&D Location (Washington, DC: National Academies Press). 59. Byers, T.H., R.C. Dorf, and A.J. Nelson (2011), Technology Entrepreneurship: From Idea to Enterprise (New York: McGraw-Hill). 60. This discussion is based on: Schumpeter, J.A. (1942), Capitalism, Socialism, and Democracy (New York: Harper & Row); Freeman, C., and L. Soete (1997), The Eco- nomics of Industrial Innovation (Cambridge, MA: MIT Press); and Foster, R., and S. Kaplan (2001), Creative Destruction: Why Companies That Are Built to Last Underper- form the Market—and How to Successfully Transform Them (New York: Currency). 61. The discussion of incremental and radi- cal innovations is based on: Hill, C.W.L., and F.T. Rothaermel (2003), “The performance of incumbent firms in the face of radical techno- logical innovation,” Academy of Management Review 28: 257–274. 62. The discussion of incremental and radi- cal innovations is based on: Hill, C.W.L., and F.T. Rothaermel (2003), “The performance of incumbent firms in the face of radical techno- logical innovation,” Academy of Management Review 28: 257–274. 63. Luna, T. (2014, Apr. 29), “The new Gil- lette Fusion Pro-Glide Flexball razor, to be available in stores June 9,” The Boston Globe;

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

and “A David and Gillette story,” The Wall Street Journal, April 12, 2012. 64. Chakravorti, B. (2016, Jul. 28), “Unilever’s big strategic bet on the dollar shave club,”  Harvard Business Review; and Terlep, S. (2016, Dec. 15), “P&G’s Gillette swipes at Harry’s in new ad campaign,” The Wall Street Journal. 65. This discussion is based on: Hill, C.W.L., and F.T. Rothaermel (2003), “The perfor- mance of incumbent firms in the face of radical technological innovation,” Academy of Management Review 28: 257–274. 66. Adner, R. (2012), The Wide Lens. A New Strategy for Innovation (New York: Portfolio); Brandenburger, A.M., and B.J. Nalebuff (1996), Co-opetition (New York: Currency Doubleday); and Christensen, C.M., and J.L. Bower (1996), “Customer power, strategic investment, and the failure of leading firms,” Strategic Management Journal 17: 197–218. 67. Henderson, R., and K.B. Clark (1990), “Architectural innovation: The reconfigura- tion of existing technologies and the failure of established firms,” Administrative Science Quarterly 35: 9–30. 68. This example is drawn from: Chesbrough, H. (2003), Open Innovation. The New Impera- tive for Creating and Profiting from Technol- ogy (Boston, MA: Harvard Business School Press). 69. The discussion of disruptive innovation is based on: Christensen, C.M. (1997), The Innovator’s Dilemma: When New Tech- nologies Cause Great Firms to Fail (Boston, MA: Harvard Business School Press); and Christensen, C.M., and M.E. Raynor (2003), The Innovator’s Solution: Creating and Sustaining Successful Growth (Boston, MA: Harvard Business School Press). 70. Android here is used to include Chrome OS. “Introducing the Google Chrome OS,” The Official Google Blog, July 7, 2009, http://googleblog.blogspot.com/2009/07/ introducinggoogle-chrome-os.html. 71. See the discussion on business models in Chapter 1. See also: Anderson, C. (2009), Free. The Future of a Radical Price (New York: Hyperion).

72. Winkler, R. (2014, Jul. 31), “Android market share hits new record,” The Wall Street Journal. 73. Auletta, K. (2014, Feb. 3), “Outside the box: Netflix and the future of television,” The New Yorker. 74. Rindova, V., and S. Kotha (2001), “Con- tinuous ‘morphing’: Competing through dynamic capabilities, form, and function,” Academy of Management Journal 44: 1263–1280. 75. The new processor not only is inexpen- sive but also consumes little battery power. Moreover, it marks a departure from the Wintel (Windows and Intel) alliance, because Microsoft did not have a suitable operating system ready for the low-end netbook mar- ket. Many of these computers are using free software such as Google’s Android operating system and Google Docs for applications. 76. Govindarajan, V., and C. Trimble (2012), Reverse Innovation: Create Far from Home, Win Everywhere (Boston, MA: Harvard Busi- ness Review Press). 77. This Strategy Highlight is based on: Immelt, J.R., V. Govindarajan, and C. Trimble (2009), “How GE is disrupting itself,” Har- vard Business Review, October; author’s inter- views with Michael Poteran of GE Healthcare (October 30 and November 4, 2009); and “Vscan handheld ultrasound: GE unveils ‘stethoscope of the 21st century,’” The Huff- ington Post, October 20, 2009. 78. This section is based on: 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). Examples are updated and revised by the author or entirely new. Other sources include: Eisenmann, T., G. G. Parker, and M. W. Van Alstyne (2006), “Strategies for two-sided markets,” Harvard Business Review, October; Gawer, A. (2014), “Bridg- ing differing perspectives on technological platforms: Toward an integrative frame- work,” Research Policy, 43: 1239–1249; Gawer, A., and M. A. Cusumano (2008), “How companies become platform leaders,” MIT Sloan Management Review, Winter: 28–35.

