Chapter 3: Assessing the Internal Environment of the Firm

Social Complexity

A firm's resources may be imperfectly inimitable because they reflect a high level of social complexity. Such phenomena are typically beyond the ability of firms to systematically manage or influence. When competitive advantages are based on social complexity, it is difficult for other firms to imitate them. A wide variety of firm resources may be considered socially complex. Examples include interpersonal relations among the managers in a firm, its culture, and its reputation with its suppliers and customers. In many of these cases, it is easy to specify how these socially complex resources add value to a firm. Hence, there is little or no causal ambiguity surrounding the link between them and competitive advantage

Path Dependency

A greater number of resources cannot be imitated because of what economists refer to as path dependency. This simply means that resources are unique and therefore scarce because of all that has happened along the path followed in their development and/or accumulation. Competitors cannot go out and buy these resources quickly and easily; they must be built up over time in ways that are difficult to accelerate.

Internal Business Perspective

Customer-based measures are important. However, they must be translated into indicators of what the firm must do internally to meet customers' expectations. Excellent customer performance results from processes, decisions, and actions that occur throughout organizations in a coordinated fashion, and managers must focus on those critical internal operations that enable them to satisfy customer needs. The internal measures should reflect business processes that have the greatest impact on customer satisfaction. These include factors that affect cycle time, quality, employee skills, and productivity.

The Balanced Scorecard:

Description and Benefits To provide a meaningful integration of the many issues that come into evaluating a firm's performance, Kaplan and Norton developed a "balanced scorecard."66 This provides top managers with a fast but comprehensive view of the business. In a nutshell, it includes financial measures that reflect the results of actions already taken, but it complements these indicators with measures of customer satisfaction, internal processes, and the organization's innovation and improvement activities—operational measures that drive future financial performance. The balanced scorecard enables managers to consider their business from four key perspectives: customer, internal, innovation and learning, and financial.

Four factors help explain the extent to which employees and managers will be able to obtain a proportionately high level of the profits that they generate:

Employee bargaining power. If employees are vital to forming a firm's unique capability, they will earn disproportionately high wages. For example, marketing professionals may have access to valuable information that helps them to understand the intricacies of customer demands and expectations, or engineers may understand unique technical aspects of the products or services. Additionally, in some industries such as consulting, advertising, and tax preparation, clients tend to be very loyal to individual professionals employed by the firm, instead of to the firm itself. This enables them to "take the clients with them" if they leave. This enhances their bargaining power. Employee replacement cost. If employees' skills are idiosyncratic and rare (a source of resource-based advantages), they should have high bargaining power based on the high cost required by the firm to replace them. For example, Raymond Ozzie, the software designer who was critical in the development of Lotus Notes, was able to dictate the terms under which IBM acquired Lotus. Employee exit costs. This factor may tend to reduce an employee's bargaining power. An individual may face high personal costs when leaving the organization. Thus, that individual's threat of leaving may not be credible. In addition, an employee's expertise may be firm-specific and of limited value to other firms. Manager bargaining power. Managers' power is based on how well they create resource-based advantages. They are generally charged with creating value through the process of organizing, coordinating, and leveraging employees as well as other forms of capital such as plant, equipment, and financial capital (addressed further in Chapter 4). Such activities provide managers with sources of information that may not be readily available to others.

Technology Development

Every value activity embodies technology.18 The array of technologies employed in most firms is very broad, ranging from technologies used to prepare documents and transport goods to those embodied in processes and equipment or the product itself.19 Technology development related to the product and its features supports the entire value chain, while other technology development is associated with particular primary or support activities.

Firm Resources and Sustainable Competitive Advantages

For a resource to provide a firm with the potential for a sustainable competitive advantage, it must have four attributes.45 First, the resource must be valuable in the sense that it exploits opportunities and/or neutralizes threats in the firm's environment. Second, it must be rare among the firm's current and potential competitors. Third, the resource must be difficult for competitors to imitate. Fourth, the resource must have no strategically equivalent substitutes. These criteria are summarized in Exhibit 3.6

Innovation and Learning Perspective

Given the rapid rate of markets, technologies, and global competition, the criteria for success are constantly changing. To survive and prosper, managers must make frequent changes to existing products and services as well as introduce entirely new products with expanded capabilities. A firm's ability to do well from an innovation and learning perspective is more dependent on its intangible than tangible assets. Three categories of intangible assets are critically important: human capital (skills, talent, and knowledge), information capital (information systems, networks), and organization capital (culture, leadership).

