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StrategyCoreConceptsandAnalyticalApproaches.pdf

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Special Note regarding Citations Those wishing to cite any of the contents are invited to use the following source citation: Arthur A. Thompson, Strategy: Core Concepts and Analytical Approaches, 5th Edition 2018-2019 (Burr Ridge, Illinois: McGraw-Hill Education, 2016)

Published and distributed by McGraw Hill Education Burr Ridge, Illinois

Core Concepts and Analytical Approaches

STRATEGY

Arthur A. Thompson The University of Alabama

5th Edition (2018-2019)

Table of Contents

Chapter 1 What Is Strategy and Why Is It Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 What Do We Mean by “Strategy”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Strategy and the Quest for Competitive Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 A Company’s Strategy Is Partly Proactive and Partly Reactive . . . . . . . . . . . . . . . . . . . . . . 6 Strategy and Ethics: Passing the Test of Moral Scrutiny . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 The Relationship Between a Company’s Strategy and Its Business Model . . . . . . . . . . . . . 8 What Makes a Strategy a Winner? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Why Crafting and Executing Strategy Are Important Tasks . . . . . . . . . . . . . . . . . . . . . . . . . 11 The Road Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Chapter 2 Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 What Does the Strategy-Making, Strategy-Executing Process Entail? . . . . . . . . . . . . . . . . . 14 Task 1: Developing a Strategic Vision, Mission Statement, and Set of Core Values . . . . . . 15 Task 2: Setting Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Task 3: Crafting a Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Task 4: Implementing and Executing the Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Task 5: Evaluating Performance and Initiating Corrective Adjustments . . . . . . . . . . . . . . . . 30 Corporate Governance: The Role of the Board of Directors in the Strategy-Making, Strategy-Executing Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Chapter 3 Evaluating a Company’s External Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 The Strategically Relevant Factors Influencing a Company’s External Environment . . . . . 35 Assessing a Company’s Industry and Competitive Environment . . . . . . . . . . . . . . . . . . . . . 38 Question 1: What Competitive Forces Do Industry Members Face and How Strong Are They? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Question 2: What Factors Are Driving Industry Change and What Impact Will They Have? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Question 3: What Market Positions Do Rivals Occupy—Who Is Strongly Positioned and Who Is Not? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Question 4: What Strategic Moves Are Rivals Likely to Make Next? . . . . . . . . . . . . . . . . . 63 Question 5: What Are the Key Factors For Future Competitive Success? . . . . . . . . . . . . . . 64 Question 6: Is the Industry Outlook Conducive To Good Profitability? . . . . . . . . . . . . . . . . 65 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

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Chapter 4 Evaluating a Company’s Resources and Ability to Compete Successfully . . . . . . . . . . . . . . . 68 Question 1: How Well Is the Company’s Present Strategy Working? . . . . . . . . . . . . . . . . . . 69 Question 2: What Are the Company’s Resources and Capabilities and Do They Have the Competitive Power to Enable the Company to Build and/or Sustain a Competitive Advantage Over Rivals? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Question 3: What Are the Company’s Strengths and Weaknesses and How Do They Relate to Its Market Opportunities and External Threats? . . . . . . . . . . . 78 Question 4: Are the Company’s Prices and Costs Competitive with Those of Key Rivals, and Does It Have an Appealing Customer Value Proposition? . . . . . . . 84 Question 5: Is the Company Competitively Stronger or Weaker Than Key Rivals? . . . . . . 93 Question 6: What Strategic Issues and Problems Merit Front-Burner Managerial Attention? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

Chapter 5 The Five Generic Competitive Strategy Options: Which One to Employ? . . . . . . . . . . . . . . 98 The Five Generic Competitive Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Low-Cost Provider Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Broad Differentiation Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Focused (or Market Niche) Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Best-Cost Provider Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 Successful Competitive Strategies Are Always Underpinned by Resources and Capabilities That Allow the Strategy to Be Well-Executed . . . . . . . . . . . . . . . . . . . . . . 116 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

Chapter 6 Supplementing the Chosen Competitive Strategy—Other Important Strategy Choices . . . 118 Going on the Offensive—Strategic Options to Improve a Company’s Market Position . . . 120 Defensive Strategies—Protecting Market Position and Competitive Advantage . . . . . . . . . 124 Website Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125 Outsourcing Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Vertical Integration Strategies: Operating Across More Stages of the Industry Value Chain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129 Strategic Alliances and Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 Merger and Acquisition Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 Choosing Appropriate Functional-Area Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Timing a Company’s Strategic Moves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

Chapter 7 Strategies for Competing Internationally or Globally . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 Why Companies Decide to Enter Foreign Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 Why Competing Across National Borders Causes Strategy Making to Be More Complex . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 The Concepts of Multicountry Competition and Global Competition . . . . . . . . . . . . . . . . . 148 Strategy Options for Establishing a Competitive Presence in Foreign Markets . . . . . . . . . . 149 Competing in Foreign Markets: The Three Competitive Strategy Approaches . . . . . . . . . . 153 Building Cross-Border Competitive Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 Profit Sanctuaries and Global Strategic Offensives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

Chapter 8 Diversification Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 What Does Crafting a Diversification Strategy Entail? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Choosing The Diversification Path: Related vs. Unrelated Businesses . . . . . . . . . . . . . . . . . 168 Evaluating a Diversified Company’s Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

Chapter 9 Strategy, Ethics, and Social Responsibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 What Do We Mean by Business Ethics? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Where Do Ethical Standards Come From? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 The Three Categories of Management Morality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 What Are the Drivers of Unethical Strategies and Business Behavior? . . . . . . . . . . . . . . . . 199 Why Should Company Strategies Be Ethical? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 Strategy, Social Responsibility, and Corporate Citizenship . . . . . . . . . . . . . . . . . . . . . . . . . . 203 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

Chapter 10 Building an OrganizationCapable of Good Strategy Execution . . . . . . . . . . . . . . . . . . . . . . . . 210 A Framework for Executing Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 Building an Organization Capable of Good Strategy Execution: Three Key Actions . . . . . 214 Staffing The Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 Developing and Strengthening Execution-Critical Resources and Capabilities . . . . . . . . . . 217 Structuring the Organization and Work Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229

Chapter 11 Managing Internal Operations: Actions That Promote Good Strategy Execution . . . . . . . . . 232 Steering Needed Resources to Execution-Critical Activities . . . . . . . . . . . . . . . . . . . . . . . . . 233 Ensuring That Policies and Procedures Facilitate Strategy Execution . . . . . . . . . . . . . . . . . 234 Adopting Best Practices and Employing Process Management Tools to Improve Execution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236 Installing Information and Operating Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240 Tying Rewards and Incentives Directly to Achieving Good Execution- Critical Outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

Chapter 12 Corporate Culture and Leadership—Keys to Good Strategy Execution . . . . . . . . . . . . . . . . 247 Instilling a Corporate Culture That Promotes Good Strategy Execution . . . . . . . . . . . . . . . 248 Leading the Strategy Execution Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 Key Points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265

Chapter 1 What Is Strategy and Why Is It Important? 1

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education, Burr Ridge, IL

Arthur A. Thompson, The University of Alabama 5th Edition, 2018-2019

CHAPTER 1

What Is Strategy and Why Is It Important?

Strategy means making clear-cut choices about how to compete. —Jack Welch, former CEO, General Electric

Without a strategy the organization is like a ship without a rudder. —Joel Ross and Michael Kami

If your firm’s strategy can be applied to any other firm, you don’t have a very good one. —David J. Collis and Michael G. Rukstad

Managers of all types of businesses face three central questions: What’s our company’s present situation? What should the company’s future direction be and what performance targets should we set? What’s our plan for running the company and producing good results? Arriving at a thoughtful and probing answer to the question “What’s our company’s present situation?” prompts managers to evaluate industry conditions and competitive pressures, the company’s current market standing, its competitive strengths and weaknesses, and its future prospects in light of changes taking place in the business environment. The question “What should the company’s future direction be and what performance targets should we set?” pushes managers to consider what emerging buyer needs to try to satisfy, which growth opportunities to emphasize and which existing markets to de-emphasize or even abandon, where the company should be headed, and what outcomes the company should strive to achieve with respect to both its financial performance and its performance in the markets where it competes. The question “What’s our plan for running the company and producing good results?” challenges managers to craft a series of competitive moves and business approaches—what henceforth will be referred to as the company’s strategy—for heading the company in the intended direction, staking out a market position, attracting customers, and achieving the targeted financial and market performance.

The role of this chapter is to define the concept of strategy, identify the kinds of actions that determine what a company’s strategy is, introduce you to the concept of competitive advantage, and explore the tight linkage between a company’s strategy and its quest for competitive advantage. We will also explain why company strategies are partly proactive and partly reactive, why they evolve over time, and the relationship between a company’s strategy and its business model. We will conclude the chapter with a discussion of what sets a winning strategy apart from a ho-hum or flawed strategy and why the caliber of a company’s strategy determines whether it will enjoy a competitive advantage or be burdened by competitive disadvantage. By the end of the chapter, you will have a clear idea of why the tasks of crafting and executing strategy are core management functions and why excellent execution of an excellent strategy is the most reliable recipe for turning a company into a standout performer.

Chapter 1 • What Is Strategy and Why Is It Important? 2

What Do We Mean by “Strategy”?

A company’s strategy is defined by the specific market positioning, competitive moves, and business approaches that form management’s answer to “What’s our plan for running the company and producing good results?” A strategy represents managerial commitment to undertake one set of actions rather than another in an effort to compete successfully and achieve good performance outcomes.1 This commitment incorporates a coherent collection of choices and decisions about:

n How to attract and please customers.

n How to compete against rivals—and, ideally, gain a competitive advantage as opposed to being hamstrung by competitive disadvantage.

n How to position the company in the marketplace vis-à-vis rivals.

n How to pursue attractive opportunities to grow the business.

n How best to respond to changing economic and market conditions.

n How to manage each functional piece of the business (e.g., R&D, supply chain activities, production, sales and marketing, distribution, finance, and human resources).

n How to achieve the company’s performance targets.

In effect, when managers craft a company’s strategy, they are saying, “Among the many different business approaches and ways of competing we could have chosen, we have decided to employ this particular combination of competitive and operating approaches in moving the company in the intended direction, strengthening its market position and competitiveness, and meeting or beating our performance objectives.” Choosing among the various alternative hows is often tough, involving difficult trade- offs and sometimes high risk. But that is no excuse for company managers failing to decide upon a concrete course of action that spells out “This is the strategic path we are going to take and here’s what we are going to do to pursue competitive success in the marketplace and achieve good business results.”2

In most industries, company managers have considerable leeway in choosing the hows of strategy. For example, managers may see a promising opportunity for the company to compete against rivals by striving to keep costs low and selling products/services at attractively low prices. Often, there is room for a company to pursue competitive success by offering buyers more features, better performance, longer durability, more personalized customer service, and/or quicker delivery. Many companies strive to gain a competitive edge over rivals via cutting-edge technological features, longer warranties, clever advertising, better brand-name recognition, or the development of competencies and capabilities rivals cannot match. But it is foolhardy to pursue all of these options simultaneously in an attempt to be all things to all buyers. Choices of how best to compete against rivals have to be made in light of the firm’s resources and capabilities and in light of the competitive approaches rival companies are employing.

Likewise, there are all kinds of market-positioning options.3 Some companies target the high end of the market, whereas others go after the middle or low end. Some position themselves to compete in many market segments, endeavoring to attract many types of buyers with a wide variety of models and styles; other companies focus on a single market segment, with product offerings specifically

CORE CONCEPT A company’s strategy consists of the competitive moves and business approaches that managers employ to attract and please customers, compete successfully, capitalize on opportunities to grow the business, respond to changing market conditions, conduct operations, and achieve the targeted financial and market performance.

There’s no one roadmap or prescription for running a business in a successful manner. Many different avenues exist for competing successfully, staking out a market position, and operating the different pieces of a business.

Chapter 1 • What Is Strategy and Why Is It Important? 3

designed to meet the needs and preferences of a particular buyer type or buyer demographic. Some companies position themselves in only one part of the industry’s chain of production/distribution activities (preferring to be only in manufacturing or wholesale distribution or retailing), whereas others are partially or fully integrated, with operations ranging from components production to manufacturing and assembly to wholesale distribution to retailing. Some companies confine their operations to local or regional markets; others opt to compete nationally, internationally (in several countries), or globally (in all or most of the major country markets worldwide). Some companies decide to operate in only one industry, whereas others diversify broadly or narrowly into related or unrelated industries via acquisitions, joint ventures, strategic alliances, or starting up new businesses internally.

Strategy Is About Competing Differently Mimicking the strategies of successful industry rivals—with either copycat product offerings or maneuvers to stake out the same market position—rarely works. The best performing strategies are aimed at competing differently. This does not mean that the key elements of a company’s strategy have to be 100 percent different but rather that they must differ in at least some important respects. A strategy stands a better chance of succeeding when it is predicated on actions, business approaches, and competitive moves aimed at (1) appealing to buyers in ways that set a company apart from its rivals—particularly when it comes to doing what rivals don’t do or can’t do and (2) staking out a market position that is not crowded with strong competitors. Really successful strategies often contain some distinctive “a-ha!” quality that goes beyond merely attracting buyer attention but that, more importantly, delivers what buyers perceive as superior value and converts them into loyal customers. Indeed, the more a strategy is aimed at competing differently in ways that deliver superior value to buyers, the more likely the strategy will produce a valuable competitive edge over rivals.4

Strategy and the Quest for Competitive Advantage

The heart and soul of any strategy are the actions and moves in the marketplace that managers are taking to gain a competitive advantage over rivals. A company achieves a competitive advantage whenever it has some type of edge over rivals in attracting buyers and coping with competitive forces. There are many routes to competitive advantage, but they all involve providing buyers with what they perceive as superior value compared to the offerings of rival sellers. Superior value can mean a good product at a lower price, a superior product that is worth paying more for, or a best-value offering that represents an appealing combination of features, quality, service, and other attributes at an attractively low price. Five of the most frequently used and dependable strategic approaches to setting a company apart from rivals, delivering superior value, achieving competitive advantage, and converting buyers into loyal customers are:

1. Striving to be the industry’s low-cost provider, thereby aiming for a cost-based competitive advantage over rivals. Walmart and Southwest Airlines have earned strong market positions because of the low-cost advantages they have achieved over their rivals and their consequent ability to underprice competitors. Achieving lower costs than rivals can produce a durable competitive edge when rivals find it hard to match the low-cost leader’s approaches to driving costs out of the business.

2. Outcompeting rivals based on such differentiating features as higher quality, wider product selection, added performance, value-added services, more attractive styling, technological superiority, or some other attributes that set a company’s product offering apart from those of rivals. Successful adopters of differentiation strategies include Apple (innovative products), Johnson & Johnson in baby products (product reliability), Chanel and Rolex (top-of-the-line prestige), and Mercedes and BMW (engineering design and performance). Differentiation strategies can be powerful as long as a company is sufficiently innovative to thwart the efforts of clever rivals to copy or closely imitate its product offering and means of delivering superior value.

A creative, distinctive strategy that sets a company apart from rivals and delivers superior value to customers is a company’s most reliable ticket for winning a competitive advantage over rivals.

Chapter 1 • What Is Strategy and Why Is It Important? 4

3. Offering more value for the money. Giving customers more value for their money by meeting or beating buyers’ expectations regarding key quality/features/performance/service attributes while beating their price expectations is known as a best-cost provider strategy. This approach is a hybrid strategy that blends elements of the previous approaches. Toyota employs a best-cost provider strategy for its Lexus line of motor vehicles, as does Honda for its Acura line of cars and SUVs. Many consumers shop at L.L. Bean because of the good value it delivers: products with appealing quality/performance/features/ styling and attractively low prices. Likewise, Amazon.com has been highly successful in attracting customers with its more-value-for-the-money combination of appealing prices, wide selection, free shipping, extensive product information and reviews, and online shopping convenience.

4. Focusing on a narrow market niche and winning a competitive edge by doing a better job than rivals of serving the special needs and tastes of buyers that compose the niche. Prominent companies that enjoy competitive success in a specialized market niche include eBay in online auctions, Jiffy Lube International in quick oil changes, and The Weather Channel in cable TV.

5. Developing expertise and resource strengths that give the company competitive capabilities that rivals can’t easily imitate or trump with capabilities of their own. FedEx has superior capabilities in next- day delivery of small packages. Walt Disney has hard-to-beat capabilities in theme park management and family entertainment. Apple has formidable capabilities in innovative product design. Ritz-Carlton and Four Seasons have uniquely strong capabilities in providing their hotel guests with an array of personalized services. Hyundai has become the world’s fastest-growing automaker as a result of its advanced manufacturing processes and unparalleled quality control systems. Very often, winning a durable competitive edge over rivals hinges more on building competitively valuable expertise and capabilities than it does on having a distinctive product. Clever rivals can nearly always copy the attributes of a popular or innovative product, but for rivals to match experience, know-how, and specialized competitive capabilities that a company has developed and perfected over a long period of time is substantially harder to duplicate and takes much longer.

Forging a strategy that produces a competitive advantage has great appeal because it enhances a company’s financial performance. A company is almost certain to earn significantly higher profits when it enjoys a competitive advantage as opposed to when it competes with no advantage or is hamstrung by competitive disadvantage. Competitive advantage is the key to above-average profitability and financial performance because strong buyer preferences for a company’s products or services translate into higher sales volumes (Walmart) and/or the ability to command a higher price (Häagen-Dazs), which in turn tend to improve earnings, return on investment, and other important financial outcomes. Furthermore, if a company’s competitive edge holds promise for being sustainable (as opposed to just temporary), then so much the better for both the strategy and the company’s future profitability. What makes a competitive advantage sustainable (or durable) as opposed to temporary are actions and elements in the strategy that cause an attractive number of buyers to have lasting reasons to purchase a company’s products or services, despite competitors’ best efforts to nullify or overcome those reasons.

The tight connection between competitive advantage and profitability means the quest for sustainable competitive advantage always ranks center stage in crafting a strategy. The key to crafting a competitively powerful strategy hinges on incorporating one or more differentiating strategy elements that act as a magnet to draw customers and give them durable reasons to prefer its products or services. Indeed, what separates a powerful strategy from a run-of-the-mill or ineffective one is management’s ability to forge a series of moves, both in the marketplace and

CORE CONCEPT A company achieves competitive advantage when an attractive number of buyers are drawn to purchase its products or services rather than those of competitors. A company achieves sustainable competitive advantage when the basis for buyer preferences for its product offering relative to the offerings of its rivals is durable, despite competitors’ efforts to nullify or overcome the appeal of its product offering.

Chapter 1 • What Is Strategy and Why Is It Important? 5

internally, which tilts the playing field in the company’s favor and produces a sustainable competitive advantage over rivals. The bigger and more sustainable the competitive advantage, the better a company’s prospects for winning in the marketplace and earning superior long-term profits relative to its rivals. Without a strategy that leads to competitive advantage, a company risks being outcompeted by stronger rivals and/or handcuffed by mediocre success in the marketplace and uninspiring financial results.

Identifying a Company’s Strategy The best indicators of a company’s strategy are its actions in the marketplace and senior managers’ statements about the company’s current business approaches, future plans, and efforts to strengthen its competitiveness and performance. Figure 1.1 shows what to look for in identifying the key elements of a company’s strategy.

Once it is clear what to consider, the task of identifying a company’s strategy is mainly one of researching the company’s actions in the marketplace and its business approaches. In the case of publicly owned enterprises, senior executives often openly discuss the strategy in the company’s annual report and 10-K report, in press releases and company news (posted on the company’s website), and in the information provided to investors on the company’s website. To maintain the confidence of investors and Wall Street, most public companies are fairly open about their strategies. Company executives typically lay out key elements of their strategies in presentations to securities analysts (portions of which are usually posted in the investor relations section of the company’s website), and stories in the business media about the company often include aspects of the company’s strategy. Hence, except for some about-to-be-launched moves and changes that remain under wraps and in the planning stage, there’s usually nothing secret or undiscoverable about a company’s present strategy.

Figure 1.1 Identifying a Company’s Strategy—What to Look For

Actions to upgrade, build, or acquire competitively valuable capabilities and to correct competitive weaknesses

Actions to diversify the com- pany’s revenues and earnings by entering new businesses

Actions to gain sales and market share via more performance features, more appealing design, better quality or customer service, wider product selection, a stronger network of dealers/distributors, lower prices (based on lower costs), or other such actions

Actions to respond/adjust to changing market and competitive conditions or other external factors

Actions and approaches used in managing R&D, production, sales and marketing, finance, and other key activities

Actions to enter new geographic or product markets or to exit existing ones

Actions to capture emerging market opportunities and defend against external threats to the company’s business prospects

Actions to strengthen market standing and competitiveness by acquiring or merging with other companies

Actions to strengthen competitiveness via strategic alliances and collaborative partnerships

The Pattern of Actions and

Business Approaches that Define a Company’s

Strategy

Chapter 1 • What Is Strategy and Why Is It Important? 6

Why a Company’s Strategy Evolves Over Time All companies, sooner or later, find it necessary to modify aspects of their strategy in response to changing market conditions, advancing technology, the fresh moves of competitors, shifting buyer needs and preferences, emerging market opportunities, new ideas for improving the strategy, and/or mounting evidence that the strategy is not working well. Most of the time, a company’s strategy evolves incrementally from management’s ongoing efforts to fine-tune this or that piece of the strategy and to adjust certain strategy elements in response to new learning and unfolding events.5 However, on occasion, major strategy shifts are called for, such as when a strategy is clearly failing and the company faces a financial crisis, when market conditions or buyer preferences change significantly, or when important technological breakthroughs occur (as in medical devices and shale fracking). In some industries, conditions change at a fairly slow pace, making it feasible for the major components of a good strategy to remain in place for long periods. But in industries like smartphones, medical devices, computer chips and genetic engineering where market conditions and technology change frequently and in sometimes dramatic ways, the life cycle of a given strategy is short. It is not uncommon for companies in high-velocity environments to overhaul key elements of their strategies several times a year or even to “reinvent” how they intend to compete differently from rivals and deliver superior value to customers.6

Regardless of whether a company’s strategy changes gradually or swiftly, the important point is that its present strategy is always temporary and on trial, pending management’s next round of strategy initiatives, the emergence of new industry and competitive conditions, and other unfolding developments that management believes warrant strategy adjustments. Thus, a company’s strategy at any given point is fluid, representing the temporary outcome of an ongoing process that, on the one hand, involves reasoned and creative management efforts to craft an effective strategy and, on the other hand, involves ongoing responses to market change and constant experimentation and tinkering. Adapting to new conditions and constantly evaluating what is working well enough to continue and what needs to be improved are normal parts of the strategy-making process and result in an evolving strategy.7

A Company’s Strategy Is Partly Proactive and Partly Reactive

The evolving nature of a company’s strategy means the typical company strategy is a blend of (1) proactive actions to secure a competitive edge and improve the company’s financial performance and (2) as-needed reactions to unanticipated developments and fresh market conditions—see Figure 1.2.8 The biggest portion of a company’s current strategy flows from previously initiated actions and business approaches that are working well enough to merit continuation and newly launched initiatives aimed at edging out rivals and boosting financial performance. Typically, managers proactively modify this or that aspect of their strategy as new learning emerges about which pieces of the strategy are working well and which aren’t and as they explore and test new ideas for strategy improvement. This part of management’s action plan for running the company is deliberate and constitute its proactive strategy elements.

CORE CONCEPT Changing circumstances and ongoing manage ment efforts to improve the strategy cause a company’s strategy to evolve over time—a condition that makes the task of crafting a strategy a work in progress, not a onetime or everynow andthen event.

Chapter 1 • What Is Strategy and Why Is It Important? 7

Figure 1.2 A Company’s Strategy Is a Blend of Proactive Initiatives and Reactive Adjustments

Abandoned strategy elements

Prior Version

of Company Strategy

Latest Version

of Company Strategy

Proactive Strategy Elements

Newly-crafted strategic initiatives plus ongoing strategy elements

continued from prior periods

New strategy elements that emerge in response to

changing circumstances

Reactive Strategy Elements

But managers must always be willing to supplement or modify all the proactive strategy elements with as-needed reactions to unanticipated developments. Inevitably, there will be occasions when market and competitive conditions take an unexpected turn that call for some kind of strategic reaction or adjustment. Hence, a portion of a company’s strategy is always developed on the fly, coming as a response to fresh strategic maneuvers on the part of rival firms, unexpected shifts in customer requirements and expectations, important technological developments, newly appearing market opportunities, a changing political or economic climate, or other unanticipated happenings in the surrounding environment. These adaptive strategy adjustments form the reactive strategy elements.

As shown in Figure 1.2, a company’s strategy evolves from one version to the next as managers abandon obsolete or ineffective strategy elements, settle upon a set of proactive strategy elements, and then—as new circumstances unfold—make adaptive strategic adjustments, which gives rise to reactive strategy elements. The latest version of a company’s strategy thus reflects the disappearance of obsolete or ineffective strategy elements and a modified combination of proactive and reactive elements.

Strategy and Ethics: Passing the Test of Moral Scrutiny

In choosing among strategic alternatives, company mana- gers are well advised to embrace actions that can pass the test of moral scrutiny. Just keeping a company’s strategic actions within the bounds of what is legal does not mean the strategy is ethical. Ethical and moral standards are not governed by what is legal. Rather, they involve issues of “right” versus “wrong” and duty—what one should do. A strategy is ethical only if it does not entail actions and behaviors that cross the moral line from “should or can do” to “should not do.” For example, a company’s strategy definitely crosses into the should not do zone and cannot pass moral scrutiny if it entails actions and behaviors that are deceitful, unfair or harmful to others, disreputable,

CORE CONCEPT A strategy cannot be considered ethical just because it involves actions that are legal. To meet the standard of being ethical, a strategy must entail actions and behavior that can pass moral scrutiny in the sense of not being deceitful, unfair or harmful to others, disreputable, or unreasonably damaging to the environment.

Chapter 1 • What Is Strategy and Why Is It Important? 8

or unreasonably damaging to the environment. A company’s strategic actions or behavior cross over into the should not do zone and are likely to be deemed unethical when (1) they reflect badly on the company or (2) they adversely impact the legitimate interests and well-being of shareholders, customers, employees, suppliers, the communities where it operates, and society at large or (3) they provoke public outcries about inappropriate or “irresponsible” actions/behavior/outcomes.

Admittedly, it is not always easy to categorize a given strategic behavior as ethical or unethical. Many strategic actions fall in a gray zone and can be deemed ethical or unethical depending on how high one sets the bar for what qualifies as ethical behavior. For example, is it ethical for advertisers of alcoholic products to place ads in media having an audience of as much as 50 percent underage viewers? Is it ethical for an apparel retailer attempting to keep prices attractively low to source clothing from manufacturers who pay substandard wages, use child labor, or subject workers to unsafe working conditions? Is it ethical for Nike, Under Armour, and other makers of athletic uniforms and other sports gear to pay a university athletic department large sums of money as an “inducement” for the university’s athletic teams to use their brand of products? Is it ethical for pharmaceutical manufacturers to charge higher prices for life-saving drugs in some countries than they charge in others? Is it ethical for a company to ignore the damage its operations do to the environment in a particular country, even though its operations are in compliance with current environmental regulations in that country?

Senior executives with strong ethical convictions are generally proactive in linking strategic action and ethics; they forbid the pursuit of ethically questionable business opportunities and insist that all aspects of company strategy are in accord with high ethical standards. They make it clear that all company personnel are expected to act with integrity, and they put organizational checks and balances into place to monitor behavior, enforce ethical codes of conduct, and provide guidance to employees regarding any gray areas. Their commitment to ethical business conduct is genuine, not hypocritical lip service.

The reputational and financial damage that unethical strategies and behavior can do is substantial. When a company is put in the public spotlight because certain personnel are alleged to have engaged in misdeeds, unethical behavior, fraudulent accounting, or criminal behavior, its revenues and stock price are usually hammered hard. Many customers and suppliers shy away from doing business with a company that engages in sleazy practices or turns a blind eye to its employees’ illegal or unethical behavior. They are turned off by unethical strategies or behavior and, rather than become victims or get burned themselves, wary customers take their business elsewhere and wary suppliers tread carefully. Moreover, employees with character and integrity do not want to work for a company whose strategies are shady or whose executives lack character and integrity. Besides, immoral or unethical actions are plain wrong. Consequently, solid business reasons exist for companies to shun the use of unethical strategy elements.

The Relationship Between a Company’s Strategy and Its Business Model

Closely related to the concept of strategy is the concept of a company’s business model. A business model is manage- ment’s blueprint for delivering a valuable product or service to customers in a manner that will generate revenues sufficient to cover costs and yield an attractive profit.9 The two crucial elements of a company’s business model are (1) its customer value proposition and (2) its profit proposition (or “profit formula”).10 The customer value proposition lays out the company’s approach to satisfying buyer needs and requirements at a price they will consider a good value.11 Plainly, from a customer perspective, the greater the value delivered and the lower the price to get this value, the more appealing the company’s value proposition and product offering. From a company perspective, however, the

CORE CONCEPT A company’s business model sets forth how its strategy and operating approaches will create value for customers while at the same time generating ample revenues to cover costs and realize a profit. Absent the ability to earn good profits, a company’s strategy and operating blueprint are flawed, its business model is not viable, and its ability to survive is in jeopardy.

Chapter 1 • What Is Strategy and Why Is It Important? 9

greater the value delivered and the higher the price that can be charged, the bigger the margin for covering the costs associated with its business approach and realizing an attractive profit and return on investment.

The profit proposition or profit formula portion of a company’s business model concerns its business approach to generating sufficiently large revenues and controlling the costs of its value proposition, such that the company will be appealingly profitable in delivering the intended value to customers. For a company’s profit proposition to be appealing, it must be capable of producing three outcomes:

n Generating a big enough revenue stream to cover the costs of delivering attractive value to customers. The revenues that can be generated are a function of the volume of customers attracted at the price being charged.

n Controlling the costs of the value being delivered. The costs of the company’s business model approach are dependent on the costs of the resources and business processes it utilizes and the cost efficiency of its operating systems.

n Generating attractive profits for shareholders.

The lower a firm’s costs are in relation to its revenues, the greater its profit potential and the more attractive its profit proposition.

Magazines and newspapers employ a business model keyed to delivering information and entertainment they believe readers will find valuable and a profit formula aimed at securing sufficient revenues from subscriptions and advertising to more than cover the costs of producing and delivering their content to readers. Cell-phone providers, satellite radio companies, and Internet service providers also employ a subscription-based business model. The business model of network TV and radio broadcasters entails providing free programming to audiences but charging advertising fees based on audience size; profit is realized by generating sufficient advertising revenues to more than cover programming costs. Gillette’s business model in razor blades involves selling a “master product”—the razor—at an attractively low price and then making money on repeat purchases of razor blades that can be produced cheaply and sold at high profit margins. Printer manufacturers like Hewlett- Packard, Canon, Dell, and Epson pursue much the same business model as Gillette—selling printers at a low (virtually breakeven) price and making large profit margins on the repeat purchases of ink cartridges and other printer supplies. McDonald’s invented the business model for fast food—providing value to customers in the form of economical quick-service meals at clean, convenient locations. Its profit formula involves such elements as standardized cost-efficient store designs; equipment and food preparation systems that provide the capability to serve hotter, better-tasting food faster and accurately; extensive testing of new menu items; stringent specifications for ingredients; detailed operating procedures for each unit; heavy reliance on advertising and in- store promotions; and sizable investment in human resources and training.

Amazon.com mainly utilizes an online direct sales business model whereby it procures merchandise for display on its web pages and operates a growing network of geographically scattered distribution centers that rapidly fill, package, and ship customer orders for delivery by third-party carriers (FedEx, UPS, and the U.S. Postal Service). Amazon generates revenues by providing an online marketplace for some 2 million third-party merchants from which it derives service fees and/or sales commissions—affiliated merchants can either use Amazon’s order fulfillment capabilities or perform these activities themselves. However, Chinese-based Alibaba has adopted a “platform” business model whereby it operates online and mobile shopping marketplaces for consumers, merchants, and third-party service providers to conduct retail and wholesale trade; Alibaba’s revenues come from the commissions and fees it earns on the hundreds of millions of transactions annually made by the merchants using its web-based sales platform and associated services (that includes web-page display, auction hosting, online money transfer, cloud computing, and logistics, among others). So far, the strategic elements in Alibaba’s profit formula have delivered far superior performance compared to the strategic elements in Amazon’s profit formula. Alibaba reported fiscal year 2016 operating profits of $4.5 billion on commission and service revenues of $15.7 billion, whereas in 2016, Amazon (which has a long history of skimpy profit margins) reported operating profit of $4.2 billion on sales revenues of $136.0 billion.

Chapter 1 • What Is Strategy and Why Is It Important? 10

The nitty-gritty issue surrounding a company’s business model is whether it can execute its customer value proposition profitably. Just because company managers have crafted a strategy for competing and otherwise running various parts of the business does not automatically mean the strategy will lead to profitability—it may or may not. Companies that have been in business for a while and are making at least reasonably attractive profits have a “proven” business model—because there is hard revenue-cost evidence that their strategies and approaches to operating can yield good profits. Companies that are in a startup mode or are losing money have “questionable” business models; their strategies and operating approaches have yet to produce good bottom-line results, thus raising doubts about their blueprint for making money and their viability as business enterprises. Companies that operate in uncertain, volatile market environments often have business models that quickly lose their effectiveness; for such companies to survive, they have to be adept at spotting the signs of impending crisis early and then swiftly reinvent their business model and strategy.12

When a company pioneers a new and obviously successful business model approach, new entrants quickly appear with imitative business models—the key features of a successful business model are easy to identify and, often relatively easy to replicate.13 For example, over the past 15 years, the business model for online retailing—a functional website, appealing product offerings, convenient checkout and payment options, fast delivery (and perhaps even free shipping), no-hassle merchandise return procedures, and cost-efficient order fulfillment and inventory management systems—has been successfully implemented thousands of times all across the world.

What Makes a Strategy a Winner?

Three tests can be applied to determine the merits of one strategy versus another and distinguish a winning strategy from a so-so or flawed strategy:

1. The Fit Test: How well does the strategy fit the company’s situation? To qualify as a winner, a strategy must be well matched to industry and competitive conditions, a company’s best market opportunities, and other aspects of the enterprise’s external environment. At the same time, it must be tailored to the company’s resource strengths and weaknesses, competencies, and competitive capabilities. Unless a strategy exhibits good fit with both the external and internal aspects of a company’s overall situation, it is likely to be an underperformer and fail to produce good business results.

2. The Competitive Advantage Test: Is the strategy helping the company achieve a sustainable competitive advantage? Winning strategies enable a company to achieve a competitive advantage that is durable. The bigger and more durable the competitive edge that a strategy helps build, the more powerful and appealing it is.

3. The Performance Test: Is the strategy producing good company performance? To be a winner, a strategy must have resulted in substantially better company performance. Two kinds of performance indicators tell the most about the caliber of a company’s strategy: (1) competitive strength and market standing and (2) profitability and financial strength. Gains in market share, improving competitiveness vis-à-vis rivals, higher profitability, and better overall financial performance are all signs of a winning strategy.

Strategies—either existing or proposed—that come up short on one or more of the tests are plainly less appealing than strategies passing all three tests with flying colors. Failing grades on one or more tests should prompt managers to make immediate changes in an existing strategy. Likewise, when evaluating the picking and choosing among alternative strategic actions, managers should be quick to discard alternatives that seem ill-suited to a company’s internal and external situation or that offer little prospect of producing competitive advantage or improved performance.

CORE CONCEPT A winning strategy must fit the enterprise’s external and internal situation, help build sustainable competitive advantage, and improve company performance.

Chapter 1 • What Is Strategy and Why Is It Important? 11

Why Crafting and Executing Strategy Are Important Tasks

Crafting and executing strategy are top-priority managerial tasks for two big reasons. First, there is a compelling need for managers to proactively shape how the company’s business will be conducted. A clear and reasoned strategy is management’s prescription for doing business, its road map to competitive advantage, and its game plan for pleasing customers and improving financial performance. High-performing enterprises are nearly always the product of astute, creative, and proactive strategy-making. Companies don’t get to the top of the industry rankings or stay there with flawed strategies, copycat strategies, or with strategies built around timid actions to try and do better.14 And only a handful of companies can boast of strategies that hit home runs in the marketplace due to lucky breaks or the good fortune of having stumbled into the right market at the right time with the right product—but the good fortunes of such companies are not long-lasting without subsequent success in crafting a strategy capable of long-term competitive success. So there can be little argument that a company’s strategy matters— and matters a lot.

Second, even the best-conceived strategies will result in performance shortfalls if they are not executed proficiently. Good day-in/day-out strategy execution and operating excellence are essential for a company to perform close to its full potential. There can be no applause for managers who design a potentially brilliant strategy and then stumble in their efforts to create an organization with the skills, resource capabilities, operating practices, and culture needed to carry out the strategy in high-caliber fashion. Flawed and/or inept implementation and execution of a company’s strategy are a surefire recipe for underachievement, both financially and in competing against rivals.

Good Strategy + Good Strategy Execution = Good Management Crafting and executing strategy are thus core management tasks. Among all the things managers do, nothing affects a company’s ultimate success or failure more fundamentally than how well its management team charts the company’s direction, develops competitively effective strategic moves and business approaches, and pursues what needs to be done internally to produce good day-in/day-out strategy execution and operating excellence. Indeed, good strategy and good strategy execution are the most telling and trustworthy signs of good management. Managers don’t deserve a gold star for designing a potentially brilliant strategy and then failing to put the organizational means in place to carry it out in high-caliber fashion—weak implementation and execution undermine the strategy’s potential and pave the way for shortfalls in customer satisfaction and company performance. Competent execution of a mediocre strategy scarcely merits enthusiastic praise for management’s efforts either.

The rationale for using the twin standards of good strategy making and good strategy execution to determine whether a company is well-managed is therefore compelling: The better conceived a company’s strategy and the more competently it is executed, the more likely the company will be a standout performer in the marketplace. In stark contrast, a company that has a muddled or flawed strategy and/or can’t seem to execute its strategy competently is most likely an underperformer and in need of better management.

CORE CONCEPT How well a company performs and the degree of market success it achieves are directly attributable to the caliber of its strategy and the proficiency with which the strategy is executed.

Chapter 1 • What Is Strategy and Why Is It Important? 12

The Road Ahead

Throughout the chapters to come, the spotlight is trained on the foremost question in running a business enterprise: What must managers do, and do well, to give a company its best shot for being attractively profitable and successful in the marketplace? The answer that emerges, and that becomes the biggest lesson of the course you are taking, is that doing a good job of managing inherently requires good strategic thinking and good management of the strategy-making, strategy-executing process.

The content of the upcoming chapters focuses squarely on what every business student and aspiring manager needs to know about crafting and executing strategy. We will explore what good strategic thinking entails, describe the core concepts and tools of strategic analysis, and examine the ins and outs of crafting and executing strategy. Then, in the accompanying strategy simulation exercise where you will run a company in head-to-head competition with companies run by your classmates, you will have a golden learn-by-doing opportunity to put the chapter content into practice and gain firsthand experience in actually crafting a strategy for your company and figuring out how to execute it cost effectively and profitably. In the process, we hope to convince you that first-rate capabilities in crafting and executing strategy are basic to managing successfully and are skills every manager needs to possess.

As you tackle the chapters and undertake the activities of being a co-manager of your assigned company, ponder the following observation by the essayist and poet Ralph Waldo Emerson: “Commerce is a game of skill which many people play, but which few play well.” If the chapters and the experience of running your company help you become a savvy player and better equip you to succeed in business, the time and energy you spend here will indeed prove worthwhile.

Key Points

The tasks of crafting and executing company strategies are the heart and soul of managing a business enterprise and winning in the marketplace. A company’s strategy is the game plan management is using to stake out a market position, conduct its operations, attract and please customers, compete successfully, and achieve the desired performance targets. The central thrust of a company’s strategy is undertaking moves to build and strengthen the company’s long-term competitive position and financial performance and, ideally, gain a competitive advantage over rivals that then becomes a company’s ticket to above-average profitability. A company’s strategy typically evolves and reforms over time, emerging from a blend of (1) company managers’ proactive and purposeful actions and (2) as-needed reactions to unanticipated developments and fresh market conditions.

Closely related to the concept of strategy is the concept of a company’s business model. A company’s business model is management’s story line for how and why the company’s product offerings and competitive approaches will generate a revenue stream and have an associated cost structure that produces attractive earnings and return on investment—in effect, a company’s business model sets forth the economic logic for making money in a particular business, given the company’s current strategy.

A winning strategy fits the circumstances of a company’s external situation and its internal resource strengths and competitive capabilities, builds competitive advantage, and boosts company performance.

Crafting and executing strategy are core management functions. How well a company performs and the degree of market success it enjoys are directly attributable to the caliber of its strategy and the proficiency with which the strategy is executed. No company’s management team deserves a grade of “good” for crafting a run of the mill strategy and/or for executing a strategy satisfactorily and, as a consequence, achieving no better than adequate performance.

Chapter 2 Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 13

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education, Burr Ridge, IL

Arthur A. Thompson, The University of Alabama 5th Edition, 2018-2019

CHAPTER 2

Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy

If you don’t know where you are going, any road will take you there. —Cheshire Cat to Alice Lewis Carroll, Alice in Wonderland

Good business leaders create a vision, articulate the vision, passionately own the vision, and relentlessly drive it to completion. —Jack Welch, former CEO of General Electric

One secret to maintaining a thriving business is recognizing when it needs a fundamental change. —Mark W. Johnson, Clayton M. Christensen, and Henning Kagermann

A good goal is like a strenuous exercise—it makes you stretch. —Mary Kay Ash, Founder of Mary Kay Cosmetics

If one is even halfway convinced that crafting and executing strategy are critically important managerial tasks, then understanding exactly what is involved in developing a strategy and executing it proficiently becomes essential. What goes into charting a company’s strategic course and long-term direction? Is any analysis required? Does a company need a strategic plan? What are the various components of the strategy- making, strategy-executing process? Aside from top executives, to what extent are other senior and mid-level managers involved in crafting important parts of the company’s overall strategy? What roles and functions do nonmanagerial employees play in the process of pursuing the vision and mission, meeting or beating performance targets, and implementing and executing the strategy proficiently?

This chapter presents an overview of the managerial ins and outs of crafting and executing company strategies. The focus is on management’s direction-setting responsibilities—developing a strategic vision that sets forth where the company is headed and what its mission will be, setting performance targets, and choosing a strategy capable of producing the desired outcomes. There is coverage of why strategy making is a task for a company’s entire management team and which kinds of strategic decisions are made at which levels of management. There is a brief discussion of the principal managerial tasks associated with implementing and executing strategy and why a company’s whole managerial team is involved in the strategy execution process. The chapter concludes with a look at the roles and responsibilities of the company’s board of directors in the strategy-making, strategy-executing process and how good corporate governance protects shareholder interests and promotes good management.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 14

What Does the Strategy-Making, Strategy-Executing Process Entail?

Crafting and executing a company’s strategy is an ongoing process that consists of five interrelated managerial tasks:

1. Developing a strategic vision that charts the company’s long-term direction, a mission statement that describes the purpose of the company’s business, and a set of core values to guide the pursuit of the vision and mission.

2. Setting objectives and using them as yardsticks for measuring the company’s performance and the progress it is making in achieving the intended strategic vision and mission.

3. Crafting a strategy to achieve the objectives and move the company along the path to accomplishing the mission and vision.

4. Implementing and executing the chosen strategy efficiently and effectively.

5. Monitoring developments, evaluating performance, and initiating corrective adjustments in the company’s long-term direction, objectives, strategy, or execution in light of actual experience, changing conditions, fresh managerial ideas for improving the strategy, and newly emerging market opportunities.

Figure 2.1 displays this five-task process. Let’s examine each task in some detail, thereby setting the stage for the forthcoming chapters and giving you a bird’s-eye view of the book.

Figure 2.1 The Strategy-Making, Strategy-Executing Process

Task 1 Task 2 Task 3 Task 4 Task 5

Developing a strategic

vision, mission, and core values

Setting Objectives

Crafting a strategy

to achieve the objectives,

mission, and vision

Implementing and

executing the strategy

Monitoring developments,

evaluating performance, and initiating

corrective adjustments

Revise as needed in light of the company’s actual performance, changing conditions,

new opportunities, and new ideas

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 15

Task 1: Developing a Strategic Vision, Mission Statement, and Set of Core Values

Very early in the strategy-making process, a company’s senior executives must wrestle with the issue of what directional path the company should take. Can the company’s prospects be improved by changing its product offerings, the markets in which it participates, the customers it caters to, or the business activities in which it engages? Deciding to commit the company to one path versus another pushes top-level executives to draw some carefully reasoned conclusions about whether the company’s present strategic course offers attractive opportunities for growth and profitability or whether major or minor changes of one kind or another in the company’s strategy and long-term direction are needed. Some of the most important considerations in charting a company’s future direction are shown in Table 2.1.

Table 2.1 What to Consider in Deciding on a Company’s Future Direction

External Considerations Internal Considerations

• Does sticking with the company’s present strategic course present attractive opportunities for growth and profitability?

• How well is the company faring vis-à-vis key competitors? Is the company gaining ground or losing ground, and why?

• Are the winds of change—most especially those in the company’s market and competitive arena—acting to enhance or weaken the company’s prospects?

• Does the company have sufficient business and competitive strength to achieve attractive gains in revenues and profits in the years ahead?

• What, if any, new customer groups and/or geographic markets should the company get in position to serve?

• What organizational and resource strengths can the company leverage and which resource weaknesses need to be corrected?

• Which emerging market opportunities should the company pursue and which ones should not be pursued?

• Is the company competing in too many markets or product categories where profits are skimpy or nonexistent?

• Should the company begin to deemphasize or eventually abandon any of the markets or customer groups it is currently serving?

• Is the company at risk because of growing technological obsolescence or deficient skills and capabilities?

Top management’s views and conclusions about the company’s long-term direction and what product-customer- market-business mix seems optimal for the road ahead constitute a strategic vision for the company. A strategic vision delineates management’s aspirations for the company, providing a panoramic view of “where we are going” and a convincing rationale for why this makes good business sense. A strategic vision thus points an organization in a particular direction, charts a strategic path for it to follow in preparing for the future, and molds organizational identity. A forward-looking and clearly articulated strategic vision communicates management’s aspirations to stakeholders (shareholders, employees, suppliers, customers, etc.) and helps steer the energies of company personnel in a common direction. The vision of Google cofounders Larry Page and Sergey Brin “to organize the world’s information and make it universally accessible and useful” has been successful as the company’s guiding light because its obvious relevance has captured the imagination of stakeholders and the public at large. Their vision served as the basis for crafting the company’s strategic actions and aided internal efforts to mobilize and direct the company’s resources.

CORE CONCEPT A strategic vision describes the route a company intends to take in developing and strengthening its business. It lays out the company’s strategic course in preparing for the future.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 16

Clear, forward-looking visions are distinctive and specific to a particular organization. They avoid feel- good statements like “We will become a global leader and the first choice of customers in every market we choose to serve”—which could apply to hundreds of organizations.1 Likewise, a strategic vision proclaiming management’s quest “to be the market leader” or “to be the most innovative” or “to be recognized as the best company in the industry” offer scant guidance about a company’s long-term direction or the kind of company management is striving to build.

A surprising number of vision statements found on company websites and in annual reports are vague and unrevealing, conveying nothing meaningful about the company’s future direction. Some could apply to most any company in any industry. Many read like a public relations statement, high-sounding words and phrases that someone came up with because it is fashionable for companies to have a vision statement.2 An example is Hilton Hotel’s vision “to fill the earth with light and the warmth of hospitality,” which simply borders on the incredulous—could anyone believe these words have any connection to Hilton Hotel’s long-term direction and management’s aspirations for the future of the company’s hotel business?

For a strategic vision statement to serve a valuable managerial purpose, it cannot be just a bunch of nice words with no specifics or forward-looking content. Rather, it must lay out top executive thinking about the company’s long-term direction (“where we are headed”) and address what changes in the company’s current product-market- customer-business mix are needed to better position the company. Vision statements that use revealing language to paint a picture of where the company is going and needed changes in its business make-up provide valuable understanding and decision-making guidance to managers at all organizational levels in doing their part to get the company moving along the indicated strategic path. Table 2.2 provides some do’s and don’ts in composing a useful, effectively-worded vision statement.

Table 2.2 Wording a Vision Statement—The Do’s and Don’ts

The Do’s The Don’ts Be graphic—Paint a clear and straight-to-the-point picture of where the company is headed and the market position(s) the company intends to stake out.