79. Kingsbury, K. (2016, Aug. 2), “Face- book, Amazon knock Exxon from ranks of five biggest U.S. companies,” The Wall Street Journal. 80. Eisenmann, T., G. G. Parker, and M. W. Van Alstyne (2006, Oct.), “Strategies for two- sided markets,” Harvard Business Review. 81. Parker, G. G., M. W. Van Alstyne and S. P. Choudary (2016), Platform Revolu- tion: How Networked Markets Are Transform- ing the Economy—and How to Make Them Work for You (New York: Norton), Chapter 1. 82. https://www.fastcompany.com/ most-innovative-companies/2017. 83. 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); and Parker, G. G. (2016), “The rise of digital platforms,” The Shard, February, https://www.youtube.com/ watch?v=r3pykplgUiw&t=2s [15:44 min]. 84. Auletta, K. (2014, Feb. 3), “Outside the box: Netflix and the future of television,” The New Yorker. 85. Ramachandran, S., and T. Stynes (2016), “Netflix CEO Reed Hastings talks with WSJ Financial Editor Dennis K. Berman at the 2016 WSJDlive Conference in Laguna Beach, CA,” October 26, https://www.youtube.com/ watch?v=pBg3q2vHCLg  [25:04 min] 86. “Gendercide in India,” The Economist, April 7, 2011; “Sex-selective abortion,” The Economist, June 28, 2011; “India women: One dishonourable step backwards,” The Econo- mist, May 11, 2012; and “India’s skewed sex ratios,” The Economist, December 18, 2012. 87. Sources for this myStrategy include: “Why more MBAs are becoming entrepre- neurs straight out of business school,” Busi- ness Insider, July 24, 2014; “Top 25 colleges for entrepreneurs,” Entrepreneur, September 15, 2014; “Does college matter for entrepre- neurs?” Entrepreneur, September 21, 2011; “The secret to entrepreneurial success: Forget college,” Forbes, July 15, 2013; “Want to be an entrepreneur: Avoid student debt,” The Wall Street Journal, May 26, 2015; “Full-time MBA programs: Stanford University,” Bloom- berg Businessweek, November 13, 2008.

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Corporate Strategy: Vertical Integration and Diversification

Learning Objectives

LO 8-1 Define corporate strategy and describe the three dimensions along which it is assessed.

LO 8-2 Explain why firms need to grow, and evalu- ate different growth motives.

LO 8-3 Describe and evaluate different options firms have to organize economic activity.

LO 8-4 Describe the two types of vertical integra- tion along the industry value chain: back- ward and forward vertical integration.

LO 8-5 Identify and evaluate benefits and risks of vertical integration.

LO 8-6 Describe and examine alternatives to verti- cal integration.

LO 8-7 Describe and evaluate different types of corporate diversification.

LO 8-8 Apply the core competence–market matrix to derive different diversification strategies.

LO 8-9 Explain when a diversification strategy does create a competitive advantage and when it does not.

Chapter Outline

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

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

8.3 Vertical Integration along the Industry Value Chain Types of Vertical Integration Benefits and Risks of Vertical Integration When Does Vertical Integration Make Sense? Alternatives to Vertical Integration

8.4 Corporate Diversification: Expanding Beyond a Single Market Types of Corporate Diversification Leveraging Core Competencies for Corporate Diversification Corporate Diversification and Firm Performance

8.5 Implications for Strategic Leaders

CHAPTER

8

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Amazon.com: To Infinity and Beyond

WHEN JEFF BEZOS started Amazon.com out of a garage in a Seattle suburb to sell books online, he furnished his makeshift office with discarded wood doors for desks. In less than 25 years, Amazon morphed from a fledgling startup into one of the world’s most valuable companies, active in far-flung businesses from ecommerce and cloud computing to media entertainment and groceries. Yet, wood doors turning into desks remain a staple at Amazon, where strict cost control is paramount to this day. At the same time, in pursuing its mission of being the “earth’s most customer- centric company,” Amazon excels at customer ser- vice. Indeed, a recent survey ranked Amazon as the most well- regarded company in the United States.