Is the Resource Rare?

If competitors or potential competitors also possess the same valuable resource, it is not a source of a competitive advantage because all of these firms have the capability to exploit that resource in the same way. Common strategies based on such a resource would give no one firm an advantage. For a resource to provide competitive advantages, it must be uncommon, that is, rare relative to other competitors. This argument can apply to bundles of valuable firm resources that are used to formulate and develop strategies. Some strategies require a mix of multiple types of resources—tangible assets, intangible assets, and organizational capabilities. If a particular bundle of firm resources is not rare, then relatively large numbers of firms will be able to conceive of and implement the strategies in question. Thus, such strategies will not be a source of competitive advantage, even if the resource in question is valuable.

Marketing and Sales

Marketing and sales activities are associated with purchases of products and services by end users and the inducements used to get them to make purchases. They include advertising, promotion, sales force, quoting, channel selection, channel relations, and pricing. Example: Consider product placement. This is a marketing strategy that many firms are increasingly adopting to reach customers who are not swayed by traditional advertising. Mercedes-Benz is a firm that has aggressively pushed for product placement in Hollywood movies. In 2015, Mercedes products appeared in nine of the top 31 blockbuster movies. For example, when the villains in the James Bond movie, Spectre, showed up in the desert to pick up Bond, they arrived in a fleet of Mercedes AMGs

Financial Perspective

Measures of financial performance indicate whether the company's strategy, implementation, and execution are indeed contributing to bottom-line improvement. Typical financial goals include profitability, growth, and shareholder value. Periodic financial statements remind managers that improved quality, response time, productivity, and innovative products benefit the firm only when they result in improved sales, increased market share, reduced operating expenses, or higher asset turnover.67 A key implication is that managers do not need to look at their job as balancing stakeholder demands. They must avoid the following mind-set: "How many units in employee satisfaction do I have to give up to get some additional units of customer satisfaction or profits?" Instead, the balanced scorecard provides a win-win approach—increasing satisfaction among a wide variety of organizational stakeholders, including employees (at all levels), customers, and stockholders.

Intangible Resources

Much more difficult for competitors (and, for that matter, a firm's own managers) to account for or imitate are intangible resources, which are typically embedded in unique routines and practices that have evolved and accumulated over time. These include human resources (e.g., experience and capability of employees, trust, effectivenessPage 83 of work teams, managerial skills), innovation resources (e.g., technical and scientific expertise, ideas), and reputation resources (e.g., brand name, reputation with suppliers for fairness and with customers for reliability and product quality).35 A firm's culture may also be a resource that provides competitive advantage As an example of how a firm can leverage the value of intangible resources, we turn to Harley-Davidson. You might not think that motorcycles, clothes, toys, and restaurants have much in common. Yet Harley-Davidson has entered all of these product and service markets by capitalizing on its strong brand image—a valuable intangible resource.37 It has used that image to sell accessories, clothing, and toys, and it has licensed the Harley-Davidson Café in New York City to provide further exposure for its brand name and products.

Is the Resource Valuable?

Organizational resources can be a source of competitive advantage only when they are valuable. Resources are valuable when they enable a firm to formulate and implement strategies that improve its efficiency or effectiveness. The SWOT framework suggests that firms improve their performance only when they exploit opportunities or neutralize (or minimize) threats. The fact that firm attributes must be valuable in order to be considered resources (as well as potential sources of competitive advantage) reveals an important complementary relationship among environmental models (e.g., SWOT and five-forces analyses) and the resource-based model. Environmental models isolate those firm attributes that exploit opportunities and/or neutralize threats. Thus, they specify what firm attributes may be considered as resources. The resource-based model then suggests what additional characteristics these resources must possess if they are to develop a sustained competitive advantage.

