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When we assign various articles and book chapters, students wonder how the concepts relate to each other – academics sometimes do and sometimes do not put their ideas in context of other ideas in the field. We put this document together in order to present relevant strategy frameworks and concepts in a way that you can clearly see how they might relate to each other—this document represents the opinions of its authors. Strategy Essentials is meant to be a convenience for you…a onestop shop for the concepts covered in an advanced strategy course. You are encouraged to read the ideas in their original form as well…consider these the “Cliff Notes” (or a cheat sheet). There are still typos and need for refinement…but tolerate the flaws and appreciate the simplicity of having the concepts all in one place. This document will surely improve over time in large part due to your comments and suggestions – keep them coming! 1
We would like to profusely thank the following individuals from the Stern EMBA Class of August 2009. Collectively, these individuals contributed significant insights, examples, ideas for organization, and they found many spelling and grammatical errors. All remaining errors are ours alone. Rama Bangad Marco Barcella Matthew Beaulieu Thomas Bridgeforth Marcus Bring Rebecca Carter John Chard Taharka Farrell Greg Gilbert Cesar Gonzalez Luis Gonzalez Pankaj Gupta Rosamond Hampton Lutz Hilbrich Heather Hobson Robert Johnson John Kent Judy Lee James Lempenau Narayan Menon Josh Nasella Andrew Nelson Hemant Porwal Thomas Ma Jamal Mazhar Boris Nossovskoi Yoni Ophir Scott Osman Suguna Rachakonda Ramesh Rao Erik Rodriguez Hrishikesh Samant Thomai Serdari Lalit Shinde Joseph Spiro Jeffrey Stern Wonkyu Sun Anantha Sundaram Angel Texidor
Table of Contents
WHAT IS STRATEGY? ..................................................................................................................................................... 4 STRATEGY VS. TACTICS ................................................................................................................................................... 5 INTRODUCTION ............................................................................................................................................................ 6 VALUE CREATION.......................................................................................................................................................... 8 Defining Willingness‐to‐Pay .............................................................................................................................. 10 Value Capture ................................................................................................................................................... 15 Added Value ...................................................................................................................................................... 16 Value Chain ....................................................................................................................................................... 21 INDUSTRY ANALYSIS .................................................................................................................................................... 26 Porter’s Five Forces Framework ........................................................................................................................ 26 Disruptive Technologies .................................................................................................................................... 31 Other Forces...................................................................................................................................................... 32 Template for Analysis........................................................................................................................................ 33 Resisting Commoditization ............................................................................................................................... 35 Understanding Value Summary ........................................................................................................................ 40 POSITIONING ............................................................................................................................................................. 42 Segmentation.................................................................................................................................................... 42 Segment Selection............................................................................................................................................. 45 Generic Strategies ............................................................................................................................................. 45 Overall Cost Leadership..................................................................................................................................... 46 Differentiation................................................................................................................................................... 47 Focus ................................................................................................................................................................. 47 PREEMPTION AND SUSTAINABILITY ................................................................................................................................. 49 Investing in Capital Intensive Assets ................................................................................................................. 49 Securing Superior Scarce Resources .................................................................................................................. 50 Sustainability..................................................................................................................................................... 53 RESOURCE‐BASED VIEW .............................................................................................................................................. 61 Wealth‐Creating, Sustainable Competitive Advantage..................................................................................... 62 Resource‐Based View vs. Positional View of the Firm ....................................................................................... 69 SHIFTING PERSPECTIVES: COMPONENTS OF FIRM VALUE .................................................................................................... 69 Assets and Capabilities Value............................................................................................................................ 72 Employed Resource Value ................................................................................................................................. 72 Governance Value ............................................................................................................................................. 73 Value from ACV‐ERV‐GV Interactions ............................................................................................................... 77 FINANCIAL METRICS .................................................................................................................................................... 79 FIRM BOUNDARIES...................................................................................................................................................... 82 EXTERNALITIES AND CSR .............................................................................................................................................. 95 Remedial CSR .................................................................................................................................................... 96 Strategic CSR ................................................................................................................................................... 102 ENCAPSULATION OF CORE CONCEPTS ........................................................................................................................... 108 Strategy........................................................................................................................................................... 108 Value ............................................................................................................................................................... 109 Industry Analysis ............................................................................................................................................. 111 Positioning ...................................................................................................................................................... 112 Preemption and Sustainability ........................................................................................................................ 113 Resource‐Based View ...................................................................................................................................... 114 Shifting Perspectives: Components of Firm Value........................................................................................... 116 GLOSSARY ............................................................................................................................................................... 118 REFERENCE LIST........................................................................................................................................................ 120
and retain this advantage over extended periods of time. As you read the text. Such a firm is able to take inputs that cost x. By offering something inimitable and valuable. and how they sustain returns over time. because economic profit takes into account the opportunity cost of the capital employed by the firm on the basis of which it earned its accounting profit.CONCEPTS A successful firm is like an alchemist who is able to turn lead into gold. A wise firm that uses its advantage judiciously will be able to sustain its position in the value chain. This fundamental value transformation is the core of all wealth-creation. are implicitly referring to economic profits. In the simplest of forms. and inimitable resources and capabilities to create sustainable advantage [Resource-based view] 1 Economic profits (or rents as they are often called) are not the same as accounting profit. What Is Strategy? Strategy is how firms capture a share of the value they create. and strategic success. 4 . the firm will have leverage to retain a share of the value created in the form of firm profits. economic profit is a more fundamental indicator of firm health.” strategy is: • The pursuit of economic rents1 [Edward Bowman] • Leverage of key activities to achieve competitive advantage [Michael Porter] • Choosing a different set of activities to deliver a unique mix of value [Hamel and Prahalad] • Use of valuable. and transform these inputs into outputs that are worth more than x. rare. “In their words. A firm could have positive accounting profit but negative economic profit if it could have earned more profit employing the same capital in another investment opportunity. Highly successful firms are marked by their ability to create strategic advantage. While accounting profits simply measure a firm’s revenue less all costs actually incurred. performance. non-substitutable. profits where not qualified otherwise. The goal of strategic analysis is to engineer a unique offering to customers and/or suppliers. economic profit is accounting profit less opportunity cost of capital employed.