Amazon.com’s web- site went live in 1995 and was an instant suc- cess with booklovers everywhere. The online startup set itself apart from other internet merchants by pioneering one-click shopping, customer reviews, and order verification via e-mail. Next, Amazon executed a series of strategic alliances and acquisitions to rapidly expand its product and service offerings. In 2000, Amazon started to offer Marketplace, which is a platform on which independent third-party sellers can access Ama- zon customers globally. In 2005, Amazon launched its Prime membership service. Subscribers pay $99 a year and receive free two-day shipping, as well as access to Amazon’s video and music streaming services. Besides offering every imaginable product online, it sells its own line of consumer electronics such as tablets, e-readers, and voice-enabled wireless devices such as Echo. Among them, the Kindle e-reader (launched in 2007) has trans- formed the publishing industry. Amazon holds two-thirds market share in e-books and now sells more e-books

than print books. Launched in 2014, Echo is powered by Amazon’s Alexa, an intelligent digital assistant that marks Amazon’s foray into augmented reality. It plays any song you request, reads aloud your audiobooks, shares the lat- est news and weather forecast, controls your home’s ther- mostat and lights, and even turns on the home alarm or the yard’s sprinkler system. Exhibit 8.1 depicts Amazon’s key strategic initiatives and stock market valuation over the years.

Carrying the moniker “the everything store,” Amazon has become the largest online retailer in the United States, with an estimated 400 million items available, some 50 times the

number sold by Walmart, the world’s largest tradi- tional retailer. Globally, only Alibaba, China’s leading ecommerce con- glomerate, is larger than Amazon. Besides offering a wide variety of products and services, Amazon also diversified geograph- ically pretty much from the outset. In 1998, it added country-specific sites in the United King- dom (amazon.co.uk) and Germany (amazon.de) to accommodate its growing

popularity in Europe. French (amazon.fr) and Japanese (ama- zon.co.jp) Amazon sites debuted in 2000. Today, Amazon operates country-specific sites in more than a dozen coun- tries, including in China (amazon.cn), and is making a major push into India (amazon.in), where the domestic Flipkart— started by former Amazon employees—took an early lead.

In addition to diversification in products and services as well as geography, Amazon also integrated vertically. Created in 2006, Amazon Web Services (AWS) is a cloud- based computing service, including software applications, data storage, content delivery, payment and billing sys- tems, and other business applications. Today, AWS is the world’s largest cloud-computing provider. It is also Ama- zon’s most profitable business endeavor. In 2016, AWS gross revenues were $12 billion, with $1 billion in profits. That is, AWS’ contribution to Amazon’s total revenues of

CHAPTERCASE 8

Jeff Bezos is founder and CEO of Amazon.com, one of the world’s most valuable companies. ©Mike Kane/Bloomberg/Getty Images

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OVER TIME, AMAZON.COM has morphed from a mere online book retailer into the “everything store.”2 In the process, it transformed into one of the world’s larg-

est retailers (larger than both brick-and-mortar retailers such as Walmart and most other online retailers). From books, Amazon diversified into consumer electronics, media con- tent, cloud-computing services, and other business endeavors. Jeff Bezos decided to com- pete in a number of different industries, some related to Amazon’s core business of online retailing, some unrelated.

How does an online bookseller turn into one of the most valuable tech companies on the planet? The short answer: Vertical integration and diversification! Amazon is now a widely diversified as well as integrated technology company. Vertical integration refers to the firm’s ownership of its production of needed inputs or of the channels by which it distributes its outputs. Amazon, for example, now creates its own video content, which it distributes through its streaming services.  Diversification encompasses the variety of products and services a firm offers or markets and the geographic locations in which it competes. Amazon offers a wide range of products and services. By virtue of being an online business, Amazon has a global presence, reinforced by country-specific investments in specialized sites (such as amazon.de in Germany).

But how does a business such as Amazon.com decide exactly where to compete? Answers to this important question—in terms of products and services offered, value chain activities, or geographic markets—are captured in a firm’s corporate strategy, which we cover in the next three chapters. In this chapter, we define corporate strategy and then look at two fundamental corporate strategy topics: vertical integration and diversification. We conclude the chapter with Implications for Strategic Leaders, providing a practical appli- cation of dynamic corporate strategy at Nike and Adidas.

$136 billion was 9 percent, while its profit contribution was 74 percent. By developing its own streaming video content (such as The Man in the High Castle, an alternative history about the Axis winning World War II), Amazon integrated into media production.

Amazon continues to innovate. Besides offering same- day delivery of groceries in some metropolitan areas and testing drones for even faster distribution, Amazon has introduced checkout free shopping in physical retail out- lets (AmazonGo). In 2017 it became apparent these actions were a prelude to its acquisition of Whole Foods Market. Amazon will use AmazonGo at Whole Foods, reduce its labor force, and cut prices by a large margin to further grow its business.