Financial Ratio Analysis

The beginning point in analyzing the financial position of a firm is to compute and analyze five different types of financial ratios: Short-term solvency or liquidity Long-term solvency measures Asset management (or turnover) Profitability Market value A firm's financial position should not be analyzed in isolation. Important reference points are needed. We will address some issues that must be taken into account to make financial analysis more meaningful: historical comparisons, comparisons with industry norms, and comparisons with key competitors.

Physical Uniqueness

The first source of inimitability is physical uniqueness, which by definition is inherently difficult to copy. A beautiful resort location, mineral rights, or Pfizer's pharmaceutical patents simply cannot be imitated. Many managers believe that several of their resources may fall into this category, but on close inspection, few do.

Are Substitutes Readily Available?

The fourth requirement for a firm resource to be a source of sustainable competitive advantage is that there must be no strategically equivalent valuable resources that are themselves not rare or inimitable. Two valuable firm resources (or two bundles of resources) are strategically equivalent when each one can be exploited separately to implement the same strategies. Substitutability may take at least two forms. First, though it may be impossible for a firm to imitate exactly another firm's resource, it may be able to substitute a similar resource that enables it to develop and implement the same strategy. Clearly, a firm seeking to imitate another firm's high-quality top management team would be unable to copy the team exactly. However, it might be able to develop its own unique management team. Though these two teams would have different ages, functional backgrounds, experience, and so on, they could be strategically equivalent and thus substitutes for one another. Second, very different firm resources can become strategic substitutes. For example, Internet booksellers such as Amazon.com compete as substitutes for brick-and-mortar booksellers such as Barnes & Noble. The result is that resources such as premier retail locations become less valuable. In a similar vein, several pharmaceutical firms have seen the value of patent protection erode in the face of new drugs that are based on different production processes and act in different ways, but can be used in similar treatment regimes. The coming years will likely see even more radical change in the pharmaceutical industry as the substitution of genetic therapies eliminates certain uses of chemotherapy.53 To recap this section, recall that resources and capabilities must be rare and valuable as well as difficult to imitate or substitute in order for a firm to attain competitive advantages that are sustainable over time.54 Exhibit 3.7 illustrates the relationship among the four criteria of sustainability and shows the competitive implications.

Service

The service primary activity includes all actions associated with providing service to enhance or maintain the value of the product, such as installation, repair, training, parts supply, and product adjustment. Example: Let's see how two retailers are providing exemplary customer service. At Sephora.com, a customer service representative taking a phone call from a repeat customer has instant access to what shade of lipstick she likes best. This will help the rep cross-sell by suggesting a matching shade of lip gloss. Such personalization is expected to build loyalty and boost sales per customer. Nordstrom, the Seattle-based department store chain, goes even a step further. It offers a cyber-assist: A service rep can take control of a customer's web browser and literally lead her to just the silk scarf that she is looking for. CEO Dan Nordstrom believes that such a capability will close enough additional purchases to pay for the $1 million investment in software.

Causal Ambiguity

The third source of inimitability is termed causal ambiguity. This means that would-be competitors may be thwarted because it is impossible to disentangle the causes (or possible explanations) of either what the valuable resource is or how it can be re-created. What is the root of 3M's innovation process? You can study it and draw up a list of possible factors. But it is a complex, unfolding (or folding) process that is hard to understand and would be hard to imitate. Often, causally ambiguous resources are organizational capabilities, involving a complex web of social interactions that may even depend on particular individuals.