Don’t dwell on the present—a vision is not about what a company once did or does now; it’s about “where we are going.”

Be forward-looking and directional—Describe the strategic course management has charted and the kinds of product-market-customer-business changes that will help prepare the company for the future.

Don’t be vague or incomplete—Never skimp on specifics that delineate where the company is headed or how the company intends to prepare for the future.

Keep it focused—Include just enough specifics and details to provide managers with useful guidance in making decisions and allocating resources.

Don’t use overly broad language—Avoid all-inclusive language that gives the company license to head in most any direction, pursue most any opportunity, or enter most any business.

Have some wiggle room—Language that allows some flexibility enables the strategic course to be fine- tuned as the company’s circumstances and external environment change—significantly modifying the vision statement frequently undercuts the whole concept of establishing a long-term direction for the company.

Don’t state the vision in bland or uninspiring terms— The best vision statements are worded in a manner that motivate and inspire company personnel and shareholders about the company’s future and the merits or value of what it is trying to accomplish.

Be sure the journey is feasible—The path and direction should be within the realm of what the company can pursue and accomplish; over time, a company should be able to demonstrate measurable progress in achieving the vision.

Don’t be generic—A vision statement that could apply to companies in any of several industries (or to any of several companies in the same industry) is incapable of giving a company its own unique identity or providing useful decision-making guidance.

A well-conceived vision statement clearly conveys a company’s long-term direction and says something definitive about what top executives want the company’s product-market-customer-business makeup to be in three to five (or more) years.

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Indicate why the directional path makes good business sense—The directional path should be in the long-term interests of stakeholders (especially shareholders, employees, and customers).

Don’t rely on superlatives—Visions that claim the company’s strategic course is one of being the “best” or “the most successful” or “a global leader” usually lack revealing specifics about the path the company intends to take to get there.

Make it memorable—A well-stated vision is short, easily communicated, and memorable. Ideally, it should be reducible to a few choice lines or a one-phrase “slogan.”

Don’t run on and on—A vision statement that is not concise and to the point will tend to lose its audience.

Sources: John P. Kotter, Leading Change (Boston: Harvard Business School Press, 1996), p. 72; Hugh Davidson, The Committed Enterprise (Oxford: Butterworth Heinemann, 2002, Chapter 2; and Michel Robert, Strategy Pure and Simple II (New York: McGraw- Hill, 1992), Chapters 2, 3, and 6.

Communicating the Strategic Vision How effectively top executives communicate the strategic vision to all company personnel is as important as the strategic soundness of the long-term direction they have chosen. A vision cannot provide direction for middle managers or inspire and energize employees unless everyone in the company is familiar with it and can observe top executives’ commitment to the vision. It is particularly important for executives to provide a compelling rationale for a dramatically new strategic vision and company direction. When company personnel don’t understand or accept the need for redirecting organizational efforts, they are prone to resist or be indifferent to the changes management wants to make. Hence, explaining the basis for the new direction, addressing employee concerns head-on, calming fears, lifting spirits, and providing updates and progress reports as events unfold all become part of the task in mobilizing support for the vision and winning commitment to needed actions.

Winning the support of organization members for the vision nearly always requires putting “where we are going and why” in writing, distributing the statement organization wide, and having executives personally explain the vision and its rationale to as many people as feasible. A strategic vision can usually be adequately stated in less than a page (often in one to two paragraphs), and managers should be able to explain it to company personnel and outsiders in five to ten minutes. Ideally, executives should present their vision for the company in a manner that reaches out and grabs people. An engaging and convincing strategic vision has enormous motivational value—for the same reason that a stone mason is more inspired by building a great cathedral for the ages than simply laying stones to create floors and walls. When managers articulate a vivid and compelling case for where the company is headed, organization members begin to say, “This is interesting and has a lot of merit. I want to be involved and do my part to help make it happen.” The more a vision evokes positive support and excitement, the greater its impact in terms of arousing a committed organizational effort and getting company personnel to move in a common direction.3 Thus, executive ability to paint a convincing and inspiring picture of a company’s journey and destination is an important element of effective strategic leadership.

Expressing the Essence of the Vision in a Slogan The task of effectively conveying the vision to company personnel is assisted when the vision of where to head is expressed in an easily remembered phrase or catchy slogan. For instance, Nike aspires to exhibit “a passion for serving athletes by developing the most innovative products and services to help them reach their full potential.” Disney’s overarching vision for its five business groups—parks and resorts, movie studios, television channels, consumer products (toys, books, and licensed Disney products), and interactive media entertainment—is to “create happiness by providing the finest in entertainment for people of all ages, everywhere.” The Mayo Clinic’s vision is “to inspire hope and contribute to health and well-being by providing the best care to every patient through integrated clinical practice, education and research” while Greenpeace strives “to expose global environmental problems and to promote solutions that are essential to a green and peaceful future.” Walmart’s visionary slogan is “saving people money so they can live better”—often shortened to the tag line “Save Money. Live Better.” Creating a phrase or short slogan to

CORE CONCEPT An effectively communicated vision is a valuable management means of enlisting the commitment of company personnel to actions that get the company moving in the intended direction.

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illuminate an organization’s direction and purpose and then using it repeatedly as a reminder of “where we are headed and why” helps rally organization members to hurdle whatever obstacles lie in the company’s path and maintain their focus.

Why a Sound, Well-Communicated Strategic Vision Matters A well-thought-out, forcefully communi- cated strategic vision pays off in several respects: (1) it crystallizes top executives’ own views about the firm’s long-term direction; (2) it reduces the risk of rudderless decision making; (3) it is a tool for winning the support of organizational members for changes that will help move the company along the chosen strategic path; (4) it provides guidance to managers at lower organizational levels in making decisions and operating their assigned pieces of the business; and (5) it provides a rational for why the whole organization should begin to take steps and launch efforts to begin its journey into the future. When top executives can see evidence of progress in achieving these five benefits, the first step in organizational direction setting has been successfully completed.

Developing a Company Mission Statement The defining characteristic of a well-conceived strategic vision is what it says about the company’s future strategic course—“the direction we are headed and what market position(s) we intend to stake out.” The role of a company’s mission statement, however, is to describe the enterprise’s present business and purpose—“who we are, what we do, and why we are here.” Ideally, a company mission statement (1) identifies the company’s products/ services, (2) specifies the buyer needs that it seeks to satisfy and the customer groups or markets it serves, and (3) gives the company its own identity. The mission statements that one finds in company annual reports or posted on company websites typically are quite brief; some do a better job than others of conveying what the enterprise’s current business operations and purpose are all about.

The following mission statements provide reasonably informative specifics about “who we are, what we do, and why we are here:”

n Trader Joe’s (a specialty grocery chain): “The mission of Trader Joe’s is to give our customers the best food and beverage values that they can find anywhere and to provide them with the information required for informed buying decisions. We provide these with a dedication to the highest quality of customer satisfaction delivered with a sense of warmth, friendliness, fun, individual pride, and company spirit.

n The American Red Cross: “To prevent and alleviate human suffering in the face of emergencies by mobilizing the power of volunteers and the generosity of donors.”

n eBay: “To provide a global trading platform where practically everyone can trade practically anything.”

n Harley-Davidson: “We fulfill dreams through the experience of motorcycling, by providing to motorcyclists and to the general public an expanding line of motorcycles and branded products and services in selected market segments.”

n Amazon.com: “To build a place where people can come to find and discover anything they might want to buy online.”

But some companies have used vague or imprecise wording in their mission statements, effectively obscuring the industry (or industries) in which they operate and the real substance of their business purpose. For instance, Microsoft’s mission statement—“to help people and businesses throughout the world realize their full potential”—reveals nothing about its products or business make-up and is so non-specific it could apply to thousands

The distinction between a strategic vision and a mission statement is fairly clear-cut: A strategic vision sets forth a company’s future direction (“where we are going”), whereas a company’s mission statement describes its present business scope and purpose (“who we are, what we do, and why we are here”).

To be well worded, a company mission statement must employ language specific enough to distinguish its business make-up and purpose from those of other enterprises and give the company its own identity.

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of companies in hundreds of industries. Similarly, Coca-Cola, which markets nearly 400 beverage brands in more than 200 countries, says that its mission is “To refresh the world…To inspire moments of optimism and happiness…To create value and make a difference.” But while this mission statement is “a bunch of nice words,” it fails to convey much of value about Coca-Cola’s business activities and purpose.

Occasionally, companies say their mission is to “make a profit.” This, too, is flawed. Profit is more correctly an objective and a result of what a company does. Moreover, earning a profit is the obvious intent of every commercial enterprise. Companies such as BMW, Netflix, Shell Oil, Procter & Gamble, Apple, and McDonald’s are each striving to earn a profit for shareholders; but plainly the fundamentals of their businesses are substantially different when it comes to “who we are and what we do.” It is management’s answer to “make a profit doing what and for whom?” that reveals the substance of a company’s mission and business purpose.

Linking the Strategic Vision and Mission with Company Values Many companies have developed a set of values to guide the actions and behavior of company personnel in conducting the company’s business and pursuing its strategic vision and mission. By values (or core values, as they are often called), we are talking about certain designated beliefs, traits, and ways of doing things—actions and behaviors that are widely viewed as “good” or “desirable” or maybe even “noble.” Values relate to such things as fair treatment, honor and integrity, ethical behavior, innovativeness, teamwork, accountability, a passion for top-notch quality or superior customer service, social responsibility, and community citizenship.

Values-conscious companies normally have four to eight core values that company personnel are expected to display and that are supposed to be mirrored in how the company conducts its business. At American Express, the core values are respect for people, customer commitment, integrity, teamwork, good citizenship, a will to win, and personal accountability. At Rackspace, a provider of server hosting and managed cloud computing services for some 300,000 businesses in some 120 countries, the core values are fanatical support in all we do, a commitment to greatness, full disclosure and transparency, a passion for our work, treatment of fellow Rackers like friends and family, and results first, substance over flash.4 Toyota preaches respect for, and the development of, its employees, teamwork, getting quality right the first time, learning, continuous improvement, and embracing change in its pursuit of low-cost, top-notch manufacturing excellence in motor vehicles.5

Do companies practice what they preach when it comes to their professed values? Sometimes yes, sometimes no—it runs the gamut. Quite a large number of companies have executives who are committed to grounding company operations on sound values and principled ways of doing business. Executives at these companies deliberately seek to infuse the company with the desired character, identity, and behavioral norms by ingraining the designated core values in the corporate culture—the core values thus become an integral part of the company’s DNA and what makes it tick. At such values-driven companies, executives “walk the talk” and company personnel are held accountable for displaying the stated values. At the other extreme are companies with window-dressing values; the professed values are given lip service by top executives but have little discernible impact on either how company personnel behave or how the company operates. Such companies have values statements because they are in vogue and are seen as making the company look good. And there are some companies (with or without window-dressing values) that in actuality have “bad” or unsavory values—such companies tolerate, maybe even condone, unethical behavior on the part of company personnel, engage in deliberately dishonest dealings with others, have willful disregard for employee safety, and/or flagrantly disregard rules and regulations against environmental pollution.

At companies where the stated values are real rather than cosmetic, managers connect values to the pursuit of the strategic vision and mission in one of two ways. In companies with longstanding values that are deeply entrenched in the corporate culture, senior managers are careful to craft a vision, a mission, a strategy, and a

CORE CONCEPT A company’s values or core values are the beliefs, traits, and behavioral norms that company personnel are expected to display in conducting the company’s business and pursuing its strategic vision and mission.

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set of operating practices that match established values, and they repeatedly emphasize how the values-based behavioral norms contribute to the company’s business success. If the company changes to a different vision or strategy, executives make a point of explaining how and why the core values continue to be relevant. Few companies with sincere commitment to established core values ever undertake strategic moves that conflict with ingrained values. In new companies or those with unspecified values, top management has to consider what values, behaviors, and business conduct should characterize the company and draft a values statement to circulate among managers and employees for discussion and possible modification. A final values statement that incorporates the desired behaviors and traits and connects to the vision/mission is then officially adopted. Some companies combine their strategic vision, mission, and values into a single statement or document, circulate it to all organization members, and in many instances post the vision/mission and values statement on the company’s website.

Task 2: Setting Objectives

The managerial purpose of setting objectives is to convert the strategic vision and mission into specific performance targets. Objectives represent a managerial commitment to achieving particular results and outcomes. Well-stated objectives must be specific, quantifiable or measurable, challenging, and contain a deadline for achievement. As Bill Hewlett, cofounder of Hewlett-Packard, shrewdly observed, “You cannot manage what you cannot measure... And what gets measured gets done.”6 Concrete, measurable, and challenging objectives are managerially valuable for three reasons: (1) they focus organizational attention on what to accomplish, (2) they serve as yardsticks for tracking company performance, and (3) they motivate organizational members to perform at a high level and deliver the best possible results. Indeed, the experiences of countless companies and managers teach that precisely spelling out how much of what kind of performance by when and then pressing forward with actions and incentives calculated to help achieve the targeted outcomes greatly improve a company’s actual performance.

The Imperative of Setting Challenging or Stretch Objectives The experiences of countless companies and managers teach that one of the best ways to promote outstanding company performance is for managers to deliberately set performance targets high enough to stretch an organization to perform at its full potential and deliver the best possible results.7 Challenging company personnel to go all out and deliver “stretch” gains in performance pushes an enterprise to be more inventive, to exhibit more urgency in improving both its financial performance and its business position, and to be more intentional and focused in its actions. Stretch objectives spur exceptional performance and help build a firewall against contentment with modest gains in organizational performance. As Mitchell Leibovitz, former CEO of the auto parts and service retailer Pep Boys, once said, “If you want to have ho-hum results, have ho-hum objectives.”

How Not to Handle the Task of Setting Objectives The following three approaches to objective-setting should be scrupulously avoided:

n Setting unspecific targets like “maximize profits,” “reduce costs,” “become more efficient,” or “increase revenues.” For instance, an objective to reduce costs is technically achieved if a company’s total costs go down by $100 or if unit costs fall by a fraction of a penny—neither outcome is likely to matter. Likewise, an objective to increase revenues is realized if total revenues climb by a trivial 1 percent by 2020. This is why setting stretch objectives and always specifying how much by when are important.

CORE CONCEPT Objectives are an organization’s performance targets—the results and outcomes management wants to achieve. They function as yardsticks for measuring how well the organization is doing.

There’s no better way to avoid ho-hum results than by setting stretch objectives and motivating organizational members to perform at full potential and deliver the best possible results.

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n Setting targets for the upcoming year that, if achieved, would represent only “average” performance (because the targets are slightly higher than the most recent year’s actual performance and can be reached with only minimal or modest effort). Objectives that promote or enable organizational coasting provide little or no managerial impetus for improved performance.

n Setting targets that carry no adverse consequences for organizational members if actual performance falls short of targeted performance. Organizational members understandably attach little importance to the objectives managers announce when it has been top management practice in times past to find excuses to justify weak performance (like blaming “outside forces beyond our control”), not hold any company personnel accountable for subpar outcomes, and award bonuses and compensation increases despite failure to achieve announced objectives. Objectives—even challenging ones—are incapable of motivating company personnel to exert their best efforts to achieve stretch performance targets if they can expect to receive bonuses and increased compensation even if the performance targets are not reached.

All three ways of handling the task of setting objectives undercut the drive for good performance.

What Kinds of Objectives to Set—The Need for a Balanced Scorecard Two distinct types of performance yardsticks are required: those relating to financial performance and those relating to strategic performance. Achieving acceptable financial results is a must. Without adequate profitability and financial strength, a company’s pursuit of its strategic vision, as well as its long-term health and ultimate survival, are jeopardized. Furthermore, subpar earnings and a weak balance sheet alarm shareholders and creditors and put the jobs of senior executives at risk. But good financial performance, by itself, is not enough. Of equal or greater importance is a company’s strategic performance—out comes that indicate whether a company’s market position and competitiveness are deteriorating, holding steady, or improving. Establishing and pursuing strategic objectives are important because a stronger market standing and greater competitive vitality—especially when accompanied by competitive advantage—is what enables and empowers a company to improve its financial performance.

Among some of the most common types of financial and strategic objectives are the following:

Financial Objectives Strategic Objectives

• An x percent increase in annual revenues • Annual increases in after-tax profits of x

percent • Annual increases in earnings per share of x percent • Annual dividend increases of x percent • Profit margins of x percent • An x percent return on capital employed (ROCE) or

return on shareholders’ equity investment (ROE) • Increased shareholder value—in the form of an

upward-trending stock price • Bond and credit ratings of x • Internal cash flows of x dollars to fund new capital

investment

• Winning an x percent market share • Achieving lower overall costs than rivals • Overtaking key competitors on product performance or

quality or customer service • Deriving x percent of revenues from the sale of new

products introduced within the past five years • Having broader or deeper technological capabilities

than rivals • Having a wider product line than rivals • Having a better-known or more powerful brand name

than rivals • Having stronger national or global sales and distribution

capabilities than rivals • Consistently getting new or improved products to

market ahead of rivals

CORE CONCEPT Financial objectives relate to the financial performance targets management have established for the organization to achieve. Strategic objectives relate to target outcomes that indicate a company is strengthening its market standing, competitive vitality, and future business prospects.

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Both Short-Term and Long-Term Objectives Are Needed A company’s set of financial and strategic objectives ought to include both near-term and longer-term performance targets. Having quarterly and annual objectives prompts managers to take actions that will deliver immediate performance improvements and satisfy shareholder expectations for near-term progress on a variety of fronts. Having objectives that are to be reached in three to five years forces managers to consider what to do now to put the company in position to perform better later. For example, a company that wants to grow its revenues by 20 percent in three years cannot wait until the end of the second year to begin its revenue growth initiatives. Moreover, it is generally in investors’ best interest for companies to be managed in a manner that produces sustained long-term performance. Managers who concentrate their energies on hitting next quarter’s (or the current year’s) targets and then on some day in the future worry about achieving long-term targets, frequently fail to do the very things today that it takes to grow the business and produce good performance year after year. The seeds for achieving long-term objectives typically must be planted in the near term rather than in the months before the long-term targets have to be reached. When trade-offs must be made between achieving long-run objectives and their short-run siblings, long- run objectives should take precedence (unless the achievement of one or more short-run performance targets have unique importance).

The Case for a Balanced Scorecard: Improved Strategic Performance Fosters Better Financial Performance A company’s financial performance measures are really lagging indicators that reflect the results of past decisions and organizational activities.8 But a company’s past or current financial performance is not a reliable indicator of its future prospects—poor financial performers often turn things around and do better, whereas good financial performers can fall upon hard times. The best and most reliable leading indicators of a company’s future financial performance and business prospects are strategic outcomes that indicate whether the company’s competitiveness and market position are stronger or weaker. For instance, if a company has set aggressive strategic objectives and is achieving them—such that its competitive strength and market position are on the rise—then there’s reason to expect that its future financial performance will be better than its current or past performance. If a company is losing ground to competitors and its market position is slipping—outcomes that reflect weak strategic performance (and, very likely, failure to achieve its strategic objectives)—then its ability to maintain its present profitability is highly suspect. Hence, the degree to which a company’s managers set, pursue, and achieve stretch strategic objectives tends to be a reliable leading indicator of whether its future financial performance will improve or stall.

Consequently, it is important to use a performance measurement system that strikes a balance between financial objectives and strategic objectives.9 Focusing only on how well a company is performing financially overlooks the fact that what ultimately enables and empowers a company to deliver better financial results from its operations is the achievement of strategic objectives that improve its competitiveness and market strength. Indeed, the surest path to boosting company profitability quarter after quarter and year after year is to relentlessly pursue strategic outcomes that strengthen the company’s market position and, ideally, produce a growing competitive advantage over rivals.

The most widely used framework for developing a linked set of strategic and financial objectives and tracking their achievement is known as the balanced scorecard. Since its origination in the 1990s, balanced scorecard methodology has evolved from just a performance measurement tool into a full strategic planning and management system that transforms an organization’s vision, mission, objectives, and strategy into daily “marching orders” for company personnel and organization units, thereby facilitating better strategy execution as well as stronger performance measurement.10 Surveys indicate that the balanced scorecard tool for measuring performance has been one of the top ten most used management tools for more than five years.11 In 2015, a Bain & Co. survey found about 40 percent of companies in the United States, Europe/ Middle East/Africa, and Latin America employed a balanced scorecard approach in measuring strategic and financial performance; many employed balanced scorecards in several different parts of their organization.12

CORE CONCEPT A balanced scorecard is a widely used method for combining the use of both strategic and financial objectives, tracking their achievement, and giving management a more complete and balanced view of how well an organization is performing.

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Users included IBM, Wells Fargo, Ford Motor, ExxonMobil, DuPont, Caterpillar, General Electric, Verizon, UPS, Duke University Hospital, Royal Canadian Mounted Police, UK Ministry of Defence, the U.S. Army Medical Command, and over 30 colleges and universities.13

Strategic Intent—The Relentless Pursuit of an Ambitious Long-Term Strategic Objective On occasion, companies decide to concentrate the full force of their resources and competitive actions on a long-term campaign to achieve some ambitious strategic outcome— like unseating the existing industry leader, becoming the dominant market share leader worldwide, delivering the best customer service of any company in the industry (or the world), or turning a new technology into products capable of changing the way people work and live. When a company launches aggressive initiatives over a sustained period to achieve a bold strategic outcome, it is clearly signaling strategic intent to be a winner in the marketplace, often against long odds.14

Nike’s strategic intent during the 1960s was to overtake Adidas (which connected nicely with Nike’s core purpose “to experience the emotion of competition, winning, and crushing competitors”). Also, in the 1960’s when Canon entered the market for copying equipment, its strategic intent was to “beat Xerox.” When Fox News Channel launched operations in 1996, its strategic intent was to overtake CNN, a feat it accomplished five years later—Fox News has been the number one cable news channel every year since 2001. Most recently, Honda achieved its long-standing strategic intent of producing an ultra-light jet when its unconventionally designed, fuel-efficient five-passenger “Civic of the Sky” mini-jet went into production in 2012—Honda first initiated the project to enter the jet aircraft market in the late 1980s.

Companies that establish exceptionally bold strategic objectives and have an unshakable—often obsessive— commitment to achieving them typically lack the immediate capabilities and market grasp to achieve their lofty target. But they rally the organization around efforts to make their strategic intents a reality. They go all out to marshal the resources and capabilities to close in on their strategic target (which is often global market leadership) as rapidly as they can. They craft potent offensive strategies calculated to throw rivals off-balance, put them on the defensive, and force them into an ongoing game of catch-up. They deliberately try to alter the market contest and tilt the rules for competing in their favor. As a consequence, capably managed, up-and- coming enterprises with strategic intents exceeding their present reach and resources are a force to be reckoned with, often proving to be more formidable competitors over time than larger cash-rich rivals that have modest strategic objectives and market ambitions.

Objective Setting Should Extend to All Organizational Levels Objective setting should not stop with top management’s establishing companywide performance targets. Company objectives need to be broken down into performance targets for each of the organization’s separate businesses, product lines, functional departments, and individual work units. Company performance cannot reach full potential unless each organizational unit sets and pursues performance targets that contribute directly to the desired companywide outcomes and results. Moreover, employees within specific departments and operating units are inspired and motivated better by specific objectives relating directly to their jobs and work units than by overall companywide performance targets. Objective setting is thus a top-down process that must extend to the lowest organizational levels. And it means that each organizational unit must take care to set performance targets that support—rather than hinder— the achievement of companywide targets.

The ideal situation is a team effort in which each organizational unit strives to produce results that contribute to the achievement of the company’s performance targets and strategic vision. Such consistency signals that organizational units know their strategic role and are on board in helping the company move down the chosen strategic path and produce the desired results.

CORE CONCEPT A company exhibits strategic intent when it relentlessly pursues an ambitious strategic objective, concentrating the full force of its resources and competitive actions on achieving that objective.

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Task 3: Crafting a Strategy

As indicated in Chapter 1, the task of stitching a strategy together entails addressing a series of hows: how to attract and please customers, how to compete against rivals, how to position the company in the marketplace vis-à-vis rivals, how best to pursue attractive opportunities to grow the business, how best to respond to changing economic and market conditions, how to manage each functional piece of the business, and how to achieve the company’s strategic and financial objectives. Astute entrepreneurship is called for in choosing among the various strategic alternatives and in proactively searching for opportunities to do new things or to do existing things in new or better ways.15 The faster a company’s business environment is changing, the more critical it becomes for strategy makers to be good entrepreneurs in diagnosing the direction and force of the changes under way and in responding with timely strategy adjustments. Strategy makers have to pay attention to early warnings of future change and be willing to experiment with dare-to-be-different ways to establish and solidify a market position in that future. When obstacles unexpectedly appear in a company’s path, it is up to management to adapt rapidly and innovatively. Masterful strategies come from doing things differently from competitors where it counts— out-innovating them, being more efficient, being more imaginative, adapting faster—rather than running with the herd. Good strategy making is therefore inseparable from good business entrepreneurship. One cannot exist without the other.

Crafting Strategy Involves Managers at All Organizational Levels A company’s top executives obviously have lead strategy-making roles and responsibilities. The chief executive officer (CEO), as captain of the ship, carries the mantles of chief direction setter, chief objective setter, chief strategy maker, and chief strategy implementer for the total enterprise. Ultimate responsibility for leading the strategy-making, strategy-executing process rests with the CEO. And the CEO is always fully accountable for the results the strategy produces, whether good or bad. In some enterprises, the CEO or owner functions as strategic visionary and chief architect of the strategy, personally deciding what the key elements of the company’s strategy will be, although the advice of key subordinates may be sought in fashioning an overall strategy and deciding on important strategic moves. A CEO-centered approach to strategy development is characteristic of small owner-managed companies and sometimes large corporations that have been founded by the present CEO or that have CEOs with strong strategic leadership skills. Steve Jobs at Apple, Reed Hastings at Netflix, Christine Whitman—first at eBay and now at Hewlett-Packard, Warren Buffet at Berkshire Hathaway, and Howard Schultz at Starbucks are examples of high-profile corporate CEOs who have had a very big strategy-making role.

In most corporations, however, strategy is the product of more than just the CEO’s handiwork. Typically, other senior executives—business unit heads, the chief financial officer, and vice presidents for production, marketing, human resources, and other functional departments have influential strategy-making roles and help fashion the chief strategy components. Normally, the head of each individual business of a diversified corporation has lead responsibility for the business unit she or he heads. A company’s chief financial officer typically has the lead role in devising and implementing an appropriate financial strategy for the whole company. In a single business corporation, the production vice president usually takes the lead in developing the company’s production strategy; the marketing vice president orchestrates sales and marketing strategy; a brand manager is in charge of the strategy for a particular brand in the company’s product lineup, and so on. Moreover, the strategy-making efforts of top executives are complemented by advice and counsel from the company’s board of directors and, normally, all major strategic decisions are submitted to the board of directors for review, discussion, perhaps modification, and official approval.

But strategy making is by no means solely a top management function, the exclusive province of owner- entrepreneurs, CEOs, high-ranking executives, and board members. The more a company’s operations cut across different products, industries, and geographical areas, the more that headquarters executives have little option but to delegate considerable strategy-making authority to down-the-line managers in charge of particular

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subsidiaries, divisions, product lines, geographic sales offices, distribution centers, and plants. On-the-scene managers who oversee specific operating units can be reliably counted upon to be intimately knowledgeable about market and competitive conditions, customer requirements and expectations, and all the problems, issues, and available strategic alternatives relating to the operating unit under their direct supervision. Managers with day-to-day familiarity of, and authority over, a specific operating unit thus have a big edge over headquarters executives in sizing up their operating unit’s situation and making wise strategic choices.

Take, for example, a company like General Electric, a $130 billion global corporation with 330,000 employees, operations in about 180 countries, and businesses that include jet engines, power generation, electric transmission and distribution equipment, renewable energy, oil and gas equipment, lighting, medical imaging and diagnostics equipment, locomotives, security devices, and financial services. While top-level headquarters executives may well be personally involved in shaping GE’s overall strategy and fashioning important strategic moves, it doesn’t follow that a few senior executives in GE’s headquarters have either the expertise or a sufficiently detailed understanding of all the relevant factors to wisely craft all the strategic initiatives taken for hundreds of subsidiaries and thousands of products. They simply cannot know enough about the situation in every GE organizational unit across the world to decide upon every strategy detail and direct every strategic move made in GE’s worldwide organization. Rather, it takes involvement on the part of GE’s whole management team— top executives, business group heads, the heads of specific business units and product categories, and key managers in plants, sales offices, and distribution centers—to craft the thousands of strategic initiatives that end up composing the whole of GE’s strategy.

The key point here is this. While managers further down in a company’s managerial hierarchy obviously have a narrower, more specific strategy-making role than managers closer to the top, the important understanding here is that in most of today’s companies crafting strategy is a collaborative team effort in which every company manager typically has a strategy-making role—ranging from minor to major—for the area he or she heads. Hence, any notion that an organization’s strategists are at the top of the management hierarchy and that midlevel and frontline personnel merely carry out the strategic directives of top executives should be cast aside. A valuable strength of collaborative strategy making is that the team of people charged with crafting the strategy can easily include the very people who will also be charged with implementing and executing it. Giving people an influential stake in crafting the strategy they must later help implement and execute not only builds motivation and commitment but also holds them accountable for putting the strategy into place and making it work—the oft-used excuse of “It wasn’t my idea to do this” won’t fly.

A Company’s Strategy-Making Hierarchy It thus follows that a company’s overall strategy is a collection of strategic initiatives and actions devised by managers (and sometimes key employees) up and down the whole organizational hierarchy. The larger and more diverse the operations of an enterprise, the more points of strategic initiative it will have and the more managers at different organizational levels will have a relevant strategy-making role. In diversified companies, where multiple and sometimes strikingly different businesses must be managed (at General Electric, for instance), crafting a full-fledged strategy involves four distinct types of strategic actions and initiatives, each undertaken at different levels of the organization and partially or wholly crafted by managers at different organizational levels, as shown in Figure 2.2.

The larger and more diverse the operations of an enterprise, the more points of strategic initiative it has and the more levels of management that have a significant strategy-making role.

CORE CONCEPT In most companies, crafting and executing strategy is a collaborative team effort where every manager has a role for the area he or she heads. It is flawed thinking to view crafting and executing strategy as something only high-level executives do.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 26

n Corporate strategy concerns strategy initiatives to establish business positions in different industries, whether to hold or divest existing businesses, strategic actions to boost the combined performance of the set of businesses the company has diversified into, and how to capture cross-business synergies and turn them into a competitive advantage. The CEO and other senior-level corporate executives have lead responsibility for devising corporate strategy. Major strategic decisions are usually reviewed and approved by the company’s board of directors. We will look deeper into the strategy-making process at diversified companies in Chapter 8.

Figure 2.2 A Company’s Strategy-Making Hierarchy

Orchestrated by the CEO and other senior executives

Orchestrated by the senior executives of each line of business, often with advice and input from the heads of functional area activities within each business and other key people.

Orchestrated by the heads of major functional activities within a particular business, often in collaboration with other key people.

Orchestrated by brand managers; the operating managers of plants, distribution centers, and geographic units; and the managers of strategically important activities like advertising and website operations, often in collaboration with other key people.

In the case of a single-business company, these two levels of the strategy-making pyramid merge into one level— business strategy— that is orchestrated by the company’s CEO and other top executives.

Corporate Strategy

The overall companywide game plan for managing a

set of businesses

Business Strategy (one for each business the

company has diversified into) • How to strengthen market

position and gain competitive advantage

Two-Way Influence

Functional Area Strategies within Each Business

• Add relevant detail to the hows of overall business strategy

• Provide a game plan for managing a particular activity in ways that support the overall business strategy

Operating Strategies within Each Business

• Add detail and completeness to business and functional strategy

• Provide a game plan for managing specific lower-echelon activities with strategic significance

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 27

n Business strategy consists of the actions and approaches being employed to produce successful performance in one specific line of business. The key focus is crafting responses to changing market circumstances and initiating actions to strengthen a business’s market position and competitiveness, build or widen competitive advantage, and improve the business’s financial performance. Most often, corporate-level executives delegate lead responsibility for developing business-level strategy to the executive they have put in charge of the business. However, corporate-level executives may well exert strong influence over various aspects of business-level strategy, and in diversified companies it is not unusual for corporate officers to insist that business-level objectives and strategy be compatible with and supportive of corporate-level objectives and strategy themes. The executive in charge of each business unit has at least two other strategy-related roles: (1) seeing that lower-level strategies are well conceived, consistent with each other, and appropriately suited to the overall business strategy, and (2) keeping corporate-level officers (and sometimes the board of directors) informed of emerging strategic issues. Typically, corporate executives review business-level strategy, and there may be occasions when certain major strategic initiatives to be taken at the business-level are reviewed and approved by the company’s board of directors.

n Functional-area strategies concern the actions, approaches, and practices employed in managing particular functions within a business—like production, new product development, sales and marketing, customer service, and finance. A business’s production strategy, for example, represents the managerial game plan for running the manufacturing and assembly part of the business. A new product development strategy concerns the game plan for keeping a business’s product lineup fresh and in tune with what buyers are looking for. Functional strategies flesh out the details of the overall business strategy. Lead responsibility for functional strategies is normally delegated to the heads of the respective functions, with the executive in charge of the business unit having final approval. Since it is always important for functional strategies to be tightly aligned with the overall business strategy, there are times when a business unit head intervenes to adjust one or more aspects of certain functional strategies in order to enhance the power and impact of the business unit’s overall strategy.

n Operating strategies concern the relatively narrow strategic initiatives and approaches for managing key operating units (plants, distribution centers, geographic units) and specific operating activities with strategic significance (quality control, advertising, brand-building efforts, supply chain activities, and website sales and operations). A plant manager needs a strategy for accomplishing the plant’s objectives, carrying out the plant’s part of the company’s overall manufacturing game plan, and dealing with any strategy-related problems that exist at the plant. A company’s advertising manager needs a strategy for getting maximum audience exposure and sales impact from the ad budget. Operating strategies, while of limited scope, add further detail and completeness to functional strategies and to the overall business strategy. Lead responsibility for operating strategies is usually delegated to frontline managers, subject to the review and approval of higher-ranking managers.

Even though operating strategy is at the bottom of the strategy-making hierarchy, its importance should not be downplayed. A major plant that fails in its strategy to achieve production volume, unit cost, and quality targets can undercut the achievement of company sales and profit objectives and wreak havoc with strategic efforts to build a quality image with customers. Frontline managers are thus an important part of an organization’s strategy-making team. One cannot reliably judge the strategic importance of a given action simply by the strategy level or location within the managerial hierarchy where it is initiated.

In single-business enterprises, the corporate and business levels of strategy making merge into one level— business strategy—because the strategy for the whole company involves only one distinct line of business. Thus, a single-business enterprise has three levels of strategy: business strategy for the entire company, functional- area strategies for each main area within the business, and operating strategies undertaken by lower-echelon managers to flesh out strategically significant aspects of the company’s business and functional-area strategies. Proprietorships, partnerships, and owner-managed enterprises may have only one or two strategy-making levels since it takes only a few key people to craft and oversee the firm’s strategy.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 28

Uniting the Strategy-Making Effort Ideally, the pieces of a company’s strategy up and down the strategy pyramid should be cohesive and mutually reinforcing, fitting together like a jigsaw puzzle. Anything less than a unified collection of strategies weakens the overall strategy and is likely to impair company performance.16 It is top executives’ responsibility to achieve this unity by clearly communicating the company’s vision, objectives, and major strategy components to down-the- line managers and key personnel. Midlevel and frontline managers cannot craft unified strategic moves without first understanding the company’s long-term direction and knowing the major components of the corporate and/or business strategies that their strategy-making efforts are supposed to support and enhance. Thus, as a general rule, strategy making must start at the top of the organization and proceed downward through the pyramid from the corporate level to the business level and then from the business level to the associated functional and operating levels.

Furthermore, once strategies up and down the hierarchy have been created, lower-level strategies must be scrutinized for consistency and support of higher-level strategies. Any strategy conflicts must be addressed and resolved, either by modifying the lower-level strategies with conflicting elements or by adapting the higher-level strategy to accommodate what may be more appealing strategy ideas and initiatives bubbling up from below.

A Strategic Vision + Mission + Objectives + Strategy = A Strategic Plan Developing a strategic vision and mission, setting objectives, and crafting a strategy are basic direction- setting tasks. They map out where a company is headed, delineate its strategic and financial performance targets, and outline the competitive moves and operating approaches to be used in achieving the desired business results. Together, they constitute a strategic plan for coping with economic and market conditions, competing against rivals, and making progress along the chosen strategic course.17 Typically a strategic plan includes a commitment to allocate resources to carrying out the plan and contains a deadline for achieving the targeted strategic and financial performance.

In companies that do regular strategy reviews and develop explicit strategic plans, the strategic plan usually ends up as a written document that is circulated to most managers and perhaps selected employees. Near-term performance targets are the part of the strategic plan most often communicated to managers and employees and spelled out explicitly. A number of companies summarize key elements of their strategic plans in the company’s annual report to shareholders, in postings on their website, or in statements provided to the business media; others, perhaps for reasons of competitive sensitivity, make only vague general statements about their strategic plans.18 In small privately owned companies it is rare for strategic plans to exist in written form. Small company strategic plans tend to reside in the thinking and directives of owners/executives; aspects of the plan are revealed in meetings and conversations with company personnel, and in the understandings and commitments among managers and key employees about where to head, what to accomplish, and how to proceed.

CORE CONCEPT A company’s strategy is at full power only when its many pieces are united.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 29

Task 4: Implementing and Executing the Strategy

Managing the implementation and execution of strategy is an operations-oriented make-things-happen activity aimed at performing core business activities in a strategy-supportive manner. It is easily the most demanding and time-consuming part of the strategy management process. Converting strategic plans into actions and results tests a manager’s ability to direct organizational change, motivate company personnel, build and strengthen company competencies and competitive capabilities, create and nurture a strategy-supportive work climate, and meet or beat performance targets. Initiatives to put the strategy in place and execute it proficiently must be launched and managed on many organizational fronts.

Management’s action agenda for implementing and executing the chosen strategy emerges from assessing what the company will have to do differently or better, given its particular operating practices and organizational circumstances, to execute the strategy competently and achieve the targeted financial and strategic performance. Each company manager has to think through the answer to “What needs to be done in my area to execute my piece of the strategic plan, and what actions should I take to get the process under way?” How much internal change is needed depends on how much of the strategy is new, how far internal practices and competencies deviate from what the strategy requires, and how well the present work climate/culture supports good strategy execution. Depending on the amount of internal change involved, full implementation and proficient execution of company strategy (or important new pieces thereof) can take several months to several years.

In most situations, managing the strategy execution process includes the following principal aspects:

n Staffing the organization with the needed skills and expertise, consciously building and strengthening strategy-supportive competencies and competitive capabilities, and organizing the work effort.

n Allocating ample resources to those activities critical to strategic success.

n Ensuring that policies and procedures facilitate rather than impede effective execution.

n Using the best-known practices to perform core business activities and pushing for continuous improvement. Organizational units must periodically reassess how things are being done and diligently pursue ways to do them better and cheaper.

n Installing information and operating systems that enable company personnel to better carry out their strategic roles day in and day out.

n Motivating people and tying rewards and incentives directly to the achievement of performance objectives.

n Creating a company culture and work climate conducive to successful strategy execution.

n Exerting the internal leadership needed to drive implementation forward and keep improving on how the strategy is being executed. When stumbling blocks or weaknesses are encountered, management must see that they are addressed and rectified on a timely basis.

Good strategy execution requires diligent pursuit of operating excellence. It is a job for a company’s whole management team. In addition, success hinges upon the skills and cooperation of operating managers who can push for needed changes in their organization units and consistently deliver good results. Management’s handling of the strategy implementation and execution process can be considered successful if things go smoothly enough that the company meets or beats its strategic and financial performance targets and shows good progress in achieving management’s strategic vision.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 30

Task 5: Evaluating Performance and Initiating Corrective Adjustments

The fifth component of the strategy management process—monitoring new external developments, evaluating the company’s progress, and making corrective adjustments—is the trigger point for deciding whether to continue or change the company’s vision and mission, objectives, strategy, and/or strategy execution methods.19 As long as the company’s direction and strategy seem well matched to industry and competitive conditions and performance targets are being met, company executives may decide to stay the course. Simply fine-tuning the strategic plan and continuing with efforts to improve strategy execution are sufficient.

But whenever a company encounters disruptive changes in its environment, questions need to be raised about the appropriateness of its direction and strategy and whether the time has arrived to retool the strategic vision, objectives, and strategy and come up with a new “going forward” strategic plan. Similarly, when a company experiences a disturbing downturn in its market position or persistent shortfalls in financial performance, its managers are obligated to ferret out the causes—do they relate to poor strategy, poor strategy execution, or both? —and take timely corrective action. A company’s direction, objectives, and strategy have to be revisited any time external or internal circumstances warrant—over time, revisions are to be expected.

Likewise, managers are obligated to assess which of the company’s operating methods and approaches to strategy execution merit continuation and which need improvement. Proficient strategy execution is always the product of much organizational learning. It is achieved unevenly—coming quickly in some areas and proving troublesome in others. Consequently, top-notch strategy execution requires a company’s management team to closely monitor each and every aspect of the strategy execution effort and proactively institute timely and effective adjustments that will move the company closer to operating excellence.

Corporate Governance: The Role of the Board of Directors in the Strategy-Making, Strategy-Executing Process

Although senior managers have lead responsibility in crafting and executing a company’s strategy, it is the duty of the board of directors to exercise strong oversight and see that top management performs all five strategy- making, strategy-executing tasks in a manner that is in the best interest of shareholders and other stakeholders.20 A company’s board of directors has four important obligations to fulfill:

1. Critically appraise the company’s direction, strategy, and business approaches. Board members must ask probing questions and draw on their business acumen to make independent judgments about whether strategy proposals have been adequately analyzed and whether proposed strategic actions appear to have greater promise than alternatives. If executive management is bringing well-supported and reasoned strategy proposals to the board, there’s little reason for board members to aggressively challenge and try to pick apart everything put before them. Asking incisive questions is usually sufficient to test whether the case for management’s proposals is compelling and to exercise vigilant oversight. However, when the company has a failing strategy or is plagued with internal operating miscues, and certainly when there is a precipitous collapse in profitability, this obligation of board members takes on heightened importance. In such circumstances, board members have a duty to be proactive, expressing their concerns about the validity of the strategy and/or operating methods, initiating debate about the company’s strategic

CORE CONCEPT A company’s vision, objectives, strategy, and approach to strategy execution are never final. Reviewing whether and when to make revisions is an ongoing process, not an every-now-and- then task.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 31

path, having one-on-one discussions with key executives and other board members, offering advice and guidance (sometimes quite forcefully), and, when circumstances require, directly intervening as a group to alter the company’s executive leadership and, ultimately, its strategy and business approaches.

2. Evaluate the caliber of senior executives’ strategy-making and strategy-executing skills. The board is always responsible for determining whether the current CEO is doing a good job of strategic leadership (as a basis for awarding salary increases and bonuses and deciding on retention or removal).21 Boards must also exercise due diligence in evaluating the strategic leadership skills of other senior executives in line to succeed the CEO. When the incumbent CEO steps down or leaves for a position elsewhere, the board must elect a successor, either going with an insider or deciding that an outsider is needed to perhaps radically change the company’s strategic course.

3. Institute a compensation plan for top executives that rewards them for actions and results that serve stakeholder interests, and most especially those of shareholders. A basic principle of corporate governance is that the owners of a corporation delegate operating authority and managerial control to a team of executives who are then compensated for their efforts on behalf of the owners. In their role as agents of shareholders, corporate managers have an unequivocal duty to make decisions and operate the company in accord with shareholder interests (but this does not mean disregarding the interests of other stakeholders—employees, suppliers, the communities in which they operate, and society at large). Most boards of directors have a compensation committee, composed entirely of directors from outside the company, to develop a salary and incentive compensation plan that rewards senior executives for boosting the company’s long-term performance and growing the economic value of the enterprise on behalf of shareholders; the compensation committee’s recommendations are presented to the full board for approval. But during the past 10 to 15 years, many boards of directors have done a poor job of ensuring that executive salary increases, bonuses, and stock option awards are tied tightly to performance measures that are truly in the long-term interests of shareholders. Rather, compensation packages at many companies have increasingly rewarded executives for short-term performance improvements—most notably, for achieving quarterly and annual earnings targets and boosting the stock price by specified percentages. This has had the perverse effect of causing company managers to become preoccupied with actions to improve a company’s near-term performance, often motivating them to take unprecedented and unwise business risks to boost short-term earnings by amounts sufficient to qualify for multimillion-dollar bonuses and stock option awards (that many see as obscenely large). The greater weight being placed on short-term performance improvements has worked against shareholders since, in many cases, the excessive risk-taking has proved damaging to long-term company performance: witness the huge loss of shareholder wealth that occurred at many financial institutions in 2008–2009 because of executive risk-taking in subprime loans, credit default swaps, and collateralized mortgage securities. As a consequence, the need to overhaul and reform executive compensation has become a hot topic in both public circles and corporate boardrooms.

4. Oversee the company’s financial accounting and financial reporting practices. While top executives, particularly the company’s CEO and CFO (chief financial officer), are primarily responsible for seeing that the company’s financial statements fairly and accurately report the results of the company’s operations, it is well established that a company’s board of directors is legally obligated to exercise diligent financial oversight and protect shareholders. This means closely monitoring the company’s financial practices, ensuring that generally acceptable accounting principles are properly used in preparing the company’s financial statements and that appropriate financial controls are in place to prevent fraud and misuse of funds. Virtually all boards of directors have an audit committee, always composed entirely of outside directors, that has lead responsibility for overseeing the accounting practices of the company’s financial officers and consulting with both internal and external auditors to ensure accurate financial reporting and adequate financial controls.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 32

Every corporation should have a strong independent board of directors that (1) is well informed about the company’s performance, (2) guides and judges the CEO and other top executives, (3) has the courage to curb management actions they believe are inappropriate or unduly risky, (4) certifies to shareholders that the CEO is doing what the board expects, (5) provides insight and advice to management, and (6) is intensely involved in debating the pros and cons of key decisions and actions.22 Boards of directors that lack the backbone to challenge a strong-willed or “imperial” CEO or that rubber-stamp most anything the CEO recommends without probing inquiry and debate (perhaps because the board is stacked with the CEO’s cronies) abdicate their fiduciary duty to represent and protect shareholder interests.

Key Points

The strategy-making, strategy-executing process consists of five interrelated and integrated tasks:

1. Developing a strategic vision, mission, and set of core values that provides long-term direction, infuses the organization with a sense of purposeful action, and communicates to stakeholders management’s aspirations for the company.

2. Setting objectives and using the targeted results as yardsticks for measuring the company’s performance. Objectives need to spell out how much of what kind of performance by when. A balanced scorecard that includes both financial objectives and strategic objectives is a common and effective approach for measuring company performance. Stretch objectives spur exceptional performance and help build a firewall against complacency and mediocre performance. A company exhibits strategic intent when it relentlessly pursues an ambitious strategic objective, concentrating the full force of its resources and competitive actions on achieving that objective.

3. Crafting a strategy to achieve the objectives and move the company along the strategic course that management has charted. The total strategy that emerges is a collection of strategic actions and business approaches initiated partly by senior company executives, partly by the heads of major business divisions, partly by functional-area managers, and partly by operating managers on the frontlines. A single business enterprise has three levels of strategy—business strategy for the company as a whole, functional-area strategies for each main area within the business, and operating strategies undertaken by lower-echelon managers. In diversified multibusiness companies, the strategy-making task involves four distinct types or levels of strategy: corporate strategy for the company as a whole, business strategy (one for each business the company has diversified into), functional-area strategies within each business, and operating strategies. Typically, the strategy-making task is more top-down than bottom-up, with higher- level strategies serving as the guide for developing lower-level strategies.

4. Implementing and executing the chosen strategy efficiently and effectively. Managing the implementation and execution of strategy is an operations-oriented, make-things-happen activity aimed at shaping the performance of core business activities in a strategy-supportive manner. Management’s handling of the strategy execution process can be considered successful if things go smoothly enough that the company meets or beats its strategic and financial performance targets and shows good progress in achieving management’s strategic vision.

CORE CONCEPT The whole fabric of effective corporate governance is undermined when boards of directors shirk their responsibility to maintain ultimate control over the company’s strategic direction, the major elements of its strategy, the business approaches management is using to implement and execute the strategy, executive compensation, and the financial reporting process.