Another recent innovation was AmazonCampus, a student- centered program. Amazon runs co-branded university- specific websites (such as purdue.amazon.com) that offer textbooks, paraphernalia such as the ubiquitous logo sweat- shirts and baseball hats, and even ramen noodles! As part of this new campus initiative, Amazon offers its Prime mem- bership to students at a 50 percent discount ($49 a year) and guarantees unlimited next-day delivery of any goods

ordered online, besides all the other Prime membership ben- efits (free streaming of media content, lending one e-book a month for free, discounts on hardware, etc.). To accom- plish next-day delivery, Amazon is building fashionable delivery centers on campus, co-branded with the local uni- versity such as “amazon@purdue.” Once a package arrives, students receive a text message and can then retrieve it via code-activated lockers or from Amazon employees directly. The on-campus delivery facilities also serve as convenient return centers.

With a market capitalization of some $500 billion, Ama- zon is one of the top five most valuable technology compa- nies in the world, besides Apple, Alphabet (Google’s parent company), Microsoft, and Facebook. Over the past decade, Amazon’s stock appreciated by 2,000 percentage points, while the stock market overall (as proxied by the Dow Jones Industrial Average) grew by 62 percentage points over the same time period.1

You will learn more about Amazon.com by reading this chapter; related questions appear in “ChapterCase 8 / Consider This. . . .”

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8.1 What Is Corporate Strategy? Strategy formulation centers around the key questions of where and how to compete. Busi- ness strategy concerns the question of how to compete in a single product market. As discussed in Chapter 6, the two generic business strategies that firms can follow to pursue their quest for competitive advantage are to increase differentiation (while containing cost) or lower costs (while maintaining differentiation). If trade-offs can be reconciled, some firms might be able to pursue a blue ocean strategy by increasing differentiation and low- ering costs. As firms grow, they are frequently expanding their business activities through seeking new markets both by offering new products and services and by competing in dif- ferent geographies. Strategic leaders must formulate a corporate strategy to guide contin- ued growth. To gain and sustain competitive advantage, therefore, any corporate strategy must align with and strengthen a firm’s business strategy, whether it is a differentiation, cost-leadership, or blue ocean strategy.

Corporate strategy comprises the decisions that leaders make and the goal-directed actions they take in the quest for competitive advantage in several industries and markets simultaneously.3 It provides answers to the key question of where to compete. Corporate strategy determines the boundaries of the firm along three dimensions: vertical integration along the industry value chain, diversification of products and services, and geographic scope (regional, national, or global markets). Strategic leaders must determine corporate strategy along the three dimensions:

1. Vertical integration:  In what stages of the industry value chain should the company participate? The industry value chain describes the transformation of raw materials into finished goods and services along distinct vertical stages.

2. Diversification: What range of products and services should the company offer? 3. Geographic scope: Where should the company compete geographically in terms of

regional, national, or international markets?

In most cases, underlying these three questions is an implicit desire for growth. The need for growth is sometimes taken so much for granted that not every manager under- stands all the reasons behind it. A clear understanding will help strategic leaders to pursue growth for the right reasons and make better decisions for the firm and its stakeholders.

WHY FIRMS NEED TO GROW Several reasons explain why firms need to grow. These can be summarized as follows:

1. Increase profits. 2. Lower costs. 3. Increase market power. 4. Reduce risk. 5. Motivate management.

Let’s look at each reason in turn.

INCREASE PROFITS. Profitable growth allows businesses to provide a higher return for their shareholders, or owners, if privately held. For publicly traded companies, the stock market valuation of a firm is determined to some extent by expected future revenue and profit streams. As featured in the ChapterCase, Amazon’s high stock market valuation is based to a large extent on expectations of future profitability, because the company invests for the long term and as such has yet to show consistent profitability.

LO 8-1

Define corporate strategy and describe the three dimensions along which it is assessed.

corporate strategy The decisions that senior management makes and the goal-directed actions it takes to gain and sustain competitive advantage in several industries and markets simultaneously.

LO 8-2

Explain why firms need to grow, and evaluate different growth motives.

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If firms fail to achieve their growth target, their stock price often falls. With a decline in a firm’s stock price comes a lower overall market capitalization, exposing the firm to the risk of a hostile takeover. Moreover, with a lower stock price, it is more costly for firms to raise the required capital to fuel future growth by issuing stock.

LOWER COSTS. Firms are also motivated to grow in order to lower their cost. As discussed in detail in Chapter 6, a larger firm may benefit from economies of scale, thus driving down average costs as their output increases. Firms need to grow to achieve minimum efficient scale, and thus stake out the lowest-cost position achievable through economies of scale.