Limitations and Potential Downsides of the Balanced Scorecard

There is general agreement that there is nothing inherently wrong with the concept of the balanced scorecard.68 The key limitation is that some executives may view it as a "quick fix" that can be easily installed. If managers do not recognize this from the beginning and fail to commit to it long term, the organization will be disappointed. Poor execution becomes the cause of such performance outcomes. And organizational scorecards must be aligned with individuals' scorecards to turn the balanced scorecards into a powerful tool for sustained performance. In a study of 50 Canadian medium-size and large organizations, the number of users expressing skepticism about scorecard performance was much greater than the number claiming positive results. A large number of respondents agreed with the statement "Balanced scorecards don't really work." Some representative comments included: "It became just a number-crunching exercise by accountants after the first year," "It is just the latest management fad and is already dropping lower on management's list of priorities as all fads eventually do," and "If scorecards are supposed to be a measurement tool, why is it so hard to measure their results?" There is much work to do before scorecards can become a viable framework to measure sustained strategic performance. Problems often occur in the balanced scorecard implementation efforts when the commitment to learning is insufficient and employees' personal ambitions are included. Without a set of rules for employees that address continuous process improvement and the personal improvement of individual employees, there will be limited employee buy-in and insufficient cultural change. Thus, many improvements may be temporary and superficial. Often, scorecards that failed to attain alignment and improvements dissipated very quickly. And, in many cases, management's efforts to improve performance were seen as divisive and were viewed by employees as aimed at benefiting senior management compensation. This fostered a "what's in it for me?" attitude.

Evaluating Firm Performance: Two Approaches

This section addresses two approaches to use when evaluating a firm's performance. The first is financial ratio analysis, which, generally speaking, identifies how a firm is performing according to its balance sheet, income statement, and market valuation. As we will discuss, when performing a financial ratio analysis, you must take into account the firm's performance from a historical perspective (not just at one point in time) as well as how it compares with both industry norms and key competitors.61 The second perspective takes a broader stakeholder view. Firms must satisfy a broad range of stakeholders, including employees, customers, and owners, to ensure their long-term viability. Central to our discussion will be a well-known approach—the balanced scorecard—that has been popularized by Robert Kaplan and David Norton.62

Interrelationships among Value-Chain Activities within and across Organizations

We have defined each of the value-chain activities separately for clarity of presentation. Managers must not ignore, however, the importance of relationships among value-chain activities.27 There are two levels: (1) interrelationships among activities within the firm and (2) relationships among activities within the firm and with other stakeholders (e.g., customers and suppliers) that are part of the firm's expanded value chain.

Applying the Value Chain to Service Organizations

What are the "operations," or transformation processes, of service organizations? At times, the difference between manufacturing and service is in providing a customized solution rather than mass production as is common in manufacturing. For example, a travel agent adds value by creating an itinerary that includes transportation, accommodations, and activities that are customized to your budget and travel dates. A law firm renders services that are specific to a client's needs and circumstances. In both cases, the work process (operation) involves the application of specialized knowledge based on the specifics of a situation (inputs) and the outcome that the client desires (outputs). The application of the value chain to service organizations suggests that the value-adding process may be configured differently depending on the type of business a firm is engaged in. As the preceding discussion on support activities suggests, activities such as procurement and legal services are critical for adding value. Indeed, the activities that may provide support only to one company may be critical to the primary value-adding activity of another firm.

Integrating Customers into the Value Chain

When addressing the value-chain concept, it is important to focus on the interrelationship between the organization and its most important stakeholder—its customers. Some firms find great value by directly incorporating their customers into the value creation process. Firms can do this in one of two ways. First, they can employ the "prosumer" concept and directly team up with customers to design and build products to satisfy their particular needs. Working directly with customers in this process provides multiple potential benefits for the firm. As the firm develops Page 79individualized products and relationship marketing, it can benefit from greater customer satisfaction and loyalty. Additionally, the interactions with customers can generate insights that lead to cost-saving initiatives and more innovative ideas for the producing firm.

Tangible Resources

are assets that are relatively easy to identify. They include the physical and financial assets that an organization uses to create value for its customers. Among them are financial resource (e.g., a firm's cash, accounts receivable, and its ability to borrow funds); physical resources (e.g., the company's plant, equipment, and machinery as well as its proximity to customers and suppliers); organizational resources (e.g., the company's strategic planning process and its employee development, evaluation, and reward systems); and technological resources (e.g., trade secrets, patents, and copyrights). Example: Many firms are finding that high-tech, computerized training has dual benefits: It develops more-effective employees and reduces costs at the same time. Employees at FedEx take computer-based job competency tests every 6 to 12 months.34 The 90-minute computer-based tests identify areas of individual weakness and provide input to a computer database of employee skills—information the firm uses in promotion decisions.