Chapter 2 • Charting a Company’s Long-Term Direction: Vision, Mission, Objectives, and Strategy 33

5. Monitoring developments, evaluating performance, and initiating corrective adjustments in vision, long-term direction, objectives, strategy, or execution in light of actual experience, changing conditions, new ideas, and new opportunities. This is the trigger point for deciding whether to continue or change the company’s vision, objectives, strategy, and/or strategy execution methods.

The sum of a company’s strategic vision, mission, objectives, and strategy constitute a strategic plan.

Boards of directors have a duty to shareholders to play a vigilant role in overseeing management’s handling of a company’s strategy-making, strategy-executing process. A company’s board is obligated to (1) critically appraise the company’s direction, strategy, and business approaches; (2) evaluate the caliber of senior executives’ strategy-making and strategy-executing skills; (3) institute a compensation plan for top executives that rewards them for actions and results that serve stakeholder interests, most especially those of shareholders; and (4) oversee the company’s financial accounting and financial reporting practices.

Chapter 3 Evaluating a Company’s External Environment 34

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education, Burr Ridge, IL

Arthur A. Thompson, The University of Alabama 5th Edition, 2018-2019

CHAPTER 3

Evaluating a Company’s External Environment

Analysis is the critical starting point of strategic thinking. —Kenichi Ohmae, consultant and author

Things are always different—the art is figuring out which differences matter. —Laszlo Birinyi, investments manager

In essence, the job of a strategist is to understand and cope with competition. —Michael E. Porter, Harvard Business School professor

No matter what it takes, the goal of strategy is to beat the competition. —Kenichi Ohmae, consultant and author

In order for managers to act wisely in steering a company in a different direction or crafting a strategy, they must first have a deep understanding of the pertinent factors surrounding the company’s situation. Two facets of a company’s situation are especially relevant: (1) the industry and competitive environment in which the company operates and the forces acting to reshape this environment, and (2) the company’s own market position and competitiveness—its resources and capabilities, its strengths and weaknesses vis-à-vis rivals, and its windows of opportunity.

Insightful diagnosis of a company’s external and internal environment is a prerequisite for managers to succeed in crafting a strategy that is an excellent fit with the company’s situation, is capable of building a competitive advantage, and has good prospects for boosting company performance—the three criteria of a winning strategy. As depicted in Figure 3.1, the task of crafting a strategy begins with appraisals of the company’s external and internal environments (as a basis for deciding upon a long-term direction and developing a strategic vision), moves toward an evaluation of the most promising alternative strategies and business models, and culminates in choosing a specific strategy.

This chapter presents the concepts and analytical tools for zeroing in on those aspects of a single-business company’s external environment that should be considered in making strategic choices. Attention centers on broad aspects of the company’s “macro-environment,” the specific market arena in which the company operates, the drivers of market change, the market positions and likely actions of rival companies, and the factors that determine competitive success. In Chapter 4, we explore the methods of evaluating a company’s internal circumstances and competitive capabilities.

Chapter 3 • Evaluating a Company’s External Environment 35

Figure 3.1 From Thinking Strategically about the Company’s Situation to Choosing a Strategy

Form a strategic vision of

where the company

needs to head

Thinking strategically

about a company’s

external environment

Thinking strategically

about a company’s

internal environment

Identify promising strategic options for the

company

Select the best

strategy and

business model for

the company

The Strategically Relevant Factors Influencing a Company’s External Environment

Every company operates in a broad macro-environment shaped by influences relating to national and/or global economic conditions; political, legal, and regulatory factors; technological factors; sociocultural factors (societal values, lifestyles, and shifting population demographics); considerations relating to the natural environment; and, closer to home, the industry and competitive arena in which the company operates (see Figure 3.2). Strictly speaking, a company’s macro-environment includes all factors and influences outside the company’s boundaries that are strategically relevant enough to have a bearing on the decisions the company ultimately makes about its direction, objectives, strategy, and business model.

When new developments occur in the outer ring of the macro-environment with or without warning, the impact of their resulting influences on a company’s business can range from big to small and occur slowly or rapidly. It is typical for different industries—and often different companies within the same industry—to be affected in different ways and to different degrees. Moreover, even though there may be multiple signs that certain outer- ring macro-environmental factors are undergoing change, it is frequently difficult to quickly discern what the resulting influences will be and the size and nature of the impact these influences will have. But despite the difficulties, there can be no doubt that company managers need to keep a watchful eye on the macro-environment. It is an important managerial responsibility to scan the external environment for potentially important outer-ring developments, assess their impact and influence, and adapt the company’s direction and strategy as needed.

For example, when stringent new federal banking regulations pertaining to lending risk and lending requirements are announced and take effect, the affected banks must rapidly adapt their strategies and lending practices to be in compliance. Cigarette producers must adapt to anti-smoking ordinances, the decisions of governments to impose higher cigarette taxes, the cultural stigma attached to smoking, and newly-emerging e-cigarette technology. The homebuilding industry is affected by such macro-influences as trends in household incomes and buying power; rules and regulations that make it easier/harder for homebuyers to obtain mortgages; changes in mortgage interest rates; shifting preferences of families for renting versus owning a home; shifts in buyer preferences for homes

Chapter 3 • Evaluating a Company’s External Environment 36

of various sizes, styles, and price ranges; and changing preferences for particular kinds of home features—most homebuilders watch such developments and trends closely, making frequent adjustments in home sizes, styles, and features. Companies in the food processing industry must assess the impact and influence of changing consumer attitudes toward processed foods laden with chemical ingredients, growing consumer preferences for natural and organic foods, and heightened public concerns about nutrition, healthy-eating, and obesity/diabetes risks—and adapt their long-term direction, performance targets, business model, and strategies in ways they deem appropriate.

Table 3.1 provides brief descriptions of the five components in the outer ring of the macro-environment, along with examples of the industries or business situations they can affect.

However, the factors and forces in a company’s external environment having the biggest strategy-shaping impact typically pertain to the company’s own industry and competitive environment—these include industry growth, competitive pressures, anticipated actions of rivals, forces driving industry change, the key factors for future competitive success, and the industry’s outlook for profitability (as depicted in the inner ring of Figure 3.2). Consequently, the primary role of this chapter is to present a revealing discussion and analysis of the factors shaping a company’s industry and competitive environment.

Figure 3.2 The Components of a Company’s Macro-environment

Techno logic

al in flu

en ce

s Sociocultural forces (values, lifestyles,

shifting population demographics)

C on

si de

ra ta

io ns

re la

tin g

to th

na tu

ra l e

nv iro

nm en

Political, legal, and regulatory

influences

Co mp

an y’s

Imm ediat

e Industry and Competitive Environment

Ge neral

economic conditions

Factors affecting future

competitive success

The industry’s

profit outlook

Industry growth rate

Market demand-supply

conditions

Competitive pressures

Forces driving changes in the industry

The market positions and

likely actions of rival firms

COMPANY

Chapter 3 • Evaluating a Company’s External Environment 37

Table 3.1 The Five Outer-Ring Components of a Company’s Macro-Environment

Component Description General economic conditions

Concerns the general economic climate and such specifics as the rate of economic growth, trends in per capita income and discretionary income, the inflation rate, the unemployment rate, interest rates and the availability of credit, consumer confidence, exchange rates, trade deficits or surpluses, and conditions in the stock market, bond market, and the real estate market. Industries like steel, construction, and buildings materials benefit from big increases in government spending on infrastructure (roads, bridges, airports, hospitals, schools) and a booming economy that features construction of new manufacturing plants, commercial buildings, and apartment complexes. Discount retailers and budget-priced restaurants benefit when general economic conditions weaken, as consumers become more price conscious and careful about how much they spend.

Political, legal, and regulatory influences

Pertinent political, legal, and regulatory factors include (1) whether government officials are friendly or openly hostile to businesses; (2) whether the political climate is conducive to raising/lowering taxes or tougher/more lenient regulation or increasing/decreasing government spending; and whether government is using import tariffs and border adjustment taxes to protect domestic companies and from what is deemed as unfair trade agreements with foreign countries. The extent to which politicians are inclined to intervene in the economy and impose a host of burdensome laws and regulations on companies in certain industries and/or grant subsidies to companies/industries deemed worthy of special government support are often industry specific. Minimum wage legislation largely impacts low-wage industries that employ substantial numbers of relatively unskilled workers. Companies in coal-mining, meat-packing, and steel-making where many jobs are hazardous or carry high risk of injury are much more impacted by occupational safety regulations than are companies in retailing or software programming.

Technological influences

The most important technological factors concern the pace of technological change and so-called breakthrough technical innovations that have the potential for wide-ranging effects on society, such as genetic engineering, nanotechnology, and solar energy technology. Technological changes can spawn the birth of altogether new industries (Internet retailing, drones, smart phones, connected wearable devices), disrupt others (cloud computing, mobile payments, 3-D printing, big data solutions), and render others obsolete (film cameras, music CDs).

Sociocultural influences (values, lifestyles, and shifting population demographics)

Sociocultural forces concern the nature and range of values, attitudes, beliefs, cultural influences, and lifestyles that impact demand for particular goods and services, as well as demographic factors such as population size, growth rate, and age distribution. An example of sociocultural influences is the trend toward healthier lifestyles, which can shift spending toward exercise equipment and health clubs and away from snack foods. The demographic effect of people living longer lives is having a huge impact on the health care, recreation, travel, hospitality, and entertainment industries. Growing consumer preferences for healthy, less-calorific menu choices that include vegetarian and gluten-free selections, organic and pasture-fed meats, and organic and/or locally grown fruits and vegetables are prompting fine dining and other restaurants to adapt their menus, recipes, and cooking practices.

Considerations relating to the natural environment

The relevance of environmental considerations stems from the fact that some industries contribute more significantly than others to air and/or water pollution or to the depletion of irreplaceable natural resources, or to inefficient energy/resource usage, or are closely associated with other types of environmentally damaging activities (unsustainable agricultural practices, the creation of waste products that are not recyclable or biodegradable). Growing numbers of companies worldwide, in response to stricter environmental regulations and also to mounting public concerns about the environment, are implementing actions to operate in a more environmentally and ecologically responsible manner.

Chapter 3 • Evaluating a Company’s External Environment 38

Assessing a Company’s Industry and Competitive Environment

To gain deep understanding of a company’s industry and competitive environment, managers do not need to gather all the information they can find and spend lots of time digesting it. Rather, the task can be focused on using some well-defined concepts and analytical tools to get clear answers to six questions:

1. What competitive forces do industry members face, and how strong are they?

2. What forces are driving changes in the industry, and what impact will these changes have on competitive intensity and industry profitability?

3. What market positions do industry rivals occupy—who is strongly positioned and who is not?

4. What strategic moves are rivals likely to make next?

5. What are the key factors for future competitive success?

6. Is the industry outlook conducive to good profitability?

Analysis-based answers to these questions provide managers with essential understanding needed to craft a strategy that fits the company’s external situation. The remainder of this chapter is devoted to describing the methods of obtaining solid answers to these six questions and explaining how the nature of a company’s industry and competitive environment has direct bearing on company managers’ strategic choices.

Question 1: What Competitive Forces Do Industry Members Face and How Strong Are They?

The character, mix, and subtleties of the competitive forces operating in a company’s industry are never the same from one industry to another. The most powerful and widely used tool for systematically diagnosing the principal competitive pressures in a market and assessing the strength and importance of each is the five forces model of competition.1 This model, depicted in Figure 3.3, holds that the state of competition in an industry is a composite of five competitive forces:

1. The market maneuvering and jockeying for buyer patronage among rival sellers in the industry.

2. The threat of new entrants into the market.

3. The attempts of companies in other industries to win buyers over to their own substitute products.

4. The exercise of supplier bargaining power.

5. The exercise of buyer (or customer) bargaining power.

Using the five forces model to determine the nature and strength of competitive pressures in a given industry involves building the picture of competition in three steps:

n Step 1: Identify the specific competitive pressures associated with each of the five forces.

n Step 2: Evaluate how strong the pressures comprising each of the five forces are (fierce, strong, moderate to normal, or weak).

n Step 3: Determine whether the collective strength of the five competitive forces across the industry/ market is conducive to earning attractive profits.

Chapter 3 • Evaluating a Company’s External Environment 39

Figure 3.3 The Five Forces Model of Competition: A Key Analytical Tool

Firms in Other Industries O�ering

Substitute Products

Suppliers of Raw Materials,

Parts, Components,

or Other Resources

Inputs

Rivalry among Competing Sellers Competitive pressures

created by the maneuvers of rival

sellers to win increased sales and market share

and build/strengthen competitive advantage

Competitive pressures coming from the market attempts of outsiders to

win buyers over to their products

Competitive pressures stemming

from supplier bargaining

power

Buyers

Competitive pressures stemming

from buyer

bargaining power

Potential New Entrants

Competitive pressures coming from the threat of entry of new rivals

Source: Adapted from Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review 57, no. 2 (March–April 1979), pp. 137–145; Michael E. Porter, “The Five Competitive Forces that Shape Strategy,” Harvard Business Review 86, no. 1 (January 2008), pp. 80–86.

Competitive Pressures Created by the Rivalry among Competing Sellers The strongest of the five competitive forces is nearly always the market maneuvering for buyer patronage that goes on among rival sellers of a product or service. In effect, a market is a competitive battlefield where the contest among competitors is ongoing and dynamic. Each competing company endeavors to deploy whatever means in its business arsenal it believes will attract and retain buyers, strengthen its market position, and yield good profits. The challenge is to craft a competitive strategy that, at the very least, allows a company to hold its own against rivals and that, ideally, produces a competitive edge over many, if not all, rivals. But when one industry competitor deploys a strategy or makes a new strategic move that produces good results, its rivals typically respond with offensive or defensive countermoves of their own. This pattern of action and reaction, move and countermove,

CORE CONCEPT Competitive maneuvering among industry rivals is ever changing, as competing sellers initiate round after round of offensive and defensive moves, emphasizing first one mix of competitive weapons and then another in efforts to improve their market positions and profitability.

Chapter 3 • Evaluating a Company’s External Environment 40

adjust and readjust produces a continually evolving competitive landscape where the market battle ebbs and flows, sometimes takes unpredictable twists and turns, and produces winners and losers. But the winners—the current market leaders—have no guarantees of continued leadership; their market success is no more durable than the power of their latest strategies to fend off the latest strategies of ambitious challengers. In every industry, the ongoing jockeying of rivals leads to some companies gaining or losing momentum in the marketplace based on the success or failure of their latest strategic maneuvers.2

Figure 3.4 shows the competitive weapons that firms often employ in battling rivals and indicates the factors that influence the intensity of their rivalry. A brief discussion of the factors that influence the tempo of rivalry among industry competitors is in order:3

n Rivalry intensifies when competing sellers are active in launching fresh actions to boost their market standing and business performance; conversely, rivalry is weaker when competing sellers seldom make aggressive moves to boost their sales/market shares by taking customers and sales away from rivals. One indicator of active rivalry is lively price competition, a condition that puts pressure on industry members to drive costs out of the business and threatens the survival of high-cost companies. Another indicator of active rivalry is rapid introduction of next-generation products—when one or more rivals frequently introduce new or improved products, competitors that lack good product innovation capabilities feel considerable competitive heat to get their own new and improved products into the marketplace quickly. Other indicators of active rivalry among industry members include:

 Whether several/many industry members are racing to differentiate their products from rivals by offering better performance features, higher quality, improved customer service, or a wider product selection.

 How frequently some/many rivals resort to such marketing tactics as special sales promotions, heavy advertising, rebates, or low-interest-rate financing to drum up additional sales.

 How actively some/many industry members are pursuing efforts to build stronger dealer networks or expand their presence in foreign markets or otherwise expand their distribution capabilities.

 How hard one or more companies are striving to gain a market edge over rivals by developing valuable expertise and capabilities that rivals are hard-pressed to match.

Normally, competitive maneuvering among rival sellers is active because every competitor has a strong incentive to initiate fresh actions that hold promise for boosting its profitability and market standing.

n Rivalry is usually weaker when buyer demand is growing rapidly, and stronger when buyer demand is growing slowly or even falling. Rapidly expanding buyer demand produces enough new business for all industry members to grow without resorting to aggressive efforts to steal sales from rivals. But in markets where growth is only 1 to 2 percent or certainly when buyer demand is shrinking, companies anxious (or perhaps desperate) to gain more business are prone to initiate aggressive price discounting, sales promotions, or other tactics to boost their sales volumes at the expense of rivals. Aggressive moves to draw customers away from rivals always heighten competitive pressures and can often ignite a fierce industrywide battle for market share.

n Rivalry increases as it becomes less costly for buyers to switch brands and decreases as buyers’ costs to switch brands become more expensive or otherwise troublesome. The less costly it is for buyers to switch their purchases from the seller of one brand to the seller of another brand, the easier it is for sellers to steal customers away from rivals. But the higher the costs buyers incur to switch brands, the less prone they are to brand switching. Even if consumers view one or more rival brands as more attractive, they may not be inclined to switch because of the added time and inconvenience that may be involved or the psychological costs of abandoning a familiar brand. Distributors and retailers may not switch to the brands of rival manufacturers because they are hesitant to sever longstanding supplier relationships, incur any technical support costs or retraining expenses in making the switchover, go to the trouble of testing the quality and

Chapter 3 • Evaluating a Company’s External Environment 41

reliability of the rival brand, or devote resources to marketing the new brand (especially if the brand is lesser known). Consequently, unless buyers are dissatisfied with the brand they are presently purchasing, high switching costs weaken the rivalry among competing sellers.

n Rivalry increases as the products of rival sellers become less differentiated and weakens as the products of industry rivals become more strongly differentiated. When the offerings of rivals are identical or weakly differentiated (because the brands of different sellers have comparable attributes), buyers have less reason to be brand loyal—when one brand is mostly like another, buyers can shop the market for the best deal and switch brands at will. On the other hand, strongly differentiated product offerings among rivals breed high brand loyalty—because many buyers are attached to the attributes of their preferred brand as opposed to the attributes of rival brands. Strong brand attachments make it tougher for sellers to draw customers away from rivals. Unless meaningful numbers of buyers are open to considering whatever new or different product attributes rivals are offering, the high degrees of brand loyalty that accompany strong product differentiation work against fierce rivalry among competing sellers. The degree of product differentiation also affects switching costs. When rivals’ offerings are identical or weakly differentiated, it is usually easy and inexpensive for buyers to switch their purchases from one rival to another. Strongly differentiated products raise the probability that buyers will find it costly, inconvenient, or annoying to switch to brands with different and potentially less satisfying features.

n Rivalry is more intense when industry members have too much inventory or significant amounts of idle production capacity, especially if the industry’s product entails high storage costs or high fixed costs. Competitive pressures among rival sellers build quickly whenever a market is oversupplied (because many rivals have excessive inventories and/or industry-wide production capacity significantly exceeds market demand for the product). Efforts on the part of sellers to rid themselves of unwanted inventories or find ways to use idle production capacity creates a “buyer’s market” that not only prompts rival sellers to pursue various volume-boosting sales tactics (for example, price discounts, extra advertising, rebates, and favorable credit terms) but also empowers buyers to insist on a lower price and other favorable purchase terms or else take their business elsewhere—all of which intensifies rivalry. And if fixed costs account for a large fraction of total cost, industry members with significant amounts of idle production capacity (which raises fixed costs per unit sold and squeezes profit margins) are pressured by eroding profitability to cut prices and/or institute other volume-boosting competitive tactics—so as to spread the burdensome total fixed costs over a bigger unit sales volume, lower overall cost per unit sold, and therefore improve profit margins.

n Rivalry tends to be more intense when a product is costly to hold in inventory, perishable, or seasonal. This is because industry rivals have potent incentives to employ volume-boosting tactics to avoid high inventory storage costs, to rid themselves of perishable items before they spoil, and to clear out seasonal items before the end of the selling season.

n Rivalry usually becomes more intense as competitors become more equal in size and capability, and as the number of competitors increases. When rivals are of comparable size and competitive strength, they can usually compete on a fairly equal footing—an evenly matched contest tends to be fiercer than where one or more industry members have commanding market shares and substantially greater resources and capabilities than their much smaller rivals. A bigger number of competitors typically strengthens rivalry because the presence of more sellers raises the likelihood that fresh, creative strategic initiatives will be launched rather frequently, thereby prompting countermoves by rivals and precipitating a livelier market contest than might otherwise occur. However, as the number of competitors in the marketplace becomes progressively larger— so that big sales and market share gains flowing from successful strategic moves by any one company ripple out to have little discernible impact on the businesses of its many rivals—head-to-head rivalry becomes weaker. Why? Because in an industry with a large number of rivals (say, more than 20 or 30), each rival soon learns that the actions of a single rival to boost its sales and improve its market position has minimal effect on its own business—the absence of an imperative to respond to the moves of each rival weakens the intensity of head-to-head battles for market share. Furthermore, rivalry tends to grow weaker as the number of industry members declines from 5 to 4 to 3 to just 2. This is because in a market with few

Chapter 3 • Evaluating a Company’s External Environment 42

rivals, each competitor soon learns that an offensive to grow its sales and market share will be viewed by rivals as a hostile move to steal their customers. Actions that have an immediate adverse impact on rivals’ sales and profits will almost certainly provoke vigorous retaliation, potentially triggering a ferocious and costly competitive battle. Companies that have only a few strong rivals thus come to understand the merits of restrained efforts to wrest sales and market share from competitors as opposed to undertaking hard- hitting offensives that escalate into a price war or that force industry members to sharply increase their expenditures for advertising, sales promotions, and other inducements to secure and retain customers. Deep price discounting and a marketing arms race nearly always erode the profits of every industry participant.

n Rivalry increases when one or more competitors become dissatisfied with their sales volumes and launch offensives to steal business away from rivals. Firms in financial trouble or desperate for more customers often employ sales-boosting turnaround strategies that intensify rivalry. Aggressive rivals seeking to be a market leader or simply gain a bigger market share frequently initiate strategic offensives that turn competitive pressures up a notch. On occasion, rivalry intensifies because one or two industry members achieve game- changing technological breakthroughs and/or develop innovative new products that prove wildly popular, enabling them to capture significantly bigger sales volumes and market shares. In such cases, industry members that unexpectedly begin to lose many customers must scramble quickly to stay in the game; they either have to launch effective counterstrategies or become also-rans.

n Rivalry increases when strong companies outside the industry acquire weak firms in the industry and launch aggressive, well-funded moves to transform their newly acquired competitors into major market contenders. A concerted effort to turn a weak rival into a market leader nearly always entails launching well-financed strategic initiatives to dramatically improve the competitor’s product offering, excite buyer interest, and win a much bigger market share. Such actions quickly catch the attention of all industry participants and, should such actions of the aggressor prove successful, prompts them to counter with fresh strategic offensive and defensive moves of their own.

n Rivalry often becomes more intense—as well as more volatile and unpredictable—when competitors have diverse views about where the industry is headed and/or have sharply differing long-term directions, objectives, strategies, and resource capabilities and/or have production facilities in different countries with different production costs. In industries where future market conditions are murky or fast changing, differing views of rivals about where the industry is headed and the resulting differing views about how best to attract and retain customers typically sparks a spirited competitive battle for sales and market share. In globally competitive markets, attempts by cross-border rivals to gain stronger footholds in each other’s domestic markets typically boost the intensity of rivalry, especially when the aggressors have lower costs or products with more attractive features. Furthermore, a diverse group of sellers often contains one or more mavericks willing to try novel, high-risk, or rule-breaking market approaches, thus generating a livelier competitive environment that can produce surprising twists and turns.

The above factors, taken as whole, determine how strong this competitive force is. Rivalry can be characterized as cutthroat or brutal when competitors engage in protracted price wars or regularly undertake other aggressive strategic moves that prove mutually destructive to profitability and inflict losses on most industry members. Rivalry can be considered fierce to strong when the battle for sales and market share is so vigorous that profit margins are eroded and industry profitability drops to unattractively low levels. Rivalry is moderate or normal when the maneuvering among industry members, while lively and healthy, still allows most industry members to earn acceptable profits. Rivalry is weak when most companies in the industry are relatively well satisfied with their sales growth and market shares, rarely undertake offensives to steal customers away from one another, and—because of weak cross-company competition—earn consistently good profits and returns on investment.

Chapter 3 • Evaluating a Company’s External Environment 43

Figure 3.4 The “Weapons” That Can Be Used to Battle Rivals and the Factors Affecting the Strength of Rivalry

Rivalry is generally stronger when: • Competing sellers are active in making fresh moves to improve

their market standing and business performance. • Buyer demand is growing slowly. • Buyers incur low costs in switching to rival brands. • The products of rival sellers are essentially identical or else weakly

differentiated, resulting in little or no buyer brand loyalty. • Sellers have idle capacity and/or excess inventory. • The industry’s product is costly to hold in inventory, perishable, or

seasonal. • The number of rivals increases and/or rivals are of roughly equal

size and competitive capability. • One or more rivals are dissatisfied with their business performance

and are making aggressive moves to attract more customers. • Outsiders have recently acquired weak competitors and are

spending heavily to turn them into major contenders. • Rivals have diverse industry outlooks, objectives, or strategies

and/or have production facilities in countries where production costs are materially different.

Rivalry is generally weaker when: • Industry members infrequently launch aggressive actions to take

sales and market share away from rivals. • Buyer demand is growing rapidly. • Buyer costs to switch to rival brands are high. • The products of rival sellers are strongly differentiated and the

loyalty of buyers to their preferred brand is high. • There are so many rivals that any one company’s actions have

little direct impact on the businesses of rivals. • Sellers have small inventories and/or little idle capacity. • Rivals have low fixed costs and low inventory storage costs. • A few large sellers have the majority of sales and dominant

market shares. • Rivals have similar costs and similar industry outlooks—there are

no industry mavericks to disrupt the status quo.

Rivalry among Competing Sellers

How strong are the competitive pressures

stemming from the maneuvers of rivals to win higher sales and market shares

and build/strengthen competitive advantages?

Typical “Weapons” for Battling Rivals and Attracting Buyers • Reducing price; granting discounts to win the

business of particular buyers • Introducing more or different features • Innovating to improve product performance

and quality • Running ads to inform buyers of new or

special features and/or to strengthen brand awareness and brand image

• Having periodic sales promotions, holding clearance sales, advertising items on sale

• Improving selection of models/styles

• Building a bigger/better dealer network • Offering low interest rate financing • Offering coupons • Improving customer service • Allowing buyers to customize what they

purchase • Improving warranties • Providing quicker or cheaper delivery • Developing competitively valuable

capabilities rivals don’t have

Chapter 3 • Evaluating a Company’s External Environment 44

Competitive Pressures Associated with the Threat of New Entrants A looming threat that outsiders will enter an industry intensifies the competitive pressures on existing industry members. New entry threatens the positions of current industry participants. Newcomers give buyers an additional choice of which brands to purchase, add to the industry’s supply capabilities in the case of manufacturers, and expand the number of head-to-head rivals. New entrants can be expected to compete aggressively to gain a market foothold and then further expand their customer base, oftentimes taking sales and market share away from current industry members. Financially-strong newcomers with either proven competitive capabilities (or the ability to acquire them) may well evolve into formidable competitors. of competitive pressure on current industry members. To counter credible threats of entry, some/many industry members may decide to initiate defensive strategies (like announcing selective price cuts, boosting advertising, announcing intentions to accelerate new product introductions, and so on) to deter new entry and signal their intent to make it harder for new entrants to be competitively successful.

Just how serious the threat of entry is in a particular market depends on (1) whether entry barriers are high or low, (2) the expected reaction of existing industry members to the entry of newcomers, and (3) the size of the pool of likely entry candidates and the degree to which they have the resources to become formidable competitors (see Figure 3.5).

Figure 3.5 Factors Affecting the Threat of Entry

Entry threats are stronger when: • Entry barriers are low or can be readily hurdled by entry candidates

with adequate resources. • Potential entrants do not expect that industry members are likely or

able to strongly contest the entry of newcomers. • The pool of entry candidates is large and some have adequate

resources to overcome entry barriers and combat defensive actions of existing industry members.

• Existing industry members are looking to expand their market reach by entering product segments or geographic areas where they currently do not have a presence.

• Buyer demand is growing rapidly. • Newcomers can expect to earn attractive profits.

Entry threats are weaker when: • Entry barriers are high. • Entry candidates expect that industry members will strongly contest

the efforts of newcomers to gain a market foothold. • The pool of entry candidates is small. • Buyer demand is growing slowly or is stagnant. • The industry’s outlook is risky or uncertain or offers limited profit

opportunities for newcomers. • Industry conditions often cause existing competitors to struggle to

earn a decent profit.

Rivalry among

Competing Sellers

How strong are the competitive pressures

associated with the entry threat from new rivals?

Potential New

Entrants

Chapter 3 • Evaluating a Company’s External Environment 45

Whether Entry Barriers Are High or Low The strength of the threat of entry is governed to a large degree by whether potential new entrants face high or low entry barriers. High barriers reduce the threat of potential entry, whereas low barriers enable easier entry. The most widely encountered barriers that entry candidates must hurdle include:4

n The cost advantages enjoyed by industry incumbents. Existing industry members frequently have been able to reduce unit costs to levels that are hard for a newcomer to replicate. The cost advantages of industry incumbents can stem from (1) scale economies in production, distribution, or other activities, (2) the learning-based cost savings that accrue from experience in performing certain activities such as manufacturing or new product development or inventory management, (3) cost-savings accruing from patents or proprietary technology, (4) partnerships with the best and cheapest suppliers of raw materials and components, (5) favorable locations, and (6) low fixed costs (because they have older facilities that have been mostly depreciated). The bigger the cost advantages of industry incumbents, the riskier it becomes for outsiders to attempt entry (since they will have to accept thinner profit margins or even losses until the cost disadvantages can be overcome).

n Strong brand preferences and high degrees of customer loyalty. The stronger the attachments of buyers to established brands, the harder it is for a newcomer to break into the marketplace. In such cases, a new entrant must have the financial resources to spend enough on advertising and sales promotion to overcome customer loyalties and build its own clientele. Establishing brand recognition and building customer loyalty can be a slow and costly process. In addition, if it is difficult or costly for a customer to switch to a new brand, a new entrant must persuade buyers that its brand is worth the switching costs. To overcome switching-cost barriers, new entrants may have to offer buyers a discounted price or an extra margin of quality or service. All this can mean lower expected profit margins for new entrants, which increases the risk to startup companies who are dependent on sizable early profits to support their new investments.

n High capital requirements. The larger the total dollar investment needed to enter the market successfully, the more limited the pool of potential entrants. The most obvious capital requirements for new entrants relate to manufacturing facilities and equipment, introductory advertising and sales promotion campaigns, working capital to finance inventories and customer credit, and sufficient cash to cover all kinds of startup cost that must be paid before sizable revenues begin to materialize.

n The difficulties of building a network of distributors or retailers and securing adequate space on retailers’ shelves. A potential entrant can face numerous distribution channel challenges. Wholesale distributors may be reluctant to take on a product that lacks buyer recognition. Retail dealers must be recruited and convinced to give a new brand ample display space and an adequate trial period. When existing sellers have strong, well-functioning distributor–dealer networks, a newcomer has an uphill struggle in squeezing its way into existing distribution channels. Potential entrants sometimes have to “buy” their way into wholesale or retail channels by cutting their prices to provide dealers and distributors with higher markups and profit margins, or by giving them big advertising and promotional allowances. As a consequence, a potential entrant’s profits may be squeezed unless and until its product gains enough consumer acceptance that distributors and retailers are anxious to carry it.

n Restrictive or costly regulatory policies. Government agencies can limit or even bar entry by requiring licenses and permits. Regulated industries like cable TV, telecommunications, electric and gas utilities, radio and television broadcasting, liquor retailing, and railroads entail government-controlled entry. In international markets, host governments commonly limit foreign entry and must approve all foreign investment applications. Government-mandated safety regulations and environmental pollution standards are entry barriers because they raise entry costs. Recently-enacted banking regulations in many countries have made entry particularly difficult for small new bank startups—complying with all the new regulations along with the various rigors of competing against existing banks requires very deep pockets.

Chapter 3 • Evaluating a Company’s External Environment 46

n Tariffs and international trade restrictions. National governments commonly use tariffs and various kinds of burdensome trade restrictions to raise entry barriers for foreign firms and protect domestic producers from outside competition.

Whether an industry’s entry barriers ought to be considered high or low depends on the resources and competencies possessed by potential entrants. Small startup enterprises may find the prevailing entry barriers insurmountable. However, current industry participants looking to expand their market reach by entering new segments or geographic areas where they currently have no market presence normally have the resources to overcome the existing entry barriers without much difficulty. Likewise, outsiders with sizable financial resources, proven competitive capabilities, and a recognized brand name may be able to hurdle an industry’s entry barriers rather easily. For example, when Honda opted to enter the U.S. lawnmower market in competition against Toro, Snapper, Craftsman, John Deere, and others, it was easily able to hurdle entry barriers that would have been formidable to other newcomers because it had longstanding expertise in gasoline engines, and its well-known reputation for quality and durability in automobiles gave it instant credibility with homeowners. Honda had to spend relatively little on advertising to attract buyers and gain a market foothold. Distributors and dealers were quite willing to handle the Honda lawnmower line, and Honda had ample capital to build a U.S. assembly plant. Similarly, Samsung’s brand reputation in televisions, DVD players, and other electronics products gave it strong credibility in entering the market for smart phones—Samsung’s Galaxy smartphones are now a formidable rival of Apple’s iPhone.

However, it is important to understand that the barriers to entering an industry can become stronger or weaker over time. Changing industry circumstances can cause one or more entry barriers to become easier to hurdle (maybe even disappear) or harder to hurdle, thus raising or lowering the threat of entry. For example, in the pharmaceutical industry the expiration of a key patent on a widely-prescribed drug greatly lowers an important entry barrier and virtually guarantees that one or more drug makers will enter with generic offerings of their own. When companies win new patents on their technological discoveries or develop proprietary low-cost production techniques, entry barriers rise significantly. Regulatory changes can raise entry barriers when new regulations impose significant cost and compliance burdens on industry members and lower entry barriers when rules and regulations become more relaxed.

The Expected Reaction of Industry Members in Defending against New Entry A second factor affecting the threat of entry relates to the ability and willingness of industry incumbents to launch strong defensive maneuvers to maintain their positions and make it harder for a newcomer to compete successfully and profitably. Entry candidates may have second thoughts about attempting entry if they conclude that existing firms will mount well-funded campaigns to hamper (or even defeat) a newcomer’s strategy to gain a market foothold big enough to compete successfully; such campaigns can include reducing prices, offering special price discounts to the very customers a newcomer is seeking to attract, stepping up advertising expenditures, running frequent sales promotions, adding attractive new product features (to match or beat the newcomer’s product offering), increasing spending on R&D to speed the introduction of new and improved products, or providing additional services to customers. Strong expectations on the part of new entrants that some or many important industry incumbents will strongly contest a newcomer’s entry raise a new entrant’s costs and risks, perhaps by enough to dissuade some/many entry candidates from going forward. Microsoft can be counted on to fiercely defend the position that Windows enjoys in computer operating systems and that Microsoft Office has in office productivity software. The world’s leading motor vehicle producers (General Motors, Ford, BMW, Volkswagen, Toyota, Daimler Benz, and others) are mounting strong defensive actions to contest the strategic intent and strategic actions of newcomer Tesla Motors to sell 500,000 battery-powered Tesla vehicles by 2021.

However, there are occasions when industry incumbents have nothing in their competitive arsenal that is formidable enough to either discourage entry or put obstacles in a newcomer’s path that will defeat its strategic efforts to become a viable competitor. In the restaurant industry, for example, existing restaurants in a given geographic market have few actions they can take to discourage a new restaurant from opening or to block it from attracting enough patrons to be profitable. A fierce competitor like Nike has not prevented newcomer Under

Chapter 3 • Evaluating a Company’s External Environment 47

Armour from rapidly growing its sales and market share in sports apparel. Amazon.com, despite its competitively formidable size, attractively low prices, wide selection, fast delivery, and well-regarded reputation, lacks the ability to prevent other online retailers whose merchandise lineups include items comparable to items found on Amazon’s website from building a profitable customer base—rather, the number of online retailers is growing and the sales of all kinds of online retailers are exploding.

Furthermore, there are occasions when industry incumbents can be expected to refrain from taking or initiating any actions specifically aimed at contesting a newcomer’s entry. In large industries, entry by small startup enterprises normally poses no immediate or direct competitive threat to industry incumbents and their entry is not likely to provoke defensive actions. For instance, a new online retailer with sales prospects of maybe $5–$10 million annually can reasonably expect to escape competitive retaliation from Amazon.com. The less that a newcomer’s entry will adversely impact the sales and profitability of industry incumbents, the more reasonable it is for potential entrants to expect industry incumbents to ignore the entry of newcomers (in the sense of not making new competitive moves to combat the newcomer’s efforts to attract customers and become profitable).

The Pool of Likely Entry Candidates and Their Resource Capabilities A third factor relates to the size of the pool of likely entry candidates and the resources at their command. As a rule, the bigger the pool of entry candidates, the stronger the threat of potential entry. This is especially true when some entry candidates have ample resources to hurdle existing entry barriers and may also have the potential to become formidable contenders for market leadership. However, in many industries the strongest entry threat frequently comes not from companies outside the industry but from existing industry members seeking to expand by entering market segments or geographic areas where they currently do not have a market presence. Companies already well established in certain product categories or geographic areas usually possess the resources, competencies, and competitive capabilities to hurdle the barriers of entering a different market segment or new geographic area.

Industry Attractiveness Factors The fourth and final factor shaping whether the threat of entry is strong or weak is how attractive the growth and profit prospects are for new entrants. Rapidly growing market demand and high potential profits act as magnets, growing the pool of entry candidates and motivating potential entrants to commit the resources needed to hurdle entry barriers.5 When the growth opportunities and profit prospects of new entrants are sufficiently attractive, entry barriers are unlikely to be an effective entry deterrent. At most, they limit the pool of candidate entrants to enterprises with the requisite resources and competencies to compete head-to-head with incumbent firms. In contrast, when an industry’s growth prospects are minimal, if its outlook is risky/uncertain, or if industry members often struggle to earn a decent profit (because the industry is plagued by intense competition or other profit-limiting conditions), the pool of potential entrants shrinks—there is seldom any good business reason for a company to enter an industry or a market segment if its prospects for good long-term profitability are poor.

Therefore, a very revealing indicator of whether potential entry is a strong or weak competitive force in the marketplace is to inquire if the industry’s growth and profit prospects are strongly attractive to potential entry candidates. When the answer is no, potential entry is a weak competitive force. When the answer is yes and there are entry candidates with sufficient (maybe even competitively powerful) expertise and resources to contend with entry barriers and retaliatory moves by industry incumbents, then the looming entry threat definitely intensifies competitive pressure on current industry members.

CORE CONCEPT The threat of entry is stronger when entry barriers are low, when incumbent firms are unable or unwilling to vigorously contest a newcomer’s entry, when there’s a sizable pool of entry candidates, and when the industry’s outlook is highly attractive to outsiders.

Chapter 3 • Evaluating a Company’s External Environment 48

Competitive Pressures from the Sellers of Substitute Products Companies in one industry come under competitive pressure from the actions of companies in a closely adjoining industry whenever buyers view the products of the two industries as good substitutes. For instance, the producers of wine face competitive pressures from the makers of beer and hard liquors (bourbon, vodka, tequila, rum, etc.). The producers of sugar experience competitive pressures from the producers of sugar substitutes (high-fructose corn syrup, agave syrup, and artificial sweeteners). Internet providers of news-related information have put brutal competitive pressure on the publishers of newspapers. The makers of smart phones, by building ever better cameras into their cell phones, have cut deeply into the sales of producers of handheld digital cameras—most smart phone owners now use their phone to take pictures rather than carrying a digital camera for picture-taking purposes.

As depicted in Figure 3.6, three factors determine whether the competitive pressures from substitute products are strong, moderate, or weak:

1. Whether substitutes are readily available and attractively priced. The presence of readily available and attractively priced substitutes creates competitive pressure by placing a ceiling on the prices industry members can charge without giving customers an incentive to switch to substitutes and risking sales erosion.6 This price ceiling, at the same time, puts a lid on the profits that industry members can earn unless they find ways to cut costs.

2. Whether buyers view the substitutes as comparable or better in terms of quality, performance, and other relevant attributes. The availability of substitutes inevitably invites buyers to compare performance, features, ease of use, and other attributes besides price. The users of paper cartons constantly weigh the performance trade-offs with plastic containers and metal cans. Movie enthusiasts are increasingly weighing whether to go to movie theaters to watch newly released movies or wait till they can watch the same movies streamed to their home TV by Netflix, Amazon Prime, cable providers, and other on-demand sources. Strong competition from the providers of good-performing substitutes pressures industry participants to incorporate new features and attributes that make their product offerings more competitive and attractive to buyers.

3. Whether the costs that buyers incur in switching to the substitutes are low or high. Low switching costs make it easier for the sellers of attractive substitutes to lure buyers to their offering; high switching costs deter buyers from purchasing substitute products.7

As a rule, the lower the price of readily available substitutes, the higher their quality and performance, and the lower the user’s switching costs, the more intense the competitive pressures posed by the sellers of substitute products. Other market indicators of the competitive strength of substitute products include (1) whether the sales of substitutes are growing faster than the sales of the industry being analyzed (a sign that the sellers of substitutes may be drawing customers away from the industry in question); (2) whether the producers of substitutes are investing in added capacity and market coverage; and (3) whether the producers of substitutes are earning progressively higher profits.

Chapter 3 • Evaluating a Company’s External Environment 49

Figure 3.6 Factors Affecting Competition from Substitute Products

Competitive pressures from substitutes are stronger when: • Good substitutes are readily available or new ones are emerging. • Substitutes are attractively priced. • Substitutes have comparable or better performance features. • Buyers have low costs in switching to substitutes. • Buyers are growing more comfortable with using substitutes.

Competitive pressures from substitutes are weaker when: • Good substitutes are not readily available or don’t exist. • Substitutes are higher priced relative to the value they

deliver to buyers. • Substitutes lack comparable or better performance features. • Buyers have high costs in switching to substitutes.

Firms in Other Industries Offering

Substitute Products

How strong are competitive pressures coming from

the attempts of companies outside the industry to win buyers over to their products?

Rivalry among

Competing Sellers

Signs that Competition from Substitutes Is Strong • Sales of substitutes are growing faster than sales of the industry

being analyzed (an indication that the sellers of substitutes are stealing the industry’s customers away).

• Producers of substitutes are investing in new capacity and expanding their market coverage.

• Profits of the producers of substitutes are rising.

Competitive Pressures Stemming from Supplier Bargaining Power Whether the suppliers of industry members represent a strong, moderate, or weak competitive force depends on how much bargaining power suppliers have to influence the terms and conditions of supply in their favor. Powerful or influential suppliers can be a source of competitive pressure because of their ability to charge industry members higher prices and/or make it difficult or costly for industry members to switch to other suppliers.

A number of circumstances determine the nature and strength of supplier bargaining power:8

n Whether certain needed inputs are in short supply. Suppliers of items in short supply have some degree of pricing power, whereas a surge in the available supply of particular items greatly weakens supplier pricing power and bargaining leverage.

n Whether certain suppliers provide a differentiated input that enhances the performance or quality of the industry’s product. The more valuable a particular input is in terms of enhancing the performance or quality of industry members’ products, the more bargaining leverage and pricing power such suppliers have.

n Whether certain suppliers provide equipment or services that deliver valuable cost-saving efficiencies to industry members in operating their production processes. Suppliers who provide cost-saving equipment or other valuable or necessary production-related services are likely to possess bargaining leverage and be in a position both to resist requests for concessions from industry members and to charge higher prices than they might otherwise be able to charge. Industry members that do not source from such suppliers may find themselves at a cost disadvantage and thus under competitive pressure to buy the cost-saving equipment or services of these suppliers (on terms that are favorable to the suppliers).

Chapter 3 • Evaluating a Company’s External Environment 50

n Whether the item being supplied is a standard item or commodity that is readily available from a host of suppliers at the going market price. The suppliers of commodities (like copper or steel reinforcing rods or shipping cartons) are in a weak position to demand a premium price or insist on other favorable terms because industry members can readily obtain essentially the same item at the same price from any of several other suppliers eager to win their business, perhaps dividing their purchases among two or more suppliers to promote lively competition for orders. The suppliers of commodity items have market power only when supplies become so tight that industry members agree to pay more to have their orders filled and delivered on time.

n Whether it is difficult or costly for industry members to switch their purchases from one supplier to another or to switch to attractive substitute inputs. High switching costs convey strong bargaining power to suppliers, whereas low switching costs and ready availability of good substitute inputs weaken the bargaining power of suppliers. Soft drink bottlers, for example, can counter the bargaining power of aluminum can suppliers by shifting or threatening to shift to greater use of plastic containers and introducing more attractive plastic container designs.

n Whether industry members are major customers of suppliers. As a rule, suppliers have less bargaining leverage when their sales to members of this one industry constitute a big percentage of their total sales. In such cases, the well-being of suppliers is closely tied to the well-being of their major customers. Suppliers have a big incentive to protect and enhance the competitiveness of their major customers via reasonable prices, exceptional quality, and ongoing advances in the technology of the items supplied.

n Whether suppliers provide an item that accounts for a sizable fraction of the costs of the industry’s product. The bigger the cost of a particular part or component, the harder it is for suppliers to boost their prices because such higher prices result in big increases in unit costs and total costs for industry members—cost increases that may adversely affect their competitiveness and long-term well-being. In such cases, suppliers must be cautious about charging prices that damage the business performance of their customers, and they can expect industry members to bargain hard in resisting suppliers’ price increases. On the other hand, when suppliers’ product or service accounts for a small or tiny fraction of industry members’ unit costs and total costs, suppliers have added power over the price and other terms of supply; this is especially true when industry members are not major customers of these suppliers and their purchases generate only small revenues.

n Whether only a few suppliers are regarded as the best or preferred sources of a particular item. Highly regarded suppliers with strong demand for the items they supply generally have sufficient bargaining power to deny industry members’ requests for lower prices or other concessions, and they may also have the clout to charge higher prices when they make innovative improvements in the items they supply. Nonetheless, the bargaining power of preferred suppliers can erode substantially if their profits are suffering and they need to boost sales. Moreover, the larger the number of acceptable suppliers that industry members have to purchase from, the weaker the bargaining power of any one supplier, even if they enjoy preferred status.

n Whether industry members have sound business reasons to integrate backward and self-manufacture items they have been buying from suppliers. The make-or-buy issue generally boils down to whether suppliers who specialize in the production of a particular part or component and who make them in volume for many different customers have the expertise and scale economies to supply as good or better components at a lower cost than industry members could achieve via self-manufacture. Frequently, it is difficult for industry members to self-manufacture parts and components more economically than they can obtain them from suppliers who specialize in making such items. For instance, most producers of outdoor power equipment (such as lawn mowers, rotary tillers, and leaf blowers) find it cheaper to source the small engines they need from outside manufacturers who specialize in small engine manufacture rather than make their own engines because the quantity of engines they need is too small to justify the investment in production facilities, master the production process, and capture scale economies. Specialists in small engine manufacture, by supplying many kinds of engines to the whole power

Chapter 3 • Evaluating a Company’s External Environment 51

equipment industry, can obtain a big enough sales volume to fully realize scale economies, become proficient in all the manufacturing techniques, and keep costs low. As a rule, suppliers are safe from the threat of self-manufacture by their customers until the volume of parts a customer needs becomes large enough for the customer to justify backward integration into self-manufacture of the component.

n Whether suppliers have the resources and profit incentive to integrate forward into the business of the customers they are supplying. In instances where such is the case, suppliers have strong bargaining leverage because industry members may be willing to pay such suppliers a higher price to keep them from entering their business and potentially becoming a formidable rival.

Figure 3.7 summarizes the conditions that tend to make supplier bargaining power strong or weak.

Figure 3.7 Factors Affecting the Bargaining Power of Suppliers

Supplier bargaining power is stronger when: • A needed input is in short supply. • Certain suppliers either have a differentiated

input that enhances the quality or performance of sellers’ products or provide equipment/services that deliver valuable cost-saving efficiencies.

• Industry members incur high costs in switching to alternative suppliers.

• There are no good substitutes for certain products/services being supplied.

• Suppliers are not dependent on industry members for a large portion of their revenues.

• Suppliers provide an item that accounts for a small fraction of the costs of the industry’s product.

• There are only a few “preferred” suppliers of a particular input.

• Some suppliers are a threat to integrate forward into the business of industry members and perhaps become a powerful rival.

Supplier bargaining power is weaker when: • There are ample supplies of a needed input. • The item being supplied is a “commodity”

obtainable from many different suppliers at the going market price.

• Industry members incur low costs in switching to alternative suppliers.