INCREASE MARKET POWER. Firms might be motivated to achieve growth to increase their market share and with it their market power. When discussing an industry’s structure in Chapter 3, we noted that firms often consolidate industries through horizontal merg- ers and acquisitions (buying competitors) to change the industry structure in their favor (we’ll discuss mergers and acquisitions in detail in Chapter 9). Fewer competitors gener- ally equates to higher industry profitability. Moreover, larger firms have more bargaining power with suppliers and buyers (see the discussion of the five forces in Chapter 3).

REDUCE RISK. Firms might be motivated to grow in order to diversify their product and service portfolio through competing in a number of different industries. The rationale behind these diversification moves is that falling sales and lower performance in one sector (e.g., GE’s oil and gas unit) might be compensated by higher performance in another (e.g., GE’s health care unit). Such conglomerates attempt to achieve economies of scope (as first discussed in Chapter 6).

MOTIVATE MANAGEMENT. Firms need to grow to motivate management. Growing firms afford career opportunities and professional development for employees. Firms that achieve profitable growth can also pay higher salaries and spend more on benefits such as health care insurance for its employees and paid parental leave, among other perks.

Research in behavioral economics, moreover, suggests that firms may grow to achieve goals that benefit managers more than stockholders.4 As we will discuss in detail when pre- senting the principal–agent problem later in the chapter, managers may be more interested in pursuing their own interests such as empire building and job security—plus managerial perks such as corporate jets or executive retreats at expensive resorts—rather than increas- ing shareholder value. Although there is a weak link between CEO compensation and firm performance, the CEO pay package often correlates more strongly with firm size.5

Finally, we should acknowledge that promising businesses can fail because they grow unwisely—usually too fast too soon, and based on shaky assumptions about the future. There is a small movement counter to the need for growth, seen both in small businesses and social activism. Sometimes small-business owners operate a business for convenience, stability, and lifestyle; growth could threaten those goals. In social entrepreneurship, business micro- solutions are often operated outside of capital motives, where the need to solve a social prob- lem outweighs the need of the firm to insure longevity beyond the solution of the problem.

THREE DIMENSIONS OF CORPORATE STRATEGY All companies must navigate the three dimensions of vertical integration, diversification, and geographic scope. Although many managers provide input, the responsibility for corpo- rate strategy ultimately rests with the CEO. Jeff Bezos, Amazon’s CEO, determined in what stages of the industry value chain Amazon would participate (question 1). With its prevalent delivery lockers in large metropolitan areas and its first brick-and-mortar retail store opened

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in New York City, Amazon moved forward in the industry value chain to be closer to its end customer. With its offering of Amazon-branded electronics and other everyday items, it also moved backward in the industry value chain toward manufacturing, production. Simi- larly, the creation of AWS, now the largest cloud-computing service provider globally with some 100 million customers, is a backward vertical integration move. AWS provides Ama- zon with back-end IT services such as website hosting, computing power, data storage and management, etc., which in turn are all critical inputs to its online retail business.

Bezos also chooses what range of products and services to offer, and which not to offer (question 2). The ChapterCase discusses Amazon’s diversification over time. Finally, Bezos also decided to customize certain country-specific websites despite the instant global reach of ecommerce firms. With this strategic decision, he decided where to com- pete globally in terms of different geographies beyond the United States. In short, Bezos determined where Amazon competes geographically (question 3).

Where to compete in terms of industry value chain, products and services, and geography are the fundamental corporate strategic decisions. The underlying strategic management con- cepts that will guide our discussion of vertical integration, diversification, and geographic com- petition are core competencies, economies of scale, economies of scope, and transaction costs.

■ Core competencies are unique strengths embedded deep within a firm (as discussed in Chapter 4). Core competencies allow a firm to differentiate 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. According to the resource-based view of the firm, a firm’s boundaries are delineated by its knowledge bases and core compe- tencies.6 Activities that draw on what the firm knows how to do well (e.g., Amazon’s core competency in developing proprietary recommendation algorithms) should be done in-house, while noncore activities such as payroll and facility maintenance can be outsourced. In this perspective, the internally held knowledge underlying a core competency determines a firm’s boundaries.

■ Economies of scale occur when a firm’s average cost per unit decreases as its output increases (as discussed in Chapter 6). Anheuser-Busch InBev (AB InBev), the largest global brewer (producer of some 225 brands worldwide, including famous ones such as Budweiser, Bud Light, Miller, Stella Artois, and Beck’s), reaps significant econo- mies of scale. After AB InBev merged with SABMiller in a more than $100 billion deal in 2016, it now captures some 30 percent of global beer consumption.7 As a con- sequence of its huge scale, the beer giant captures some 50 percent of global beer profits. In terms of beer volume, the new AB InBev is also more than double the size of Heineken, the number-two competitor worldwide. Given its tremendous size, AB InBev is able to spread its fixed costs over the millions of gallons of beer it brews each year, in addition to the significant buyer power its large market share affords. Larger market share, therefore, often leads to lower costs.