Organizational Capabilities

are not specific tangible or intangible assets, but rather the competencies or skills that a firm employs to transform inputs into outputs.39 In short, they refer to an organization's capacity to deploy tangible and intangible resources over time and generally in combination and to leverage those capabilities to bring about a desired end.40 Examples of organizational capabilities are outstanding customer service, excellent product development capabilities, superb innovation processes, and flexibility in manufacturing processes.41 In the case of Apple, the majority of components used in its products can be characterized as proven technology, such as touch-screen and MP3-player functionality.42 However, Apple combines and packages these in new and innovative ways while also seeking to integrate the value chain. This is the case with iTunes, for example, where suppliers of downloadable music are a vital component of the success Apple has enjoyed with its iPod series of MP3 players. Thus, Apple draws on proven technologies and its ability to offer innovative combinations of them.

resource-based view (RBV) of the firm

combines two perspectives: (1) the internal analysis of phenomena within a company and (2) an external analysis of the industry and its competitive environment.32 It goes beyond the traditional SWOT (strengths, weaknesses, opportunities, threats) analysis by integrating internal and external perspectives. The ability of a firm's resources to confer competitive advantage(s) cannot be determined without taking into consideration the broader competitive context. A firm's resources must be evaluated in terms of how valuable, rare, and hard they are for competitors to duplicate. Otherwise, the firm attains only competitive parity. A firm's strengths and capabilities—no matter how unique or impressive—do not necessarily lead to competitive advantages in the marketplace.

General Administration

consists of a number of activities, including general management, planning, finance, accounting, legal and government affairs, quality management, and information systems. Administration (unlike the other support activities) typically supports the entire value chain and not individual activities.25 Example: Although general administration is sometimes viewed only as overhead, it can be a powerful source of competitive advantage. In a telephone operating company, for example, negotiating and maintaining ongoing relations with regulatory bodies can be among the most important activities for competitive advantage. Also, in some industries top management plays a vital role in dealing with important buyers

Human Resource Management

consists of activities involved in the recruiting, hiring, training, development, and compensation of all types of personnel.21 It supports both individual primary and support activities (e.g., hiring of engineers and scientists) and the entire value chain (e.g., negotiations with labor unions). Example: Like all great service companies, JetBlue Airways Corporation is obsessed with hiring superior employees.23 But the company found it difficult to attract college graduates to commit to careers as flight attendants. JetBlue developed a highly innovative recruitment program for flight attendants—a one-year contract that gives them a chance to travel, meet lots of people, and then decide what else they might like to do. It also introduced the idea of training a friend and employee together so that they could share a job. With such employee-friendly initiatives, JetBlue has been very successful in attracting talent.

Customer Perspective Clearly,

how a company is performing from its customers' perspective is a top priority for management. The balanced scorecard requires that managers translate their general mission statements on customer service into specific measures that reflect the factors that really matter to customers. For the balanced scorecard to work, managers must articulate goals for four key categories of customer concerns: time, quality, performance and service, and cost.

Five primary activities

inbound logistics, operations, outbound logistics, marketing and sales, and service—contribute to the physical creation of the product or service, its sale and transfer to the buyer, and its service after the sale.

Operations

include all activities associated with transforming inputs into the final product form, such as machining, packaging, assembly, testing, printing, and facility operations. Example: Creating environmentally friendly manufacturing is one way to use operations to achieve competitive advantage. Shaw Industries (now part of Berkshire Hathaway), a world-class competitor in the floor-covering industry, is well known for its concern for the environment.7 It has been successful in reducing the expenses associated with the disposal of dangerous chemicals and other waste products from its manufacturing operations. Its environmental endeavors have multiple payoffs. Shaw has received many awards for its recycling efforts—awards that enhance its reputation.

Can the Resource Be Imitated Easily?

inimitability (difficulty in imitating) is a key to value creation because it constrains competition.46 If a resource is inimitable, then any profits generated are more likely to be sustainable.47 Having a resource that competitors can easily copy generates only temporary value.48 This has important implications. Since managers often fail to apply this test, they tend to base long-term strategies on resources that are imitable. IBP (Iowa Beef Processors) became the first meatpacking company in the United States to modernize by building a set of assets (automated plants located in cattle-producing states) and capabilities (low-cost "disassembly" of carcasses) that earned returns on assets of 1.3 percent in the 1970s. By the late 1980s, however, ConAgra and Cargill had imitated these resources, and IBP's profitability fell by nearly 70 percent, to 0.4 percent.