• Good substitutes exist for the products/services of suppliers.

• Industry members are major customers and continuing to secure their business is important to suppliers’ well-being.

• Suppliers provide an item that accounts for a sizable fraction of the costs of the industry’s product.

• Industry members can purchase what they need from any of many different “good to acceptable” suppliers.

• Industry members are a threat to integrate backward into the business of suppliers and to self-manufacture their own requirements.

Rivalry among Competing

Sellers

How strong are the competitive pressures

stemming from supplier bargaining power?

Suppliers of Raw Materials, Parts,

Components, or Other Resource Inputs

Competitive Pressures Stemming from Buyer Bargaining Power Whether buyers are able to exert strong competitive pressures on industry members depends on the degree to which some or many buyers have sufficient bargaining power to obtain price concessions and other favorable purchase terms. Buyers with strong bargaining power are a competitive force because they are in position to push hard for price concessions, better payment terms, additional features and services, and/or other special treatment that typically squeeze industry members’ profit margins.

The Factors Affecting Whether Buyers Have More or Less Bargaining Power As with suppliers, the leverage that buyers have in negotiating favorable terms can range from weak to strong. Individual consumers seldom have much bargaining power in negotiating price concessions or other favorable terms with sellers; the

Chapter 3 • Evaluating a Company’s External Environment 52

primary exceptions involve situations in which price haggling is customary, such as the purchase of new and used motor vehicles, homes, and other big-ticket items like luxury watches, jewelry, works of art, and pleasure boats. For most consumer products and services, individual buyers have negligible bargaining leverage because they purchase in small quantities and often irregularly—their option is to pay a seller’s posted price or take their business elsewhere. Small businesses usually have weak bargaining power because of the small-size orders they place with sellers. Many relatively small wholesalers and retailers that have very little buyer bargaining power acting on their own join buying groups to pool their purchasing power and approach manufacturers for better terms than could be gotten individually.

Understandably, large retail chains like Walmart, Best Buy, Staples, The Home Depot, and Kroger typically have considerable bargaining power in purchasing products from manufacturers not only because they buy in large quantities but also because of manufacturers’ need for broad retail exposure and the most appealing shelf locations. Retailers may stock two or three competing brands of a product but rarely all competing brands, so competition among rival manufacturers for visibility on the shelves of popular multistore retailers gives such retailers significant bargaining strength. Major supermarket chains like Kroger, Safeway, and Publix have sufficient bargaining power to demand promotional allowances and lump-sum payments (called slotting fees) from food products manufacturers in return for stocking certain brands or putting them in the best shelf locations. Motor vehicle manufacturers have strong bargaining power in negotiating to buy original equipment tires from Goodyear, Michelin, Bridgestone/Firestone, Continental, and Pirelli partly because they buy in large quantities and partly because tire makers believe they gain an advantage in supplying replacement tires to vehicle owners if their tire brand is original equipment on the vehicle. On occasions, “prestige” buyers have a degree of clout in negotiating with sellers because a seller’s reputation is enhanced by having prestige buyers on its customer list.

Even if buyers do not purchase in large quantities or provide sellers better market exposure or an enhanced reputation, their bargaining strength increases in the following circumstances:9

n When buyer demand is weak in relation to the available supply and industry members are eager to sell more units. Weak or declining demand and the resulting excess supply create a “buyers’ market” where bargain-hunting buyers have leverage in pressing industry members for better deals and special treatment. Conversely, strong or rapidly growing market demand creates a “sellers’ market” characterized by tight supplies or shortages—conditions that put buyers in a weak position to wring concessions from industry members.

n When industry members’ products are standardized “commodities” or else weakly differentiated. In such instances, buyer loyalty to any one brand is low, and buyers tend to shop for the best price, which usually spurs price competition among industry members. However, buyer bargaining power declines as the products/services of industry members become strongly differentiated—the bigger the differences among the features, performance, and quality of rival brands, the more buyers come to prefer the brand most suitable to their preferences and pocketbook. Strong buyer attachment to a favorite brand diminishes buyer bargaining power, particularly when an industry member knows full well that buyers recognize the superiority of its product offering.

n When buyers have low costs in switching to competing brands or substitutes. Buyers who can readily switch brands or source from several competing sellers have more negotiating leverage than buyers who have high switching costs or strong loyalty to a particular brand.

n When the number of buyers is small or retaining a particular buyer’s business is important to a seller. The smaller the number of buyers, the harder it is for industry members to find alternative buyers when a customer is lost to a rival. The prospect of losing a customer not easily replaced often makes an industry member willing to grant concessions of one kind or another to retain the customer’s business.

Buyers’ bargaining power is stronger when they are few in number and purchase in large volumes. The larger buyers’ purchases, the more important their business is to sellers and the more likely that sellers will grant them concessions or special treatment.

Chapter 3 • Evaluating a Company’s External Environment 53

n When buyers are well informed and have compared the product offerings of industry members regarding prices, product features, quality, buyer reviews, and other pertinent factors. The more information buyers have about the comparative product offerings of industry members, the better bargaining position they are in. The mushrooming availability of product information at Internet websites enables businesses and individuals to compare different products and locate industry members with the best deals. Armed with this information, bargain-hunting businesses can contact one or more low-priced industry members and try to wrangle an even better deal. Similarly, individuals can use information gleaned from the Internet to bargain with local retailers, a technique that works well when it comes to buying new and used motor vehicles and other big-ticket items.

n When buyers pose a credible threat of integrating backward into the business of sellers. Retailers gain bargaining power in negotiating with the makers of popular name brand products by stocking and promoting their own private-label brands alongside manufacturers’ brands. But such bargaining power evaporates if there is no credible threat of buyers integrating backward into the business of industry members.

n When buyers have discretion to delay their purchases or perhaps not make a purchase at all. Consumers often have the option to delay purchases of durable goods (cars, major appliances, a home addition) or discretionary goods (hot tubs, home entertainment centers) if they are unhappy with the prices offered. If college students believe the prices of new textbooks are too high, they can purchase used textbooks or rent them or share them with friends. Business buyers may be able to defer spending for new equipment, software upgrades, or maintenance services. Such options put pressure on industry members to grant concessions to prospective buyers to keep their sales numbers from dropping off.

Strong Buyer Price Sensitivity Creates Competitive Pressures Low-income and budget-constrained consumers are almost always price sensitive; bargain-hunting consumers are highly price sensitive by nature. Most consumers grow more price sensitive as the price tag of an item becomes a bigger fraction of their spending budget. Business buyers besieged by weak sales, intense competition, and other factors squeezing their profit margins are price sensitive. Price sensitivity also grows among all businesses as the cost of an item becomes a bigger fraction of their cost structure. Rising prices of frequently purchased items heightens the price sensitivity of all types of buyers.

Widespread or rapidly growing price sensitivity among buyers creates competitive pressures on industry members in two ways: (1) it limits their ability to charge prices that buyers perceive as “too high” and (2) it constrains industry member ability to raise prices. Price-related competitive pressures on industry members escalate further if buyer concerns about overly high prices spark a falloff in demand for the industry’s product/ service—buyers having a hard time making ends meet may decide to reduce or defer their purchases or switch to cheaper-priced substitutes. Business customers suffering weak sales or profitability problems may communicate their unhappiness over prices directly to industry members and announce their intention to curtail purchases or switch to lower-priced substitutes.

Collective action on the part of growing numbers of individuals, households, and businesses to curtail purchases can escalate competitive pressures on industry members, sometimes exponentially, and become a potent competitive force. Fear of a potential sales decline or the harsh winds of an actual sales decline can prompt industry members to act on their own to trim prices or grant other more favorable purchase terms to buyers. In such circumstances, buyer bargaining power increases, and industry members anxious to grow their sales volumes become more willing to bargain with buyers over price and other terms of sale.

Figure 3.8 highlights the circumstances causing buyer bargaining power to be strong or weak.

Chapter 3 • Evaluating a Company’s External Environment 54

Figure 3.8 Factors Affecting the Bargaining Power of Buyers

Buyer bargaining power is stronger when: • Large-volume purchases by buyers enable them

to gain special treatment. • A buyer’s identity adds prestige to the seller’s list

of customers. • Supplies of the product are greater than buyer

demand. • There are only a few buyers, so each one’s

business is important to sellers. • Buyers have low costs in switching to competing

brands or substitute products. • The products of industry members are

“commodities” or else weakly differentiated. • Buyers are well informed about the product

offerings of industry members. • Buyers can postpone purchases if they do not like

the deals sellers are offering. • Some buyers are a threat to integrate backward

into the business of sellers and become an important competitor.

• Buyers are highly price sensitive.

Buyer bargaining power is weaker when: • Buyers purchase the item in small

quantities. • Buyers have insufficient “prestige” to command

special treatment. • Strong buyer demand creates tight supply

conditions or shortages. • There are so many buyers that any one buyer’s

purchases account for a tiny fraction of total industry sales.

• Buyers have high costs in switching to competing brands or substitute products.

• The products of industry members are strongly differentiated.

• Buyers have limited information about the product offerings of industry members.

• Buyers cannot easily postpone purchases. • There is no credible threat of buyers integrating

backward into the business of industry members. • Buyer price sensitivity is relatively low.

Buyers How strong are the competitive

pressures stemming from buyer bargaining power?

Rivalry among Competing Sellers

Is the Collective Strength of the Five Competitive Forces Conducive to Good Profitability? Assessing whether each of the five competitive forces gives rise to strong, moderate, or weak competitive pressures sets the stage for evaluating whether the collective strength of the five forces is conducive to good profitability. Can companies in this industry reasonably expect to earn decent profits in light of the prevailing competitive forces? Are competitive forces sufficiently powerful to undermine industry profitability? Or, is the state of competition in the industry weaker than “normal,” thus opening opportunities for industry members to earn very attractive profits?

As a rule, the stronger the collective impact of the five competitive forces, the lower the combined profitability of industry participants. The most extreme case of a “competitively unattractive” industry occurs when all five forces are producing strong competitive pressures: rivalry among sellers is vigorous, low entry barriers allow new rivals to gain a market foothold, competition from substitutes is intense, and both suppliers and buyers are able to exercise considerable bargaining leverage. Fierce to strong competitive pressures coming from all five directions nearly always drive industry profitability to unacceptably low levels, frequently producing losses for many industry members and forcing some out of business. But an industry can be competitively unattractive without all five competitive forces being strong. Intense competitive pressures from just two or three (maybe even just one) of the five forces may suffice to

The stronger the forces of competition, the harder it becomes for industry members to earn attractive profits.

Chapter 3 • Evaluating a Company’s External Environment 55

destroy the conditions for good profitability, and prompt struggling companies to exit the business. Especially intense competitive conditions seem to be the norm in tire manufacturing, apparel, and commercial airlines—all three industries have long been characterized by historically thin profit margins.

In contrast, when the collective impact of the five competitive forces is moderate to weak, an industry is competitively attractive in the sense that industry members can reasonably expect to earn good profits and a nice return on investment. The ideal competitive environment for earning superior profits is one in which both suppliers and customers are in weak bargaining positions, there are no good substitutes, high barriers block further entry, and rivalry among present sellers generates only moderate competitive pressures. Weak competition is the best of all possible worlds for also-ran companies because even they can usually eke out a decent profit—if a company can’t make a decent profit when competition is weak, then its business outlook is indeed grim.

In most industries, the collective strength of the five competitive forces is somewhere near the middle of the two extremes of intense and weak, typically ranging from slightly stronger than normal to slightly weaker than normal and typically allowing well-managed companies with sound strategies to earn attractive profits.

Matching Company Strategy to Competitive Conditions Working through the five forces model step by step not only aids strategy-makers in assessing whether the intensity of competition allows good profitability but also promotes sound strategic thinking about how to better match company strategy to the specific competitive character of the marketplace. Effectively matching a company’s strategy to prevailing competitive conditions has two aspects:

1. Pursuing avenues that shield the firm from as many of the different competitive pressures as possible.

2. Initiating actions calculated to produce sustainable competitive advantage, thereby shifting competition in the company’s favor, putting added competitive pressure on rivals, and perhaps even defining the business model for the industry.

But making headway on these two fronts first requires identifying competitive pressures, gauging the relative strength of each of the five competitive forces, and gaining a deep enough understanding of the state of competition in the industry to know which strategy buttons to push.

Question 2: What Factors Are Driving Industry Change and What Impact Will They Have?

While it is critical to understand the nature, intensity, and fluidity of competitive forces in an industry, there are also other types of factors that gradually or speedily alter industry conditions in ways important enough to require a strategic response from participating firms. The popular hypothesis that industries go through a life cycle of takeoff, rapid growth, early maturity and slowing growth, market saturation, and stagnation or decline is but one aspect of industry change—many other new developments and emerging trends cause industry change besides an industry’s normal progression through the life cycle.10

A company’s strategy is increasingly effective the more it provides some insulation from competitive pressures and shifts the competitive battle in the company’s favor.

Chapter 3 • Evaluating a Company’s External Environment 56

The Concept of Driving Forces Industry environments are dynamic and, in most all cases, contain forces that are enticing or pressuring certain industry participants (competitors, customers, suppliers) to alter their actions in important ways.11 The most powerful of the change agents are called driving forces because they have the biggest influences in reshaping the industry landscape and altering competitive conditions. Some driving forces originate in the outer ring of the company’s macro-environment (see Figure 3.2), but most originate in the company’s more immediate industry and competitive environment.

Driving-forces analysis has three steps: (1) identifying what the driving forces are, (2) assessing whether the drivers of change are, on the whole, acting to make the industry more or less attractive, and (3) determining what strategy changes are needed to prepare for the impacts of the driving forces. All three steps merit further discussion.

Identifying an Industry’s Driving Forces Many developments can affect an industry powerfully enough to qualify as driving forces. Some drivers of change are unique and specific to a particular industry situation, but most drivers of industry and competitive change fall into one of the following categories:12

n Changes in an industry’s long-term growth rate. Faster industry growth triggers a race among established firms and newcomers to capture the new sales opportunities; ambitious companies with trailing market shares may see the upturn in buyer demand as a golden opportunity to launch offensive strategies to broaden their customer base and move up several notches in the industry standings. Slower industry growth nearly always intensifies rivalry as firms anxious to grow rapidly pursue ways to take sales and market share away from rivals. Other industry members may respond to a growth slowdown by merging with or acquiring other industry members. Should industry sales stagnate or enter into long-term decline, some competitively weak and/or growth-oriented companies may opt to exit the industry by selling their operations to those industry members who elect to stick it out. When demand for an industry’s product continues to shrink, the remaining industry members will likely be forced to close inefficient plants and retrench to a smaller production base. Hence, whether an industry’s growth rate turns up or down, starts to stagnate, or becomes negative, the usual outcome is a much-changed competitive landscape.

n Increasing globalization. Competition begins to shift from primarily a regional or national focus to an international or global focus when industry members begin seeking out customers in foreign markets or when production activities begin to migrate to countries where costs are lowest. Globalization of competition really starts to take hold when one or more ambitious companies precipitate a race for worldwide market leadership by launching initiatives to expand into more and more country markets. Globalization can also be precipitated by the blossoming of consumer demand in more and more countries and by government actions in certain countries to reduce trade barriers or open up once-closed markets to foreign competitors, as is occurring in many parts of Europe, Latin America, and Asia. Significant differences in labor costs among countries give manufacturers a strong incentive to locate plants for labor-intensive products in low-wage countries and use these plants to supply market demand across the world. Wages in China, India, Vietnam, Mexico, and Brazil, for example, are much lower than those in the United States, Germany, and Japan. The forces of globalization are sometimes such a strong driver that companies find it highly advantageous, if not necessary, to spread their operating reach into more and more country markets. Globalization is very much a driver of industry change in industries like motor vehicles, steel, petroleum, electronics, cell phones, video games, public accounting, commercial aircraft, and electric power generation equipment.

CORE CONCEPT Industry conditions change because important forces are driving industry participants (competitors, customers, or suppliers) to alter their actions. The driving forces in an industry are the major underlying causes of changing industry and competitive conditions—they have the biggest influence on how the industry landscape will be altered. Some driving forces originate in the outer ring of the macro-environment, and some originate in the inner ring.

Chapter 3 • Evaluating a Company’s External Environment 57

n Emerging new Internet capabilities and applications. Mushrooming use of high-speed Internet service and Voice-over-Internet-Protocol (VoIP) technology, growing acceptance of online shopping, and the exploding popularity of Internet applications (“apps”) have been major drivers of change in industry after industry. The ability of companies to reach consumers via the Internet increases their geographic reach, brings more sellers into head-to-head competition, and often escalates rivalry by pitting pure online sellers against combination brick-and-click sellers and against pure brick-and-mortar sellers. The Internet gives buyers an unprecedented ability to research competitors’ product offerings and shop the market for the best value. Widespread use of e-mail has forever eroded the business of providing fax services and the first-class mail delivery revenues of governmental postal services worldwide. Videoconferencing via the Internet erodes the demand for business travel. Online course offerings are profoundly affecting higher education. The “Internet of things” will feature faster speeds, dazzling applications, and billions of connected gadgets performing an array of functions, thus driving further industry and competitive changes. But Internet-related impacts vary from industry to industry. The challenges here are to assess precisely how emerging Internet developments are altering a particular industry’s landscape and to factor these impacts into the strategy-making equation.

n Changes in who buys the product and how they use it. Shifts in buyer demographics and the ways products are used can greatly alter industry and competitive conditions. Longer life expectancies are driving demand growth in health care, prescription drugs, and assisted living residences. Growing percentages of relatively well-to-do retirees are driving demand growth in cosmetic surgery, vacation travel, and leisure time industries. New features of next-generation smart phones, along with an ever-growing array of apps, continue to transform the user experience, attract more types of buyers, shorten the life cycles of cell phone models, and enable a more-connected world. The growing popularity of streaming video has impacted the businesses of broadband providers, wireless phone carriers, television broadcasters, and such content providers as Netflix and Hulu.

n Product innovation. Competition in an industry is always affected by rivals racing to be first to introduce some new product or product enhancement, one after another. An ongoing stream of product innovations tends to alter the pattern of competition in an industry by attracting more first-time buyers, rejuvenating industry growth, and/or creating wider or narrower product differentiation among rival sellers. Product innovation has been a key driving force in such industries as lightbulbs, golf clubs, performance fabrics for sports apparel, good-for-you food products, and self-driving motor vehicles.

n Technological change and manufacturing process innovation. Advances in technology and new manufacturing processes can cause disruptive change in an industry by making it possible to produce dramatically new and better products at lower cost and sometimes opening up whole new industry frontiers. Rapidly advancing self-driving technology is disrupting the motor vehicle industry, enabling such companies as Google and chip-maker Nvidia to enter the industry. Stem cell research holds promise for finding ways to cure or treat an array of diseases. Advancing robotics technology is a big driver of manufacturing process innovation.

n Marketing innovation. When firms are successful in introducing new ways to market their products, they can spark a burst of buyer interest, widen industry demand, increase product differentiation, and lower unit costs—any or all of which can alter the competitive positions of rival firms and force strategy revisions. Growing popularity of online shopping is shaking up the retailing industry, depressing buyer traffic at shopping malls and altering the mix of sales through various distribution channels. Increasing numbers of music artists are marketing their recordings at their own websites rather than entering into contracts with recording studios. The growing propensity of advertisers to place a bigger percentage of their ads on social media sites like Facebook and Twitter is shaking up the advertising industry.

n Entry or exit of major firms. The entry of one or more foreign companies into a geographic market once dominated by domestic firms nearly always shakes up competitive conditions. Likewise, when an established domestic firm from another industry attempts entry either by acquisition or by launching its own startup venture, it usually applies its skills and resources in some innovative fashion that pushes competition in new directions. Entry by a major firm thus often produces a new ball game, not only with new key players

Chapter 3 • Evaluating a Company’s External Environment 58

but also with new rules for competing. Similarly, a major firm’s exit changes the competitive structure by reducing the number of market leaders (perhaps increasing the dominance of the leaders who remain) and causing a rush to capture the exiting firm’s customers.

n Diffusion of technical know-how across more companies and more countries. As knowledge about how to perform a particular activity or execute a particular manufacturing technology spreads, the competitive advantage held by firms originally possessing this know-how erodes. Knowledge diffusion occurs through scientific journals, trade publications, onsite plant tours, word of mouth among suppliers and customers, worker migration, and Internet sources. In recent years, rapid technology transfer across national boundaries has been a prime factor in causing industries to become more globally competitive.

n Changes in cost and efficiency. Widening or shrinking differences in the costs among key competitors tend to dramatically alter the state of competition. Lower production costs and longer-life products have allowed the makers of super-efficient fluorescent-based spiral lightbulbs and LED bulbs to cut deeply into the sales of incandescent lightbulbs. Lower-cost e-books are cutting into sales of costlier hardcover books as increasing numbers of consumers have laptops, iPads, Kindles, and other brands of tablets.

n Growing buyer preferences for differentiated products instead of a commodity product (or for a more standardized product instead of strongly differentiated products). When buyer tastes and preferences start to diverge, sellers can win a loyal following by introducing products that stand apart from those of rival brands. In recent years, beer drinkers have grown less loyal to traditional brands; many are shifting to “boutique” beers with distinctive tastes. Leading beer manufacturers have responded by introducing new distinctive- tasting brands of their own. The consequently larger number of brands and varieties has made competition livelier. When a shift from standardized to differentiated products occurs, the driver of change is the contest among rivals to cleverly out-differentiate one another.

Sometimes, however, buyers decide that a standardized budget-priced product suits their requirements as well as or better than a premium-priced product with lots of snappy features and personalized services. Pronounced shifts toward greater product standardization (as in grocery items where the difference between brand-name products and private-label products is frequently miniscule) usually spawn lively price competition and force rival sellers to drive down their costs to maintain profitability. The lesson here is that competition is driven partly by whether the market forces in motion are acting to increase or decrease product differentiation.

n Reductions in uncertainty and business risk. Many companies are hesitant to enter industries with uncertain futures or high levels of business risk, and firms already in these industries may be cautious about making aggressive capital investments to expand—often because it is unclear how much time and money it will take to overcome various technological hurdles and achieve acceptable production costs (as is the case in the solar power industry). Likewise, firms entering foreign markets where demand is just emerging or where political conditions are volatile may be cautious and limit their downside exposure by using less risky strategies. Over time, however, diminishing risk levels and uncertainty tend to stimulate new entry and capital investments by growth-minded companies seeking new opportunities, thus dramatically altering industry and competitive conditions.

n Regulatory influences and government policy changes. Government regulatory actions can often mandate significant changes in industry practices and strategic approaches—as has recently occurred in the world’s banking industry, where a deluge of much stricter banking regulations resulted in dramatically higher regulatory compliance costs for banks of all sizes, making it difficult for many people and companies to obtain loans, and forcing large banks to withdraw totally from certain types of activities. New rules and regulations pertaining to government-sponsored and/or government-mandated health insurance programs are potent driving forces in the health care industry. In international markets, host governments can drive competitive changes by opening their domestic markets to foreign participation, by entering into multi-country trade agreements, or by altering existing trade agreements to make the term of trade “more fair” to companies in one or more participating countries. Clearly, the Trump Administration is pursuing efforts to revamp existing trade agreements in ways more favorable to domestic companies and their domestic employees and, further, to institute tax reforms that

Chapter 3 • Evaluating a Company’s External Environment 59

(1) reduce the incentives for domestic companies to close down operations in the United States and relocate them to foreign locations and (2) increase the incentives for both domestic and foreign companies to locate new manufacturing facilities in the United States.

n Changing societal concerns, attitudes, and lifestyles. Emerging social issues, as well as changing attitudes and lifestyles, can be powerful instigators of industry change. Growing public concern about global warming has emerged as a major driver of change in the energy industry. The trend to more casual business dress has dramatically affected the apparel industry. Greater affinity for having household pets has driven growth across the whole pet industry. Shifting societal concerns, attitudes, and lifestyles alter the pattern of competition, usually favoring those players that respond quickly and creatively with products targeted to the new trends and conditions.

That there are so many different potential driving forces explains why a full understanding of all types of change drivers is a fundamental part of industry analysis. However, labeling every change or trend as a driving force must be resisted; no more than three or four are likely to be true driving forces powerful enough to reshape an industry’s landscape in significant ways. The true analytical task is to evaluate the forces of change carefully enough to separate the major ones from the minor ones.

Assessing the Impact of the Driving Forces Just identifying the driving forces is not sufficient, however. The second, and more important, step in driving- forces analysis is to determine whether the prevailing driving forces are, on the whole, acting to make the industry environment more or less attractive. Answers to three questions are needed:

1. Are the driving forces, on balance, acting to cause demand for the industry’s product to increase or decrease?

2. Is the collective impact of the driving forces making competition more or less intense?

3. Will the combined impacts of the driving forces lead to higher or lower industry profitability?

Getting a handle on the collective impact of the driving forces usually requires looking at the likely effects of each force separately since the driving forces may not all be pushing change in the same direction. For example, two driving forces may be spurring demand for the industry’s product, while one driving force may be curtailing demand. Whether the net effect on industry demand is up or down hinges on which driving forces are the more powerful.

Adjusting Strategy to Prepare for the Impacts of Driving Forces The third step of driving-forces analysis—where the real payoff for strategy making comes—is for managers to draw some conclusions about what strategy adjustments will be needed to deal with the impacts of the driving forces. But taking the “right” actions to prepare for the industry and competitive changes being wrought by the driving forces first requires accurate diagnosis of the forces driving industry change and the impacts these forces will have on both the industry environment and the company’s business. To the extent that managers are unclear about the drivers of industry change and their impacts, or if their views are off-base, the chances of making astute and timely strategy adjustments are slim. So, driving-forces analysis is not something to take lightly; it is a valuable tool for managers to use in thinking strategically about where the industry is headed and preparing for the changes ahead.

The most important part of driving-forces analysis is to determine whether the collective impact of the driving forces will be to increase or decrease market demand, make competition more or less intense, and lead to higher or lower industry profitability.

The real payoff of driving-forces analysis is to help managers understand what strategy changes are needed to prepare for the impacts of the driving forces.

Chapter 3 • Evaluating a Company’s External Environment 60

Question 3: What Market Positions Do Rivals Occupy— Who Is Strongly Positioned and Who Is Not?

Some industry rivals occupy stronger (or at least distinguish- ably different) market positions than others, having opted to incorporate product features that appeal to different types of buyers, or charge widely differing prices for products with widely differing quality and/or performance, or emphasize different distribution channels, or compete in different geographic areas, and so on. Understanding which companies are strongly positioned and which are weakly positioned is an integral part of analyzing an industry’s competitive structure. The best technique for revealing the market positions of industry competitors is strategic group mapping.13

Using Strategic Group Maps to Assess the Market Positions of Key Competitors A strategic group consists of those industry members with similar competitive approaches and positions in the overall market.14 Companies in the same strategic group can resemble one another in any of several ways: they may have comparable product-line breadth, sell in the same price/quality range, emphasize the same distribution channels, use essentially the same product attributes to appeal to similar types of buyers, depend on identical technological approaches, compete in much the same geographic areas, or offer buyers similar services and technical assistance.15 An industry contains only one strategic group when all sellers compete in much the same market space, employing much the same strategies to appeal to much the same types of buyers. At the other extreme, an industry may contain as many strategic groups as there are competitors when each rival pursues a distinctly different competitive approach, strives to attract different types of buyers with distinctly different product offerings, and thus occupies a distinctly different market position. The number of strategic groups in an industry and their respective market positions can be displayed on a strategic group map.

The procedure for drawing a strategic group map is straightforward:

n Identify the competitive characteristics that differentiate firms in the industry. Typical variables are price/ quality range (high, medium, low), geographic coverage (local, regional, national, global), product-line breadth (wide, narrow), degree of service offered (no-frills, limited, full), use of distribution channels (one, some, all), and degree of vertical integration (none, partial, full).

n Plot the firms on a two-variable map using pairs of these differentiating characteristics.

n Assign firms that are located close together on the two-dimensional map to the same strategic group.

n Draw circles around each strategic group, making the circles proportional to the size of the group’s share of total industry sales revenues.

This produces a two-dimensional diagram like the one shown in Figure 3.9.

Several guidelines need to be observed in mapping the positions of strategic groups in the industry’s overall market space.16 First, the two variables selected as axes for the map should not be highly correlated. If they are, the circles on the map will fall along a diagonal and reveal nothing more about the relative positions

CORE CONCEPT A strategic group is a cluster of industry rivals that employ similar competitive approaches, have product offerings that appeal to similar types of buyers, and thus occupy similar market positions.

CORE CONCEPT Strategic group mapping is a technique for displaying the different market positions that rival firms occupy in the industry.

Chapter 3 • Evaluating a Company’s External Environment 61

of competitors than would be revealed by comparing the rivals on just one of the variables. For instance, if companies with broad product lines use multiple distribution channels while companies with narrow lines use a single distribution channel, then looking at broad versus narrow product lines reveals just as much about who is positioned where as does looking at single versus multiple distribution channels—rendering one of the variables redundant. Second, the two variables chosen as axes should be ones where there are big differences in the competitive characteristics and positioning among the rivals—when rivals differ on both variables, the locations of the rivals will be scattered, thus showing how they are positioned differently. Third, the variables used as axes do not have to be quantitative or continuous; rather they can be defined as distinct conditions like use of only one distribution channel (Internet sales at the company’s website), use of two distribution channels (company-owned retail stores and Internet sales), use of three distribution channels (independent wholesale distributors, big-box discount retailers, and Internet sales at the company’s website), and use of multiple distribution channels (four or more). Fourth, drawing the sizes of the circles on the map proportional to the combined sales of the firms in each strategic group allows the map to reflect the relative market shares that each strategic group commands. Fifth, if three or more variables are good candidates for being chosen as axes for the map, it is wise to draw two or more maps to give different exposures to the competitive positioning relationships present in the industry’s structure—there is not necessarily any one best map for portraying how competing firms are positioned.

Figure 3.9 Comparative Market Positions of Selected Retail Chains: An Example of a Strategic Group Map

Many Localities

Geographic Coverage

P ric

e/ Q

ua lit

High

Low

Few Localities

Neiman Marcus,

Saks Fifth Avenue

Polo Ralph

Lauren

Macy’s, Nordstrom,

Dillards

Target

Walmart, Kmart

Gap, Banana Republic

Sears

Kohl’sT.J. Maxx

Gucci, Chanel, Fendi

Note: Circles are drawn roughly proportional to the total revenues of the retailers shown in each strategic group.

Chapter 3 • Evaluating a Company’s External Environment 62

What Can Be Learned from Strategic Group Maps? Strategic group maps are revealing in several respects. The most important information revealed is which industry members are close rivals and which are distant rivals. Firms in the same strategic group are the closest rivals; the next closest rivals are in the immediately adjacent groups. Often, firms in strategic groups that are far apart on the map hardly compete at all. For instance, Walmart’s clientele, merchandise selection, and pricing points are much too different to justify calling them close competitors of Neiman Marcus, Saks Fifth Avenue, or Gucci.

The second thing to be gleaned from strategic group mapping is that not all positions on the map are equally attractive.17 Two reasons account for why some positions can be more attractive than others:18

1. Prevailing competitive pressures and industry driving forces favor some strategic groups and hurt others. Discerning which strategic groups are advantaged and disadvantaged requires scrutinizing the map in light of what has also been learned from the prior analysis of competitive forces and driving forces. Quite often the strength of competition varies from group to group—there’s little reason to believe that all firms in an industry feel the same degrees of competitive pressure, since their strategies and market positions may well differ in important respects. For instance, the competitive battle between Walmart and Target is of a different character and intensity than the rivalry among Gucci, Chanel, Fendi, and other high-end fashion retailers. Likewise, industry driving forces can boost the business outlook for some strategic groups and adversely impact the business prospects of others. Firms in strategic groups that are being adversely impacted by intense competitive pressures or driving forces may try to shift to a more favorably situated group if they can hurdle the barriers to enter the target strategic group. If certain firms are known to be trying to change their competitive positions on the map, then attaching arrows to the circles showing the targeted direction helps clarify the picture of competitive maneuvering among rivals.

2. Profit prospects vary from strategic group to strategic group. The profit prospects of firms in different strategic groups can vary from good to ho-hum to poor because of differing growth rates in buyer demand for the market segments each group serves, differing degrees of competitive rivalry within strategic groups (due perhaps to variations in entry barriers, product/brand differentiation, and customer loyalty), differing degrees of exposure to competition from substitute products outside the industry, differing degrees of supplier or buyer bargaining power from group to group, and differing impacts from the industry’s driving forces.

Thus, part of strategic group map analysis always entails drawing conclusions about where on the map is the “best” place to be and why. Which companies/strategic groups are destined to prosper because of their positions? Which companies/strategic groups seem destined to struggle because of their positions? What accounts for why some parts of the map are better than others? Do big white spaces on the map correctly imply that these spaces are not attractive positions to be in or might one or more industry members be able to profitably create and capture new demand by moving into a particular white space?

Strategic group maps reveal which companies are close competitors and which are distant competitors.

CORE CONCEPT Some strategic groups are more favorably positioned than others because they confront weaker competitive forces and/or because they stand to be favorably impacted by the industry’s driving forces.

Chapter 3 • Evaluating a Company’s External Environment 63

Question 4: What Strategic Moves Are Rivals Likely to Make Next?

Unless a company pays attention to competitors’ strategies and situations and has some inkling of what moves they will be making, it ends up flying blind into competitive battle. As in sports, scouting the opposition and trying to prepare for the actions close rivals are likely to take is essential to competing effectively against them. Gathering competitive intelligence about rivals’ strategies, their financial performance, their resource strengths and weaknesses, the actions and plans they have announced, and the thinking and leadership styles of their top executives is valuable for predicting or anticipating the strategic moves competitors are likely to make next. The more a company can get into the minds of the managers of rival companies and anticipate rivals’ moves, the better able it is to be ready with defensive countermoves, to craft its own strategic moves with some confidence about what market maneuvers to expect from rivals, and to capitalize on opportunities stemming from competitors’ missteps or strategy flaws. Failure to study rival companies well enough to accurately anticipate some of their probable competitive moves makes it (highly?) likely that a company will suffer unexpected declines in sales and profits because it is caught flat-footed or “surprised” by aggressive moves on the part of one or more rivals to boost their sales and market share in order to improve their profitability and overall performance.

Good clues about what actions a specific company is likely to undertake can often be gleaned from how well it is faring in the marketplace, the problems or weaknesses it needs to address, and how much pressure it is under to improve its financial performance.19 Rivals with good financial performance are likely to continue their present strategy with only minor fine-tuning. Poorly performing rivals are virtually certain to make fresh strategic moves. Ambitious rivals looking to move up in the industry ranks are strong candidates for launching new strategic offensives to pursue emerging market opportunities and exploit the vulnerabilities of weaker rivals. Other sources of clues about what actions a rival may take include company press releases, information posted on the company’s website (especially the presentations management has recently made to securities analysts), and such public documents as annual reports and 10-K filings.

Company managers can pose several useful questions to help predict the likely actions of important rivals:

n Which competitors have strategies that are producing good results—and thus are likely to make only minor strategic adjustments (other than increasing expenditures for one or more strategy elements in order to further boost their competitiveness and performance)?

n Which competitors are losing ground in the marketplace or otherwise struggling to come up with a good strategy—and thus are strong candidates for altering their prices, improving the appeal of their product offerings, perhaps moving to a different part of the strategic group map, and otherwise adjusting important elements of their strategy?

n Which competitors are poised to gain market share, and which ones seem destined to lose ground?

n Which competitors are likely to rank among the industry leaders five years from now? Do one or more up-and-coming competitors have powerful strategies and sufficient resource capabilities to overtake the current industry leader?

Closely monitoring the actions of competitors and preparing a defense against their expected next moves reduces the risk of being caught napping and suffering a damaging loss of sales and profits.

Perhaps the most frequent reason why a company gets outcompeted by what it considers the “surprising” actions of rivals goes directly to the failure of its management to do a competent job of studying the situation of one or more rivals and recognizing their need to undertake certain actions in the marketplace to improve their market share and profitability.

Chapter 3 • Evaluating a Company’s External Environment 64

n Which rivals badly need to increase their unit sales and market share? What strategic options are they most likely to pursue: lowering prices, adding new models and styles, expanding their dealer networks, entering additional geographic markets, boosting advertising to build better brand-name awareness, acquiring a weaker competitor, or placing more emphasis on direct sales via their website?

n Which rivals are likely to enter new geographic markets or make major moves to substantially increase their sales and market share in a particular geographic region?

n Which rivals are strong candidates to expand their product offerings and enter new product segments where they do not currently have a presence?

n Which rivals are good candidates to be acquired? Which rivals might well acquire one or more industry rivals (or an outsider with competitively valuable capabilities)?

To succeed in predicting a competitor’s next moves, company strategists need to have a good feel for each rival’s situation, how its managers think, and what the rival’s best strategic options are. Many companies have competitive intelligence units that sift through the available information to construct up-to-date strategic profiles of rival firms. Doing the necessary detective work can be tedious and time-consuming, but scouting competitors well enough to anticipate their next moves allows managers to prepare effective countermoves (perhaps to even beat a rival to the punch) and to take rivals’ probable actions into account in crafting their own best course of action.

Question 5: What Are the Key Factors For Future Competitive Success?

An industry’s key success factors (KSFs) are those competitive factors that most affect industry members’ ability to prosper in the marketplace—the particular strategy elements, product attributes, resource strengths, competitive capabilities, and market achievements that spell the difference between being a strong competitor and a weak competitor—and sometimes between profit and loss. KSFs by their very nature are so important to future competitive success that all firms in the industry must pay close attention to them or risk becoming an industry laggard or failure. To indicate the significance of KSFs another way, how well a company’s product offering, resources, and capabilities measure up against an industry’s KSFs determines just how financially and competitively successful that company will be. Identifying KSFs, in light of the prevailing and anticipated industry and competitive conditions, is therefore always a top-priority analytical and strategy-making consideration. Company strategists need to understand the industry landscape well enough to separate the factors most important to competitive success from those that are less important.

KSFs vary from industry to industry, and even from time to time within the same industry, as driving forces and competitive conditions change. In the case of manufacturers of national and international brands of beer, the KSFs are full utilization of brewing capacity (to keep the fixed costs of manufacturing low), a strong network of wholesale distributors (to get the company’s brand stocked and favorably presented in retail outlets, bars, restaurants, and stadiums where beer is sold), and clever advertising and branding capabilities (to induce beer drinkers to buy the company’s brand and thereby pull beer sales through the established wholesale/retail channels). In apparel manufacturing, the KSFs are appealing designs and color combinations (to create buyer interest) and low-cost manufacturing efficiency (to permit attractive retail pricing and ample profit margins).

CORE CONCEPT Key success factors are the strategy elements, product attributes, resource strengths, competitive capabilities, and market achievements with the greatest impact on future competitive success in the marketplace.

Chapter 3 • Evaluating a Company’s External Environment 65

Regardless of the circumstances, an industry’s key success factors can be identified by asking three questions:

• On what basis do buyers of the industry’s product or service choose between the competing brands of sellers? That is, what product or service attributes are crucial?

• Given the nature of competitive rivalry and the competitive forces prevailing in the marketplace, what resources and competitive capabilities must a company have to be competitively successful?

• What shortcomings are almost certain to put a company at a significant competitive disadvantage?

Only rarely are there more than five key factors for future competitive success. And even among these, two or three usually outrank the others in importance. Managers should therefore bear in mind the purpose of identifying KSFs—to determine which factors are most important to future competitive success—and resist the temptation to label a factor that has only minor importance as a KSF. To compile a list of every factor that matters even a little bit defeats the purpose of concentrating management attention on the factors truly critical to long-term competitive success.

Correctly diagnosing an industry’s KSFs also raises a company’s chances of crafting a sound strategy. The goal of company strategists should be to design a strategy that not only enables the company to compare favorably vis-à-vis rivals on each and every one of the industry’s future KSFs but that also aims at being distinctly better than rivals on one (or possibly two) of the KSFs—being distinctly better than rivals on one or two key success factors tends to translate into competitive advantage.20 The competitive advantage potential of such an approach to crafting a company’s strategy stands in sharp contrast to what happens when company executives misdiagnose industry KSFs or discount their strategic importance. When a strategy falls far short of delivering competitive parity on the industry’s KSFs, the company is destined to be a weak competitor and earn below-average profits. When the strategy puts a company somewhere in the middle of the pack of rivals relative to industry KSFs, its overall performance will likely approximate the industry average. Hence, making sure the company’s strategy contains top-priority strategic actions aimed at comparing favorably with rivals on each and every KSF—and then going a step further to achieve competitive superiority on at least one KSF—is a powerful and rewarding approach to crafting a company’s strategy.

Question 6: Is the Industry Outlook Conducive To Good Profitability?

The final step in evaluating the industry and competitive environment is to use the preceding analysis to decide whether the outlook for the industry presents the company with good prospects for attractive profitability and growth. The important factors on which to base such a conclusion include:

n Whether the industry and the company are being favorably or unfavorably impacted by macro- environmental factors.

n The industry’s growth potential.

n The anticipated strength of competitive forces—the overriding issue here is whether competitive forces seem likely to intensify and squeeze industry profitability to subpar levels or whether the company should be able to earn good profits despite the expected strength of competitive forces.

n Whether and to what degree industry profitability will be favorably or unfavorably affected by the industry’s driving forces.

To be a winner, a company’s strategy must compare favorably with rivals on all industry KSFs and be competitively superior on one, maybe two, of the industry’s KSFs.

Chapter 3 • Evaluating a Company’s External Environment 66

n Whether the company is strongly or weakly positioned on the industry’s strategic group map.

n How well the company’s strategy, product offering, and capabilities stack up against industry KSFs.

n The degrees of risk and uncertainty in the industry’s future.

As a general proposition, the anticipated industry environment is fundamentally attractive if it presents a company with good opportunity for above-average profitability; the industry outlook is fundamentally unattractive if a company’s profit prospects are unappealingly low.

However, it is a mistake to view future conditions in a particular industry as being equally attractive or unattractive to all industry participants and all potential entrants.21 For instance, even though analysis reveals numerous factors that make an industry’s outlook unattractive, a favorably situated and competitively capable company may nonetheless see ample opportunity to out-compete weaker rivals and significantly grow its revenues and profits. And even if an industry is deemed to have appealing potential for growth and profitability, a weak competitor may conclude that having to fight a steep uphill battle against much stronger rivals holds little promise of eventual market success or even average profitability. Similarly, some industry outsiders may conclude that they have the resources and capabilities to readily hurdle the barriers to entering an attractive industry, while other outsiders conclude that the same industry is unattractive because of the difficulty of challenging current market leaders with their particular resources and competencies and the better opportunities they have elsewhere.

When a company decides an industry is fundamentally attractive, a strong case can be made that it should invest aggressively to capture the opportunities it sees and to improve its long-term competitive position in the business. When a strong competitor concludes an industry is relatively unattractive and lacking in opportunity, it may elect to simply protect its present position, investing cautiously, if at all, and look for opportunities in other industries. A competitively weak company in an unattractive industry may see its best option as finding a buyer, perhaps a rival, to acquire its business.

Key Points

Evaluating a company’s external environment involves probing for answers to seven questions:

1. To what extent are factors in the broad macro-environment acting to make the outlook for the industry and the company more or less attractive? Industries and companies differ significantly as to how they are affected by developments and trends in the broad macro-environment. Identifying which of these is strategically relevant and their probable impact is the first step in understanding how attractively a company is situated in its external environment.

2. What kinds of competitive forces are industry members facing, and how strong is each force? The strength of competition is a composite of five forces: (1) the jockeying and market maneuvering among industry rivals, (2) the threat of new entrants into the market, (3) the market inroads being made by the sellers of substitutes, (4) supplier bargaining power, and (5) buyer bargaining power. All five must be examined force by force and their collective strength evaluated. Working through the five-forces model aids strategy-makers in crafting a strategy that is well-suited to prevailing competitive conditions and has good prospects for producing the best possible business results.

CORE CONCEPT The degree to which an industry’s outlook is attractive or unattractive is not the same for all industry participants and all potential entrants. Some companies may be strongly positioned with the strategies and competitive strengths to capture the opportunities an industry presents; others may not.

Chapter 3 • Evaluating a Company’s External Environment 67

3. What forces are driving changes in the industry, and what impact will these changes have on competitive intensity and industry profitability? Industry and competitive conditions change because certain forces are creating incentives or pressures for change. The most common driving forces include changes in the long-term industry growth rate, increasing globalization, Internet-related developments, changing buyer demographics and uses of the product, product innovation, the entry or exit of major firms, changes in cost and efficiency, changing buyer preferences for standardized versus differentiated products or services, regulatory influences and government policy changes, changing societal and lifestyle factors, and reductions in uncertainty and business risk. Once an industry’s driving forces have been identified, the analytical task becomes one of determining whether the driving forces, taken together, are acting to make the industry environment more or less attractive. Are the driving forces causing demand for the industry’s product to increase or decrease? Are the driving forces acting to make competition more or less intense? Will the driving forces lead to higher or lower industry profitability?

4. What market positions do industry rivals occupy—who is strongly positioned and who is not? Strategic group mapping is a valuable tool for understanding the similarities, differences, strengths, and weaknesses inherent in the market positions of rival companies. Rivals in the same or nearby strategic groups are close competitors, whereas companies in distant strategic groups usually pose little or no immediate threat. The lesson of strategic group mapping is that some positions on the map are more favorable than others. The profit potential of different strategic groups varies due to strengths and weaknesses in each group’s market position. Often, industry driving forces and competitive pressures favor some strategic groups and hurt others.

5. What strategic moves are rivals likely to make next? Scouting competitors well enough to anticipate their actions can help a company prepare effective countermoves (perhaps even beating a rival to the punch) and allows managers to take rivals’ probable actions into account when designing their own company’s best course of action. Managers who fail to study competitors risk being caught unprepared by rivals’ strategic moves.

6. What are the key factors for future competitive success? An industry’s key success factors (KSFs) are the particular strategy elements, product attributes, competitive capabilities, and business outcomes that spell the difference between being a strong competitor and a weak competitor—and sometimes between profit and loss. KSFs are so important to competitive success that all firms in the industry must pay close attention to them or risk becoming an industry also-ran. To be a winner, a company’s strategy must compare favorably with rivals on all industry KSFs and be competitively superior on one, maybe two, of the industry’s KSFs.

7. Is the industry outlook conducive to good profitability? An industry’s outlook is fundamentally attractive if it presents a company with good opportunity for above-average profitability; its outlook is fundamentally unattractive when a company’s profit prospects are unappealingly low. On occasion, an industry with a bleak outlook is still very attractive to a favorably situated company with the capabilities to take business away from weaker rivals.

Clear insightful diagnosis of a company’s external environment is an essential first step in crafting strategies that are well matched to industry and competitive conditions and, therefore, have a good chance to produce the best possible business results. To engage in cutting-edge strategic thinking about the external environment, managers must know what questions to pose and what analytical tools to use in answering these questions. That is why this chapter has concentrated on suggesting the right questions to ask, explaining concepts and analytical approaches, and indicating the kinds of things to look for.

Chapter 4 Evaluating a Company’s Resources and Ability to Compete Successfully 68

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education, Burr Ridge, IL

Arthur A. Thompson, The University of Alabama 5th Edition, 2018-2019

CHAPTER 4

Evaluating a Company’s Resources and Ability to Compete Successfully

Before executives can chart a new strategy, they must reach common understanding of the company’s current position. —W. Chan Kim and Rene Mauborgne

Organizations succeed in a competitive marketplace over the long run because they can do certain things their customers value better than can their competitors. —Robert Hayes, Gary Pisano, and David Upton

A new strategy nearly always involves acquiring new resources and capabilities. —Laurence Capron and Will Mitchell

Chapter 3 described how to use the tools of industry and competitive analysis to assess a company’s external environment and lay the groundwork for matching a company’s strategy to its external situation. This chapter discusses techniques for evaluating a company’s internal situation, with emphasis on its resource capabilities, relative cost position, and competitive strength versus rivals. The analytical spotlight is trained on six questions:

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

2. What are the company’s important resources and capabilities, and do they have the competitive power to enable the company to build and/or sustain a competitive advantage over rival companies?

3. What are the company’s competitively important strengths and weaknesses in relation to its market opportunities and the external threats to its future well-being?

4. Are the company’s prices and costs competitive with those of key rivals, and does it have an appealing customer value proposition?

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

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

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 69

In probing for answers to these questions, five analytical tools—resource and capability analysis, SWOT analysis, value chain analysis, benchmarking, and competitive strength assessment—are used. All five are valuable techniques for revealing a company’s competitiveness and for helping company managers match their strategy to the company’s particular circumstances.