■ Economies of scope are the savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, though using the same resources and technology (as discussed in Chapter 6). Leveraging its online retailing expertise, for example, Amazon benefits from economies of scope: It can offer a large range of different product and service categories at a lower cost than it would take to offer each product line individually.

■ Transaction costs are all costs associated with an economic exchange. Applying the logic of transaction cost economics enables managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification. This implies taking on greater ownership of the production of needed inputs or of the channels by which it distributes its outputs, or adding business units that offer new products and services.

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We continue our study of corporate strategy by drawing on transaction cost economics to explain vertical integration, meaning the choices a firm makes concerning its boundar- ies. Later, we will explore managerial decisions relating to diversification, which directly affect the firm’s range of products and services in multi-industry competition. The third question of geographic scope will receive attention later, especially in Chapter 10.

8.2 The Boundaries of the Firm Determining the boundaries of the firm so that it is more likely to gain and sustain a competitive advantage is the critical challenge in corporate strategy.8  Transaction cost economics provides useful theoretical guidance to explain and predict the boundaries of the firm. Insights gained from transaction cost economics help strategic leaders decide what activities to do in-house versus what services and products to obtain from the external market. This stream of research was initiated by Nobel Laureate Ronald Coase, who asked a fundamental question: Given the efficiencies of free markets, why do firms even exist? The key insight of transaction cost economics is that different institutional arrangements— markets versus firms—have different costs attached.

Transaction costs are all internal and external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or in markets.9 Exhibit 8.2 visualizes the notion of transaction costs. It shows the respective internal transactions costs within Firm A and Firm B, as well as the external transactions that occur when Firm A and Firm B do business with one another.

The total costs of transacting consist of external and internal transaction costs, as follows:

■ When companies transact in the open market, they incur external transaction costs: the costs of searching for a firm or an individual with whom to contract, and then nego- tiating, monitoring, and enforcing the contract.

■ Transaction costs can occur within the firm as well. Considered internal transac- tion costs these include costs pertaining to organizing an economic exchange within a firm—for example, the costs of recruiting and retaining employees; paying salaries and benefits; setting up a shop floor; providing office space and computers; and organizing,

LO 8-3

Describe and evaluate different options firms have to organize economic activity.

EXHIBIT 8.2 / Internal and External Transaction Costs

Internal Transaction

Costs

Firm B

Internal Transaction

Costs

Firm A

External Transaction

Costs

Market

transaction cost economics A theoretical framework in strategic management to explain and predict the boundaries of the firm, which is central to formulating a corporate strategy that is more likely to lead to competitive advantage.

transaction costs All internal and external costs associated with an economic exchange, whether within a firm or in markets.

external transaction costs Costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract.

internal transaction costs Costs pertaining to organizing an economic exchange within a hierarchy; also called administrative costs.

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monitoring, and supervising work. Internal transaction costs also include administra- tive costs associated with coordinating economic activity between different business units of the same corporation such as transfer pricing for input factors, and between business units and corporate headquarters including important decisions pertaining to resource allocation, among others. Internal transaction costs tend to increase with orga- nizational size and complexity.

FIRMS VS. MARKETS: MAKE OR BUY? Predictions derived from transaction cost economics guide strategic leaders in deciding which activities a firm should pursue in-house (“make”) versus which goods and services to obtain externally (“buy”). These decisions help determine the boundaries of the firm. In some cases, costs of using the market such as search costs, negotiating and drafting contracts, monitoring work, and enforcing contracts when necessary may be higher than integrating the activity within a single firm and coordinating it through an organizational hierarchy. When the costs of pursuing an activity in-house are less than the costs of trans- acting for that activity in the market (Cin–house < Cmarket), then the firm should vertically integrate by owning production of the needed inputs or the channels for the distribution of outputs. In other words, when firms are more efficient in organizing economic activity than are markets, which rely on contracts among many independent actors, firms should vertically integrate.10

For example, rather than contracting in the open market for individual pieces of software code, Google (a unit of Alphabet) hires programmers to write code in-house. Owning these software development capabilities is valuable to the firm because its costs, such as salaries and employee benefits to in-house computer programmers, are less than what they would be in the open market. More importantly, Google gains economies of scope in software develop- ment resources and capabilities and reduces the monitoring costs. Skills acquired in writing software code for its different internet-based service offerings are transferable to new offer- ings. Programmers working on the original proprietary software code for the Google search

engine leveraged these skills in creating a highly profitable online advertising busi- ness (AdWords and AdSense).11  Although some of Google’s software products are open source, such as the Android operating system, many of the company’s internet ser- vices are based on closely guarded and pro- prietary software code. Google, like many leading high-tech companies such as Ama- zon, Apple, Facebook, and Microsoft, relies on proprietary software code and algorithms, because using the open market to transact for individual pieces of software would be pro- hibitively expensive. Also, the firms would need to disclose the underlying software code to outside developers, thus negating the value-creation potential.