Outbound Logistics

is associated with collecting, storing, and distributing the product or service to buyers. These activities include finished goods, warehousing, material handling, delivery vehicle operation, order processing, and scheduling. Campbell Soup uses an electronic network to facilitate its continuous-replenishment program with its most progressive retailers.8 Each morning, retailers electronically inform Campbell of their product needs and of the level of inventories in their distribution centers. Campbell uses that information to forecast future demand and to determine which products require replenishment (based on the inventory limits previously established with each retailer). Trucks leave Campbell's shipping plant that afternoon and arrive at the retailers' distribution centers the same day. The program cuts the inventories of participating retailers from about a four- to a two-weeks' supply. Campbell Soup achieved this improvement because it slashed delivery time and because it knows the inventories of key retailers and can deploy supplies when they are most needed. The Campbell Soup example also illustrates the win-win benefits of exemplary value-chain activities. Both the supplier (Campbell) and its buyers (retailers) come out ahead. Since the retailer makes more money on Campbell products delivered through continuous replenishment, it has an incentive to carry a broader line and give the company greater shelf space. After Campbell introduced the program, sales of its products grew twice as fast through participating retailers as through all other retailers. Not surprisingly, supermarket chains love such programs.

Inbound Logistics

is primarily associated with receiving, storing, and distributing inputs to the product. It includes material handling, warehousing, inventory control, vehicle scheduling, and returns to suppliers. Example: Just-in-time (JIT) inventory systems, for example, were designed to achieve efficient inbound logistics. In essence, Toyota epitomizes JIT inventory systems, in which parts deliveries arrive at the assembly plants only hours before they are needed. JIT systems will play a vital role in fulfilling Toyota's commitment to fill a buyer's new-car order in just five days.6 This standard is in sharp contrast to most competitors that require approximately 30 days' notice to build vehicles. Toyota's standard is three times faster than even Honda Motors, considered to be the industry's most efficient in order follow-through. The five days represent the time from the company's receipt of an order to the time the car leaves the assembly plant. Actual delivery may take longer, depending on where a customer lives.

Procurement

refers to the function of purchasing inputs used in the firm's value chain, not to the purchased inputs themselves.13 Purchased inputs include raw materials, supplies, and other consumable items as well as assets such as machinery, laboratory equipment, office equipment, and buildings Example: Microsoft has improved its procurement process (and the quality of its suppliers) by providing formal reviews of its suppliers. One of Microsoft's divisions has extended the review process used for employees to its outside suppliers.16 The employee services group, which is responsible for everything from travel to 401(k) programs to the on-site library, outsources more than 60 percent of the services it provides. Unfortunately, the employee services group was not providing suppliers with enough feedback. This was feedback that the suppliers wanted to get and that Microsoft wanted to give. The evaluation system that Microsoft developed helped clarify its expectations to suppliers. An executive noted: "We had one supplier—this was before the new system—that would have scored a 1.2 out of 5. After we started giving this feedback, and the supplier understood our expectations, its performance improved dramatically. Within six months, it scored a 4. If you'd asked me before we began the feedback system, I would have said that was impossible."

support activities

support activities—procurement, technology development, human resource management, and general administration—either add value by themselves or add value through important relationships with both primary activities and other support activities. Exhibit 3.1 illustrates Porter's value chain.

Value-chain analysis

views the organization as a sequential process of value-creating activities. The approach is useful for understanding the building blocks of competitive advantage and was described in Michael Porter's seminal book Competitive Advantage. Value is the amount that buyers are willing to pay for what a firm provides them and is measured by total revenue, a reflection of the price a firm's product commands and the quantity it can sell. A firm is profitable when the value it receives exceeds the total costs involved in creating its product or service. Creating value for buyers that exceeds the costs of production (i.e., margin) is a key concept used in analyzing a firm's competitive position.