Question 1: How Well Is the Company’s Present Strategy Working?

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

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

Planned, proactive moves to attract customers and out-compete rivals via improved product design, better features, higher quality, wider selection, lower prices, and so on

Actions to respond to changing conditions in the macroenvironment or in industry and competitive conditions

Initiatives to build competitive advantage based on: • Lower costs relative to rivals? • A different or better product

offering? • Superior ability to serve a

market niche or specific group of buyers?

Efforts to expand or narrow geographic coverage

Efforts to build competitively valuable partnerships and strategic alliances with other enterprises

R&D, technology, product design strategy

Supply chain management strategy

Production strategy

Sales, marketing, and distribution strategies

Information technology strategy

Human resources strategy

Finance strategy

BUSINESS STRATEGY

The actions and approaches crafted

to compete successfully in a particular

business

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 70

The three best indicators of how well a company’s strategy is working are (1) whether the company is achieving its stated financial and strategic objectives, (2) whether the company is an above-average industry performer, and (3) whether the company is gaining customers and gaining market share. Persistent shortfalls in meeting company performance targets and mediocre performance in the marketplace relative to rivals are reliable warning signs that the company has a weak strategy, suffers from poor strategy execution, or both. Specific metrics to use in determining how well a company’s strategy is working include:

n Whether the firm’s sales are growing faster, slower, or at about the same pace as the market as a whole, thus resulting in a rising, eroding, or stable market share.

n How well the company stacks up against rivals on product innovation, product quality, price, customer service, and other relevant factors on which buyers base their choice of brands.

n Whether the firm’s brand image and reputation is growing stronger or weaker.

n Whether the firm’s profit margins are increasing or decreasing.

n Trends in the firm’s net profits, return on investment, and stock price and how these compare to the same trends for other companies in the industry.

n Whether the company’s overall financial strength, credit rating, key financial and operating ratios, and cash flows from operations are improving, remaining steady, or deteriorating.

The bigger the improvements in a company’s market standing and competitive strength and the stronger its financial performance, the more likely it has a well- conceived, well-executed strategy. Run-of-the-mill market results and mediocre financial performance are red flags that raise questions about a company’s strategy and whether radical changes in strategy may be needed.

Table 4.1 provides a compilation of the financial ratios most commonly used to evaluate a company’s financial performance and balance sheet strength.

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

Ratio How Calculated What It Shows Profitability Ratios 1. Gross profit margin Sales revenues – Cost of goods sold

Sales revenues Shows the percentage of revenues available to cover operating expenses and yield a profit. Higher is better and the trend should be upward.

2. Operating profit margin (or return on sales)

Sales revenues – Operating expenses Sales revenues

or Operating income

Sales revenues

Shows the profitability of current operations without regard to interest charges and income taxes. Earnings before interest and taxes is commonly referred to as EBIT. Higher is better and the trend should be upward.

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

Profits after taxes Sales revenues

Shows after-tax profits per dollar of sales. Higher is better and the trend should be upward.

4. Total return on assets Profits after taxes + Interest Total assets

A measure of the return on total monetary investment in the enterprise. Interest is added to after-tax profits to form the numerator since total assets are financed by creditors as well as by stockholders. Higher is better and the trend should be upward.

5. Net return on total assets (ROA)

Profits after taxes Total assets

A measure of the return earned by stockholders on the firm’s total assets. Higher is better, and the trend should be upward.

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

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 71

6. Return on stockholder’s equity (ROE)

Profits after taxes Total stockholders’ equity

Shows the return stockholders are earning on their capital investment in the enterprise. A return in the 12–15% range is “average,” and the trend should be upward.

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

Profits after taxes Long-term debt +

Total stockholders’ equity

A measure of the return shareholders are earning on the long-term monetary capital invested in the enterprise. A higher return reflects greater bottom-line effectiveness in the use of long-term capital, and the trend should be upward.

8. Earnings per share (EPS)

Profits after taxes Number of shares of common stock

outstanding

Shows the earnings for each share of common stock outstanding. The trend should be upward, and the bigger the annual percentage gains, the better.

Liquidity Ratios 1. Current ratio Current assets

Current liabilities Shows a firm’s ability to pay current liabilities using assets that can be converted to cash in the near term. Ratio should definitely be higher than 1.0; ratios of 2 or higher are better still.

2. Working capital Current assets – Current liabilities Bigger amounts are better because the company has more internal funds available to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital.

Leverage Ratios 1. Total debt-to-assets

ratio Total liabilities Total assets

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

2. Long-term debt-to- capital ratio

Long-term debt Long-term debt +

Total stockholders’ equity

An important measure of creditworthiness and balance sheet strength. It indicates the percentage of capital investment in the enterprise that has been financed by both long-term lenders and stockholders. A ratio below 0.25 is usually preferable since monies invested by stockholders account for 75% or more of the company’s total capital. The lower the ratio, the greater the capacity to borrow additional funds. Debt-to-capital ratios above 0.50 and certainly above 0.75 indicate a heavy and perhaps excessive reliance on long-term borrowing, lower creditworthiness, and weak balance sheet strength.

3. Debt-to-equity ratio Total liabilities Total stockholders’ equity

Shows the balance between debt (funds borrowed both short term and long term) and the amount that stockholders have invested in the enterprise. The further the ratio is below 1.0, the greater the firm’s ability to borrow additional funds. Ratios above 1.0 and definitely above 2.0 put creditors at greater risk, signal weaker balance sheet strength, and often result in lower credit ratings.

4. Long-term debt-to- equity ratio

Long-term debt Total stockholders’ equity

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

Ratio How Calculated What It Shows

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 72

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

Operating income Interest expenses

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

Activity Ratios

Days of inventory Inventory Cost of goods sold ÷ 365

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

Inventory turnover Cost of goods sold Inventory

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

Average collection period

Accounts receivable Total sales ÷ 365

or Accounts receivable Average daily sales

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

Other Important Measures of Financial Performance

Dividend yield on common stock

Annual dividends per share Current market price per share

A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2–3%. The dividend yield for fast-growth companies is often below 1% (maybe even 0); the dividend yield for slow-growth companies can run 4–5%.

Price-earnings ratio Current market price per share Earnings per share

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

Dividend payout ratio Annual dividends per share Earnings per share

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

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

Free cash flow After-tax profits + Depreciation – Capital expenditures – Dividends

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

Ratio How Calculated What It Shows

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 73

Question 2: What Are the Company’s Resources and Capabilities and Do They Have the Competitive Power to Enable the Company to Build and/or Sustain a Competitive Advantage Over Rivals?

An essential element of deciding whether a company’s internal situation is fundamentally healthy or unhealthy entails examining the attractiveness of its resources and capabilities. A company’s resources and capabilities are competitive assets and determine whether its competitive power in the marketplace will be impressively strong or disappointingly weak. Companies with second-rate competitive assets nearly always are relegated to a trailing position in the industry.

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

Identifying a Company’s Competitively Important Resources and Capabilities A company’s competitively important resources and capabilities are fundamental building blocks in crafting a competitive strategy.1 Broadly speaking, any asset or productive input that a firm owns or control qualifies as a resource. Most firms have many kinds and types of resources, and these tend to vary widely in quality and competitive relevance. Our interest here is not in cataloging every resource a company has but rather in identifying those resources that have competitive value and can underpin its strategy.

Identifying Valuable Company Resources Valuable or competitively relevant resources can relate to any of the following:

n Physical assets: ownership of or access rights to valuable natural-resource deposits, valuable real estate and store locations, attractive real estate or store locations, and state-of-the-art plants and/or equipment and/or distribution facilities.

n Human assets and intellectual capital: an educated, well-trained, and experienced workforce, the cumulative learning and know-how of key personnel and work groups regarding technology and/or key business functions; special expertise and skills, managerial and leadership skills, the creativity and innovativeness of certain personnel, the work ethic and motivational drive of the company’s workforce.2

n Organizational resources: proven quality control systems, proprietary technology, patents, state-of-the- art information systems (systems for monitoring various operating activities in real-time, just-in-time inventory management systems, and so on)

n Financial resources: cash and marketable securities, a strong balance sheet and credit rating (thus giving the company access to additional financial capital).

n Intangible assets: brand names, trademarks, copyrights, company image, reputational assets (for technological leadership or excellent product quality or customer service or honesty and trustworthiness), buyer loyalty and goodwill.

n Relationships: alliances, joint ventures or partnerships that provide access to valuable technologies, specialized know-how, or attractive geographic markets; fruitful partnerships with suppliers that reduce costs and/or enhance product quality and performance; a strong network of distributors and/or retail dealers.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 74

Identifying Valuable Company Capabilities A capability concerns the proficiency with which a company can perform an activity. A company’s skill or proficiency in performing different facets of its operations can range from one of minimal capability (perhaps having just struggled to perform an activity for the first time) to the other extreme of being able to perform the activity with a level of competence that exceeds any other company in the industry. In general, the competitive value of a capability depends on two factors: the competence a company has achieved in performing the activity and the role of the activity in the company’s strategy, as explained below:

1. A company’s proficiency rises from that of mere ability to perform an activity to the level of a competence when it learns to perform the activity consistently well and at acceptable cost. Usually competence in performing an activity originates with deliberate efforts to simply develop the ability to do it, however imperfectly or inefficiently. Then, as experience builds and the company gains proficiency to perform the activity consistently well and at an acceptable cost, its ability evolves into a true competence and capability. Whether a competence has competitive value depends on whether it relates directly to a company’s strategy or competitive success or whether it concerns an activity that has minimal competitive bearing (like administering employee benefit programs).

Some competitively valuable competencies relate to fairly specific skills and expertise (like just- in-time inventory control, low-cost manufacturing efficiency, picking locations for new stores, or designing an unusually appealing and user-friendly website). They spring from proficiency in a single discipline or function and may be performed in a single department or organizational unit. Other competencies, however, are inherently multidisciplinary and cross-functional. They are the result of effective collaboration among people with different expertise working in different organizational units. A competence in continuous product innovation, for example, comes from teaming the efforts of people and groups with expertise in market research, new product R&D, design and engineering, cost-effective manufacturing, and market testing. Virtually all organizational capabilities are knowledge based, residing in people and in a company’s intellectual capital and not in its assets on the balance sheet.

2. A core competence is a proficiently performed internal activity that is central to a company’s strategy and competitiveness.4 A core competence is a more competitively valuable capability than a competence because of the well-performed activity’s key role in the company’s strategy and the contribution it makes to the company’s market success and profitability. A core competence can relate to any of several aspects of a company’s business: expertise in integrating multiple technologies to create families of new products, skills in manufacturing a high-quality product at a low cost, or the capability to fill customer orders accurately and swiftly. Most core competencies are grounded in cross-department combinations of knowledge and expertise rather than being the product of a single department or work group. Amazon. com has a core competence in online retailing and website operations. Kellogg has a core competence in developing, producing, and marketing breakfast cereals. Microsoft has a core competence in developing operating systems for computers and user software like Microsoft Office®.

CORE CONCEPT A company has a competence in performing an activity when, over time, it gains the experience and know-how to perform an activity consistently well and at acceptable cost.

CORE CONCEPT A core competence is an activity that a company performs quite well and that is also central to its strategy and competitiveness. A core competence is a more important capability than a competence because it adds power to a company’s strategy and has a bigger positive impact on its competitive success.

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3. A distinctive competence is a competitively valuable activity that a company performs better than its rivals.5 A distinctive competence thus signifies greater proficiency than a core competence. Because a distinctive competence represents a level of proficiency that rivals do not have, it qualifies as a competitively superior capability with competitive advantage potential. It is always easier for a company to build competitive advantage when it has a distinctive competence in performing an activity important to market success, when rival companies do not have offsetting competencies, and when it is costly and time-consuming for rivals to imitate the competence. Companies that have a distinctive competence include Google, which has a distinctive competence in search engine technology, and Walt Disney Co., which has a distinctive competence in creating and operating theme parks.

In determining whether a company has a competitively attractive collection of resources and capabilities, it is important to identify which of its skills and proficiencies qualify as a competence, which represent a core competence, and whether it may enjoy a distinctive competence in one or more activities it performs.6 Both core competencies and distinctive competencies are valuable because they enhance a company’s competitiveness. But mere ability to perform an activity well does not necessarily give a company competitive clout. Some competencies merely enable market survival because most rivals also have them—indeed, not having a competence or competitive capability that rivals have can result in competitive disadvantage. An apparel manufacturer cannot survive without the capability to produce its apparel items cost efficiently, given the intensely price-competitive nature of the apparel industry. A cell-phone maker cannot survive without the capability to introduce next- generation cell phones with appealing new features and functions that attract a profitable number of buyers.

Astute Bundling of a Company’s Resources and Capabilities Can Result in Added Competitive Power. In identifying company resources and capabilities with competitive value, it is important to understand that a particular resource or capability which may not seem to have much competitive value by itself can be much more valuable when bundled with certain other company resources and/or capabilities (that also, taken singly, appear to lack important competitive value). There are numerous instances when resource/capability bundles have important competitive power even when individual components of the bundle do not. For example, Nike’s resource bundle of styling expertise, professional endorsements, well-regarded brand name and image, marketing and brand-building skills, network of distributors/retailers, and managerial know-how has provided sufficient competitive power for Nike to remain the dominant global leader in athletic footwear and sports apparel for over 20 years.

It is equally important to understand that the value of a company resource/capability is often also a function of the company’s proficiency in using the resource/capability to perform an activity. For instance, the degree to which a company’s manufacturing plants are a competitively valuable resource hinges, in part, upon whether the products being manufactured are of poor quality, lower-than-average quality, better-than-average quality, or superior quality. A company’s manufacturing capabilities thus matter. Moreover, in most cases, a company’s manufacturing capabilities are enhanced or weakened by its product R&D capabilities and its product design capabilities.

CORE CONCEPT A distinctive competence is a competitively important activity that a company performs better than its rivals—it thus represents a competitively superior capability.

CORE CONCEPT A resource/capability bundle is a group of resources and/or capabilities that, when linked and integrated into a functioning whole, has greater competitive value than the summed value of the individual components—in other words, combining individual resources and capabilities into an integrated bundle produces a 1 + 1 = 3 gain in competitive power versus just a 1 + 1 = 2 gain when the same resources and capabilities are unbundled.

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Four Ways to Test the Competitive Power of a Resource or Capability What is most telling about the importance and value of a company’s resources and capabilities, individually and collectively, is how powerful they are in the marketplace. The competitive power of a resource or capability is measured by how many of the following four tests it can pass:7

1. Does the resource or capability have competitive value? The competitive value of a resource or capability is determined by how much it helps a company improve its customer value proposition (and thereby better attract and please customers), the degree to which it enables a company to compete effectively against rivals, and its role in the company’s profit proposition. Unless a resource or capability contributes to the power of a company’s strategy and helps maintain or enhance the company’s competitiveness vis-à-vis rivals, it cannot pass the test of being competitively valuable. Companies must guard against contending that most any kind of expertise or know-how or well-performed activity qualifies as a core or a distinctive competence or gives them substantial competitive clout. Apple’s iOS operating system for its PCs is by most accounts a world beater (compared to Windows 8 and Windows 10), but Apple has failed to convert its know-how and capability in operating system design into competitive success in the global PC market—its global market share in PCs has lagged well behind HP, Dell, and Lenovo for over two decades. Moreover, it is important to recognize that a resource or capability can quickly lose its competitive value because of rapid changes in technology or customer preferences or the importance of certain distribution channels or other market-related factors. For example, a company’s ability to benefit from strong capabilities in product innovation is governed by how quickly rivals can introduce their own new products with many of the same features. The branch offices of commercial banks are becoming a less valuable competitive asset because of growing use of direct deposits, automated teller machines, debit cards, and telephone and Internet banking options that reduce the need to “go to the bank.”

2. Do many or most rivals have much the same resource or capability? A resource or capability that most of a company’s rivals also possess cannot be a basis for outcompeting rivals or achieving competitive advantage. Indeed, when most companies in an industry can legitimately lay claim to having a particular resource or capability, then that resource or capability is valuable only from the standpoint of helping industry members maintain competitive parity in the marketplace and perhaps indicating the resource or capability is an industry key success factor. A resource or capability achieves its greatest competitive value only if (1) it is rare (in the sense of being possessed by no more than a few companies competing in the same market arena) and (2) has sufficient competitive power (like a distinctive competence) to enable a firm to outcompete rivals and gain a sustainable competitive advantage.

3. Is the resource or capability hard to copy? The more difficult and more expensive it is for rivals to imitate a competitively valuable resource or capability, the greater its potential for enabling a company to outcompete rivals and win a competitive advantage. Resources tend to be difficult to copy when they are unique (a fantastic real estate location, patent-protected technology or product features, an unusually talented and motivated labor force), when they must be built over time in ways that are difficult to imitate (a well-known brand name, mastery of a complex production process, a global network of dealers and distributors), and when they entail financial outlays or large-scale operations that few industry members can undertake. Such hard-to-copy resources and capabilities are valuable competitive assets, adding to a company’s market strength and contributing to sustained profitability.

4. Can the value of a resource or capability be trumped by substitute resources and capabilities of rivals? Resources that are valuable, not widely possessed by rivals, and hard to copy, lose much of their competitive power if rivals have substitute resources or capabilities of equal or greater competitive power.8 For instance, manufacturers relying on robotics and automated production processes to gain a cost advantage in production activities may find their technology-based cost advantage completely nullified overcome by rivals who move their production operations to countries having both low wages and an adequately skilled labor force and thereby achieve even lower costs.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 77

The vast majority of companies are not well endowed with standout resources or capabilities capable of passing all four tests with high marks. Most firms have a mixed bag of resources and capabilities—one or two quite valuable, some good, many satisfactory to mediocre. Resources and capabilities that are valuable pass the first of the four tests. As contributors to the competitiveness of a company’s strategy, they are mainly important in gaining competitive parity with many (maybe most) rivals; but such resources/capabilities lack the competitive power to produce competitive advantage without the presence of important bundling effects.

For a company to have resources/capabilities that can pass the first two tests entails a much higher hurdle—having a resource or capability that is valuable, likely not possessed by rivals (rare), and potentially has significant competitive power because it is competitively superior in some important respect. Companies in the top tier of their industry may have as many as two or three core competencies but only a very few companies, usually the strongest industry leaders or up-and-coming challengers, have a capability that truly qualifies as a distinctive competence. A standout resource that delivers competitive superiority is as rare as a distinctive competence. This is why, absent important resource/capability bundling effects, it is so hard for a company to achieve a sustainable competitive advantage over rivals. Achieving sustainable competitive advantage usually requires a company to have at least one resource/capability that can pass the first three tests (except in those instances where important resource/capability bundling effects are present).

However, a company that lacks a standout resource or distinctive competence and only has resources/ capabilities that can pass the first test can still marshal a group of good-to-adequate resources and capabilities that collectively make it competitive enough to be profitable, even attractively profitable. Fast-food chains like Wendy’s, Taco Bell, and Subway, despite having only satisfactory resources and capabilities, have nonetheless achieved respectable market positions and profitability competing against McDonald’s. Discount retailers Target and Kohl’s have bundled good enough resources and capabilities to profitably compete against Walmart and its richer, deeper resources/capabilities. Underdog Under Armour, whose chief competitors, Nike and Adidas, have three times larger revenues and the financial strength to develop competitively strong resources and capabilities, has developed sufficiently potent resources and capabilities to take market share away from Nike and Adidas, boost its domestic and international market standing, be attractively profitable, and drive up its stock price.

A Company’s Important Resources and Capabilities Must Be Dynamic and Freshly-Honed to Sustain Its Competitiveness For a company’s important resources and capabilities to remain competitively valuable over time, they must be continually polished, updated, and sometimes augmented with altogether new kinds of resources and expertise.9 It takes freshly honed and sometimes totally refurbished or altogether new resources/capabilities for a company to effectively respond to ongoing changes in customer needs and expectations. Diligent managerial attention to sharpening and recalibrating company competencies and capabilities protects a company’s long-term competitiveness against the improving capabilities of rivals and their strategic maneuvering to win bigger sales and market shares. Absent such attention, a company’s competencies and capabilities risk becoming stale over time and contributing to an erosion of company performance.10

CORE CONCEPT The degree of success a company enjoys in the marketplace is governed by the combined competitive power of its resources and capabilities.

CORE CONCEPT A company requires a dynamically evolving portfolio of competitively valuable resources and capabilities to sustain its competitiveness and help drive improvements in its performance. Otherwise, the power of its competitive assets grow stale.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 78

The Role of Dynamic Capabilities Management’s challenge in creating and maintaining a dynamic and competitively effective portfolio of resources and capabilities has two elements: (1) attending to ongoing recalibration and refurbishment of the company’s competitive assets and (2) casting a watchful eye for opportunities to develop totally new resources and capabilities for delivering better customer value and/or outcompeting rivals. Companies that succeed in meeting these challenges are likely to be in the enviable position of having an ever-stronger and competitively potent arsenal of resources and capabilities.

Company executives that grasp the strategic importance of incrementally improving the company’s existing competitive assets and from time-to-time adding new resources/capabilities make a point of ensuring that these actions are an ongoing, high-priority activity. By making proactive oversight of these activities a routine managerial function, they gain the experience and know-how to do a consistently good job of dynamically managing the company’s important competitive assets. At that point, their ability to freshen and augment the company’s resource/capability portfolio becomes what is known as a dynamic capability.11 This dynamic capability also includes an ongoing top management search for opportunities to create new resources and capabilities to increase the company’s competitiveness. When a company’s executive management team achieves proficient dynamic capability to modify, deepen, and augment the company’s competitively important resources and capabilities, the company’s competitiveness in the marketplace is significantly enhanced.

Question 3: What Are the Company’s Strengths and Weaknesses and How Do They Relate to Its Market Opportunities and External Threats?

One of the simplest and most powerful tools for assessing a company’s overall situation is widely known as SWOT analysis, so named because it zeros in on a company’s competitively important Strengths and Weaknesses, its market Opportunities, and those external Threats that can adversely impact the company’s well-being. Doing a first- rate SWOT analysis has considerable managerial value because it helps company managers single out and focus on all the factors needed to craft a winning strategy that fits the company’s overall internal and external situation. To achieve good fit with the company’s situation, managers must devise a strategy that capitalizes on the company’s most potent competitive strengths, corrects important competitive weaknesses, aims squarely at capturing the company’s best market opportunities, and defends against the external threats to its future well-being and business prospects.

SWOT analysis is a simple but powerful tool for sizing up a company’s competitively relevant strengths and weaknesses, its market opportunities, and the external threats to its future well-being.

Executive attention to making sure a company always has competitively valuable resources and capabilities that dynamically evolve and help sustain the company’s competitiveness is a strategically important top management task.

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Identifying a Company’s Competitively Relevant Strengths A strength can relate to something a company is good at doing (a competitively important capability or a core competence), a competitively valuable resource (like a well-known brand name or a reputation for award-winning customer service or large numbers of high-traffic store locations), and certain kinds of competitively relevant achievements or attributes that contribute to a company’s competitiveness in the marketplace (like having low overall costs relative to competitors, being a market share leader, having a wider product line than rivals, and having wider geographic market coverage than rivals).

Most usually, a company’s strengths stem from the caliber and competitive power of its resources and capabilities; managers can draw on resource and capability analysis to make objective assessments of the potency of the company’s resources and capabilities. While individual resources and capabilities that can pass one or more of the four texts of competitive power typically represent the company’s greatest strengths, managers should be careful not to overlook the competitive strength that results from bundling less potent resources and capabilities. Further, a resource or capability that lacks much competitive power may still be useful for successfully gaining entry into a new market or market segment. A resource bundle that fails to match those of top-tier companies may, nonetheless, allow a company to compete quite successfully against second-tier rivals.

Identifying a Company’s Important Weaknesses and Competitive Deficiencies A weakness, or competitive deficiency, is something a company lacks or does poorly (in comparison to others) or a condition that puts it at a disadvantage in the marketplace. A company’s weaknesses can relate to (1) inferior or unproven skills, expertise, capabilities, or intellectual capital in competitively important areas of the business; (2) deficiencies in competitively important physical, organizational, or intangible resources; or (3) missing capabilities in key areas. Company weaknesses are thus internal shortcomings or deficiencies that constitute competitive liabilities. Nearly all companies have competitive liabilities of one kind or another. Whether a company’s weaknesses make it competitively vulnerable depends on how much they matter in the marketplace and whether they are mostly offset or minimized by the company’s strengths.

Table 4.2 contains a representative sample of things to consider in identifying a company’s competitively relevant strengths and weaknesses. Sizing up a company’s complement of strengths and weaknesses is akin to constructing a strategic balance sheet, where strengths represent competitive assets and weaknesses represent competitive liabilities. Obviously, the ideal outcome is for a company’s competitive assets to outweigh its competitive liabilities by a healthy margin—a 50-50 balance (or worse) is ominous.

CORE CONCEPT A company’s weaknesses are internal short- comings that constitute competitive liabilities.

CORE CONCEPT A company’s competitively relevant strengths are competitive assets that positively impact its competitiveness and ability to succeed in the marketplace.

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

Potential Strengths and Competitive Assets • Core competencies in _______ • A distinctive competence in _______ • A product strongly differentiated from those of rivals • Resources and capabilities well matched to industry

key success factors • A strong financial condition; ample financial resources

to grow the business • Strong brand name/company reputation • Strong customer loyalty • Proven technological capabilities, proprietary

technology/important patents • Strong bargaining power over suppliers or buyers • Cost advantages over rivals • Skills in advertising and promotion • Product innovation capabilities • Proven capabilities in improving production processes • Good supply chain management capabilities • Strong customer service capabilities • Better product quality relative to rivals • Wide geographic coverage and/or strong global

distribution capability • Alliances/joint ventures with firms that provide access

to valuable technology, expertise and/or attractive geographic markets

Potential Market Opportunities • Openings to win market share from rivals • Sharply rising buyer demand for the industry’s product • Serving additional customer groups or market

segments • Expanding into new geographic markets • Expanding the company’s product line to meet a

broader range of customer needs • Utilizing existing company skills or technological

know-how to enter new product lines or new businesses

• Online sales via the Internet • Integrating forward or backward • Falling trade barriers in attractive foreign markets • Acquiring rival firms or companies with attractive

capabilities • Entering into alliances or joint ventures to expand the

firm’s market coverage or boost its competitiveness • Openings to exploit emerging new technologies

Potential Weaknesses and Competitive Deficiencies • No well-developed or proven core competencies • Resources and capabilities that are not well matched to

an industry’s key success factors • Too much debt; a weak credit rating • Short on financial resources to grow the business and

pursue promising initiatives • Higher overall unit costs relative to key rivals • Weaker product innovation capabilities than key rivals • A product/service with attributes or features inferior to

those of rivals • Too narrow a product line relative to rivals • Weaker brand name/reputation than rivals • Weaker dealer network than key rivals • Weak global distribution capability • Weaker product quality, R&D, and/or technological

know-how than key rivals • In an overcrowded strategic group • Losing market share because _________ • Competitive disadvantages in ________ • Inferior intellectual capital relative to rivals • Subpar profitability because _________ • Plagued with internal operating problems or obsolete

facilities • Too much underutilized plant capacity

Potential External Threats to a Company’s Future Profitability • More intense competitive pressures from industry rivals

and/or sellers of substitute products—may squeeze profit margins

• The entry (or likely entry) of new competitors into the company’s market stronghold (especially lower-cost foreign competitors)

• Growing bargaining power of buyers or suppliers • Slowing or declining market demand for the industry’s

product • A shift in buyer needs and tastes away from the

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

demand for the industry’s product • Vulnerability to unfavorable industry driving forces • Unfavorable trade policies and tariffs; a threat of trade

wars • Costly new regulatory requirements • Tight credit conditions • Rising prices for energy or other key inputs

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 81

Identifying a Company’s Market Opportunities Market opportunity is a big factor in shaping a company’s strategy. Indeed, managers can’t properly tailor strategy to the company’s external situation without first identifying its market opportunities and appraising the growth and profit potential each one holds. Depending on the prevailing circumstances, a company’s opportunities can be plentiful or scarce, fleeting or lasting, and can range from wildly attractive (an absolute “must” to pursue) to marginally interesting (because of the high risks, large capital requirements, or unappealing revenue growth and profit potentials) to unsuitable (because the company’s resource strengths and capabilities are ill-suited to successfully capitalize on some opportunities). Typical market opportunities are shown in Table 4.2.

Newly emerging and fast-changing markets sometimes present stunningly big or “golden” opportunities, but it is typically hard for managers at one company to peer into “the fog of the future” and spot them much ahead of managers at other companies.12 But as the fog begins to clear, golden opportunities are nearly always pursued rapidly. And the companies that seize them are usually those that have been actively waiting, staying alert with diligent market reconnaissance, and preparing themselves to capitalize on shifting market conditions by patiently assembling an arsenal of competitively valuable resources and a war chest of cash to finance aggressive action when the time comes.13 In mature markets, unusually attractive market opportunities emerge sporadically, often after long periods of relative calm—but future market conditions may be less foggy, thus facilitating good market reconnaissance and making emerging opportunities easier for industry members to detect.

In evaluating a company’s market opportunities and ranking their attractiveness, managers have to guard against viewing every industry opportunity as a company opportunity. Rarely does a company have the resource depth to pursue all available market opportunities simultaneously without spreading itself too thin. Some companies have resources and capabilities better-suited for pursuing some opportunities than others, and a few companies are often hopelessly outclassed in competing against stronger rivals to capture attractive industry opportunities. A company is always well advised to pass on a particular market opportunity unless it has or can acquire potent enough resources and capabilities to profitably compete for it.

Identifying the Threats to a Company’s Future Profitability Often, certain factors in a company’s external environment pose threats to its profitability and competitive well-being. Threats can stem from such factors as the emergence of cheaper or better technologies, the entry of lower-cost foreign competitors into a company’s market stronghold, new regulations that are more burdensome to a company than to its competitors, unfavorable demographic shifts, and political upheaval in a foreign country where the company has facilities. Table 4.2 lists representative potential threats.

External threats may pose no more than a moderate degree of adversity (all companies confront some threatening elements in the course of doing business), or they may be so ominous they put a company’s future survival at risk. On rare occasions, market shocks can give birth to a sudden-death threat that throws a company into an immediate crisis and battle to survive. Many of the world’s major financial institutions were plunged into unprecedented crisis in 2008–2009 by the after-effects of high-risk mortgage lending, inflated credit ratings on subprime mortgage securities, the collapse of housing prices, and a market flooded with mortgage-related investments (collateralized debt obligations) whose values suddenly evaporated. It is management’s job to identify the threats to the company’s future prospects and to evaluate what strategic actions can be taken to neutralize or lessen their impact.

CORE CONCEPT The market opportunities most relevant to a company are those that can be pursued with its competitively strong resources and capabilities, offer the best prospects of growth and profitability, and present the most potential for achieving competitive advantage.

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What Do the SWOT Listings Reveal? SWOT analysis involves more than making four lists. The two most important parts of SWOT analysis are drawing conclusions from the SWOT listings about the company’s overall situation, and translating these conclusions into strategic actions and an overall strategy that is well-matched to the company’s overall situation— as indicated by its strengths and weaknesses, its market opportunities, and its external threats. Figure 4.2 shows the steps involved in gleaning insights from SWOT analysis.

The answers to the following questions often reveal just what story the SWOT listings tell about the company’s overall situation:

n What are the attractive aspects of the company’s situation?

n What aspects are of the most concern?

n Do the company’s strengths have sufficient competitive power to enable it to compete successfully?

n Are the company’s weaknesses/deficiencies of major or minor consequence? Must remedial action be taken immediately? Or, are the weaknesses/deficiencies sufficiently negated by the company’s strengths that corrective action is probably not the best use of company resources?

n Does the company have resources and capabilities that are especially well-suited to successfully pursuing and capturing its most attractive market opportunities? Is the company lacking certain resources or capabilities that make it inadvisable to pursue any of the identified market opportunities?

n Are the external threats alarming, or are they something the company appears able to deal with and defend against?

n All things considered, where on a scale of 1 to 10 (where 1 is alarmingly weak and 10 is exceptionally strong), does the company’s overall situation and future prospects rank?

Simply making lists of a company’s strengths, weaknesses, opportunities, and threats is not enough. The payoff from SWOT analysis comes from the conclusions about a company’s situation and the implications for strategy improvement that flow from the four lists.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 83

Figure 4.2 The Three Steps of SWOT Analysis: Identify, Draw Conclusions, Translate into Strategic Action

Identify the company’s competitively relevant strengths and competitive assets

Identify the company’s competitively relevant weaknesses and deficiencies

Identify the company’s market opportunities

Identify external threats to the company’s future well-being

Conclusions concerning the company’s overall business situation: • Where on the scale from “alarmingly weak” to

“exceptionally strong” does the attractiveness of the company’s situation rank?

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

Implications for improving company strategy: • Use company strengths and capabilities as

corner stones for strategy. • Pursue those market opportunities best suited to

company strengths and capabilities. • Correct weaknesses and deficiencies that impair

pursuit of important market opportunities or heighten vulnerability to external threats.

• Use company strengths to lessen the impact of important external threats.

What Can Be Gleaned from the SWOT Listings?

The final piece of SWOT analysis is to translate the diagnosis of the company’s internal and external circumstances into actions for improving the company’s strategy and business prospects.

Translating the SWOT Analysis Results into Effective Strategic Action The SWOT analysis results provide excellent guidance to managers in crafting a strategy (or improving an existing strategy) in ways that may enable the strategy to pass the three tests of a winning strategy. As you should recall, a winning strategy must fit the company’s internal and external situation, help build competitive advantage, and boost company performance. Four conditions are necessary for a company’s strategy to be a good to excellent fit with its overall situation:

1. The foundation and centerpiece of a company’s strategy to profitably compete against rivals must be its most competitively powerful resources and capabilities. Using a company’s most potent resources and capabilities to power its strategy gives the company its best chance for market success, competitive advantage, and better performance.14 Should the power of the company’s resources and capabilities prove competitively stronger than those of some or many rivals, its business performance is certain to improve. And, in the best-case outcome, if certain of the company’s most potent resources and capabilities are hard for rivals to copy or trump, then achieving a sustainable competitive advantage can be within reach. Strategies that place heavy demands on areas and activities where the company is comparatively weak or has unproven competitive capability should be avoided.

CORE CONCEPT Relying on a company’s strongest resources and capabilities to power its strategy produces the best fit with the company’s internal and external situation, thereby making such an approach to crafting strategy the surest route to market success and good business results.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 84

2. The strategy must include actions to correct those competitive weaknesses that make the company vulnerable to attack from rivals, depress profitability, or disqualify it from pursuing a particularly attractive opportunity. However, there is scant reason to devote much attention to correcting those weaknesses or deficiencies that are well defended by other company resources and capabilities.

3. The company’s strategy must include strategic initiatives aimed squarely at capturing those market opportunities best suited to the company’s strengths and competitive assets. Management should almost always deploy some of the company’s most potent resources and capabilities to spearhead such initiatives. Indeed, what makes a market opportunity attractive to pursue is that the company has competitively powerful resources and capabilities that can be used to seize upon the opportunity to grow the business, boost performance, and potentially achieve competitive advantage. However, there are instances where some market opportunities can be pursued with resource/capability bundles having sufficient competitive power to get the job done.

4. The strategy should include efforts to defend against those external threats that can adversely impact the company’s long-term business prospects or put its survival at risk. How much attention to devote to defending against external threats hinges on how vulnerable the company is, whether attractive defensive moves can be taken to lessen their impact, and whether the costs of undertaking such moves represent the best use of company resources. Some external threats are often beyond a firm’s ability to influence or defend against; in such cases, the best course of action can be to wait until the threat materializes and try to offset its impact with actions in other parts of the business.

Question 4: Are the Company’s Prices and Costs Competitive with Those of Key Rivals, and Does It Have an Appealing Customer Value Proposition?

Company managers are often stunned when a competitor cuts its price to “unbelievably low” levels or when a new market entrant comes on strong with a very low price. Such rivals may not, however, be “dumping” (an economic term for selling at prices below cost) or buying market share with a super-low price or waging a desperate move to gain sales—they may simply have substantially lower costs. Then there are occasions when a competitor storms the market with a new product that ratchets the quality level up so high some customers will abandon competing sellers even if they have to pay more for the new product—this is what seems to have happened with Apple’s iPhone 7 and iMac computers.

Regardless of where on the price-quality-performance spectrum a company competes, it must remain competitive in terms of its customer value proposition to stay in the game. Two telling signs of whether a company’s business position is strong or precarious are (1) whether its prices are justified by the value it delivers to customers and (2) whether its costs are competitive with industry rivals delivering similar customer value at a similar price. The greater the amount of customer value a company can offer profitably compared to its rivals, the less vulnerable it is to competitive attack. And if it can deliver the same amount of value at lower costs (or more value at the same cost), it will enjoy a competitive edge.

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

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The Concept of a Company Value Chain Every company’s business consists of a collection of activities undertaken in the course of designing, producing, marketing, delivering, and supporting its product or service. All of the various activities a company performs internally combine to form a value chain—so-called because creating value for customers is what chains a company’s various activities into a purposeful group of functions and tasks. A company has no sound business justification for performing any activity that does not contribute to greater value for customers.

As shown in Figure 4.3, a company’s value chain consists of two broad categories of activities: the primary activities foremost in the company’s scheme for creating and delivering value to customers and the requisite support activities that facilitate and enhance the performance of the primary activities.15 The kinds of primary and secondary activities that comprise a company’s value chain vary according to the specifics of its business—hence, the primary and secondary activities shown in Figure 4.3 are illustrative rather than definitive. For example, the primary activities at hotel operators like Marriott include site selection and construction, reservations, the operation of hotel properties (check-in and check-out, maintenance and housekeeping, dining and room service, and conventions and meetings), and management of its portfolio of hotel property locations. Its principal support activities include accounting, hiring and training, advertising, building a recognized and reputable brand name, and general administration. The primary activities for retailers like Best Buy or Home Depot involve merchandise selection and buying, supply chain management, store layout and product display, sales floor operations, website operations, and customer service, whereas its support activities include site selection, hiring and training, store maintenance, advertising, and general administration. Supply chain management is a crucial activity for Nissan and Amazon. com but is not a value chain component at Facebook or Twitter. Sales and marketing are dominant activities at Procter & Gamble and Nike but have minor roles at oil drilling companies and natural gas pipeline companies. Customer delivery is a crucial activity at Domino’s Pizza but insignificant at McDonald’s.

With its focus on value-creating activities, the value chain is an ideal tool for examining the workings of a company’s business model—its customer value proposition and profit proposition. It permits a deep look at the company’s cost structure and ability to charge low prices. It can reveal the costs a company is spending on product differentiation efforts to deliver greater customer value, support higher prices, and earn bigger profits. Company value chains necessarily include a profit margin component, since profits are necessary to compensate owners/shareholders who bear risks and provide capital. When the revenues generated from a company’s value-creating activities are sufficient to cover operating costs and yield an attractive profit, then the organization has an appealing value chain— its customer value proposition and its profit proposition are well aligned and signal a successful business model. Absent the ability to create a value chain capable of delivering sufficient customer value and producing adequate profitability, a company is competitively vulnerable and its survival open to question.

Comparing the Value Chains of Rival Companies Value chain analysis facilitates a comparison of how rivals, activity-by-activity, deliver value to customers. Typically, there are important differences in the value chains of rival companies. A company that makes a no-frills product and provides minimal customer services has a value chain with activities and costs that are different from a competitor that produces a full-featured, high-performance product and has a full range of customer service offerings. The “operations” component of the value chain for a manufacturer that makes all of its own parts and components and assembles them into a finished product differs from the “operations” of a rival producer that buys the needed parts and components from outside suppliers and only performs assembly

CORE CONCEPT A company’s value chain identifies the primary activities it performs that create customer value and the related support activities. The “outputs” of an organization’s value chain activities are the value delivered to customers and the resulting revenues it collects. The “inputs” are all of the resources required to conduct the various value chain activities; use of these resources creates costs.

CORE CONCEPT The greater the value a company can profitably deliver to its customers relative to the value close rivals deliver, the less competitively vulnerable it becomes. The higher a company’s costs relative to those of rivals delivering comparable customer value at a comparable price, the more competitively vulnerable it becomes.

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operations. Movie theaters that show the new releases of movie studios and derive a big portion of their revenues from concession sales employ different value-creating activities and have different costs from Netflix and other providers of movies streamed over the Internet directly to viewers’ TVs and mobile devices.

Differences in the value chains of close competitors raise two very important questions. One, whose value chain delivers the best customer value relative to the prices being charged? Two, which company has the lowest cost value chain? When one competitor employs a value chain approach that delivers greater value to customers relative to the price it charges, it gains competitive advantage even if its costs are equivalent to (or maybe slightly higher than) those of its close rivals. When close competitors deliver much the same value to customers, charge comparable prices, and employ similar value chains, then competitive advantage accrues to the company that operates its value chain most cost efficiently. Consequently, it is incumbent on company managers to vigilantly monitor how effectively and efficiently the company delivers value to customers relative to rival companies— gaining a competitive edge over rivals hinges on being able to deliver equivalent customer value at lower cost or greater customer value at the same cost.

Figure 4.3 A Representative Company Value Chain

PRIMARY ACTIVITIES • Supply Chain Management—Activities, costs, and assets associated with purchasing fuel, energy, raw

materials, parts and components, merchandise, and consumable items from vendors; receiving, storing and disseminating inputs from suppliers; inspection; and inventory management.

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

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

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

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

SUPPORT ACTIVITIES • Product R&D, Technology, and Systems Development—Activities, costs, and assets relating to product R&D, process

R&D, process design improvement, equipment design, computer software development, telecommunications systems, computer-assisted design and engineering, database capabilities, and development of computerized support systems.

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

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

Supply Chain

Manage- ment

Operations Distribution Sales and Marketing Service Profit

Margin

Product R&D, Technology, and Systems Development

Human Resources Management

General Administration

Primary Activities

and Costs

Support Activities

and Costs

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

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 87

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

Evaluating a company’s cost-competitiveness involves using what accountants call activity-based costing to determine the costs of performing each value chain activity.16 The degree to which a company’s total costs should be broken down into costs for specific activities depends on how valuable it is to know the costs of specific activities versus broadly defined activities. At the very least, cost estimates are needed for each broad category of primary and support activities, but cost estimates for more specific activities within each broad category may be needed if a company discovers it has a cost disadvantage vis-à-vis rivals and wants to pin down the exact source or activity causing the cost disadvantage. However, a company’s own internal costs are insufficient to assess whether its product offering and customer value proposition are competitive with those of rivals. Cost and price differences among competing companies can have their origins in activities performed by suppliers or by distribution allies involved in getting the product to the final customers or end users of the product, in which case the company’s entire value chain system becomes relevant.

The Value Chain System for an Entire Industry A company’s value chain is embedded in a larger system of activities that includes the value chains of its suppliers and the value chains of whatever wholesale distributors and retailers it utilizes in getting its product or service to end users.17 Suppliers’ value chains are relevant because suppliers perform activities and incur costs in creating and delivering the purchased inputs used in a company’s own value-creating activities. The costs, performance features, and quality of these inputs influence a company’s own costs and product differentiation capabilities. Anything a company can do to help its suppliers drive down the costs of their value chain activities or improve the quality and performance of the items being supplied can enhance its own competitiveness—a powerful reason for working collaboratively with suppliers in managing supply chain activities.18

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

As a consequence, accurately assessing a company’s competitiveness entails scrutinizing the nature and costs of value chain activities across an industry’s entire value chain system for delivering a product or service to end-use customers. A typical industry value chain that incorporates the value chains of suppliers and forward channel allies (if any) is shown in Figure 4.4. As was the case with company value chains, the specific activities comprising industry value chains vary significantly from industry to industry. The primary value chain activities

Each activity in a company’s value chain gives rise to costs and ties up assets.

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

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in the pulp and paper industry (timber farming, logging, pulp mills, paper making, and distribution) differ from the primary value chain activities in the home appliance industry (parts and components manufacture, assembly, wholesale distribution, retail sales) and differ yet again for the soft drink industry (processing of basic ingredients and syrup manufacture, bottling and can filling, wholesale distribution, advertising, and retail merchandising).

Figure 4.4 A Representative Value Chain System for an Entire Industry

Supplier-Related Value Chains

A Company’s Own Value Chain

Forward Channel Value Chains

Activities, costs, and margins of suppliers

Internally performed activities,

costs, and

margins

Activities, costs, and margins

of forward channel

allies and strategic partners

Buyer or end-user

value chains

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

Once a company has developed good cost estimates for each major activity in its own value chain, has a good grasp of the value chains its close rivals employ, and has sufficient cost data relating to the value chain activities of suppliers and distribution allies, it is ready to explore whether its costs compare favorably or unfavorably with those of key rivals. This is where benchmarking comes in.

Benchmarking: A Tool for Assessing Whether the Costs and Effectiveness of a Company’s Value Chain Activities Are in Line Benchmarking entails comparing how different companies (both inside and outside the industry) perform various value chain activities—how inventories are managed, how products are assembled, how fast the company can get new products to market, how customer orders are filled and shipped—and then making cross- company comparisons of the costs of these activities.19 The objectives of benchmarking are to identify the best means of performing an activity, to learn how other companies have actually achieved lower costs or better results in performing benchmarked activities, and to take action to emulate those best practices whenever benchmarking reveals that its costs and results of performing an activity are not on a par with what other companies have achieved. A best practice is a method or technique of performing an activity or business process that produces results superior to those achieved with other methods/techniques. To qualify as a legitimate best practice, the method must have been employed by at least one enterprise and shown to be consistently effective in lowering costs, improving quality or performance, shortening time requirements, enhancing safety, or achieving some other highly positive operating outcome.

Xerox pioneered the use of benchmarking to become more cost competitive, quickly deciding not to restrict its benchmarking efforts to its office equipment rivals but to extend them to any company regarded as “world class” in performing any activity relevant to Xerox’s business.20 Other companies quickly picked up on Xerox’s

CORE CONCEPT Benchmarking is a potent tool for learning which companies are best at performing particular activities and emulating their techniques (or “best practices”) to improve the cost and effectiveness of a company’s own internal activities.

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approach. Toyota managers got their idea for just-in-time inventory deliveries by studying how U.S. supermarkets replenished their shelves. Southwest Airlines reduced the turnaround time of its aircraft at each scheduled stop by studying pit crews on the auto racing circuit. More than 80 percent of Fortune 500 companies reportedly use benchmarking for comparing themselves against rivals in performing activities in ways that produce superior outcomes.

The tough part of benchmarking is not whether to do it but rather how to gain access to information about other companies’ practices and costs. Sometimes benchmarking can be accomplished by collecting information from published reports, trade groups, and industry research firms and by talking to knowledgeable industry analysts, customers, and suppliers. Sometimes field trips to the facilities of competing or noncompeting companies can be arranged to observe how things are done, ask questions, compare practices and processes, and perhaps exchange data on various cost components—but the problem here is that most companies, even if they agree to host facilities tours and answer questions, are unlikely to share competitively sensitive cost information. Furthermore, comparing one company’s costs to another’s costs may not involve comparing apples to apples if the two companies employ different cost accounting principles to calculate the costs of particular activities.

However, a third and fairly reliable source of benchmarking information has emerged. The explosive interest of companies in benchmarking costs and identifying best practices has prompted consulting organizations (Accenture, A.T. Kearney, Benchnet—The Benchmarking Exchange, and Best Practices, LLC) and several trade associations (the Qualserve Benchmarking Clearinghouse and the Strategic Planning Institute’s Council on Benchmarking) to gather benchmarking data, distribute information about best practices, and provide comparative cost data without identifying the names of particular companies. Having an independent group gather the information and report it in a manner that disguises the names of individual companies protects competitively sensitive data and lessens the potential for unethical behavior by company personnel in gathering their own data about competitors.

Strategic Options for Creating an Advantage or Remedying a Disadvantage as Concerns Cost or the Value Delivered to Customers Examining the costs of a company’s own value chain activities and comparing them to rivals indicates who has how much of a cost advantage or disadvantage and which cost components are responsible. Value chain analysis and benchmarking can also disclose whether a company has an advantage or disadvantage vis-à-vis rivals in delivering value to customers. Such information is vital in strategic actions to create a cost or value advantage or eliminate a cost/value disadvantage. The three main areas in a company’s total value chain system where company managers can try to create a cost/value advantage or remedy a cost/value disadvantage are (1) a company’s own activity segments, (2) suppliers’ part of the overall value chain, and (3) the distribution channel portion of the chain.