Firms and markets, as different insti- tutional arrangements for organizing eco- nomic activity, have their own distinct advantages and disadvantages, summarized in Exhibit 8.3.

EXHIBIT 8.3 / Organizing Economic Activity: Firms vs. Markets

• Command and control - Fiat - Hierarchical lines of authority

• Coordination • Transaction-specific investments • Community of knowledge

• High-powered incentives • Flexibility

• Administrative costs • Low-powered incentives • Principal–agent problem

• Search costs • Opportunism

- Hold-up • Incomplete contracting

- Specifying & measuring performance - Information asymmetries

• Enforcement of contracts

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es Di

sa dv

an ta

ge s

MarketsFirm

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The advantages of firms include: ■ The ability to make command-and-control decisions by fiat along clear hierarchical

lines of authority. ■ Coordination of highly complex tasks to allow for specialized division of labor. ■ Transaction-specific investments, such as specialized robotics equipment that is highly

valuable within the firm, but of little or no use in the external market. ■ Creation of a community of knowledge, meaning employees within firms have ongoing

relationships, exchanging ideas and working closely together to solve problems. This facilitates the development of a deep knowledge repertoire and ecosystem within firms. For example, scientists within a biotech company who worked together developing a new cancer drug over an extended time period may have developed group-specific knowledge and routines. These might lay the foundation for innovation, but would be difficult, if not impossible, to purchase on the open market.12

The disadvantages of organizing economic activity within firms include: ■ Administrative costs because of necessary bureaucracy.

■ Low-powered incentives, such as hourly wages and salaries. These often are less attrac- tive motivators than the entrepreneurial opportunities and rewards that can be obtained in the open market.

■ The principal–agent problem.

The principal–agent problem is a major disadvantage of organizing economic activity within firms, as opposed to within markets. It can arise when an agent such as a manager, performing activities on behalf of the principal (the owner of the firm), pursues his or her own interests.13 Indeed, the separation of ownership and control is one of the hallmarks of a publicly traded company, and so some degree of the principal–agent problem is almost inevitable.14 For example, a manager may pursue his or her own interests such as job secu- rity and managerial perks (e.g., corporate jets and golf outings) that conflict with the prin- cipal’s goals—in particular, creating shareholder value. One potential way to overcome the principal–agent problem is to give stock options to managers, thus making them own- ers. We will revisit the principal–agent problem, with related ideas, in Chapters 11 and 12.

The advantages of markets include: ■ High-powered incentives. Rather than work as a salaried engineer for an existing firm,

for example, an individual can start a new venture offering specialized software. High- powered incentives of the open market include the entrepreneur’s ability to capture the venture’s profit, to take a new venture through an initial public offering (IPO), or to be acquired by an existing firm. In these so-called liquidity events, a successful entrepre- neur can make potentially enough money to provide financial security for life.15

■ Increased flexibility. Transacting in markets enables those who wish to purchase goods to compare prices and services among many different providers.

The disadvantages of markets include: ■ Search costs. On a very fundamental level, perhaps the biggest disadvantage of trans-

acting in markets, rather than owning the various production and distribution activities within the firm itself, entails nontrivial search costs. In particular, a firm faces search costs when it must scour the market to find reliable suppliers from among the many firms competing to offer similar products and services. Even more difficult can be the search to find suppliers when the specific products and services needed are not offered by firms currently in the market. In this case, production of supplies would require transaction-specific investments, an advantage of firms.

principal–agent problem Situation in which an agent performing activities on behalf of a principal pursues his or her own interests.

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■ Opportunism by other parties. Opportunism is behavior characterized by self-interest seeking with guile (we’ll discuss this in more detail later).

■ Incomplete contracting. Although market transactions are based on implicit and explicit contracts, all contracts are incomplete to some extent, because not all future contingencies can be anticipated at the time of contracting. It is also difficult to specify expectations (e.g., What stipulates “acceptable quality” in a graphic design project?) or to measure performance and outcomes (e.g., What does “excess wear and tear” mean when returning a leased car?). Another serious hazard inherent in contracting is infor- mation asymmetry (which we discuss next).

■ Enforcement of contracts. It often is difficult, costly, and time-consuming to enforce legal contracts. Not only does litigation absorb a significant amount of managerial resources and attention, but also it can easily amount to several million dollars in legal fees. Legal exposure is one of the major hazards in using markets rather than integrat- ing an activity within a firm’s hierarchy.

Frequently, sellers have better information about products and services than buyers, which creates information asymmetry, a situation in which one party is more informed than another, because of the possession of private information. When firms transact in the market, such unequal information can lead to a lemons problem. Nobel Laureate George Akerlof first described this situation using the market for used cars as an exam- ple.16 Assume only two types of used cars are sold: good cars and bad cars (lemons). Good cars are worth $8,000 and bad ones are worth $4,000. Moreover, only the seller knows whether a car is good or is a lemon. Assuming the market supply is split equally between good and bad cars, the probability of buying a lemon is 50 percent. Buyers are aware of the general possibility of buying a lemon and thus would like to hedge against it. Therefore, they split the difference and offer $6,000 for a used car. This discounting strategy has the perverse effect of crowding out all the good cars because the sellers perceive their value to be above $6,000. Assuming that to be the case, all used cars offered for sale will be lemons.

The important take-away here is caveat emptor—buyer beware. Information asymme- tries can result in the crowding out of desirable goods and services by inferior ones. This has been shown to be true in many markets, not just for used cars, but also in ecommerce (e.g., eBay), mortgage-backed securities, and even collaborative R&D projects.17

ALTERNATIVES ON THE MAKE-OR-BUY CONTINUUM The “make” and “buy” choices anchor each end of a continuum from markets to firms, as depicted in Exhibit 8.4. Several alternative hybrid arrangements are available between these two extremes.18 Moving from transacting in the market (“buy”) to full integration (“make”), alternatives include short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) and parent–subsidiary

relationships.

SHORT-TERM CONTRACTS. When engaging in short-term contracting, a firm sends out requests for proposals (RFPs) to several companies, which initiates competi- tive bidding for contracts to be awarded with a short duration, generally less than one year.19 The benefit to this approach lies in the fact that it allows a somewhat

longer planning period than individual market transactions. Moreover, the buy- ing firm can often demand lower prices due to the competitive bidding process. The

drawback, however, is that firms responding to the RFP have no incentive to make any transaction-specific investments (e.g., buy new machinery to improve product quality) due to the short duration of the contract. This is exactly what happened in the U.S. automotive

information asymmetry Situation in which one party is more informed than another because of the possession of private information.

© Big Pants Production/ Shutterstock.com RF

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industry when GM used short-term contracts for standard car components to reduce costs. When faced with significant cost pressures, suppliers reduced component quality in order to protect their eroding margins. This resulted in lower-quality GM cars, contributing to a competitive advantage vis-à-vis competitors, most notably Toyota but also Ford, which used a more cooperative, longer-term partnering approach with suppliers.20

STRATEGIC ALLIANCES. As we move toward greater integration on the make-or-buy contin- uum, the next organizational forms are strategic alliances. Strategic alliances are voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabili- ties with the intent of developing processes, products, or services.21 Alliances have become a ubiquitous phenomenon, especially in high-tech industries. Moreover, strategic alliances can facilitate investments in transaction-specific assets without encountering the internal transac- tion costs involved in owning firms in various stages of the industry value chain.

Strategic alliances is an umbrella term that denotes different hybrid organizational forms—among them, long-term contracts, equity alliances, and joint ventures. Given their prevalence in today’s competitive landscape as a key vehicle to execute a firm’s corporate strategy, we take a quick look at strategic alliances here and then study them in more depth in Chapter 9.

Long-Term Contracts. We noted that firms in short-term contracts have no incentive to make transaction-specific investments. Long-term contracts, which work much like short- term contracts but with a duration generally greater than one year, help overcome this drawback. Long-term contracts help facilitate transaction-specific investments. Licensing, for example, is a form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property such as a patent. The first biotechnology drug to reach the market, Humulin (human insulin), was developed by Genentech and commer- cialized by Eli Lilly based on a licensing agreement.

In service industries, franchising is an example of long-term contracting. In these arrangements, a franchisor, such as McDonald’s, Burger King, 7-Eleven, H&R Block, or Subway, grants a franchisee (usually an entrepreneur owning no more than a few outlets) the right to use the franchisor’s trademark and business processes to offer goods and ser- vices that carry the franchisor’s brand name. Besides providing the capital to finance the expansion of the chain, the franchisee generally pays an up-front (buy-in) lump sum to the franchisor plus a percentage of revenues.

EXHIBIT 8.4 / Alternatives on the Make-or-Buy Continuum

BUY

Arm’s-length market

transactions

Strategic Alliances

Short-term contracts

Long-term contracts • Licensing • Franchising

Equity alliances

Joint ventures

Parent– subsidiary

relationship

MAKE

Activities performed in-house

Integration LESS MORE

strategic alliances Voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services.

licensing A form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property.

franchising A long- term contract in which a franchisor grants a franchisee the right to use the franchisor’s trademark and business processes to offer goods and services that carry the franchisor’s brand name.

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