Improving the Performance of Internally Performed Activities Managers can pursue any of several strategic approaches to reduce the costs of internally performed value chain activities and improve a company’s cost competitiveness:21

n Implement best practices throughout the company, particularly for high-cost activities.

n Redesign the product and/or some of its components to eliminate high-cost components or facilitate speedier and more economical manufacture or assembly.

n Relocate high-cost activities (such as manufacturing) to geographic areas like Southeast Asia, Latin America, or Eastern Europe where they can be performed more cheaply.

n Outsource certain internally performed activities if vendors or contractors can perform them more cheaply than they can be performed in-house.

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n Shift to lower-cost technologies and/or invest in productivity-enhancing, cost-saving technological improvements (robotics, flexible manufacturing techniques, real-time process monitoring).

n Stop performing activities of minimal value to customers. Examples include seldom-used customer services and maintaining large raw material or finished goods inventories.

Managers can take several approaches to deliver better value to customers and thereby eliminate a disadvantage or create an advantage vis-à-vis rivals. They can adopt best practice approaches for quality and customer service activities. They can put more emphasis on better performance of those activities known to impact buyer brand preferences (most especially why buyers like or dislike the company’s brand). They can adopt new technologies and/or design innovations that improve quality, curtail the need for repairs or maintenance, extend product life, or otherwise enhances performance. They can outsource certain activities to vendors/contractors with the resources/capabilities to help deliver higher customer value at the same or lower cost.

In searching for cost-reducing opportunities or value-enhancing opportunities, it is important to recognize that the manner in which one activity is done spills over to impact the costs/value of how other activities are performed. For instance, how a television or washing machine is designed impacts the number of parts and components, their respective manufacturing costs, the time and expense of assembling the various parts and components into a finished product, and, from a customer value perspective, how well the product performs, repair frequencies, maintenance costs, and product life.

Improving the Performance of Supplier-Related Value Chain Activities A company can gain cost savings in supplier-related value chain activities by pressuring suppliers for lower prices, switching to lower- priced substitute inputs, and collaborating closely with suppliers to identify mutual cost-saving opportunities (like curtailing defects in the items being supplied).22 For example, just-in-time deliveries from suppliers can lower a company’s inventory and internal logistics costs and may also allow suppliers to economize on their warehousing, shipping, and production scheduling costs—a win–win outcome for both. In a few instances, companies may find it is cheaper to integrate backward into the business of high-cost suppliers and make the item in-house instead of buying it from outsiders.

A company can enhance the value it delivers to customers through its supplier relationships by selecting/retaining only those suppliers that meet higher-quality standards, bringing in suppliers to partner in the design process, and providing quality-based incentives to suppliers, particularly as concerns reducing parts defects. Fewer defects not only improve quality throughout the value chain system but also can curtail the annoyance customers have when a recently purchased product fails shortly after purchase (due to parts failures) and has to be repaired or replaced under warranty. In addition, fewer defects lower warranty costs and lower the costs of product testing and replacement of defective parts/components prior to shipment.

Improving the Performance of Distribution-Related Value Chain Activities Any of three means can be used to achieve better cost-competitiveness in the distribution portion of an industry value chain:23

1. Pressure distributors, dealers, and other forward channel allies to reduce their costs and markups to make the final price to buyers more competitive with the prices of rival brands.

2. Collaborate with forward channel allies to identify win–win opportunities to reduce costs—for example, a chocolate manufacturer learned that by shipping its bulk chocolate in liquid form in tank cars instead of in 10-pound molded bars, it could save its candy bar manufacturing customers the costs associated with unpacking and melting and also eliminate its own costs of molding and packing bars.

3. Change to a more economical distribution strategy, including switching to cheaper distribution channels (selling direct via the Internet) or integrating forward into company-owned retail outlets.

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The means of enhancing differentiation through the activities of distribution-related allies include (1) engaging in cooperative adverting and promotion campaigns, (2) creating exclusive distribution arrangements or using other incentives to boost the efforts of distribution allies to deliver enhanced value to end-use customers, (3) creating and enforcing higher standards for distribution allies to observe in performing their activities, and (4) providing training to forward channel partners in using best practices to perform their activities.

Translating Proficient Performance of Value Chain Activities into Competitive Advantage A company that does a first-rate job of managing its value chain activities relative to competitors stands a good chance of achieving sustainable competitive advantage. As shown in Figure 4.5, competitive advantage can be achieved by out-managing rivals in either of two ways: (1) by performing value chain activities more efficiently and cost effectively, thereby gaining a low-cost advantage over rivals or (2) by performing certain value chain activities in ways that drive value-creating improvements in quality, features, performance, and other aspects, thereby gaining a differentiation-based competitive advantage keyed to what customers perceive as a superior product offering.

Achieving Proficient Performance of Value Chain Activities Depends on Having the Right Resources and Capabilities As laid out in Figure 4.5, either approach requires focused management attention on building and nurturing resources and capabilities that enable the value chain activities to be performed proficiently enough to produce the desired outcome—lower costs or greater value-creating differentiation. A company’s value chain is all about performing activities, and proficient performance of key activities requires having not just the right resources and capabilities but developing and constantly improving them so they become ever more competitively valuable.

Achieving a cost-based competitive advantage requires determined efforts to be cost-efficient in performing value chain activities. Such efforts must be ongoing and persistent, and they have to involve each and every value chain activity. The goal must be continuous cost reduction, not on-again/off-again efforts. This requires a frugal culture where all company personnel not only exhibit cost-conscious behavior but also where they are diligent in finding and implementing operating practices that lower costs. Cost-benchmarking and aggressive implementation of cost-lowering best practices must be the norm. Companies whose managers are truly committed to low-cost performance of value chain activities and succeed in engaging company personnel to discover innovative ways to drive costs out of the business have a real chance of gaining a durable low-cost edge over rivals. It is not as easy as it seems to imitate a company’s low-cost practices. Walmart, Nucor Steel, Dollar General, Irish airline Ryanair, Toyota, and French discount retailer Carrefour have been highly successful in preserving a low-cost advantage by out-managing their rivals in how cost efficiently company value chain activities are performed.

On the other hand, companies that succeed in achieving a differentiation-based competitive advantage do so because of a strong commitment to proficiently performing those value chain activities that add value for customers and more strongly differentiate their product offering from rivals. For example, uniquely good customer service capabilities are crucial at such high-end hotel properties as Ritz-Carlton, Four Seasons, and St. Regis. First-rate product innovation capabilities are paramount at Google, Microsoft, Johnson & Johnson, and Walt Disney. Product design capabilities underlie IKEA’s success in the furniture business. Standout engineering design and manufacturing/assembly capabilities are essential at Mercedes and BMW. To the extent that a company continues to invest resources in building greater and greater proficiency in performing the targeted value chain activities,

Performing value chain activities in ways that give a company either a lower-cost advantage or a value-creating differentiation advantage over rivals are two surefire ways to secure competitive advantage.

Becoming more cost efficient than rivals in performing value chain activities entails building and nurturing resources and capabilities that differ substantially from those needed to achieve a value-enhancing, differentiation- based competitive advantage.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 92

and top management makes the associated resources and capabilities cornerstones of the company’s strategy to attract and please customers, then, over time, its proficiencies rise to the level of a core competence. Later, with further organizational learning and gains in proficiency, a core competence may evolve into a distinctive competence. Such superiority over rivals in performing one (or possibly several) differentiation-enhancing value chain activities can prove unusually difficult to match or offset. As a general rule, it is substantially harder for rivals to achieve “best in industry” proficiency in performing a key value chain activity than it is for them to clone the features and attributes of a hot-selling product or service.24 This is especially true when a company with a distinctive competence avoids becoming complacent and works diligently to maintain its industry-leading expertise and capability.

Figure 4.5 Translating Company Performance of Value Chain Activities into Competitive Advantage

Company managers decide to perform value chain activities in ways that drive

improvements in quality, features,

performance, and other

differentiation- enhancing

aspects

Competencies and

capabilities gradually emerge in performing

certain differentiation-

enhancing value chain

activities

Company proficiency in

performing some of these differentiation-

enhancing value chain

activities rises to the

level of a core competence

Company proficiency in

performing one or more

differentiation- enhancing value chain

activities continues to

build and evolves into a distinctive competence

Company gains a

competitive advantage based on superior

differentiation capabilities

Option 2: Beat rivals by performing certain differentiation-enhancing value chain activities more proficiently, thus creating a differentiation-based competitive advantage keyed to delivering what customers perceive as a superior product offering.

Option 1: Beat rivals by performing value chain activities more cheaply, thus achieving a cost-based competitive advantage

Company managers decide to perform value chain activities

in the most cost-efficient

manner—every value chain activity is

examined for possible cost

savings

Competencies and

capabilities gradually emerge in performing

many value chain

activities very cost efficiently

Company proficiency in cost-efficient performance

of value chain activities

rises to the level of a core

competence

Company proficiency in cost-efficient performance

of value chain activities

continues to build and

evolves into a distinctive competence

Company gains a

competitive advantage based on superior

cost-lowering capabilities

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 93

Question 5: Is the Company Competitively Stronger or Weaker Than Key Rivals?

Using value chain analysis and benchmarking to determine a company’s competitiveness on price, cost, and delivering value to customers is necessary but not sufficient. A more comprehensive assessment needs to be made of the company’s overall competitive strength. The answers to two questions are of particular interest: First, how does the company rank relative to competitors on each important factor that determines market success? Second, all things considered, does the company have a net competitive advantage or disadvantage versus its closest rivals?

An easy-to-use method for answering these two questions involves developing quantitative strength ratings for the company and its key competitors on each industry key success factor and each competitive trait or capability that impacts a company’s competitiveness and determines whether it is competitively strong or weak. Much of the information needed for doing a competitive strength assessment comes from previous analyses. Industry and competitive analysis reveals the key success factors and competitive capabilities that separate industry winners from losers. Benchmarking data and scouting key competitors provide a basis for judging the competitive strength of rivals on such factors as cost, key product attributes (quality, styling, performance features), customer service, image and reputation, financial strength, technological capability, distribution capability, and other competitively important traits. SWOT analysis reveals how the company in question stacks up on these same strength measures.

Step 1 in doing a competitive strength assessment is to make a list of the industry’s key success factors and the most telling measures of competitive strength or weakness (six to ten measures usually suffice). Step 2 is to assign weights to each of the measures of competitive strength based on their perceived importance—it is highly unlikely that all the different measures are equally important. For instance, in an industry where the products/ services of rivals are virtually identical, having low unit costs relative to rivals is nearly always the most important determinant of competitive strength. Importance weights can be as high as 0.50 in situations where one particular competitive strength measure is overwhelmingly decisive, or the high weights might be only 0.20 or 0.25 when two or three strength measures are more important than the rest. Lesser competitive strength indicators can carry weights of 0.05 or 0.10. The sum of the weights for each measure must add up to 1.0.

Step 3 is to rate the firm and its rivals on each competitive strength measure, using a rating scale of 1 to 10 (where 1 is very weak and 10 is very strong). Step 4 is to multiply each strength rating by its importance weight to obtain weighted strength scores (a strength rating of 4 times a weight of 0.20 gives a weighted strength score of 0.80). Step 5 is to sum each company’s weighted strength ratings to obtain an overall weighted competitive strength rating. Step 6 is to use the overall strength ratings to draw conclusions about the size and extent of the company’s net competitive advantage or disadvantage vis-à-vis its rivals and to take specific note of areas of strength and weakness.

Table 4.3 provides an example of competitive strength assessment in which a hypothetical company (ABC Company) competes against two rivals. In the example, relative cost is the most telling measure of competitive strength and the other strength measures are of lesser importance. The company with the highest rating on a given measure has an implied competitive edge on that measure, with the size of its edge reflected in the difference between its weighted rating and rivals’ weighted ratings. For instance, Rival 1’s 3.00 weighted strength rating on relative cost signals a considerable cost advantage versus ABC Company (with a 1.50 weighted score on relative cost) and an even bigger cost advantage against Rival 2 (with a weighted score of 0.30). The measure- by-measure ratings reveal the competitive areas where a company is strongest and weakest, and against whom.

The overall competitive strength scores indicate how all the different strength measures add up—whether the company is at a net overall competitive advantage or disadvantage against each rival. The more a company’s overall weighted strength rating exceeds the scores of lower-rated rivals, the stronger its overall competitiveness

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 94

versus those rivals; the further a company’s score is below those of higher-rated rivals, the weaker its ability to compete successfully. The bigger the difference between a company’s overall weighted rating and the scores of lower-rated rivals, the bigger is its implied net competitive advantage over these rivals. Thus, Rival 1’s overall weighted score of 7.70 indicates a greater net competitive advantage over Rival 2 (with a score of 2.10) than over ABC Company (with a score of 5.95). Conversely, the bigger the difference between a company’s overall rating and the scores of higher-rated rivals, the greater its implied net competitive disadvantage. Rival 2’s score of 2.10 gives it a smaller net competitive disadvantage against ABC Company (with an overall score of 5.95) than against Rival 1 (with an overall score of 7.70).

Table 4.3 A Representative Weighted Competitive Strength Assessment

Competitive Strength Assessments [Rating scale: 1 = Very weak; 10 = Very strong]

ABC Co. Rival 1 Rival 2 Key Success Factors and Strength Measures

Importance Weight

Strength Weighted Rating Score

Quality/product performance 0.10 8 0.80 5 0.50 1 0.10

Reputation/image 0.10 8 0.80 7 0.70 1 0.10

Manufacturing capability 0.10 8 0.20 10 1.00 5 0.50

Technological skills 0.05 10 0.50 1 0.05 3 0.15

Dealer network/distribution capability 0.05 9 0.45 4 0.20 5 0.25

New product innovation capability 0.05 9 0.45 4 0.20 5 0.25

Financial resources 0.10 5 0.50 10 1.00 3 0.30

Relative cost position 0.30 5 1.50 10 3.00 1 0.30

Customer service capabilities 0.15 5 0.75 7 1.05 1 0.15

Sum of importance weights 1.00

Weighted overall competitive strength rating 5.95 7.70 2.10

Strategic Implications of the Competitive Strength Assessments In addition to showing how competitively strong or weak a company is relative to its rivals, the strength ratings provide guidelines for designing wise offensive and defensive strategies. For example, if ABC Co. wants to go on the offensive to win additional sales and market share, such an offensive probably needs to be aimed directly at winning customers away from Rival 2 (which has a lower overall strength score) rather than Rival 1 (which has a higher overall strength score). Moreover, while ABC has high ratings for technological skills (a 10 rating), dealer network/distribution capability (a 9 rating), new product innovation capability (a 9 rating), quality/product performance (an 8 rating), and reputation/image (an 8 rating), these strength measures have low importance weights—meaning that ABC has strengths in areas that don’t translate into much competitive clout in the marketplace. Even so, it outclasses Rival 2 in all five areas, plus it enjoys substantially lower costs than Rival 2 (ABC has a 5 rating on relative cost position versus a 1 rating for Rival 2)—and relative cost position carries the highest importance weight of all the strength measures. ABC also has greater competitive strength than Rival 2 regarding customer service capabilities (which carries the second-highest importance weight). Hence, because ABC’s strengths are in the very areas where Rival 2 is weak, ABC is in good position to attack Rival 2. Indeed, ABC may well be able to persuade a number of Rival 2’s customers to switch their purchases over to its product.

The sizes of the differences between a company’s overall weighted score and that of a lower rated rival signals both their differing degrees of competitiveness and the size of the higher rated company’s net competitive advantage and the lower-rated company’s net disadvantage.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 95

But ABC should be cautious about cutting price aggressively to win customers away from Rival 2, because Rival 1 could interpret that as an attack by ABC to win away Rival 1’s customers as well. And Rival 1 is in far and away the best position to compete on the basis of low price, given its high rating on relative cost in an industry where low costs are competitively important (relative cost carries an importance weight of 0.30). Rival 1’s very strong relative cost position vis-à-vis both ABC and Rival 2 arms it with the ability to use its lower-cost advantage to thwart any price-cutting on ABC’s part. Clearly ABC is vulnerable to any retaliatory price cuts by Rival 1—Rival 1 can easily defeat both ABC and Rival 2 in a price-based battle for sales and market share. If ABC wants to defend against its vulnerability to potential price-cutting by Rival 1, it needs to aim a portion of its strategy at lowering its costs.

The point here is that a competitively astute company should take both the individual and overall strength scores into account in deciding what strategic moves to make. When a company has important competitive strengths in areas where one or more rivals are weak, it makes sense to consider offensive moves based on these strengths to exploit rivals’ competitive weaknesses. When a company has important competitive weaknesses in areas where one or more rivals are strong, it makes sense to consider defensive moves to curtail its vulnerability.

Question 6: What Strategic Issues and Problems Merit Front-Burner Managerial Attention?

The final and most important analytical step is to zero in on exactly which strategic issues company managers need to worry about and consider in crafting a strategy well-suited to the company’s specific circumstances. Compiling a “worry list” involves drawing heavily on the results of both the analysis of the company’s external environment and the evaluations of the company’s resources and ability to compete successfully. The task here is to get a clear fix on exactly what strategic and competitive challenges confront the company, which of the company’s competitive shortcomings need fixing, what obstacles stand in the way of improving the company’s competitive position in the marketplace, and what specific problems/issues merit front-burner attention by company managers in crafting future strategic actions.

The “worry list” of significant strategic issues and problems that need to be dealt with can include such things as how to stave off market challenges from new foreign competitors, how to combat the price discounting of rivals, how to reduce the company’s high costs and pave the way for price reductions, how to sustain the company’s present rate of growth in light of slowing buyer demand, whether to expand the company’s product line, whether to correct the company’s competitive deficiencies by acquiring a rival company with the missing strengths, whether to expand into foreign markets rapidly or cautiously, whether to reposition the company and move to a different strategic group, what to do about growing buyer interest in substitute products, and what to do to combat the aging demographics of the company’s customer base. The worry list thus always centers on such concerns as “how to…,” “what to do about…,” and “whether to…”—the purpose of the worry list is to highlight the specific issues/ problems that management needs to address in deciding what upcoming strategic actions to take. The worry list thus serves as an agenda of strategically relevant issues/problems that managers need to deal with in crafting a refurbished strategy that is better suited to the particulars of the company’s external and internal situation.

Compiling a “worry list” that zeros in on the strategic issues and problems a company faces always centers on such concerns as “how to…,” “what to do about…,” and “whether to….” The purpose of compiling a worry list is to create an agenda of items that merit top-priority managerial consideration before attempting to craft a strate- gy well-suited to the company’s overall situation.

A company’s competitive strength scores pinpoint its strengths and weaknesses against rivals and point directly to the kinds of offensive/ defensive actions it can use to exploit its competitive strengths and reduce its competitive vulnerabilities.

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 96

Only after managers have first done serious strategic thinking about the items on the worry list are they truly prepared to pick and choose among the alternative strategic actions and initiatives and otherwise fashion an overall strategy that fits the company’s circumstances and addresses all the items on the worry list.25 If the items on the worry list are relatively minor—which suggests the company’s present strategy is mostly on track and reasonably well matched to the company’s overall situation—company managers seldom need to go much beyond fine-tuning the present strategy to arrive at a strategy suitable for the road ahead. If, however, the issues and problems confronting the company signal that the present strategy requires significant overhaul, the task of crafting a revamped strategy better suited to the company’s internal and external situation needs to be right at the top of management’s action agenda.

Key Points

There are six key questions to consider in evaluating a company’s resources and ability to compete successfully:

1. How well is the present strategy working? This involves evaluating the strategy from a qualitative standpoint (completeness, internal consistency, rationale, and suitability to the situation) and also from a quantitative standpoint (the strategic and financial results the strategy is producing). The stronger a company’s current overall performance, the less likely the need for radical strategy changes. The weaker a company’s performance and/or the faster the changes in its external situation, the more its current strategy must be questioned.

2. What are the company’s important resources and capabilities, and do they have the competitive power to enable the company to build and/or sustain a competitive advantage over rival companies? The task here is to identify the company’s most valuable resources and capabilities and to assess their competitive power using four tests. The degree of success a company enjoys in the marketplace is governed by the combined competitive power of its resources and capabilities. Executive attention to making sure a company always has competitively valuable resources and capabilities that dynamically evolve and help sustain the company’s competitiveness is a strategically important top management task.

3. What are the company’s competitively important strengths and weaknesses in relation to its market opportunities and the external threats to its future well-being? A SWOT analysis provides an overview of a firm’s situation and is an essential component of crafting a strategy that is well-suited to the company’s internal and external circumstances. The two most important parts of a SWOT analysis are (1) drawing conclusions about what story the compilation of strengths, weaknesses, opportunities, and threats tells about the company’s overall situation, and (2) acting on those conclusions to better develop a strategy that satisfies the three requirements of a winning strategy: (1) fit the company’s internal and external situation, (2) help build competitive advantage, and (3) improve performance. A company’s most competitively potent resources and capabilities should be the foundation of its strategy. Using a company’s most potent resources and capabilities to power its strategy gives the company its best chance for market success, competitive advantage, and better performance. A well-conceived strategy must include actions to correct those competitive weaknesses that make the company vulnerable to attack from rivals, depress profitability, or disqualify it from pursuing a particularly attractive opportunity. Market opportunities and external threats come into play because fitting a company’s strategy to a company’s situation requiring aiming an important portion of the company’s strategy at pursuing attractive market opportunities and defending against threats to its future profitability and well-being.

CORE CONCEPT A strategy is neither complete nor well matched to the company’s situation unless it contains actions and initiatives to address each issue or problem on the “worry list.”

Chapter 4 • Evaluating a Company’s Resources and Ability to Compete Successfully 97

4. Are the company’s prices and costs competitive with those of key rivals, and does it have an appealing customer value proposition? The greater the value a company can profitably deliver to its customers relative to the value delivered by close rivals, the less competitively vulnerable it becomes. The higher a company’s costs relative to those of rivals delivering comparable customer value at a comparable price, the more competitively vulnerable it becomes. Value chain analysis and benchmarking are essential tools in determining how well a company is performing particular functions and activities, learning whether its costs are in line with competitors, and deciding which internal activities and business processes need to be scrutinized for improvement. Performing value chain activities in ways that give a company either a lower-cost advantage or a value-creating differentiation advantage over rivals are two surefire ways to create competitive advantage.

5. Is the company competitively stronger or weaker than key rivals? The key appraisals here involve how the company matches up against key rivals on industry key success factors and other chief determinants of competitive success and whether and why the company has a competitive advantage or disadvantage. Quantitative competitive strength assessments, using the method presented in Table 4.3, indicate where a company is competitively strong and weak, and provide insight into the company’s ability to defend or enhance its market position. As a rule, a company’s competitive strategy should be built around its competitive strengths and should aim at shoring up areas where it is competitively vulnerable. When a company has important competitive strengths in areas where one or more rivals are weak, it makes sense to consider offensive moves to exploit rivals’ competitive weaknesses. When a company has important competitive weaknesses in areas where one or more rivals are strong, it makes sense to consider defensive moves to curtail its vulnerability.

6. What strategic issues and problems merit front-burner managerial attention? This analytical step zeros in on the strategic issues and problems that stand in the way of the company’s success. It involves drawing on the results of both the analysis of the company’s external environment and the evaluations of the company’s overall internal situation to compile a “worry list” of issues that managers need to deal with in refurbishing the company’s strategy to better fit its overall situation. The worry list always centers on such concerns as “how to…,” “what to do about…,” and “whether to….” Items on a worry list merit front-burner management attention. A company’s strategy is neither complete nor well matched to the particulars of its situation unless it contains actions and initiatives to address every issue or problem on the “worry list.”

Accurate appraisal of a company’s internal situation, like penetrating analysis of its external environment, is a valuable precondition for good strategy making. Absent such analysis, company managers are unlikely to craft a strategy that is well suited to the company’s competitive capabilities and best market opportunities.

Chapter 5 The Five Generic Competitive Strategy Options: Which One to Employ? 98

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education, Burr Ridge, IL

Arthur A. Thompson, The University of Alabama 5th Edition, 2018-2019

CHAPTER 5

The Five Generic Competitive Strategy Options: Which One to Employ?

Competitive strategy is about being different. It means deliberately choosing to perform activities differently or to perform different activities than rivals to deliver a unique mix of value. —Michael E. Porter

Strategy is all about combining choices of what to do and what not to do into a system that creates the requisite fit between what the environment needs and what the company does. —Costas Markides

The essence of strategy lies in creating tomorrow’s competitive advantages faster than competitors mimic the ones you possess today. —Gary Hamel and C. K. Prahalad

A company can employ any of several basic approaches to competing successfully and gaining a competitive advantage over rivals, but they all involve striving to deliver superior value to customers compared to the offerings of rival sellers. Superior customer value can mean a good product at a lower price, a superior product that is worth paying more for, or a best-value offering that represents an attractive combination of price, features, quality, service, and other appealing attributes. Delivering superior value—whatever form it takes— nearly always requires performing value chain activities differently from rivals and developing competitively potent resources and capabilities that rivals cannot readily match or trump.

This chapter describes the five generic competitive strategy options—which one to employ is a company’s first and foremost choice in crafting an overall strategy and beginning the quest for competitive advantage.

The Five Generic Competitive Strategies

A company’s competitive strategy deals exclusively with the specifics of management’s game plan for competing successfully—how it intends to please customers, offensive and defensive moves to counter the maneuvers of rivals, responses to shifting market conditions, and initiatives to strengthen the company’s market position and achieve a particular kind of competitive advantage. Chances are remote that any two companies—even companies in the same industry—will employ competitive strategies that are exactly alike in every detail. Why? Because the differing external and internal circumstances that company managers have to deal with vary too widely for them to arrive at precisely the same conclusion about what strategy to employ, down to each and every detail.

Chapter 5 • The Five Generic Competitive Strategy Options: Which One to Employ? 99

However, when one strips away the details to get at the real substance, the two biggest factors that distinguish one competitive strategy from another boil down to (1) whether a company’s market target is broad or narrow, and (2) whether the company is pursuing a competitive advantage linked to lower costs or differentiation. As shown in Figure 5.1, these two factors give rise to five competitive strategy options for staking out a market position, operating the business, and delivering superior value to buyers:1

1. A low-cost provider strategy—striving to achieve lower overall costs than rivals in offering a mostly comparable product/service to a broad spectrum of buyers. Gaining a low-cost advantage over rivals enables a company to either boost sales and market share by underpricing rivals or else earn bigger profits by simply matching whatever prices its higher-cost rivals are charging.

2. A broad differentiation strategy—seeking to differentiate the company’s product offering from rivals’ offerings with attributes that will appeal to a broad spectrum of buyers.

3. A focused low-cost strategy—concentrating on a narrow buyer segment (or market niche) and striving to meet the specific needs and requirements of niche members at lower costs than rivals, thus being in a position to win buyer favor and outcompete rivals with a lower-priced product offering.

4. A focused differentiation strategy—concentrating on a narrow buyer segment (or market niche) and striving to outcompete rivals by offering niche members customized attributes that meet their tastes and requirements better than the product offerings of rivals.

5. A best-cost provider strategy—striving to incorporate upscale product attributes at a lower cost than rivals. Being the “best-cost” producer of an upscale, multi-featured product allows a company to give customers more value for their money by underpricing rivals whose products have similar upscale, multi-featured attributes. This competitive approach is a hybrid strategy that blends elements of the previous four options in a unique and often effective way.

The remainder of this chapter explores the ins and outs of these five generic competitive strategy options.

Figure 5.1 The Five Generic Competitive Strategy Options

Overall Low-Cost Provider Strategy

Broad Differentiation

Strategy

Focused Low-Cost Strategy

Focused Differentiation

Strategy

Best-Cost Provider Strategy

A Broad Cross-Section of Buyers

A Narrow Buyer Segment (or Market Niche)

M ar

ke t T

ar ge

Type of Competitive Advantage Being Pursued

Lower Cost Differentiation

Source: This is an author-expanded version of a three-strategy classification discussed in Michael E. Porter, Competitive Strategy (New York: Free Press, 1980), pp. 35–40.

Chapter 5 • The Five Generic Competitive Strategy Options: Which One to Employ? 100

Low-Cost Provider Strategies

Striving to achieve lower overall costs than rivals is an especially potent competitive approach in markets with many price-sensitive buyers. A company achieves low-cost leadership when it becomes the industry’s lowest-cost provider rather than just being one of perhaps several competitors with comparatively low costs. A low-cost provider’s foremost strategic objective is meaningfully lower costs than rivals—but not necessarily the absolutely lowest possible cost. In striving for a cost advantage over rivals, company managers must take care to incorporate features and attributes that buyers consider essential—a product offering that is too frills-free can undermine its attractiveness to buyers even if it is cheaper priced. For maximum effectiveness, a low-cost provider also needs to pursue cost- saving approaches and/or have cost-reducing capabilities that are difficult for rivals to copy. When it is relatively easy or inexpensive for rivals to imitate the low-cost firm’s methods, any resulting cost advantage evaporates too quickly to gain a valuable edge in the marketplace.

A company has two options for translating a low-cost advantage over rivals into attractive profit performance. Option 1 is to use its lower-cost edge to underprice competitors and attract price-sensitive buyers in great enough numbers to increase total profits. Option 2 is to charge a price comparable to other low-priced rivals, be content with the resulting sales volume and market share, and rely upon the low-cost edge over rivals to earn a bigger profit margin per unit sold, thereby boosting the firm’s total profits and return on investment.

While many companies are inclined to exploit a low-cost advantage by using Option 1 (attacking rivals with lower prices in hopes that the expected gains in sales and market share will lead to higher total profits), this strategy can backfire if rivals respond with retaliatory price cuts of their own (to defend against a loss of sales and protect their customer base). Such a rush to cut prices can often trigger a ferocious price war that lowers the profits of all price discounters. The bigger the risk that rivals will respond with matching price cuts, the more appealing it becomes to employ the second option for using a low-cost advantage to achieve higher profitability.

The Two Major Avenues for Achieving a Cost Advantage To achieve a low-cost edge over rivals, a firm’s cumulative costs across its overall value chain must be lower than competitors’ cumulative costs—and the means of achieving the cost advantage must be durable. There are two ways to accomplish this.2

1. Perform value chain activities more cost effectively than rivals.

2. Revamp the firm’s overall value chain to eliminate or bypass some cost-producing activities.

Cost-Efficient Management of Value Chain Activities For a company to do a more cost-efficient job of managing its value chain than rivals, managers must diligently search out cost-saving opportunities in every part of the value chain. No activity can escape cost-saving scrutiny, and all company personnel must be expected to use their talents and ingenuity to come up with innovative and effective ways to keep costs down. Particular attention must be paid to a set of factors known as cost drivers that have a strong effect on a company’s costs and can be used as levers to lower costs. Figure 5.2 shows the most important cost drivers. Cost-saving approaches that demonstrate effective use of the cost drivers include:

CORE CONCEPT A low-cost leader’s basis for competitive advantage is lower overall costs than rivals. Successful low-cost leaders are exceptionally good at finding ways to drive costs out of their businesses.

A low-cost advantage over rivals can translate into better profitability than rivals.

CORE CONCEPT A cost driver is a factor that has a strong influence on a company’s costs.

Chapter 5 • The Five Generic Competitive Strategy Options: Which One to Employ? 101

n Striving to capture all available economies of scale. Economies of scale stem from an ability to lower unit costs by increasing the scale of operation—many occasions arise when a large plant can achieve lower costs per unit produced than a small or medium-sized plant, when a large distribution center is more cost-efficient than a small one, or when the unit selling and marketing costs for a wide product line are lower than for a small product line. Often, manufacturing economies can be achieved by using common parts and components in different models and/or by cutting back on the number of models offered (especially slow-selling ones)—which enables a company to escape the costs of inventorying a greater number of parts and components, avoid the costs associated with model changeover, and schedule longer production runs for fewer models.

Figure 5.2 Cost Drivers— The Keys to Driving Down Costs

Product design and production technology

Outsourcing or vertical integration Economies of scale

Learning and experience

Labor efficiency, pay scales, and incentives

Capacity utilization

Raw materials and components

Bargaining power vis-à-vis suppliers

Supply chain efficiency

COST DRIVERS

Online systems and software

Source: Adapted by the author from Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1985), Chapter 3.

n Taking full advantage of experience and learning-curve effects. The cost of performing an activity can decline over time as the learning and experience of company personnel build. Learning/experience economies can stem from debugging and mastering newly introduced technologies, using the experiences and suggestions of workers to install more efficient plant layouts and assembly procedures, and the added speed and effectiveness that accrues from repeatedly picking sites for and building new plants, distribution centers, or retail outlets.

n Trying to operate facilities at full capacity. Whether a company is able to operate at or near full capacity has a big impact on unit costs when its value chain contains activities associated with substantial fixed costs. Higher rates of capacity utilization allow depreciation and other fixed costs to be spread over a larger unit volume, thereby lowering fixed costs per unit. The more capital-intensive the business, or the higher the percentage of fixed costs as a percentage of total costs, the greater the unit-cost penalty for operating at less than full capacity. Also, successful efforts to boost sales volumes and move closer to full capacity utilization spread R&D, advertising, sales promotion, and administrative support costs across more units, thus contributing to lower costs per unit sold.

Chapter 5 • The Five Generic Competitive Strategy Options: Which One to Employ? 102

n Substituting the use of low-cost for high-cost raw materials or component parts whenever there’s little or no sacrifice in product quality or product performance. If the costs of certain raw materials and parts are “too high,” a company can switch to using lower-cost items or maybe even design the high-cost components out of the product altogether.

n Using the company’s bargaining power vis-à-vis suppliers to gain concessions. A company may have sufficient bargaining clout with suppliers to win price discounts on large-volume purchases or realize other cost savings.

n Improving supply chain efficiency. Partnering with suppliers to streamline the ordering and purchasing process, to reduce inventory carrying costs via just-in-time inventory practices, to economize on shipping and materials handling, and to ferret out other cost-saving opportunities is a much-used approach to cost reduction. A company with a core competence (or better still, a distinctive competence) in cost-efficient supply chain management can sometimes achieve a sizable cost advantage over less adept rivals.

n Pursuing ways to boost labor productivity, reduce workforce size, and otherwise trim compensation costs. A company can economize on labor costs by installing labor-saving equipment, shifting production from geographic areas where pay scales are high to geographic areas where pay scales are low, using incentive compensation systems that promote high labor productivity, and avoiding the use of union labor where possible (because costly work rules can stifle productivity and because of “unreasonable” union demands for above-market pay scales and costly fringe benefits).

n Improving product design and employing cost-saving production techniques. Many companies aggressively search for ways to redesign parts and components to permit speedier and more economical manufacture or assembly. Often production costs can be cut by (1) using design for manufacture (DFM) procedures and computer-assisted design (CAD) techniques that enable more integrated and efficient production methods, (2) investing in highly automated robotic production technology, and (3) shifting to a production process that enables manufacturing multiple versions of a product as cost efficiently as mass-producing a single version. Many companies use process management tools like total quality management systems and Six Sigma techniques to boost efficiency, eliminate errors and mistakes, and reduce the costs of activities across the value chain.

n Using online systems and sophisticated software to achieve operating efficiencies. For example, sharing data and production schedules with suppliers, coupled with the use of enterprise resource planning (ERP) and manufacturing execution system (MES) software, can reduce parts inventories, trim production times, and lower labor requirements.

n Being alert to the cost advantages of outsourcing and vertical integration. Outsourcing the performance of certain value chain activities can be more economical than performing them in-house if outside specialists, by virtue of their expertise and volume, can perform the activities at a lower cost. Furthermore, integrating into the activities of either suppliers or distribution channel allies can lower costs by increasing internal efficiency, lowering transactions costs, and bypassing suppliers or distributors with considerable bargaining power.

In addition to the preceding ways of performing value chain activities at lower costs than rivals, managers can also achieve important cost savings by deliberately opting for a strategy with lower cost elements than the strategies employed by rivals. For instance, a company can often open up a durable cost advantage over rivals by:

n Having lower specifications for purchased materials, parts, and components than rivals. For example, a maker of personal computers can use the cheapest hard drives, microprocessors, monitors, and other components to achieve lower production costs than rival PC makers.

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n Stripping frills and features from its product offering that are not highly valued by price-sensitive or bargain-hunting buyers. Deliberately restricting the company’s product offering to “the essentials” can help a company cut costs associated with snazzy attributes and a full lineup of options and extras. Activities and costs can also be eliminated by offering buyers fewer services.

n Offering a limited product line as opposed to a full product line. Pruning slow-selling items from the product lineup and being content to meet the needs of most rather than all buyers can eliminate activities and costs associated with numerous product versions and a wide selection.

n Distributing the company’s product only through low-cost distribution channels and avoiding high-cost distribution channels.

n Choosing to use the most economical method for delivering customer orders (even if it results in longer delivery times).

The point here is that a low-cost provider strategy entails not only performing value chain activities cost effectively but also judiciously choosing cost-saving strategic approaches.

Revamping the Value Chain Dramatic cost advantages can often emerge from reengineering the company’s value chain in ways that eliminate costly work steps and entirely bypass certain cost-producing value chain activities. Such value chain revamping can include:

n Selling direct to consumers and cutting out the activities and costs of distributors and dealers. To circumvent the need for distributors–dealers, a company can (1) create its own direct sales force (which adds the costs of maintaining and supporting a sales force but which may well be cheaper than using independent distributors and dealers), and/or (2) conduct sales operations at the company’s website (costs for website operations and shipping may be a substantially cheaper way to make sales to customers than going through distributor–dealer channels). Costs in the wholesale/retail portions of the value chain frequently represent 35–50 percent of the price final consumers pay, so establishing a direct sales force or selling online may offer big cost savings.

n Shifting to the use of technologies and/or information systems that bypass the need to perform certain high-cost value chain activities. Some manufacturers have adopted innovative production or processing technologies that eliminate the need for costly facilities or equipment and require fewer employees. Still others have instituted procedures whereby suppliers combine particular parts and components into preassembled modules, thus permitting a manufacturer to assemble its own product in fewer work steps and with a smaller workforce. Numerous companies have online systems and software that automate and communicate order acceptances and shipping notices to customers via e-mail and turn formerly time-consuming and labor-intensive tasks like purchasing, inventory management, invoicing, and bill payment into speedily performed mouse clicks.

n Streamlining operations by eliminating low value-added or unnecessary work steps and activities. At Walmart, some items supplied by manufacturers are delivered directly to retail stores rather than being routed through Walmart’s distribution centers and delivered by Walmart trucks. In other instances, Walmart unloads incoming shipments from manufacturers’ trucks arriving at its distribution centers directly onto outgoing Walmart trucks headed to particular stores without ever moving the goods into the distribution center. Many supermarket chains have greatly reduced in-store meat butchering and cutting activities by shifting to meats that are cut and packaged at the meat-packing plant and then delivered to their stores in ready-to-sell form. Online systems allow warranty claims and product performance problems involving supplier components to be instantly relayed to the relevant suppliers so corrections can be expedited. New software has greatly reduced the time it takes to do product design and graphic design.

n Reducing materials handling and shipping costs by having suppliers locate their plants or warehouses close to a company’s own facilities. Having suppliers locate their plants or warehouses close to a company’s own plant facilitates just-in-time deliveries of parts and components to the exact work

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station where they will be used in assembling the company’s product. This not only lowers incoming shipping costs but also curbs or eliminates the company’s need to build and operate storerooms for incoming parts and components, and have plant personnel move the inventories to work stations as needed for assembly.

Examples of Companies That Revamped Their Value Chains to Reduce Costs Nucor Corporation, the most profitable steel producer in the United States and one of the largest steel producers worldwide, drastically revamped the value chain process for manufacturing steel products by using relatively inexpensive electric arc furnaces where scrap steel and direct-reduced iron are melted and then sent to a continuous caster and rolling mill to be shaped into steel bars, steel beams, steel plates, and sheet steel. Using electric arc furnaces to make new steel products by recycling scrap steel eliminated many of the steps used by traditional steel mills that made their steel products from iron ore, coke, limestone, and other ingredients using costly coke ovens, basic oxygen blast furnaces, ingot casters, and multiple types of finishing facilities—plus Nucor’s value chain system required far fewer employees. As a consequence, Nucor produces steel with a lower capital investment, a smaller workforce, and lower operating costs than traditional steel mills. Nucor’s strategy to replace the traditional steel-making value chain with its simpler, quicker value chain approach has made it one of the world’s lowest-cost producers of steel, enabling it to take substantial sales and market share away from traditional steel companies and earn consistently good profits (Nucor reported a profit in 195 out of 200 quarters during 1966–2016—a remarkable feat in a mature and cyclical industry notorious for roller coaster bottom-line performance).

Southwest Airlines has achieved considerable cost-savings by reconfiguring the traditional value chain of commercial airlines, thereby permitting it to offer travelers lower fares. Its mastery of fast turnarounds at the gates (about 25 minutes versus 45 minutes for rivals) allows its planes to fly more hours per day. This translates into being able to schedule more flights per day with fewer aircraft, allowing Southwest to generate more revenue per plane on average than rivals. Southwest does not offer assigned seating, baggage transfer to connecting airlines, or first-class seating and service, thereby eliminating all the cost-producing activities associated with these features. The company’s fast and user-friendly online reservation system facilitates e-ticketing and reduces staffing requirements at telephone reservation centers and airport counters. Its use of automated check-in equipment reduces staffing requirements for terminal check-in. The company’s carefully designed point-to-point route system minimizes connections, delays, and total trip time for passengers, allowing about 75 percent of Southwest passengers to fly nonstop to their destinations while at the same time reducing Southwest’s costs for flight operations.

The Keys to Being a Successful Low-Cost Provider To succeed with a low-cost provider strategy, company managers must scrutinize each cost-creating activity and determine what factors cause costs to be high or low. Then, they have to use this knowledge about the cost drivers to streamline or reengineer how activities are performed, exhaustively pursuing cost efficiencies throughout the value chain. Normally, low-cost producers try to engage all company personnel in continuous cost-improvement efforts, and they strive to keep administrative costs to a minimum. Many successful low-cost leaders also use benchmarking to keep close tabs on how their costs compare with rivals and firms performing comparable activities in other industries, and they are quick to implement best practices.

But while low-cost providers are champions of frugality, they seldom hesitate to spend aggressively on technologies and resource capabilities that promise to drive down costs. Indeed, investing in state-of-the art cost-saving competitive assets is one of the best pathways to achieving sustainable competitive advantage as a low-cost provider. Walmart, one of the world’s foremost low-cost providers, has been an early adopter of state-of-the-art technology throughout its operations—its distribution facilities are an automated showcase, it has developed sophisticated online systems to order goods from suppliers and manage inventories, it equips

Success in achieving a low-cost edge over rivals comes from out-managing rivals in finding ways to perform value chain activities faster, more accurately, and more cost efficiently.

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its stores with cutting-edge sales-tracking and check-out systems, and it sends daily point-of-sale data to 4,000 vendors, but Walmart carefully estimates the cost savings of new technologies before it rushes to invest in them. By continuously, yet prudently, investing in cost-saving technologies and operating improvements, Walmart has sustained its low-cost advantage over rivals for more than 30 years.

Uber and Lyft™, employing a formidable low-cost provider strategy and an innovative business model, have stormed their way into hundreds of locations across the world, totally disrupting and seemingly forever changing competition in the taxi markets where they have a presence. And, most significantly, the ultra- low fares charged by Uber and Lyft™ have resulted in dramatic increases in the demand for taxi services, particularly those provided by these two low-cost providers. Other companies noted for their successful use of low-cost provider strategies include Vizio in big-screen TVs, Briggs & Stratton in small gasoline engines, Bic in ballpoint pens, Stride Rite in footwear, Poulan in chain saws, and General Electric and Whirlpool in major home appliances.

When a Low-Cost Provider Strategy Works Best A low-cost provider strategy becomes increasingly appealing and competitively powerful when:

n Price competition among rival sellers is vigorous. Low-cost providers are in the best position to compete offensively on the basis of price, to use the appeal of lower price to grab sales (and market share) from rivals, to win the business of price-sensitive buyers, to remain profitable despite strong price competition, and to survive price wars.

n The products of rival sellers are essentially identical and readily available from many eager sellers. Look-alike products and/or overabundant supplies set the stage for lively price competition. In such markets, it is the less efficient, higher-cost companies whose profits get squeezed the most.

n It is difficult to achieve product differentiation in ways that have value to buyers. When the differences between brands do not matter much to buyers, buyers are nearly always sensitive to price differences and the industry-leading companies tend to be those with the lowest price brands.

n Most buyers use the product in the same ways. With common user requirements, a standardized product can satisfy the needs of most buyers, in which case low selling price, not features or quality, becomes the dominant factor in causing buyers to choose one seller’s product over another’s.

n Buyers incur low costs in switching their purchases from one seller to another. Low switching costs give buyers the flexibility to shift purchases to lower-priced sellers having equally good products, or to attractively priced substitute products. A low-cost leader is well positioned to use low price both to attract new customers and to induce its customers not to switch to rival brands or substitutes.

n Large-volume buyers with significant power to bargain down prices account for a big fraction of the industry’s sales. Low-cost providers have partial profit-margin protection in bargaining with high- volume buyers, since powerful buyers are rarely able to bargain prices down past the survival level of the next most cost-efficient seller.

n Industry newcomers use introductory low prices to attract buyers and build a customer base. A low-cost provider can use price cuts of its own to make it harder for a new rival to win customers. Moreover, the pricing power of a low-cost provider acts as a barrier for new entrants.

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Pitfalls to Avoid in Pursuing a Low-Cost Provider Strategy Perhaps the biggest mistake a low-cost provider can make to spoil the profitability of its low-cost advantage is getting carried away with overly aggressive price cutting to win sales and market share away from rivals. Higher unit sales and market shares do not automatically translate into higher total profits. Reducing price results in earning a lower profit margin on each unit sold. For a lower price to result in larger total profits, the gains in unit sales must be large enough to produce revenue increases sufficient to overcome the effects of a lower profit margin. Otherwise, a lower price results in lower, not higher profitability. A simple numerical example tells the story: suppose a firm selling 1,000 units at a price of $10, a cost of $9, and a profit margin of $1 opts to cut the price 5 percent to $9.50—which reduces the firm’s profit margin to $0.50 per unit sold (unless higher sales volumes cause unit costs to fall below $9); assuming unit costs remain at $9, then it takes a 100 percent sales increase to 2,000 units just to offset the narrower profit margin and get back to total profits of $1,000—and a more than 100 percent sales increase for the price cut to boost total profits above what was being earned at the $10 price. Hence, whether a price cut will result in higher or lower profitability depends on how big the resulting sales gains will be and how much, if any, unit costs will fall as sales volumes increase.

A second pitfall of a low-cost provider strategy is relying on cost reduction approaches that can be easily copied by rivals. The value of a cost advantage depends on its sustainability. Sustainability, in turn, hinges on whether the company achieves its cost advantage in ways that can be kept proprietary or that are very costly and/or time- consuming for rivals to copy.

A third pitfall is becoming too fixated on cost reduction. Low cost cannot be pursued so zealously that a firm’s offering ends up being too features poor to generate buyer appeal. Furthermore, a company driving hard to push its costs down must guard against misreading or ignoring increased buyer interest in added features or service, declining buyer sensitivity to price, or new developments that start to alter how buyers use the product. A low-cost zealot risks losing market ground if buyers start opting for more upscale or features-rich products.

Even if these mistakes are avoided, a low-cost provider strategy still entails risk. An innovative rival may discover an even lower-cost value chain approach. Important cost-saving technological breakthroughs may suddenly emerge. And if a low-cost provider has heavy investments in its present means of operating, it can prove costly to quickly shift to the new value chain approach or a new technology.

Broad Differentiation Strategies

Differentiation strategies are attractive whenever buyers’ needs and preferences are too diverse to be fully satisfied by a standardized product offering. Successful product differentiation requires careful study to determine what features and attributes buyers will view as appealing, valuable, and worth paying for.3 Then the company must incorporate a combination of these features and attributes into its product offering that will not only be attractive to a broad range of buyers but also be unique and different enough to stand apart from rivals’ product offerings—in this latter regard, a strongly differentiated product offering is always preferable to a weakly differentiated one. A broad differentiation strategy can yield a competitive advantage when an attractively large number of buyers become strongly attached to a company’s differentiated attributes.

A lower price improves profitability only if the lower price results in gains in unit sales (and thus revenues) that are big enough to overcomethe combined effects of a smaller profit margin and the added costs of the extra units sold.

A low-cost provider’s product offering must always contain enough attributes to be attractive to prospective buyers—low price, by itself, is not always appealing to buyers.

CORE CONCEPT The essence of a broad differentiation strategy is to offer unique product attributes that a wide range of buyers find appealing and worth paying for (because of the added value they deliver).

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Successful differentiation allows a firm to do one or more of the following:

n Command a premium price for its product.

n Increase unit sales (because additional buyers are won over by the differentiating features).

n Gain buyer loyalty to its brand (because many customers really like the differentiating features and bond with the company and its products).

Differentiation enhances profitability whenever a company’s product can command a sufficiently higher price or generate sufficiently bigger unit sales to more than cover the added costs of achieving the differentiation. Company differentiation strategies fail when buyers don’t place much value on the brand’s uniqueness and/or when a company’s differentiating features are easily copied by rivals.

Companies can pursue differentiation from many angles: a unique taste (Dr Pepper, Listerine); multiple features (Microsoft Office, Apple’s iPhone); wide selection and one-stop shopping (The Home Depot, Amazon.com); superior service (Nordstrom, Ritz-Carlton); engineering design and performance (Mercedes, BMW); prestige and distinctiveness (Rolex); quality manufacture (Michelin in tires); technological leadership (3M Corporation in bonding and coating products); spare parts availability (Caterpillar in heavy construction equipment); a full range of services (Charles Schwab); many varieties (Campbell’s soups); and high-fashion design (Gucci, Chanel).

Managing Value Chain Activities in Ways That Enhance Differentiation Differentiation opportunities can exist in activities all along an industry’s value chain. Success in employing a differentiation strategy comes from deliberate efforts to perform value chain activities in ways that create value-adding differentiating attributes and also better differentiate the company’s product/service offering from rivals’ offerings. Perhaps, the most systematic approach managers can take to achieve successful differentiation involves focusing on the value drivers, a set of factors—analogous to cost drivers—that are particularly effective in creating differentiation and adding value for customers—see Figure 5.3.

Figure 5.3 Value Drivers—Keys to Value-Adding Differentiation

Marketing, adver- tising, and brand- building

Product features and performance

Product quality and reliability

Employee skills, training, experience

New product R&D and product innovation

Production R&D and breakthrough production techniques

Product selectionCustomer service

VALUE DRIVERS

Distribution activities

Source: Adapted by the author from Michael E. Porter, Competitive Advantage (New York: The Free Press, 1985), pp. 124–126.

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Ways that managers can use the value drivers to enhance differentiation include the following:

n Create value-adding product features and performance attributes that appeal to a wide range of buyers. A product’s physical and functional features have a big influence on differentiation. Styling and looks are big differentiating factors in the apparel and motor vehicle industries. Size and weight matter in binoculars and mobile devices. Most companies employing broad differentiation strategies make a point of incorporating innovative and novel features in their product/service offering, especially those that improve performance and functionality, and they regularly introduce next-generation versions with both upgraded existing features and additional features. Offering a growing set of features is generally a strong plus. Having unique features and performance capabilities not found in rival products is a must. Often new or improved attributes that will have wide buyer appeal are developed in close collaboration with suppliers.

n Pursuing continuous quality improvements via the use of better parts, components, or ingredients and the use of quality control processes throughout the value chain. Customer-perceived differences in quality are an important differentiating and value-adding attribute. Improvements in product quality can lead to greater reliability, fewer repairs and less frequent maintenance, longer product life, and the convenience of trouble-free use—all of which make it economical to offer longer warranty coverage and contribute to an enhanced reputation for quality among customers. Quality improvement opportunities exist in such value chain activities as product design, the caliber of items purchased from suppliers, manufacturing and assembly, and customer service. For example, Starbucks gets high ratings on its coffees partly because it works closely with coffee growers to produce coffee beans that will meet its strict quality specifications. Quality differentiation can also be achieved by using assorted quality control techniques throughout the value chain rather than in just manufacturing or assembly. For instance, using quality control techniques in customer service can lead to more accurate handling of service requests and consistently solving customer problems on the first attempt or contact.

n Emphasizing new product R&D and product innovation. The potential differentiating outcomes here include greater ongoing ability to introduce new and improved innovative products (which can lead to more first-on-the-market victories and a reputation for product innovation), new or improved features and styling, better functional performance, more aesthetic product designs and appearance, expanded end uses and applications, added user safety, or environmentally safe use of the product. Innovation that is hard for rivals to replicate is a source of competitive advantage.

n Improving production selection. Amazon.com and big-box retailers like The Home Depot and Target have demonstrated that an expansive lineup of products, together with multiple models/styles/varieties of each type of product, is attractive to a broad spectrum of shoppers. Not only does wide selection offer the time-saving benefit of a one-stop shopping experience, but it also enables shoppers to compare the assorted models/styles/varieties within a product category and pick what suits their tastes, requirements, and pocketbook. An added differentiating feature of shopping at Amazon.com and other online retailers is one-click access to reviews of each item offered for sale—information gleaned from reviews often facilitates making wiser buying decisions.

n Investing in production-related R&D, striving for technological advances, and implementing better production techniques. Better or different performance of production-related value chain activities can spur breakthrough production techniques for making an innovative product, enable custom-order manufacture at an efficient cost, make production methods safer for the environment, curtail production- related defects, reduce premature product failure, or improve economy of use.

n Improving customer service and/or providing more service options. In some businesses, offering better customer service and/or a bigger range of service options contribute as much to differentiation enhancement as attributes relating to product quality, features, or performance. Examples of differentiation-enhancing customer services include no-hassle return policies, multiple payment plans, better credit terms, faster or better-quality maintenance and repairs, expert technical assistance, personal concierge services, more

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and better product information, training for end users, and round-the-clock availability of knowledgeable customer-service representatives (as opposed to having to call only during regular business hours).

n Emphasizing human resource management activities that improve the skills, expertise, and knowledge of company personnel. A company with high-caliber intellectual capital often has the capacity to generate the kinds of ideas that drive product innovation, technological advances, better product design and product performance, improved production techniques, and higher product quality. Skilled customer service representatives can make a huge difference in how customers perceive the caliber of a company’s customer services. Well-designed incentive compensation systems can often unleash the efforts of talented personnel to develop and implement new and effective differentiating attributes.

n Pursuing sales, marketing, and advertising activities that lead to greater brand name power. The manner in which a company conducts its marketing and brand management activities has a significant influence on customer perceptions of the value of a company’s product offering and the price they will pay for it. A highly skilled and competent sales force, effectively communicated product information, eye-catching ads, in-store displays, and special promotional campaigns can all cast a favorable light on the differentiating attributes of a company’s product/service offering and contribute to greater brand- name awareness and brand-name power. A highly positive brand image keyed to various differentiating attributes builds customer loyalty to the brand and raises customers’ perceived cost of switching to a rival brand. Activities that contribute to greater brand name power are thus an important avenue for achieving stronger differentiation.

n Improving distribution capabilities and collaborating with distribution allies to enhance customer perceptions of value. Distribution activities hold potential for a variety of differentiating attributes. Differentiation can be enhanced via a bigger distributor/dealer network than rivals and/or wider geographic distribution capabilities than rivals. Close collaboration with distribution partners—independent distributors, dealers, and retailers—can produce an assortment of differentiating attributes. It is common for motor vehicle manufacturers to set facilities standards for their dealerships (nice showrooms, well- appointed waiting areas) and to insist that all mechanics and service managers be factory trained and maintain ongoing factory certification. Many manufacturers work directly with retailers on in-store displays and signage, joint advertising campaigns, and providing sales clerks with product knowledge and tips on sales techniques—all to enhance customer buying experiences. Companies can work with distributors and shippers to ensure fewer “out-of-stock” annoyances, quicker delivery to customers, more accurate order filling, lower shipping costs, and provide a variety of shipping choices to customers.

Signaling Value to Buyers A company can often assist its efforts to achieve differentiation by signaling the value of its product offering to buyers.4 Typical signals of value include a high price (in instances where high price implies high quality and performance), more appealing or fancier packaging than competing products, ongoing or extensive ad campaigns (which impact a product’s image and make it more widely known), ad content that emphasizes a product’s standout attributes, the quality of brochures and sales presentations, the luxuriousness and ambience of a seller’s facilities (important for high-end retailers and for offices or other facilities that customers frequent), making buyers aware that a company has prestigious customers, and the professionalism, appearance, and personalities of the seller’s employees. Signaling value is particularly important when (1) the nature of differentiation is subjective or hard to quantify, (2) buyers are making a first-time purchase and are unsure what their experience with the product will be, (3) buyers are not fully aware of a product’s many attributes, and (4) repurchase is infrequent and buyers need to be reminded of a product’s value.

Achieving Sustainable Competitive Advantage The most appealing approaches to differentiation are those that are hard or expensive for rivals to duplicate. Resourceful competitors can, in time, clone almost any product feature or attribute. If General Motors offers self-driving features in many of its models, so can Ford and Toyota. If

Signaling value to buyers can assist a company’s differentiation efforts.

Easy-to-copy differentiating attributes cannot produce sustainable competitive advantage.

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Samsung offers QLED TVs with super ultra-high definition, so can Sony and Panasonic. Consequently, for a company to build a sustainable competitive advantage via differentiation, it needs to base its differentiation strategy on attributes that are difficult or expensive for rivals to copy or to overcome or that creates high switching costs for users. The best routes to sustainable differentiation include:

n Focusing on continuous product innovation, with a goal of developing the resources and capabilities to out-innovate rivals with regard to appealing product features, better product performance, and/or higher product quality. Patent-protected innovations have enormous differentiating value because rivals must wait until the patent expires to introduce the innovation into its own product offering.

n Incorporating features that raise product performance and deliver added value to the buyer/end-user. This can be accomplished by including attributes that add functionality, expand the range of uses, save time for the user, are more reliable, or make the product cleaner, safer, quieter, simpler to use, portable, more convenient, or longer lasting than rival brands.

n Incorporating product attributes and user features that lower the buyer’s overall costs of using the company’s product. Fewer product defects, greater product reliability, and longer maintenance intervals reduce user costs for repairs and maintenance. Energy-saving light bulbs and appliances cut buyers’ utility bills. Fuel-efficient vehicles reduce buyer outlays for gasoline.

n Incorporating features or attributes that enhance buyer satisfaction in intangible ways. Toyota’s Prius appeals to environmentally conscious motorists who wish to help reduce global carbon dioxide emissions. Rolls Royce, Tiffany, Rolex, and Prada enjoy differentiation-based competitive advantages linked to the desires of luxury goods buyers for status, prestige, upscale fashion, craftsmanship, and the finer things in life. While rivals can often duplicate tangible product features quickly, such intangible attributes as a highly-regarded brand name and long-standing relationships with customers take a long time to imitate.

n Delivering value to customers on the basis of valuable resources and capabilities that rivals don’t have or can’t afford to match. Competencies and capabilities that are sufficiently unique in delivering value to buyers provide a route to differentiation that is not tied exclusively to the attributes of a product or service. A company with superior technological capabilities vis-à-vis rivals can incorporate attributes into its product offering directly linked to its technological capabilities and thereby gain substantial protection from the rivals’ attempts to match its product offering. Health care facilities like M.D. Anderson, Mayo Clinic, and Cleveland Clinic have specialized expertise and equipment for treating certain diseases that most hospitals and health care providers cannot afford to emulate.

When a Broad Differentiation Strategy Works Best Broad differentiation strategies tend to work best in market circumstances where:

n Buyer needs and uses of the product are diverse. Diverse buyer preferences present competitors with a bigger window of opportunity to do things differently and set themselves apart with product attributes that appeal to particular buyers. For instance, the diversity of consumer preferences for menu selection, ambience, pricing, and customer service gives restaurants exceptionally wide latitude in creating a differentiated product offering. Other companies having many ways to strongly differentiate themselves from rivals include magazine publishers, motor vehicle manufacturers, and the makers of cabinetry and countertops.

n There are many ways to differentiate the product or service that have value to buyers. There’s plenty of room for retail apparel competitors to stock different styles and quality of apparel merchandise. Likewise, there is ample differentiation opportunity among the makers of furniture and breakfast cereals. Hotels and restaurants have easy pathways to setting themselves apart. But there are almost no ways for the makers of paper clips, copier paper, gasoline, and sugar to set their products apart in ways that deliver added value to consumers.

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n Few rival firms are following a similar differentiation approach. The best differentiation approaches involve trying to appeal to buyers on the basis of attributes that rivals are not emphasizing. A differentiator encounters less head-to-head rivalry when it goes its own separate way in creating uniqueness. When several (or even worse, many) rivals base their differentiation efforts on the same attributes, the most likely result is weak brand differentiation and “strategy overcrowding”—competitors end up chasing much the same buyers with similar product offerings.

n Technological change is fast paced, and competition revolves around rapidly evolving product features and attributes. Rapid product innovation and frequent introductions of next-version products heighten buyer interest and provide space for companies to pursue separate differentiating paths. In wearable Internet devices, golf equipment, battery-powered and self-driving cars, unmanned drones for hobbyists and commercial use, rivals are locked into an ongoing battle to set themselves apart by introducing the best next-generation products. Companies that fail to come up with ongoing product improvements and unique features quickly lose ground in the marketplace.

Pitfalls to Avoid in Pursuing a Differentiation Strategy Differentiation strategies can fail for any of several reasons. A differentiation strategy keyed to product or service attributes that are easily and quickly copied is always doomed. Rapid imitation means that no rival achieves differentiation, since whenever one firm introduces some aspect of uniqueness that strikes the fancy of buyers, fast- following copycats quickly reestablish similarity. This is why a firm must search out sources of uniqueness that are time-consuming or burdensome for rivals to match if it hopes to use differentiation to win a sustainable competitive edge.

A second pitfall is that the company’s attempt at differentiation produces an unenthusiastic response on the part of buyers. Thus, even if a company succeeds in setting its product apart from those of rivals, its strategy can result in disappointing sales and profits in the event that buyers do not perceive the differentiating features as valuable or worth paying for. Any time many potential buyers look at a company’s differentiated product offering and conclude “so what,” the company’s differentiation strategy is in deep trouble.

The third big pitfall of a differentiation strategy is overspending on efforts to differentiate the company’s product offering, thus eroding profitability. Company efforts to achieve differentiation nearly always raise costs. The key to profitable differentiation is either to keep the costs of achieving differentiation below the price premium the differentiating attributes can command in the marketplace (thus increasing the profit margin per unit sold) or to offset thinner profit margins per unit by selling enough additional units to increase total profits. If a company goes overboard in pursuing costly differentiation efforts and then unexpectedly discovers that buyers are unwilling to pay a sufficient price premium to cover the added costs of differentiation, it ends up saddled with unacceptably thin profit margins or even losses. The need to contain differentiation costs is why many companies add little touches of differentiation that add to buyer satisfaction but are inexpensive to institute. Upscale restaurants often provide valet parking. Laundry detergent and soap manufacturers add pleasing scents to their products. Ski resorts provide skiers with complimentary coffee or hot apple cider at the base of the lifts in the morning and late afternoon.

Other common mistakes in crafting a differentiation strategy include:6

n Being timid and not striving to open up meaningful gaps in quality or service or performance features vis-à-vis the products of rivals. Tiny or trivial differences between rivals’ product offerings may not be visible or important to buyers. If a company wants to generate the fiercely loyal customer following needed to earn superior profits and open up a differentiation-based competitive advantage over rivals, then its strategy must result in strong rather than weak product differentiation. In markets where

CORE CONCEPT Any differentiating feature that works well is a magnet for imitators.

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differentiators do no better than achieve weak product differentiation (because buyers view the attributes of rival brands as very similar), customer loyalty to any one brand is weak, the costs of buyers to switch to rival brands are fairly low, and no one company has enough of a differentiation edge to command much of a price premium.

n Adding so many frills and extra features that the product exceeds the needs and use patterns of most buyers. A dazzling array of features and options not only drives up a product’s price but also runs the risk that many buyers will conclude that a less deluxe and lower-priced brand is a better value since they have little occasion or reason to use some of the deluxe attributes.

n Charging too high a price premium. While buyers may be intrigued by a product’s deluxe features, they may nonetheless see it as being overpriced relative to the value delivered by the differentiating attributes. A company must guard against turning off would-be buyers with what is perceived as “price gouging.” Normally, the bigger the price premium for the differentiating extras, the harder it is to keep buyers from switching to the lower-priced offerings of competitors.

A low-cost provider strategy can defeat a differentiation strategy when buyers are satisfied with a basic product and don’t think “extra” attributes deliver enough added value to justify paying a higher price.

Focused (or Market Niche) Strategies

What sets focused strategies apart from low-cost provider and broad differentiation strategies is concentrated attention on a narrow piece of the total market. The target segment, or niche, can be defined by geographic uniqueness, by specialized requirements in using the product, or by special product attributes that appeal only to buyers comprising the market niche. Examples of firms that concentrate on a well-defined market niche keyed to a particular product or buyer segment include Animal Planet and the History Channel (in cable TV); Tiffany and Cartier (in high-end jewelry); Bandag (a specialist in truck tire recapping that promotes its recaps aggressively at more than 1,000 truck stops), CGA, Inc. (a specialist in providing insurance to cover the cost of lucrative hole- in-one prizes at golf tournaments); and Ferrari (in sports cars). Micro-breweries, bed-and-breakfast inns, local bakeries, and local owner-managed retail boutiques have also scaled their operations to serve niche markets.

A Focused Low-Cost Strategy A focused low-cost strategy seeks to achieve a competitive advantage by serving buyers in the target market niche at a lower cost and lower price than rival competitors. This strategy has considerable attraction when a firm can lower costs significantly by limiting its customer base to a well-defined buyer segment. The avenues to achieving a cost advantage over rivals also serving the target market niche are the same as for low-cost leadership—out-manage rivals in using the cost drivers to perform value chain activities very cost-efficiently and search for innovative ways to bypass non-essential value chain activities. The only real difference between a low-cost provider strategy and a focused low-cost strategy is the size of the buyer group that a company is trying to appeal to—the former involves a product offering that appeals broadly to most all buyer groups and market segments, whereas the latter aims to satisfy the needs of a narrowly defined buyer group.

Focused low-cost strategies are fairly common. Producers of private-label goods are able to achieve low costs in product development, marketing, distribution, and advertising by concentrating on making generic items imitative of name-brand merchandise and selling directly to retail chains wanting a basic house brand to sell to price-sensitive shoppers. Budget motel chains—like Motel 6, Sleep Inn, Super 8, and Days Inn—cater to price- conscious travelers who just want to pay for a clean, no-frills place to spend the night.

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A Focused Differentiation Strategy A focused strategy keyed to differentiation aims at securing a competitive advantage with a product offering tailored to the unique preferences and needs of a narrow well-defined group of buyers (as opposed to a broad differentiation strategy aimed at many buyer groups and market segments). Successful use of a focused differentiation strategy depends on (1) the existence of a buyer segment that is looking for special product attributes or seller capabilities and (2) a firm’s ability to create an appealing product offering that stands apart from those of rivals competing in the same target market niche.

Whole Foods Market, which bills itself as “America’s Healthiest Grocery Store,” has become the largest organic and natural foods supermarket chain in the United States (2016 sales of nearly $15.7 billion; over 456 stores; 8 million customer visits per week). By catering to healthy-eating and nutrition-conscious consumers who prefer organic, natural, minimally processed, locally grown, and healthier-style prepared foods, Whole Foods prides itself on stocking the highest-quality organic and natural foods it can find; the company defines quality by evaluating the ingredients, freshness, taste, nutritive value, appearance, and safety of the products it carries.

Celebrity-chef restaurants employ focused differentiation strategies aimed at fine dining enthusiasts. Companies like Godiva Chocolates, Louis Vuitton, Haägen-Dazs, and W. L. Gore (the maker of GORE-TEX) have been successful with differentiation-based focused strategies targeting upscale buyers wanting products and services with world-class attributes. Indeed, most markets contain a buyer segment willing to pay a big price premium for the finest items available, thus opening the strategic window for some competitors to pursue differentiation- based focused strategies aimed at the high-end of the market.

When a Focused Low-Cost or Focused Differentiation Strategy Is Attractive A focused strategy aimed at securing a competitive edge based either on low cost or differentiation becomes increasingly attractive as more of the following conditions are met:

n The target market niche is big enough to be profitable and offers good growth potential.

n Industry leaders have chosen not to compete in the niche—in which case focusers can avoid battling head-to-head against some of the industry’s biggest and strongest competitors.

n It is costly or difficult for multisegment competitors to put capabilities in place to meet the specialized needs of buyers comprising the target market niche and at the same time satisfy the expectations of their mainstream customers.

n The industry has many different niches and segments, thereby allowing a focuser to pick a competitively attractive niche suited to its resources and capabilities. Also, with more niches there is room for focusers to concentrate on different market segments and avoid competing in the same niche for the same customers.

n Few, if any, other rivals are attempting to specialize in the same target segment—a condition that reduces the risk of segment overcrowding.

n The focuser has a reservoir of customer goodwill and loyalty (accumulated from having catered to niche members’ specialized needs and preferences over many years) that it can draw upon to help stave off any ambitious challengers looking to horn in on its business.

The advantages of focusing a company’s entire competitive effort on a single market niche are considerable, especially for smaller and medium-sized companies that may lack the breadth and depth of resources to tackle going after a broad customer base with a “something for everyone” lineup of models, styles, and product selection. YouTube has become a household name by concentrating on short video clips posted online. Papa John’s and Domino’s Pizza have created impressive businesses by focusing on the home delivery segment. Porsche and Ferrari have done well catering to wealthy sports car enthusiasts.

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The Risks of a Focused Low-Cost or Focused Differentiation Strategy Focusing carries several risks. One is the chance that competitors outside the niche will find effective ways to match the focused firm’s capabilities in serving the target niche—perhaps by coming up with products or brands specifically designed to appeal to buyers in the target niche or by developing resources and capabilities that offset the focuser’s strengths. In the lodging business, large chains like Marriott have launched multibrand strategies that allow them to compete effectively in several lodging segments simultaneously. Marriott has flagship JW Marriott and Ritz-Carlton hotels with deluxe accommodations for business travelers and resort vacationers. Its Courtyard by Marriott and SpringHill Suites brands cater to business travelers looking for moderately priced lodging, whereas Marriott Residence Inns and TownePlace Suites are designed as a “home away from home” for travelers staying five or more nights, and the Fairfield Inn & Suites brand is intended to appeal to travelers looking for quality lodging at an “affordable” price. Multibrand strategies are attractive to large companies like Marriott, Procter & Gamble, and Nestlé precisely because they enable entry into smaller market segments and siphon away business from companies employing a focused strategy.

A second risk of employing a focus strategy is the potential for the preferences and needs of niche members to shift over time toward the product attributes desired by buyers in the mainstream portion of the market. An erosion of the differences across buyer segments lowers entry barriers into a focuser’s market niche and provides an open invitation for rivals in adjacent segments to begin competing for the focuser’s customers. A third risk is that the segment may become so attractive it is soon inundated with competitors, intensifying rivalry and splintering segment profits. And there is always the risk for segment growth to slow to such a small rate that a focusers’ prospects for future sales and profit gains become unacceptably dim.

Best-Cost Provider Strategies

As Figure 5.1 indicates, best-cost provider strategies stake out a middle ground between pursuing a low-cost advantage and a differentiation advantage, and between appealing to the broad market as a whole and a narrow market niche. Such a middle ground allows a company to aim squarely at the sizable mass of buyers looking for a good-to-very-good product or service at an economical price. Such buyers frequently shy away from both cheap low-end products and expensive high-end products, but they are quite willing to pay a “fair” price for extra features and functionality they find appealing and useful. The essence of a best-cost provider strategy is giving customers the best value for the money by satisfying buyer desires for appealing features/performance/quality/ service and charging a lower price for these attributes compared to rivals with similar-caliber product offerings.7 From a competitive positioning standpoint, best-cost provider strategies are thus a hybrid, balancing a strategic emphasis on low cost against a strategic emphasis on differentiation (desirable extras at an attractive price).

To profitably employ a best-cost provider strategy, a company must have the capability to incorporate attractive upscale attributes at a lower cost than those rivals with comparable upscale product offerings. When a company can incorporate appealing features, good-to-excellent product performance or quality, or more satisfying customer service into its product offering at a lower cost than rivals, then it enjoys “best cost” status—it is the low-cost provider of a product or service with upscale attributes. A best-cost provider can use its low-cost advantage to underprice rivals whose products or services have similar upscale attributes and still earn attractive profits. It is usually not difficult for a company to entice buyers away from rivals when it offers buyers an equally good product at a more economical price.

CORE CONCEPT The competitive advantage of a best-cost provider is lower costs than rivals in incorporating upscale attributes (appealing features or functionality or quality, or satisfying customer service), putting the company in a position to underprice rivals whose products have similar upscale attributes.

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Being a best-cost provider is different from being a low-cost provider because the additional upscale attributes entail additional costs (that a low-cost provider can avoid by offering buyers a basic product with fewer features). Moreover, the two strategies aim at a distinguishably different target market. The target market for a best-cost provider is buyers looking for appealing extras and functionality at an appealingly low price. The target market for a low-cost provider is price-conscious buyers who are looking for or are satisfied with a basic low-priced product. One of the attractive reasons for adopting a best-cost provider strategy is that buyers hunting for upscale products at a “good” price often constitute a large segment of the overall market for a product or service.

Toyota has employed a classic best-cost provider strategy for its Lexus line of motor vehicles. It has designed an array of high-performance characteristics and upscale features into its Lexus models to make them comparable in performance and luxury to Mercedes, BMW, Audi, Jaguar, Cadillac, and Lincoln models. To further draw buyer attention, Toyota established a network of Lexus dealers, separate from Toyota dealers, dedicated to providing exceptional and attentive customer service. Most important, though, Toyota has drawn upon its considerable skills and know-how in making high-quality Toyota models at low cost to produce its high-tech upscale-quality Lexus models at substantially lower costs than Mercedes, BMW, and other luxury vehicle makers have been able to achieve in producing their models. To capitalize on its lower manufacturing costs, Toyota prices its Lexus models below those of comparable Mercedes, BMW, Audi, and Jaguar models to induce value-conscious luxury car buyers to purchase a Lexus instead. The price differential has typically been quite significant. For example, in 2017 a well-equipped Lexus RX 350, a mid-sized SUV, had a sticker price of $54,370, whereas the sticker price of a comparably equipped Mercedes GLE-class SUV was $62,770 and the sticker price of a comparably equipped BMW X5 SUV was $66,670.

When a Best-Cost Provider Strategy Works Best A best-cost provider strategy works best in markets where product differentiation is the norm and attractively large numbers of buyers shopping for “best value for the money” products can be induced to purchase midrange or near-luxury products rather than the cheap basic products of low-cost producers or the expensive products of top-of-the-line differentiators. A best-cost provider usually needs to position itself near or just above the middle of the market with either a medium-quality product at a below-average price or a good-to-high quality product at a price significantly lower than premium-priced, premium quality products. Best-cost provider strategies also work well in hard economic times when even more buyers are attracted to economically-priced products and services with especially appealing attributes. But unless a company has the resources and capabilities to incorporate upscale product or service attributes at a lower cost than rivals, adopting a best-cost strategy is ill- advised because the company lacks ability to execute it.

The Big Risk of a Best-Cost Provider Strategy A company’s biggest vulnerability in employing a best-cost provider strategy is getting squeezed between the strategies of firms using low-cost and high-end differentiation strategies. Low-cost providers may be able to siphon customers away with the appeal of a lower price (despite their less appealing product attributes). High- end differentiators may be able to steal customers away with the appeal of better product attributes (even though their products carry a higher price tag). Thus, to be successful, a best-cost provider must offer buyers significantly better product attributes to justify a price above what low-cost leaders are charging. Likewise, it has to achieve significantly lower costs in providing upscale features so it can out-compete high-end differentiators on the basis of a significantly lower price.

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Successful Competitive Strategies Are Always Underpinned by Resources and Capabilities That Allow the Strategy to Be Well-Executed

For a company’s competitive strategy to deliver good profitability and the intended competitive edge over rivals, it must be underpinned by competitively potent resources and capabilities. To succeed in employing a low-cost provider strategy, a company must have the resource and capabilities to keep its costs below those of competitors. This means having the expertise to leverage the cost drivers and manage value chain activities more cost- efficiently than rivals and/or the innovative capability to bypass certain value chain activities being performed by rivals. To succeed in strongly differentiating its product in ways that are appealing to buyers, a company must have the capabilities to leverage the value drivers and incorporate unique attributes into its product offering that a broad range of buyers will find appealing and worth paying for. This is easier said than done because, given sufficient time, competitors can clone most any product feature that buyers find appealing. Hence, long-term differentiation success is usually dependent on having a hard-to-imitate portfolio of resources and capabilities (like key patents, top-notch technological know-how, proven skills in product innovation, expertise in customer service) to achieve and sustain a competitive edge. Successful focus strategies require the resources and capabilities to do an outstanding job of satisfying the needs and expectations of niche buyers. Success in employing a best-cost strategy requires the resources and capabilities to incorporate upscale product or service attributes at a lower cost than rivals. For all types of competitive strategies, success in sustaining the competitive edge depends on having at least some unique and valuable resources/capabilities that are hard for rivals either to duplicate or to develop offsetting close substitute resources/capabilities.

Key Points

Deciding which of the five generic competitive strategies to employ—overall low-cost, broad differentiation, focused low-cost, focused differentiation, or best-cost—is perhaps the most important strategic commitment a company makes. It tends to drive the remaining strategic actions a company undertakes and sets the whole tone for pursuing a competitive advantage over rivals.

In employing a low-cost provider strategy and trying to achieve a low-cost advantage over rivals, a company must do a better job than rivals of cost effectively managing value chain activities and/or it must find innovative ways to bypass or eliminate cost-producing value chain activities. Low-cost provider strategies work particularly well when the products of rival sellers are virtually identical or very weakly differentiated, when supplies are readily available from eager sellers, when there are not many ways to achieve value-adding differentiation, when many buyers are price sensitive and shop the market for the lowest price, and when buyer switching costs are low.

Broad differentiation strategies seek to produce a competitive edge by incorporating attributes and features that set a company’s product/service offering apart from rivals in ways that buyers consider valuable and worth paying for. Successful differentiation allows a firm to (1) command a premium price for its product, (2) increase unit sales (because additional buyers are won over by the differentiating features), and/or (3) gain buyer loyalty to its brand (because some buyers are strongly attracted to the differentiating features and bond with the company and its products). Differentiation strategies work best when diverse buyer preferences open up windows of opportunity to strongly differentiate a company’s product offering from those of rival brands, in situations

CORE CONCEPT A company’s competitive strategy is unlikely to result in good performance or sustainable competitive advantage unless the company has a competitively potent collection of resources and capabilities that enable the company to execute its strategy with great proficiency.

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where few other rivals are pursuing a similar differentiation approach, and in circumstances where companies are racing to bring out the most appealing next-generation product. A differentiation strategy is doomed when competitors are able to quickly copy most or all of the appealing product attributes a company comes up with, when a company’s differentiation efforts fail to interest many buyers, and when a company overspends on efforts to differentiate its product offering or tries to overcharge for its differentiating extras.

A focus strategy delivers competitive advantage either by achieving lower costs than rivals in serving buyers comprising the target market niche, or by developing a specialized ability to offer niche buyers an appealingly differentiated offering that meets their needs better than rival brands. A focused strategy based on either low cost or differentiation becomes increasingly attractive when the target market niche is big enough to be profitable and offers good growth potential, when it is costly or difficult for multi-segment competitors to put capabilities in place to meet the specialized needs of the target market niche and at the same time satisfy the expectations of their mainstream customers, when there are one or more niches that present a good match with a focuser’s resources and capabilities, and when the target segment is not overcrowded with rivals.

Best-cost provider strategies create competitive advantage by giving buyers the best value for the money—an approach that entails (1) matching close rivals on key quality/service/features/performance attributes, (2) beating them on the costs of incorporating such attributes into the product or service, and (3) charging a more economical price. A best-cost provider strategy works best when there is a big buyer segment desirous of purchasing upscale products/services for less money than comparable upscale products.

In all cases, achieving sustained competitive advantage depends on having first-rate resources and capabilities that enable the company to execute its chosen competitive strategy with great proficiency.

Chapter 6 Supplementing the Chosen Competitive Strategy— Other Important Strategy Choices 118

Strategy: Core Concepts and Analytical Approaches

An e-book published by McGraw-Hill Education, Burr Ridge, IL

Arthur A. Thompson, The University of Alabama 5th Edition, 2018-2019

CHAPTER 6

Supplementing the Chosen Competitive Strategy— Other Important Strategy Choices

Competing in the marketplace is like war. You have injuries and casualties, and the best strategy wins. —John Collins

Winners in business play rough and don’t apologize for it. The nicest part of playing hardball is watching your competitors squirm. —George Stalk, Jr. and Rob Lachenauer

Don’t form an alliance to correct a weakness and don’t ally with a partner that is trying to correct a weakness of its own. The only result from a marriage of weaknesses is the creation of even more weaknesses. —Michel Robert

Think of your priorities not in terms of what activities you do, but when you do them. Timing is everything. —Dan Millman

Once a company has settled on which of the five generic competitive strategies to employ, attention turns to what other strategic actions it can take to complement its competitive approach and maximize the power of its overall strategy. Several decisions must be made: n Whether to go on the offensive and initiate aggressive strategic moves to improve the company’s market

position.

n Whether to employ defensive strategies to protect the company’s market position.

n What role the company’s website should play in its overall strategy to be a successful performer.

n Whether to outsource certain value chain activities or perform them in-house.

n Whether to integrate backward or forward into more stages of the industry value chain.

n Whether to enter into strategic alliances or partnership arrangements with other enterprises.

n Whether to bolster the company’s market position via mergers or acquisitions.

n When to undertake strategic moves—whether advantage or disadvantage lies in being a first mover, a fast follower, or a late mover.

118

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This chapter presents the pros and cons of each of these strategy-enhancing measures.

Figure 6.1 shows the menu of strategic options a company has in crafting a full menu of strategic actions and the order in which the choices should generally be made. The portion of Figure 6.1 below the five generic competitive strategy options illustrates the structure of this chapter and the topics that will be covered.

Figure 6.1 A Company’s Menu of Strategy Options

First Mover? Fast-Follower? Late-Mover?

Generic Competitive Strategy Options

What type of website strategy to employ?

Whether to outsource selected value chain activities?

Initiate offensive strategic moves?

Employ defensive strategic moves?

Employ backward or forward vertical integration strategies?

Enter into strategic alliances and partnerships?

Use merger and acquisition strategies to strengthen competitiveness?

Low-Cost Provider?

Broad Differentiation?

Focused Low Cost?

Focused Differentiation?

Best-Cost Provider?

(A company’s first strategic choice)

Complementary Strategy Options (A company’s second set of strategic choices)

R&D Engineering Production

Marketing & Sales

Human Resources

Finance

Functional Area Strategies to Support the Above Strategic Choices

Timing a Company’s Strategic Moves in the Marketplace

(When to initiate actions to pursue or make adjustments in any of the above strategic choices—timing matters!)

(A company’s third set of strategic choices)

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Going on the Offensive—Strategic Options to Improve a Company’s Market Position

No matter which of the five basic competitive strategies a company employs, there are times when it makes sense for a company to go on the offensive to improve its market position and business performance. Strategic offensives are called for when a company spots opportunities to gain profitable market share at rivals’ expense, when a company has no choice but to try to whittle away at a strong rival’s competitive advantage, and when a company opts to pursue newly emerging market opportunities. Companies like Google, Amazon, Apple, and Facebook play hardball, aggressively pursuing competitive advantage and trying to reap the benefits a competitive edge offers—a leading market share, excellent profit margins, rapid growth (as compared to rivals), and the reputational rewards of being known as a company on the move. The best offensives tend to incorporate several behaviors and principles: (1) focusing relentlessly on building competitive advantage and then striving to convert competitive advantage into decisive advantage, (2) employing the element of surprise as opposed to doing what rivals expect and are prepared for, (3) applying resources where rivals are least able to defend themselves, and (4) being impatient with the status quo and displaying a strong bias for swift and decisive actions to overwhelm rivals.2

Choosing the Basis for Competitive Attack As a rule, challenging rivals on competitive grounds where they are strong is an uphill struggle. Offensive initiatives that exploit competitor weaknesses stand a better chance of succeeding than do those that challenge competitor strengths, especially if the weaknesses represent important vulnerabilities and weak rivals can be caught by surprise with no ready defense.4

A company’s strategic offensives should be powered by competitively powerful resources and capabilities—such as a better-known brand name, lower production and/ or distribution costs, better technological capability, or a core or distinctive competence in designing and producing superior performing products. Designing a strategic offensive spearheaded by relatively weak company resources and capabilities is like marching into battle with a popgun—the prospects for success are dim. For instance, it is foolish for a company with relatively high costs to employ a price-cutting offensive. Price-cutting offensives are best left to financially strong companies whose costs are relatively low in comparison to those of the companies being attacked. Likewise, it is ill-advised to pursue a product innovation offensive without proven expertise in R&D, new product development, and speeding new or improved products to market.

The principal offensive strategy options include the following:

n Offering an equally good or better product at a lower price. Lower prices can produce market share gains if competitors don’t respond with price cuts of their own and if the challenger convinces buyers that its product is just as good or better. However, such a strategy increases total profits only if the gains in additional unit sales are enough to offset the impact of thinner margins per unit sold. Price- cutting offensives generally work best when a company first achieves a cost advantage and then hits competitors with a lower price.5

CORE CONCEPT Sometimes a company’s best strategic option is to seize the initiative, go on the attack, and launch a strategic offensive to improve its market position. It takes successful offensive strategies to build competitive advantage, widen an existing advantage, or narrow the advantage held by a strong competitor.

CORE CONCEPT The best offensives use a company’s most potent resources and capabilities to attack rivals where they are competitively weakest.

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n Leapfrogging competitors by being the first adopter of next-generation technologies or being first to market with next-generation products. In technology-based industries, the opportune time to launch an offensive against rivals is by leading the way in introducing a next-generation technology or product. Microsoft got its next-generation Xbox 360 to market a full 12 months ahead of Sony’s PlayStation 3 and Nintendo’s Wii, helping it build a sizable market share on the basis of cutting-edge innovation. Sony was careful to avoid a repeat, timing its release of PlayStation 4 to coincide with Microsoft’s introduction of the Xbox One.

n Pursuing continuous product innovation to draw sales and market share away from rivals with comparatively weak product innovation capabilities. Ongoing introductions of new/improved products can put rivals with deficient product innovation capabilities under tremendous competitive pressure. But such offensives can be sustained only if a company can keep its product development pipeline full of new and improved products that spark buyer enthusiasm.

n Pursuing disruptive product innovation to create new markets. While this strategy can be riskier and more costly than continuous product innovation, “big bang” disruptive product innovation can be a game changer if successful. Disruptive innovation involves perfecting a new product with a few trial users, then quickly rolling it out to the whole market in an attempt to get many buyers to embrace an altogether new and better value proposition quickly. Examples include online degree programs, self-driving capabilities for motor vehicles, and Amazon’s Kindle (which undercut the sales of hardcopy fiction and non-fiction books).

n Adopting and improving on the good ideas of other companies (rivals or otherwise).8 The idea of warehouse home improvement centers did not originate with The Home Depot cofounders Arthur Blank and Bernie Marcus. They got the “big box” concept from their former employer Handy Dan Home Improvement. But they were quick to improve on Handy Dan’s business model and strategy and take The Home Depot to the next plateau in terms of product line breadth and customer service. Offense-minded companies are often quick to adopt any good idea (not nailed down by a patent or other legal protection) in an effort to create competitive advantage for themselves.9

n Deliberately attacking those market segments where a key rival makes big profits.10 Long a dominant force in small automobiles, Toyota launched a hardball attack on General Motors, Ford, and Chrysler in the U.S. market for light trucks and SUVs, the very market segments where the Detroit automakers historically earned big profits (roughly $10,000 to $15,000 per vehicle). Toyota now offers equivalent vehicles, earns handsome profits of its own in these two market segments, and has stolen sales and market share from its U.S.-based rivals. Dell Computer opted to introduce its own brand of printers and printing supplies because its principal rival in desktop and laptop computers was Hewlett-Packard, which made its biggest profits in printing and printing supplies; by attacking H-P in the market for printers, Dell sought to force H-P to devote management attention and resources to defending its printing business and distract its attention away from trying to wrest market leadership away from Dell in the PC market.

n Attacking the competitive weaknesses of rivals. Such offensives present many options. One is to go after the customers of those rivals whose products lag on quality, features, or product performance. If a company has especially good customer service capabilities, it can make special sales pitches to the customers of those rivals who provide subpar customer service. Aggressors with a recognized brand name and strong marketing skills can launch efforts to win customers away from rivals with weak brand recognition. There is considerable appeal in emphasizing sales to buyers in geographic regions where several rivals have low market shares or are less well-equipped to serve. If the attacker’s most potent resources and capabilities should prove powerful enough to outcompete the targeted rivals and result in competitive advantage, so much the better.

n Maneuvering around competitors and concentrating on capturing unoccupied or less contested market territory. Examples include launching initiatives to build strong positions in geographic areas or market segments where close rivals have little or no market presence. Southwest Airlines became a major carrier not by invading the turf where big airlines had their “hubs”—like Chicago O’Hare, Dallas-Fort Worth, Los

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Angeles, and New York LaGuardia, but by scheduling point-to-point flights to lesser-sized airports (Las Vegas, Baltimore-Washington, Chicago Midway, and Fort Lauderdale) where relatively weak competition enabled it to gain the leading market share in a fairly short time. Going into 2016, Southwest commanded the biggest share of passenger traffic in over 60 of the 84 airports it served in the United States.

n Using hit-and-run or guerrilla warfare tactics to grab sales and market share from complacent or distracted rivals. Options for “guerrilla offensives” include occasional low-balling on price (to win a big order or steal a key account from a rival); surprising key rivals with sporadic but intense bursts of promotional activity (offering a 20 percent discount for one week to draw customers away from rival brands); or undertaking special campaigns to attract buyers away from rivals plagued with a strike or problems in meeting buyer demand.11 Guerrilla offensives are particularly well suited to small challengers who have neither the resources nor the market visibility to mount a full-fledged attack on industry leaders.

n Launching a preemptive strike to secure an advantageous position that rivals are prevented or discouraged from duplicating.12 What makes a move preemptive is its one-of-a-kind nature—whoever strikes first stands to acquire competitive assets that rivals can’t readily match. Examples of preemptive moves include (1) securing the best distributors in a particular geographic region or country; (2) obtaining the most favorable site along a heavily traveled thoroughfare, at a new interchange or intersection, in a new shopping mall, in a natural beauty spot, close to cheap transportation or raw material supplies or market outlets, and so on; (3) tying up the most reliable, high-quality suppliers via exclusive partnerships, long-term contracts, or even acquisition; and (4) moving swiftly to acquire the assets of distressed rivals at bargain prices. To be successful, a preemptive move doesn’t have to totally block rivals from following or copying; it merely needs to give a firm a prime position that is not easily circumvented.

How long it takes for an offensive to yield good results varies with the competitive circumstances.13 It can be short if buyers respond immediately (as can occur with a dramatic price cut, an imaginative ad campaign, or an especially appealing new product). Securing a competitive edge can take much longer if winning consumer acceptance of the company’s product will take some time or if the firm may need several years to debug a new technology or put new production capacity in place. But how long it takes for an offensive move to improve a company’s market standing—and whether the move will prove successful—depends in part on whether and how quickly rivals recognize the threat and begin a counter-response. And any responses on the part of rivals hinge on whether (1) they have effective countermoves in their arsenal of strategic options and (2) they believe that a counterattack is worth the expense and the distraction.14

Blue Ocean Strategy—A Special Kind of Offensive A blue ocean strategy seeks to gain a dramatic and durable competitive advantage by abandoning efforts to beat out competitors in existing markets and, instead, invent a new industry or distinctive market segment that renders existing competitors largely irrelevant and allows a company to create and capture altogether new demand.14 This strategy views the business universe as consisting of two distinct types of market space. One is where industry boundaries are defined and accepted, the competitive rules of the game are well understood and accepted by all industry members, and companies use their resources and capabilities to compete against rivals and achieve satisfactory or better performance. In such markets, lively competition constrains a company’s prospects for rapid growth and superior profitability since rivals move quickly to either imitate or counter the successes of competitors. The second type of market space is a “blue ocean” where the industry does not really exist yet, is untainted by competition, and offers wide open opportunity for profitable and rapid growth if a company can come up with an innovative new product offering and strategy that allow it to create new demand rather than fight over existing demand. Companies that create blue ocean market spaces can often sustain their initially won competitive advantage without encountering a major competitive challenge for 10 to 15 years provided their blue ocean strategy translates into strong brand name awareness and there are other high barriers to imitating its product offering.

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A terrific example of blue ocean market creation is the online auction market that eBay created and now dominates. Other examples of companies that have created blue ocean market spaces include NetJets in fractional jet ownership, Drybar in hair blowouts, and Cirque du Soleil in live entertainment. Cirque du Soleil “reinvented the circus” by creating a distinctly different market space for its performances (Las Vegas night clubs and theater settings) and pulling in a whole new group of customers—adults and corporate clients—who not only were noncustomers of traditional circuses (like Ringling Brothers, the legendary industry leader), but were also willing to pay several times more than the price of a conventional circus ticket to have an “entertainment experience” featuring sophisticated clowns and star-quality acrobatic acts in a comfortable atmosphere.

Choosing Which Rivals to Attack Offensive-minded firms need to analyze which of their rivals to challenge as well as how to mount that challenge. The following are the best targets for offensive attacks:15

n Market leaders that are vulnerable. Offensive attacks make good sense when a company that leads in size and market share is not a true leader in serving the market well. Signs of leader vulnerability include unhappy buyers, an inferior product line, a weak competitive strategy with regard to low-cost leadership or differentiation, strong emotional commitment to an aging technology the leader has pioneered, outdated plants and equipment, a preoccupation with diversification into other industries, and mediocre or declining profitability. Offensives to erode the positions of market leaders have real promise when the challenger is able to revamp its value chain or innovate to gain a fresh cost-based or differentiation-based competitive advantage.16 To be judged successful, attacks on leaders don’t have to result in making the aggressor the new leader; a challenger may “win” by simply becoming a stronger runner-up. Caution is well advised in challenging strong market leaders—there’s a significant risk of squandering valuable resources in a futile effort or precipitating a fierce and profitless industry-wide battle for market share.

n Runner-up firms with weaknesses in areas where the challenger is strong. Runner-up firms are an especially attractive target when a challenger’s resource strengths and competitive capabilities are well suited to exploiting their weaknesses.

n Struggling enterprises on the verge of going under. Challenging a hard-pressed rival in ways that further deplete its financial strength and competitive position can weaken its resolve and hasten its exit from the market. It often makes sense to attack a struggling enterprise in its most profitable market segments, since this will threaten its survival the most.

n Small local and regional firms with limited resources and/or capabilities. Because small firms typically have limited expertise and resources, a challenger with broader and/or deeper capabilities is well positioned to raid their biggest and best customers—particularly those customers that are growing rapidly, have increasingly sophisticated requirements, and may already be thinking about switching to a supplier with more full-service capability.

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Defensive Strategies—Protecting Market Position and Competitive Advantage

In a competitive market, all firms are subject to offensive challenges from rivals. The purposes of defensive strategies are to lower the risk of being attacked, weaken the impact of any attack that occurs, and influence challengers to aim their efforts at other rivals. While defensive strategies usually don’t enhance a firm’s competitive advantage, they can definitely help fortify its competitive position, protect its most valuable resources and capabilities from imitation, and defend whatever competitive advantage it might have. Defensive strategies can take either of two forms: actions to block challengers and actions to signal the likelihood of strong retaliation.

Blocking the Avenues Open to Challengers The most frequently employed approach to defending a company’s present position involves actions that restrict a challenger’s options for initiating competitive attack. There are any number of obstacles that can be put in the path of would-be challengers.17 A defender can participate in alternative technologies as a hedge against rivals attacking with a new or better technology. A defender can introduce new features, add new models, or broaden its product line to close off gaps and vacant niches to opportunity-seeking challengers. It can thwart rivals’ efforts to attack with a lower price by maintaining a lineup of product selections that includes economy-priced options for price-sensitive buyers. It can try to discourage buyers from trying competitors’ brands by lengthening warranties, offering free training and support services, developing the capability to deliver spare parts to users faster than rivals can, providing coupons and sample giveaways to buyers most prone to experiment, and making early announcements about impending new products or price changes to induce potential buyers to postpone switching. It can challenge the quality or safety of rivals’ products. Finally, a defender can grant volume discounts or better financing terms to dealers and distributors to discourage them from experimenting with other suppliers, or it can convince them to handle its product line exclusively and force competitors to use other distribution outlets.

Signaling Challengers that Retaliation Is Likely The goal of signaling challengers that strong retaliation is likely in the event of an attack is either to dissuade challengers from attacking at all or to divert them to less- threatening options. Either goal can be achieved by letting challengers know the battle will cost more than it is worth. Would-be challengers can be signaled by:18

n Publicly announcing management’s commitment to maintain the firm’s present market share.

n Publicly committing the company to a policy of matching competitors’ prices and terms of sale.

n Maintaining a war chest of cash and marketable securities.

n Making an occasional strong counter-response to the moves of weak competitors to enhance the firm’s image as a tough defender.

For signaling to be effective, however, challengers must believe that the signaler has every intention of pursuing retaliatory actions if attacked.

There are many ways to throw obstacles in the path of would-be challengers.

CORE CONCEPT Good defensive strategies can help protect competitive advantage but rarely are the basis for creating it.

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Website Strategies

Every company with a website has to address what role the site should play in the company’s competitive strategy. In particular, to what degree should a company use online sales as a means for selling its products or services direct to users? Should a company use its website only as a means of disseminating information about the company and its products (relying exclusively on its wholesale and retail partners to make all sales to end users)? Or should online sales at the company’s website be (1) a secondary or minor channel for accessing customers, (2) one of several important distribution channels for accessing customers, (3) the primary distribution channel for accessing customers, or (4) the exclusive channel for trans- acting sales with customers?19 Let’s look at each of these strategic options in turn.

Product Information-Only Strategies—Avoiding Channel Conflict Operating a website that contains extensive product information but relies on click-throughs to the websites of distribution channel partners for sales transactions (or that informs site visitors where nearby retail stores are located) is an attractive option for manufacturers and/or wholesalers that have invested heavily in building and cultivating retail dealer networks to access end users. A company vigorously pursuing online sales to consumers at the same time it is also heavily promoting sales to consumers through its network of wholesalers and retailers is competing directly against its distribution allies. Such actions constitute channel conflict and are a tricky road to negotiate. A company actively trying to grow online sales is signaling a weak strategic commitment to its dealers and a willingness to cannibalize dealers’ sales and growth potential. The likely result is angry dealers and loss of dealer goodwill. Some or many of the company’s dealers may opt to put more effort into marketing the brands of rival manufacturers who don’t sell online or whose online sales effort is passive and nonthreatening. Quite possibly, a company may lose more sales by offending its dealers than it gains from its own online sales effort. Consequently, in industries where the strong support and goodwill of dealer networks is essential, companies may conclude that it is important to avoid channel conflict and their website should be designed to partner with dealers rather than compete with them.

Website Sales as a Minor Distribution Channel A second strategic option is to use online sales as a relatively minor distribution channel for achieving incremental sales, gaining online sales experience, and doing marketing research. If channel conflict poses a big obstacle to online sales, or if only a small fraction of buyers can be attracted to make online purchases, then companies are well advised to pursue online sales with the strategic intent of gaining experience, learning more about buyer tastes and preferences, testing reaction to new products, creating added market buzz about their products, and boosting overall sales volume a few percentage points. Sony and Nike, for example, sell most all of their products at their websites without provoking resistance from their retail dealers—their website prices are the same (sometimes higher) than the prices of their dealers, which gives buyers little incentive to buy online as compared shopping at the stores of local dealers. However, Nike does allow shoppers at its website to order custom-designed shoes, which gives Nike valuable insight into buyer fashion preferences and aids the company’s new product development personnel in deciding what new shoe designs, colors, and accents to introduce.

Companies today must wrestle with whether to use their websites just as a means of disseminating information about the company and its product offerings or whether to operate an e-store that sells direct to online shoppers.

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Sometimes, manufacturers are willing to accept the channel conflict problems that arise from selling online in head-to-head competition with distribution channel allies because they expect that over the long term online sales at their websites will become progressively large and quite profitable. A strategy to gradually grow online sales into an important distribution channel can make sense in three instances:

n When profit margins from online sales are bigger than those earned from selling to wholesale/retail customers.

n When encouraging buyers to visit the company’s website helps educate them about the ease and convenience of purchasing online and, over time, prompts more and more buyers to purchase online (where company profit margins are greater)—which makes incurring channel conflict in the short term and competing against traditional distribution allies potentially worthwhile.

n When selling directly to end users allows a manufacturer to make greater use of build-to-order manufacturing and assembly, which if met with growing buyer approval would increase the rate at which sales migrate from distribution allies to the company’s website; such migration could lead to streamlining the company’s value chain and boosting its profit margins.

Brick-and-Click Strategies Some companies employ brick-and-click strategies, whereby they sell to consumers both at their own websites and at their own company-owned retail stores (or the stores of independent retailers). Brick-and-click strategies have two big appeals: They are an economic means of expanding a company’s geographic reach, and they give both existing and potential customers another choice of how to communicate with the company, shop for product information, make purchases, or resolve customer service problems. Software developers, for example, have come to rely on the Internet as a highly effective distribution channel to complement sales at brick-and-mortar retailers. Allowing end users to make an online purchase and download it immediately has the big advantage of eliminating the costs of producing and packaging CDs and cutting out the costs and margins of software wholesalers and retailers (often 35 to 50 percent of the retail price). Chain retailers like Walmart and Best Buy operate online stores for their products primarily as a convenience to customers who prefer to buy online and have the items shipped or available for pickup at nearby stores.

Many brick-and-mortar retailers can enter online retailing at relatively low cost—all they need is a web store for displaying products, accepting customer orders, and systems for filling and delivering orders. Brick-and-mortar retailers (as well as manufacturers with company-owned retail stores) can use personnel at their distribution centers and/or retail stores to fill and ship the orders of online buyers, and they can allow online buyers to pick up their orders at the nearest local retail store. Walgreens, a leading drugstore chain, lets customers order a prescription online and then pick it up at the drive-through window or inside counter of a local store. In banking, a brick-and-click strategy allows customers to use local branches and ATMs for depositing checks and getting cash while using online systems to pay bills, monitor account balances, and transfer funds. Bed Bath & Beyond uses its web store to display and sell the items stocked in its stores but also to display and sell a wider number of brands, colors, and selections in the same product categories that, for reasons of limited shelf space, are not available in its stores—such a strategy gives customers a much wider selection and boosts its online sales.

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Strategies for Online Enterprises A company that elects to use its website as the exclusive channel for accessing buyers is essentially an online business—all customer-related transactions occur at the company’s website. Thousands of enterprises have chosen this strategic approach, including Netflix, TripAdvisor, Quicken Loans, and Expedia. For a company to succeed in using online sales as its exclusive distribution channel, its product or service must be one for which buying online holds strong appeal. The strategies adopted by online enterprises must address several issues:

n How it will deliver unique value to buyers. Online businesses must usually attract buyers on the basis of low price, convenience, superior product information, build-to-order options, or attentive online service.

n Whether it will pursue competitive advantage based on lower costs, differentiation, or better value for the money. For an online-only sales strategy to succeed in head-to-head competition with brick-and- mortar and brick-and-click rivals, an online seller’s value chain approach must hold potential for a low- cost advantage, competitively valuable differentiating attributes, or a best-cost provider advantage.

n Whether it will have a broad or a narrow product offering. A one-stop shopping strategy like that employed by Amazon.com (which offers “Earth’s Biggest Selection” of items for sale at its websites in the United States, Canada, Britain, France, Germany, Denmark, and Japan) has the appealing economics of helping spread fixed operating costs over a wide number of items and a large customer base. Online sellers like Zappos.com (footwear and apparel), Quicken Loans (the largest online provider of home mortgages), and Hotels.com have adopted classic focus strategies and cater to a sharply defined target audience shopping for a particular product or product category.

n Whether to outsource order fulfillment activities or perform them internally. Most online sellers find it more economical to outsource order fulfillment activities to specialists who make a business of providing warehouse space, stocking inventories, and installing the capabilities to pick, pack, and ship orders cost-efficiently for a number of different online retailers. Only very high-volume online retailers can develop and install the capabilities to perform order fulfillment activities internally at costs below those of outside specialists. Buy.com, an online superstore with some 30,000 items, obtains products from name brand manufacturers and uses outsiders to stock and ship those products—thus, its focus is not on manufacturing or order fulfillment but rather on online sales.

n How it will draw traffic to its website and then convert page views into revenues. Websites must be cleverly marketed. Unless web surfers hear about the site, like what they see on their first visit (and perhaps make a purchase), and are intrigued enough to return again and again to both view information and make purchases, the site is unlikely to generate adequate revenues. The best test of effective marketing and the appeal of an online company’s product offering is the ratio at which page views are converted into revenues (the “look-to-buy” ratio).

Outsourcing Strategies

Outsourcing strategies involve a conscious decision to abandon or forgo attempts to perform certain value chain activities internally and to instead farm them out to outside specialists and strategic allies.20 Many PC makers, for example, have shifted from assembling units in-house to outsourcing the entire assembly process to manufacturing specialists that assemble many brands of PCs (and thus can capture all the available economies of scale), are better able to bargain down the prices of PC components (by buying in large volumes), and have developed best practice capabilities in performing specific assembly tasks accurately and cheaply. Most all name brand apparel firms have in-house capability to design, market, and distribute their

CORE CONCEPT Outsourcing involves farming out certain value chain activities to outside vendors and narrowing the scope of its internal operations.

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products but they outsource all fabric manufacture and garment-making activities to contract manufacturers in low-wage countries. Starbucks finds purchasing coffee beans from independent growers far more advantageous than having its own coffee-growing operation, with locations scattered across most of the world’s coffee-growing regions.

Outsourcing certain value chain activities can be strategically advantageous whenever:

n An activity can be performed better or more cheaply by outside specialists. A company should generally not perform any value chain activity internally that outsiders can perform more efficiently or effectively. The chief exception is when a particular activity is strategically crucial and internal control over that activity is deemed essential. Dolce and Gabbana, for example, outsources manufacture of its brand of sunglasses to Luxottica—a company considered to be the world’s best producer of top-quality fashion sunglasses and high-tech prescription eyewear, known for its Ray-Ban, Oakley, and Oliver Peoples brands.

n The activity is not crucial to the firm’s ability to achieve sustainable competitive advantage and won’t hollow out its core competences, capabilities, or technical know-how. Outsourcing of maintenance services, data processing and data storage, fringe benefit management, website operations, call center operations, and similar administrative support activities to specialists is commonplace. Colgate has reduced its information systems costs by more than 10 percent annually through an outsourcing agreement with IBM.

n It streamlines company operations in ways that improve organizational flexibility or speeds the time to get new products to market. Outsourcing gives a company the flexibility to switch suppliers in the event one or more of its present suppliers fall behind competing suppliers. To the extent that its suppliers can speedily get next-generation parts and components into production, a company can get its own next- generation product offerings into the marketplace quicker. Moreover, seeking new suppliers with the needed capabilities already in place is frequently quicker, easier, less risky, and cheaper—firms that internally produce the parts and components they need are periodically confronted with sometimes formidable costs to update obsolete parts-making capabilities or to install and master new parts-making technologies.

n It reduces the company’s risk exposure to changing technology or shifting buyer preferences. When a company outsources certain parts, components, and services, its suppliers must bear the burden of incorporating state-of-the-art technologies and/or undertaking redesigns and upgrades to accommodate a company’s plans to introduce next-generation products. If what a supplier provides is designed out of next-generation products or rendered unnecessary by technological change, it is the supplier’s business that suffers rather than the company’s.

n It improves a company’s ability to innovate. Collaborative partnerships with world-class suppliers who have cutting-edge intellectual capital and are early adopters of the latest technology give a company access to ever better parts and components—such supplier-driven innovations, when incorporated into a company’s own product offering, fuel a company’s ability to introduce its own new and improved products.

n It allows a company to assemble diverse kinds of expertise speedily and efficiently. A company can nearly always gain quicker access to first-rate capabilities and expertise by partnering with suppliers who already have them in place rather than trying to build them from scratch with its own company personnel.

n It allows a company to concentrate on its core business, leverage its key resources, and do even better what it already does best. A company is better able to build and develop its own competitively valuable competences and capabilities when it concentrates its full resources and energies on performing those

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value chain activities that it can perform better than outsiders and/or that it needs to have under its direct control. Nike, for example, devotes its energy to designing, marketing, and distributing athletic footwear, sports apparel, and sports equipment, while outsourcing the manufacture of all its products to contract factories. Apple outsources production of its iPod, iPhone, and iPad models to Chinese contract manufacturer Foxconn. Recently, Hewlett-Packard and IBM sold some of their manufacturing plants to outsiders and contracted to repurchase the output from the new owners.

The Big Risk of Outsourcing Value Chain Activities The biggest danger of outsourcing is that a company will farm out too many or the wrong types of activities, thereby unduly narrowing the scope of capabilities in ways that unwittingly reduce its long-term competitiveness.21 For example, in recent years, companies anxious to reduce operating costs have opted to outsource such strategically important activities as product development, engineering design, and sophisticated manufacturing tasks—the very capabilities that underpin a company’s ability to lead sustained product innovation. While these companies have apparently been able to lower their operating costs by outsourcing these functions to outsiders, their ability to lead the development of innovative new products is weakened because so many of the cutting-edge ideas and technologies for next-generation products come from outsiders. For example, most U.S. brands of laptops and cell phones are now not only manufactured but also designed in Asia.22 It is strategically dangerous for a company to be dependent on outsiders to provide it with the skills, knowledge, and capabilities that over the long run heavily influence its competitiveness and market success. Companies like Cisco are alert to the danger of farming out the performance of strategy-critical value chain activities and take actions to protect against being held hostage by outside suppliers. Cisco guards against loss of control and protects its manufacturing expertise by designing the production methods its contract manufacturers must use. Cisco keeps the source code for its designs proprietary, thereby controlling the initiation of all improvements and safeguarding its innovations from imitation. Further, Cisco has developed online systems to monitor the factory operations of contract manufacturers around the clock, so that it knows immediately when problems arise and can decide whether to get involved.

Vertical Integration Strategies: Operating Across More Stages of the Industry Value Chain

Vertical integration extends a firm’s competitive and operating scope within the same industry. It involves expanding the firm’s range of activities backward into sources of supply and/or forward toward end users. Thus, if a manufacturer invests in facilities to produce certain component parts that it formerly purchased from outside suppliers, it has engaged in backward vertical integration and extended its competitive scope backward into the production of component parts, but its business remains in the same industry as before. The only change is that it has operations in two stages of the industry value chain. Similarly, if a paint manufacturer—Sherwin-Williams, for example—elects to integrate forward by opening 500 retail stores to market its paint products directly to consumers, its entire business is still in the paint industry even though its competitive scope extends from manufacturing to retailing.

A firm can pursue vertical integration by starting its own operations in other stages in the industry’s activity chain or by acquiring a company already performing the activities it wants to bring in-house. Vertical integration strategies can aim at full integration (participating in all stages of the industry value chain) or partial integration (building positions in selected stages of the industry’s total value chain).

A company must guard against outsourcing activities that can unwittingly degrade its capabilities to be a master of its own destiny.

CORE CONCEPT A vertically integrated firm is one whose business activities extend across several portions or stages of an industry’s overall value chain.

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The Advantages of a Vertical Integration Strategy The two best reasons for investing company resources in vertical integration are to strengthen the firm’s competitive position and/or boost its profitability.23 Vertical integration has no real payoff with respect to profits or strategy unless it produces sufficient cost savings/profit increases to justify the extra investment, adds materially to a company’s competitive strengths, and/or helps differentiate the company’s product offering in ways buyers deem valuable.

Integrating Backward to Achieve Greater Competitiveness It is harder than one might think to generate cost savings or boost profitability by integrating backward into activities such as parts and components manufacture (which could otherwise be purchased from suppliers with specialized expertise in making these parts and components). For backward integration to be a viable and profitable strategy, a company must be able to (1) achieve the same scale economies as outside suppliers and (2) match or beat suppliers’ production efficiency with no drop-off in quality. Neither outcome is a slam dunk. To begin with, a company’s in-house requirements are often too small to reach the optimum size for low-cost operation— for instance, if it takes a minimum production volume of 1 million units to achieve mass production economies and a company’s in-house requirements are just 250,000 units, then it falls way short of being able to capture the scale economies of outside suppliers (who may readily find buyers for 1 million or more units). Furthermore, matching the production efficiency of suppliers is fraught with problems when suppliers have high-caliber production capabilities of their own, when the technology they employ has elements that are hard to master, and/or when substantial R&D expertise is required to develop next- version parts and components, or keep pace with advances in parts/components manufacturing processes.

That said, occasions still arise when a company can improve its cost position and competitiveness by performing a broader range of value chain activities internally rather than having some of these activities performed by outside suppliers. The best potential for being able to reduce costs via a backward integration strategy exists in situations where a company must deal with a few suppliers with substantial bargaining power, where suppliers have outsized profit margins, where the item being supplied is a major cost component, and where the requisite technological/production capabilities are easily mastered or can be gained by acquiring a supplier with most or all of the needed capabilities. Situations also arise when integrating backward can enable a company to reduce costs by facilitating the coordination of production flows from one stage to the next and avoiding bottlenecks and delays that disrupt production schedules. Furthermore, if a company has proprietary know-how that it wants to keep from rivals, then in-house performance of value chain activities related to this know-how is beneficial even if outsiders can perform such activities. Backward integration also spares a company the risk of being heavily dependent on suppliers for crucial components or support services and reduces exposure to supplier price increases.

Backward vertical integration can produce a differentiation-based competitive advantage when a company, by performing activities internally, ends up with a better-quality or better-performing product, improved customer service capabilities, or in other ways is able to deliver added value to customers. On occasion, integrating into more stages along the industry value chain can add to a company’s differentiation capabilities by allowing it to build or strengthen its core competences, better master strategy-critical capabilities, or add features that deliver greater customer value. Panera Bread has been quite successful with a backward vertical integration strategy to produce fresh dough that company-owned and franchised bakery-cafés use in making baguettes, pastries, bagels, and other types of bread—not only does internally producing fresh dough promote consistent-quality bakery products at Panera’s 2,000 locations and lower store costs for baking, but it has also enhanced Panera’s profitability. Twenty First Century Fox, the parent of Fox Broadcasting, the Fox family of cable channels, and pay-television businesses in Europe and Asia, backward integrated into film production (Twentieth Century Fox Film studio) and the production of TV programs to provide differentiated content for its TV businesses, avoid total dependence on outsiders for needed programming, and limit the bargaining power of outside content providers.

CORE CONCEPT Backward vertical integration involves entry into activities performed by suppliers or other enterprises positioned in earlier stages of an industry’s overall value chain.

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Integrating Forward to Enhance Competitiveness The strategic impetus for forward integration is to gain better access to end users, improve market visibility, and enhance brand name awareness. In many indus- tries, independent sales agents, wholesalers, and retailers handle competing brands of the same product. Because they have no allegiance to any one company’s brand, they concentrate their energies on pushing whatever brand sells and earns them the biggest profits. Independent insurance agencies, for example, represent a number of different in- surance companies; in trying to find the best match between a customer’s insurance requirements and the policies of al- ternative insurance companies, they have opportunity to promote the policies of certain insurers and downplay the policies of other insurers. Consequently, insurers like State Farm and Allstate have integrated forward and set up local sales offices with local agents to exclusively market and service their insurance policies. Likewise, it can be advantageous for a manufacturer to integrate forward into wholesaling or retailing via company-owned distributorships or a chain of retail stores rather than depend on the marketing and sales efforts of independent distributors/retailers that stock multiple brands and steer customers to those brands earning them the highest profits. To avoid dependence on distributors/dealers with divided loyalties, Goodyear has integrated forward into company-owned and franchised retail tire stores. Consumer-goods companies like Coach, Under Armour, Nike, Tommy Hilfiger, Pepperidge Farm, Samsonite, Ann Taylor, and Polo Ralph Lauren have integrated forward and operate company-operated retail stores as well as their own branded stores in factory outlet malls that enable them to move overstocked items, slow-selling items, and seconds. Growing numbers of producers have integrated forward and begun selling directly to end- users at company websites, thus reducing dependence on traditional wholesale and retail channels.

The Disadvantages of a Vertical Integration Strategy Vertical integration has important disadvantages, however.24 The biggest drawbacks include the following:

n Vertical integration boosts a firm’s capital investment in the industry, thereby increasing business risk (what if industry growth and profitability unexpectedly go sour?)

n Integrating backward or forward creates a vested interest for a firm to continue performing the integrated system of value chain activities it has invested money and effort into establishing (even if internal performance of certain of these value chain activities later becomes suboptimal). Why? Because there are barriers to quickly or easily exiting the performance of value chain activities spanning two of more stages on the industry’s value chain, including facilities shutdowns, costly write-offs of undepreciated assets, employee layoffs, and disrupted performance of related value chain activities. However, a company that obtains parts and components from outside suppliers can always shop the market for the newest, best, or cheapest parts and components. A company that does not have its own network of company-owned distributorships and retail stores can switch distributors and/or distribution channel emphasis whenever it is advantageous to do so.

n Some vertically integrated companies are slow to adopt new technologies or production methods because of reluctance to write off undepreciated assets or because they assign higher priority to spending capital for other company projects or because they see benefits in sticking with the present technology or production methods a while longer. It is a constant struggle for manufacturers that have integrated backward to keep up with all the ongoing advances in technology and best practice production techniques for each of the many parts and components they make in-house. The faster the pace of change in an industry’s value chain, the bigger the risk of a vertical integration strategy.

CORE CONCEPT Forward vertical integration involves entering into the performance of industry value chain activities located closer to end users.

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n Integrating backward into parts and components manufacture reduces a company’s flexibility to implement a cheaper/better product design or adjust its lineup of product offering in response to shifting buyer preferences. It is one thing to eliminate use of a component made by a supplier and another to stop using a component being made in-house (which can mean laying off employees and writing off the associated investment in equipment and facilities and then making the investments needed to produce the new / cheaper better part/component). It is more disruptive and costly to delete or add new products when a company not only assembles its own products but also operates facilities to produce many of the associated parts/components. Most of the world’s automakers, despite their manufacturing expertise, have concluded that purchasing a majority of their parts and components from best-in-class suppliers results in greater design flexibility, higher quality, and lower costs than producing parts/components in-house.

n Vertical integration poses all kinds of capacity-matching problems. In motor vehicle manufacturing, for example, the most efficient scale of operation for making axles is different from the most economic volume for radiators, and different yet again for both engines and transmissions. Building the capacity to produce just the right number of axles, radiators, engines, and transmissions in-house—and doing so at the lowest unit costs for each—poses significant challenges in cost-effectively producing each different part/component.

n Integrating forward or backward typically requires new or different skills and business capabilities. Parts and components manufacturing, assembly operations, wholesale distribution, retailing, and direct sales via the Internet involve using different know-how, resources, and capabilities to master the performance of different value chain activities. A manufacturer that integrates backward into parts and components production has to become proficient in different technologies and production methods and very likely source needed materials from different suppliers. A manufacturing company contemplating forward integration needs to consider carefully whether it makes good business sense to invest time and money in developing the expertise and merchandising skills to be successful in wholesaling and/ or retailing. Many manufacturers learn the hard way that company-owned wholesale/retail networks present many headaches, fit poorly with what they do best, and don’t always add the kind of value to their core business as originally planned. Selling to customers via the Internet poses still another set of problems to achieve proficient performance of strikingly different value chain activities.

In today’s world of close working relationships with suppliers and efficient supply chain management systems, relatively few companies can make a strong economic case for integrating backward into the business of suppliers. The best materials and components suppliers stay abreast of advancing technology and best practices and are adept in making good quality items, delivering them on time, and keeping their costs and prices competitive.

Weighing the Pros and Cons of Vertical Integration All in all, therefore, a strategy of vertical integration can have both important strengths and weaknesses. The tip of the scales depends on (1) the difficulties and costs of acquiring or developing the resources and capabilities needed to operate in another stage of the industry value chain, (2) the size of the benefits vertical integration offers in terms of lowering costs or enhancing differentiation and the value delivered to customers; (3) the impact of vertical integration on investment costs, flexibility, and response times, (4) the administrative costs of coordinating operations across more value chain activities; and (5) whether the integration substantially enhances a company’s competitiveness and profitability. Vertical integration strategies have merit according to which capabilities and value chain activities truly need to be performed in-house and which can be performed better or cheaper by outsiders. Absent solid benefits in relation to the associated costs and risks, integrating forward or backward is not likely to be an attractive strategy option.

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Strategic Alliances and Partnerships

Companies in all types of industries and in all parts of the world have elected to form strategic alliances and partnerships to complement their own strategic initiatives and strengthen their competitiveness in domestic and international markets. A strategic alliance is a formal agreement between two or more separate companies in which there is strategically relevant collaboration of some sort, joint contribution of resources, shared risk, shared control, and mutual dependence. Collaborative relationships between partners may entail a contractual agreement but they commonly stop short of formal ownership ties (although sometimes an alliance member may have minority ownership of another member).

When an alliance involves formal ownership ties, it is called a joint venture. A joint venture entails forming a new corporate entity that is jointly owned by two or more companies that agree to share in the revenues, expenses, and profits (losses) of the venture according to their ownership percentages. In many joint ventures, it is formally agreed that one of the owners (typically a majority owner) will exercise operating control over the venture. Because a joint venture involves mutual ownership, it tends to be more durable than an alliance where a partner can just abruptly decide to abandon the alliance. A joint venture owner who wants out of the venture must negotiate arrangements to be bought out or else get the other owners to agree to dissolve the venture.

An alliance or joint venture becomes “strategic”—as opposed to just a useful collaborative arrangement—when it serves any of the following purposes or intended outcomes:25

n It facilitates achievement of an important business objective (like reducing risk to a company’s business, lowering costs, or delivering more value to customers in the form of better quality, extra features, and greater durability).

n It helps build or strengthen a company’s competitively valuable resources and capabilities.

n It helps remedy an important resource deficiency or competitive weakness.

n It speeds the development of competitively important new technologies and/or product innovations.

n It facilitates entry into new geographic markets or pursuit of important market opportunities.

n It helps block or defend against a competitive threat or mitigate a significant risk to a company’s business.

The current high interest in making strategic alliances a key component of a company’s overall strategy is an about-face from times past, when the vast majority of companies confidently believed they already had or could independently develop whatever resources and capabilities were needed to be successful in their markets. But in today’s world, large corporations—even those that are successful and financially strong—have concluded it doesn’t always make good strategic and economic sense to be totally independent and self-sufficient with regard to every resource and capability it may need or every market opportunity it wants to pursue. Joint ventures are a favored partnership arrangement where two or more companies conclude they each want to pursue an attractive business opportunity but lack the resources and capabilities to do so independently. By joining forces and pooling their resources and capabilities in a joint venture, the resource/capability deficiencies can be readily corrected and overcome; joint pursuit of a mutually attractive business opportunity therefore becomes less risky and more likely to succeed.

CORE CONCEPT Strategic alliances are collaborative arrange- ments where two or more companies join forces to achieve mutually beneficial outcomes.

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Why and How Strategic Alliances Are Advantageous The most common reasons why companies enter into strategic alliances are to expedite the development of promising new technologies or products, to overcome deficits in their own expertise and capabilities, to bring together the personnel and expertise needed to create desirable new skill sets and capabilities, to improve supply chain efficiency, to gain economies of scale in production and/or marketing, and to acquire or improve market access through joint marketing agreements.26 When a company needs to correct particular resource/capability gaps or deficiencies, it may be faster and cheaper to partner with other enterprises that have the missing resources and capabilities. Moreover, partnering offers greater flexibility should a company’s competitive requirements later change. Manufacturers frequently pursue alliances with parts and components suppliers to wring cost savings out of supply chain activities, to improve the quality of parts and components, to better assure reliable supplies and on-time deliveries, and to speed new products to market. In industries where technology is advancing rapidly, alliances are all about fast cycles of learning, staying abreast of the latest developments, and gaining quick access to the latest round of technological know-how and capability. In bringing together firms with different skills and intellectual capital, alliances open up learning opportunities that help partner firms strengthen their own portfolios of resources, core competences, and capabilities and thereby become more competitive.27

Companies find strategic alliances particularly valuable in several other instances. A company racing for global market leadership needs alliances to:28

n Get into critical country markets quickly and accelerate the process of building a potent global market presence.

n Gain inside knowledge about unfamiliar markets and cultures through alliances with local partners. For example, U.S., European, and Japanese companies wanting to build market footholds in China and other fast-growing Asian markets have pursued local partnership arrangements to help guide them through the maze of government regulations, to supply knowledge of local markets, to provide guidance on adapting their products to better match local buying preferences, to set up local manufacturing capabilities, and/ or to assist in distribution, marketing, and promotional activities.

n Access valuable skills and competences that are concentrated in particular geographic locations (such as software design competences in the United States, fashion design skills in Italy, and efficient manufacturing skills in Japan, Taiwan, and China).

A company that is racing to stake out a strong position in an industry of the future needs alliances to:29

n Establish a stronger beachhead for participating in the target industry.

n Master new technologies and build valuable expertise and capabilities faster than would be possible through internal efforts alone.

n Open up broader opportunities in the target industry by melding the firm’s own resources and capabilities with the resources and capabilities of partners to create competitively potent resource/capability bundles.

Because of the varied benefits of strategic alliances, many large corporations have become involved in 30 to 50 alliances, and a number have formed hundreds of alliances. Genentech, a leader in biotechnology and human genetics, has formed R&D alliances with more than 30 companies to boost its prospects for developing new cures for various diseases and ailments. Increasing numbers of companies with a host of alliances now manage their alliances like a portfolio—terminating those that no longer serve a useful purpose or that have produced meager results, forming promising new alliances, and restructuring certain existing alliances to correct performance problems and/or redirect the collaborative effort.30

The best strategic alliances are highly selective, focusing on particular value chain activities and on obtaining a specific competitive benefit. They tend to enable a firm to build on its strengths and learn.

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Many Alliances Are Short-Lived or Break Apart Most alliances that aim at technology-sharing or providing market access turn out to be temporary, fulfilling their purpose after a few years because the benefits of mutual learning have occurred and because both partners’ businesses have developed to the point where they are ready to go their own ways. The likelihood that such alliances will be temporary makes it important for each partner to learn thoroughly and rapidly about the other partner’s technology, business practices, and organizational capabilities and then promptly transfer valuable ideas and practices into its own value chain activities. Alliances tend to be longer lasting when (1) they involve collaboration with suppliers or distribution allies, (2) each party’s contribution involves activities in different portions of the industry value chain, or (3) both parties conclude that continued collaboration is in their mutual interest.

Most alliance partners don’t hesitate to terminate their collaboration when the payoffs run out or when alliance members conclude the expected benefits are unlikely to materialize. A 1999 study by Accenture, a global business consulting organization, revealed that 61 percent of alliances were either outright failures or “limping along.” In 2004, McKinsey & Company estimated that the overall success rate of alliances was around 50 percent, based on whether the alliance achieved the stated objectives. A 2007 study found that, even though the number of strategic alliances was increasing about 25 percent annually, the failure rate of alliances hovered between 60 to 70 percent.32 The high “divorce rate” among strategic allies has several causes—an inability to work well together, tendencies among alliance members to share only limited information about their valuable skills and expertise (which prevented other members from learning much of value), changing conditions that render the purpose of the alliance obsolete, growing disagreement among alliance members about the purpose, priorities, and/or targeted benefits of the alliance, the emergence of more attractive paths to capture the intended benefits, and emerging marketplace rivalry between certain alliance members.33 Experience indicates that alliances stand a reasonable chance of helping a company reduce competitive disadvantage but rarely can entering into an alliance enable a company to boost the competitive power of its resources and capabilities by enough to outcompete rivals or gain a competitive advantage.

The Strategic Dangers of Relying Heavily on Alliances and Cooperative Partnerships The Achilles heel of alliances and strategic cooperation is becoming dependent on other companies for essential expertise and capabilities. To be a market leader (and perhaps even a serious market contender), a company must ultimately develop its own capabilities in areas where internal strategic control is pivotal to protecting its competitiveness and building competitive advantage. Moreover, some alliances and cooperative arrangements hold only limited potential when a partner maintains full control over its most valuable skills and expertise and is unwilling to give other alliance members much access to these capabilities. As a consequence, acquiring or merging with a company possessing the needed resources and capabilities is a better solution.

Large numbers of strategic alliances fail to live up to expectations and are dissolved after a few years.

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Merger and Acquisition Strategies

Mergers and acquisitions are especially suited for situations in which strategic alliances or partnerships do not go far enough in providing a company with access to needed resources and capabilities.34 Ownership ties are more permanent than partnership ties, allowing the operations of the merger/acquisition participants to be tightly integrated and creating more in-house control and autonomy. A merger is the combining of two or more companies into a newly created company that usually takes on a new name. An acquisition is a combination in which one company, the acquirer, purchases and absorbs the operations of another, the acquired. The difference between a merger and an acquisition relates more to the details of ownership, management control, and financial arrangements than to strategy and competitive advantage. The resources and capabilities of the newly created enterprise end up much the same whether the combination is the result of acquisition or merger.

The main impetus for merger and acquisition strategies is to fundamentally alter a company’s trajectory and improve its business outlook. Such strategies typically aim at achieving any of four objectives:35

1. Creating a more cost-efficient operation out of the combined companies. Many mergers and acquisitions are undertaken with the objective of transforming two or more otherwise high-cost companies into one lean competitor with average or below-average costs. When a company acquires another company in the same industry, there’s usually enough overlap in operations that certain inefficient plants can be closed or distribution activities partly combined and downsized (when nearby centers serve some of the same geographic areas) or sales force and marketing activities can be combined and downsized (when each company has salespeople calling on the same customer). The combined companies may also be able to reduce supply chain costs because of buying in greater volume from common suppliers and from closer collaboration with supply chain partners. Likewise, it is usually feasible to squeeze out cost savings in administrative activities, again by combining and downsizing such administrative activities as finance and accounting, information technology, human resources, and so on.

2. Strengthening the resulting company’s resources, capabilities, and competitiveness in important ways. Combining the operations of two or more companies, via merger and/or acquisition, is often aimed at significantly bolstering the competitive power of the resulting company’s resources, know-how, skills and expertise—and doing so quickly (as compared to undertaking a time-consuming and perhaps expensive internal effort to accomplish the same result). From 2000 through January 2017, Cisco Systems purchased 121 companies to give it more technological reach and product breadth, thereby enhancing its standing as the world’s biggest provider of hardware, software, and services for building and operating Internet networks.

3. Expanding a company’s geographic coverage. One of the best and quickest ways to expand a company’s geographic coverage is to acquire rivals with operations in the desired locations. And if there is some geographic overlap, then a side benefit is being able to reduce costs by eliminating duplicate facilities in those geographic areas where undesirable overlap exists. Banks like Wells Fargo and Bank of America

Combining the operations of two companies, via merger or acquisition, is an attractive strategic option for fundamentally altering a company’s trajectory—achieving operating economies, strengthening the resulting company’s resources, capabilities, and competitiveness in important ways, and opening up avenues of new market opportunity.

CORE CONCEPT A merger is the combining of two or more companies into a newly created company that usually has a different name. An acquisition is a combination in which one company, the acquirer, purchases and absorbs the operations of another, the acquired.

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have pursued geographic expansion by making a series of acquisitions over the years, enabling them to establish a market presence in an ever-growing number of states and localities. Food products companies like Nestlé, Kraft, Unilever, and Procter & Gamble have made acquisitions an integral part of their strategies to expand internationally.

4. Extending the company’s business into new product categories. Many times, a company has gaps in its product line that need to be filled. Acquisition can be a quicker and more potent way to broaden a company’s product line than going through the lengthy exercise of doing the R&D, design and engineering, and testing to put the company in position to prepare to manufacture and then introduce an assortment of new products to grow its lineup of product offerings. PepsiCo acquired Quaker Oats chiefly to bring Gatorade into the Pepsi family of beverages. While Coca-Cola has expanded its beverage lineup by introducing its own new products (like Powerade and Dasani), it has also expanded its lineup by acquiring Minute Maid (juices and juice drinks), Odwalla (juices), Hi-C (ready-to-drink fruit beverages), and dozens of other brands of beverages. Going into 2017, Coca-Cola had a portfolio of over 500 versions of beverage products, some internally developed and many the result of an active and longstanding acquisition program.

Many companies have used mergers and acquisitions to catapult themselves from the ranks of the unknown into positions of market prominence. Clear Channel Communications began operations as a single radio station in Texas; after acquiring assorted media assets over four decades, in 2017 Clear Channel (renamed iHeart Media in 2014) was operating 858 broadcast radio stations in the United States with some 250 million monthly listeners, plus it was one of the world’s largest outdoor advertising companies with close to one million displays in over 30 countries.

Many Mergers and Acquisitions Are Not Successful Mergers and acquisitions often do not result in the hoped-for outcomes. The failure rate of mergers and acquisitions is between 70 and 90 percent. The reasons are numerous. The anticipated revenue growth may not occur. Cost savings may prove smaller than expected. Gains in competitive capabilities may take substantially longer to realize, or worse, never materialize at all. Efforts to mesh the cultures can be defeated by formidable resistance from organizational members. Key employees at the acquired company can become disenchanted with newly instituted changes and leave. Differences in management styles and operating procedures can prove hard to resolve. Personnel at the acquired company may stonewall changes, arguing forcefully for doing certain things the way they were done prior to the acquisition.

Unsuccessful mergers and acquisitions can be costly. Ford reportedly lost over $10 billion trying to make successes of its $2.5 billion acquisition of Jaguar (1989) and $2.7 billion acquisition of Land Rover (2000); frustrated by poor results, Ford sold the operations of both brands to India’s Tata Motors in 2008 for $2.3 billion.38 Bank of America’s supposedly bargain-priced $2.5 billion acquisition of ethically challenged and financially troubled Countrywide Financial in January 2008 was, according to a prominent banking and finance professor, “the worst deal in the history of American finance. Hands down.”39 Countrywide, a big originator of questionable subprime and adjustable-rate mortgages that helped trigger the Fall 2008 collapse of the housing market, cost Bank of America almost $57 billion in real estate losses, settlements with federal and state agencies for selling toxic mortgage loans that were falsely represented as quality investments, and payments for legal fees.40 Google’s $12.5 billion acquisition of struggling smartphone manufacturer Motorola Mobility in 2012 turned out to be minimally beneficial in helping to “supercharge Google’s Android ecosystem” (Google’s stated reason for making the acquisition). When Google’s efforts to rejuvenate Motorola’s smartphone business by spending over $1.3 billion on new product R&D and revamping Motorola’s product line resulted in disappointing sales and huge operating losses, Google sold Motorola Mobility to China-based PC maker, Lenovo, for $2.9 billion in 2014 (however, Google retained ownership of Motorola’s extensive patent portfolio).

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Choosing Appropriate Functional-Area Strategies

A company’s strategy is not complete until company managers have made strategic choices about how the various functional parts of the business—R&D, production, human resources, sales and marketing, finance, and so on—will be managed in support of its basic competitive strategy approach and the other important competitive moves being taken. Normally, functional-area strategy choices rank third on the menu of choosing among the various strategy options, as shown in Figure 6.1. But whether commitments to particular functional strategies are made before or after the choices of complementary strategic options (shown in Figure 6.1) is beside the point—what’s really important is what the functional strategies are and how they mesh to enhance the success of the company’s higher-level strategic thrusts.

In many respects, the nature of functional strategies is dictated by the choice of competitive strategy. For example, a manufacturer employing a low-cost provider strategy needs (1) an R&D and product design strategy that emphasizes cheap-to-incorporate features and facilitates economical assembly, (2) a production strategy that stresses capture of scale economies and actions to achieve low-cost manufacture (such as high labor productivity, efficient supply chain management, and automated production processes), and (3) a low-budget marketing strategy. A business pursuing a high-end differentiation strategy needs a production strategy geared to top-notch quality and product performance, and a marketing strategy aimed at touting differentiating features and using advertising and a trusted brand name to “pull” sales through the chosen distribution channels.

Beyond general prescriptions, it is difficult to say just what the content of the different functional-area strategies should be without first knowing what higher-level strategic choices a company has made, the industry environment in which it operates, the valuable resources and capabilities that can be leveraged, and so on. Suffice it to say here that lower-ranking company personnel who have strategy-making responsibilities must be clear about which higher-level strategies top executives have chosen and then must tailor the company’s functional-area strategies accordingly.

Timing a Company’s Strategic Moves

When to make a strategic move is often as crucial as what move to make. Timing is especially important when first-mover advantages or disadvantages exist.41 Being first to initiate a strategic move can have a high payoff when:

n Pioneering helps build a firm’s image and reputation with buyers and creates strong brand loyalty.

n An early lead enables a first mover to move down the learning curve ahead of rivals and gain an absolute cost advantage over rivals because of greater experience in working with new technologies or because it captures economies of scale sooner and enjoys volume-based cost advantages.

n A first-mover’s customers will thereafter face significant costs in switching to the product offerings of later entrants.

n Moving first constitutes a preemptive strike (like securing an especially favorable location or acquiring an appealing company with uniquely valuable resources or capabilities).

n A first-mover’s actions are protected by patents, copyrights, or other forms of property rights, thus thwarting a response by would-be followers.

n A first-mover’s actions prove so overwhelmingly popular that its product sets the technical standard for the industry.

CORE CONCEPT Because of first-mover advantages and disadvantages, competitive advantage can spring from when a move is made as well as from what move is made.

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Whenever buyers respond well to a pioneer’s initial move, the pioneer may be able to reap temporary monopoly benefits—such as faster recovery of its initial investment and good profits—until rivals are able to enter the same market space. The bigger the first-mover advantages, the more attractive making the first move becomes and the more difficult it becomes for later movers to dislodge the advantages.42

To sustain any advantage that may initially accrue to a pioneer, a first mover must be a fast learner and continue to move aggressively to capitalize on any initial pioneering advantage. It helps immensely if the first mover has deep financial pockets, important competences and competitive capabilities, and astute managers. If a first- mover’s skills, know-how, and actions are easily copied or even surpassed, then followers and even late movers can catch or overtake the first mover in a relatively short period. What makes being a first mover strategically important is not being the first company to do something but rather being the first competitor to put together the precise combination of features, customer value, and sound revenue/cost/profit economics that gives it an edge over rivals in battling for market leadership.43 If the marketplace quickly takes to a first mover’s innovative product offering, a first mover must have large-scale production, marketing, and distribution capabilities if it is to stave off fast followers who possess competitively valuable resources and capabilities. In cases where technology advances at a torrid pace, a first mover cannot hope to sustain an early lead without having strong capabilities in R&D, design, and new product development, along with the financial strength to fund these activities.

Sometimes, though, markets are slow to accept the innovative product offering of a first mover, in which case a fast follower with substantial resources and marketing muscle can overtake a first mover (as Fox News has done in competing against CNN to become the leading cable news network). Sometimes furious technological change or product innovation makes a first mover vulnerable to quickly appearing next-generation technology or products. For instance, former market leaders in cell phones Nokia and BlackBerry have been victimized by Apple’s far more innovative iPhone models and new Samsung smart phones based on Google’s Android operating system. Hence, there are no guarantees that a first mover can sustain an early competitive advantage.44

The Potential for Late-Mover Advantages or First-Mover Disadvantages There are times, however, when being an adept follower rather than a first mover actually has its advantages. Such late-mover advantages (or first-mover disadvantages) arise in five instances:

n When pioneering leadership is more costly than imitating followership, and only negligible experience or learning-curve benefits accrue to the leader—a condition that allows imitative followers to (1) quickly catch up to a first mover by learning from its experience and avoiding its mistakes and (2) achieve lower costs than the first mover.

n When an innovator’s products are somewhat primitive and do not live up to buyer expectations, thus allowing a clever follower with better-performing products to win disenchanted buyers away from the leader.

n When buyers are skeptical about the benefits of a new technology or product being pioneered by a first mover, thus allowing late movers to wait until the needs of buyers and the attributes they prefer are clarified.

n When rapid market evolution (due to fast-paced changes in either technology or buyer needs) gives fast followers and maybe even cautious late movers the opening to leapfrog a first-mover’s products with more attractive next-version products.

n When customer loyalty to the pioneer is low and a first-mover’s skills, know-how, and actions are easily copied or even surpassed.

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To Be a First Mover or Not In weighing the pros and cons of being a first mover versus a fast follower versus a slow mover, it matters whether the race to market leadership in a particular industry is likely to be closer to a 2-year sprint or a 10-year marathon. Being first out of the starting block turns out to be competitively important only when pioneering early introduction of a technology or product delivers clear and substantial benefits to early adopters and buyers, thus winning their immediate support, perhaps giving the pioneer a reputational head-start advantage, and forcing would-be competitors to quickly follow the pioneer’s lead. In the remaining instances where the race is more of a marathon, the companies that end up dominating new-to-the-world markets are almost never the pioneers that gave birth to brand-new markets—first-mover advantages are fleeting and there is time for resourceful fast followers and sometimes even late movers to overtake the early leaders.45

The first lesson here is that there is a market-penetration curve for every emerging opportunity; typically, the curve has an inflection point at which all pieces of the business model fall into place, buyer demand explodes, and the market takes off. The inflection point can come early on a fast-rising curve (like use of e-mail and watching movies streamed over the Internet) or further on up a slow-rising curve (as with battery-powered motor vehicles, solar and wind power, and digital textbooks for college students). The second lesson is that the timing of strategic moves matters, which makes it important for company strategists to be aware of the nature of first- mover advantages and disadvantages and the conditions favoring each type of move.

Key Points

Once a company has selected which of the five basic competitive strategies to employ in its quest for competitive advantage, it must decide whether and how to supplement its choice of a basic competitive strategy approach, as shown in Figure 6.1.

Companies have a number of offensive strategy options for improving their market positions and trying to secure a competitive advantage: offering an equal or better product at a lower price, leapfrogging competitors by being the first to adopt next-generation technologies or the first to introduce next-generation products, pursuing sustained product innovation, attacking competitors’ weaknesses, going after less contested or unoccupied market territory, using hit-and-run tactics to steal sales away from unsuspecting rivals, and launching preemptive strikes. A blue ocean type of offensive strategy seeks to gain a dramatic and durable competitive advantage by abandoning efforts to beat out competitors in existing markets and, instead, inventing a new industry or distinctive market segment that renders existing competitors largely irrelevant and allows a company to create and capture altogether new demand.

Defensive strategies to protect a company’s position usually take the form of making moves that put obstacles in the path of would-be challengers and fortify the company’s present position while undertaking actions to dissuade rivals from even trying to attack (by signaling that the resulting battle will be more costly to the challenger than it is worth).

One of the most pertinent strategic issues that companies face is how to use the Internet in positioning the company in the marketplace—whether to use the Internet as only a means of disseminating product information (with traditional distribution channel partners making all sales to end users), as a secondary or minor channel, as one of several important distribution channels, as the company’s primary distribution channel, or as the company’s exclusive channel for accessing customers.

Outsourcing pieces of the value chain formerly performed in-house can enhance a company’s competitiveness whenever (1) an activity can be performed better or more cheaply by outside specialists; (2) the activity is not crucial to the firm’s ability to achieve sustainable competitive advantage and won’t weaken its ability to be a master of its own destiny by hollowing out the competitive power of its internal resources and capabilities;

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(3) it reduces the company’s risk exposure to changing technology and/or changing buyer preferences; (4) it streamlines company operations in ways that improve organizational flexibility, cut cycle time, speed decision making, and reduce coordination costs; and/or (5) it allows a company to concentrate on its core business and do what it does best.

Vertically integrating forward or backward makes strategic sense only if it strengthens a company’s position via either cost reduction or creation of a value-enhancing, differentiation-based advantage. Otherwise, the drawbacks of vertical integration (increased investment, greater business risk, increased vulnerability to technological changes, and less flexibility in making product changes in response to shifting buyer preferences) are likely to outweigh any advantages.

Many companies are using strategic alliances, collaborative partnerships, and joint ventures to help them in the race to build a global market presence or be a leader in the industries of the future. These forms of strategic cooperation with other companies can be an attractive, flexible, and often cost-effective means by which companies can gain access to missing technology, expertise, and business capabilities.

Mergers and acquisitions are another attractive strategic option for strengthening a firm’s competitiveness. When the operations of two companies are combined via merger or acquisition, the new company’s competitiveness can be enhanced in any of several ways: lower costs; stronger technological skills; more or better competitive capabilities; a more attractive lineup of products and services; wider geographic coverage; and/or greater financial resources with which to invest in R&D, add capacity, or expand into new areas.

Once all the higher-level strategic choices have been made, company managers can turn to the task of crafting functional and operating-level strategies to flesh out the details of the company’s overall business and competitive strategy.

The timing of strategic moves also has relevance in the quest for competitive advantage. Company managers are obligated to carefully consider the advantages or disadvantages that attach to being a first mover versus a fast follower versus a wait-and-see late mover.