and how to ride and tend to a horse. perform the 27 steps in loading and firing a musket. are about the “small picture. Tactics without strategy is the noise before defeat. and not individual trees. it has to have a strategy as well as the tactics to help materialize the strategy. uses a skiing analogy to crystallize the concepts: Carving your turns better is a tactic [while skiing]. Strategy focuses on the “big picture”. tactics paradigm. They may be short term and long term. etc. with resources at hand by its nature of being extensively premeditated. and often practically rehearsed. Seth Godin.com/PGD/PGD_Strategy.com/seths_blog/2007/01/the_difference_.alanemrich. it looks at the entire forest. Strategy vs.” He highlighted these concepts in a course on game design: Tactics vary with circumstances and.typepad. For a firm to be successful. The right strategy puts less pressure on executing your tactics perfectly. Alan Emrich2 notes that “many authors resort to military examples when explaining the strategy vs. you would learn how to form and maneuver in lines.html 5 . are what a firm uses in order to ensure that the plan happens as the firm intended. simplicity.” -Sun Tzu It is important that students of strategy recognize the important difference between strategy and tactics. on the other hand. Choosing the right ski area in the first place is a strategy. Tactics. A firm needs to have a goal for what it wants to be when it grows up.3 a popular author and speaker. Thus. Military concepts of objective. The right strategy makes any tactic work better.htm http://sethgodin. technology. it turns out. strategy is differentiated from tactics. yesterdayʼs tactics wonʼt win todayʼs wars—but yesterdayʼs strategies still win todayʼs wars…and will win them tomorrow and into the future. and how it will sustain a strategic advantage. unity of command. Strategy will include goals and objectives for a firm. Everyone skis better in Utah. on the other hand. or immediate actions. If I were to teach you how to be a soldier during the American Revolution. represent examples of strategy. Naturally. especially. Tactics “Strategy without tactics is the slowest route to victory.” focusing on the individual trees. 2 3 See www. Tactics.
SAFE offers equal or better quality of surveillance relative to the best inhouse security team as maintained by current companies. Finally. Home security companies tend to focus their selling efforts regionally. and price. a home security company could contract with SAFE to provide surveillance for the home security companyʼs customers (surveillance includes both alarm monitoring and alarm response). SAFE. we will reflect on the home-security industry through the lens of the home-security firm supplier. SAFE. SAFE enters the Home Security industry The year is 1995 and according to Consumerʼs Reports©. Questions: Does SAFE make the firms in the Home Security industry better off or worse off? o How? How should the typical firm in the industry respond to the entry of SAFE? How would the response of the typical firm differ from the potential response of the industry leader? Could the entry of a firm like SAFE have been anticipated? o How? The following diagram demonstrates how various strategy concepts relate to each other and to the central themes of strategy. shoppers for home security systems base their purchase decision upon several variables. 4 SAFE represents the type of home-security industry where the home is wired to a security company that deploys a guard to the home when the alarm is triggered.Introduction As we develop the tool kit that we consider to be Strategy Essentials. while maintaining their own individual security force. An enterprising group of former police officers form a company. offering themselves as a substitute for the home security firmsʼ in-house security force. features offered by the company. contracting with SAFE is significantly less expensive than using an in-house security force because of lower payroll expenses and SAFEʼs commitment to setting price caps on its services. instead of each security firm having its own independent team of security personnel. 6 . Thus. and can also cover wider geographic areas. including the reputation of the security company (especially its security force). 4 Considering questions around SAFE (see below) will help highlight the utility of the tools. and frameworks presented here. techniques.
The firm takes inputs that are worth some amount. To understand this process. To understand how some firms are able to retain a greater share of their self-created “value surplus” than other firms. including the opportunity cost of the capital and resources utilized). Journal of Economics & Management Strategy 5 (1):5-24. Although the SAFE case does not ask us to explicitly describe how value is created in the home security industry. 8 . thinking about value creation is a productive way to warm up and begin a strategic analysis. we will evaluate issues of corporate scope—is the firm able to create more value. we will dissect the process of value creation.The crux of business strategy is the creation of value by an enterprise. Jr. We will learn to explicitly argue for or against a firmʼs likelihood of sustaining its economic profits over time. Complementing sustainability analysis. These interactions are based on the firmʼs market position 5 The section draws from Brandenburger. say $X. consider a simple visual concept. which are then sold to buyers (Brandenburger and Stuart 1996).” The goal of strategy is to convert a portion of this wedge into firmʼs economic profits. and Harborne W. in monetary terms. Hence firms create a “value surplus” that is the source of all the worldʼs financial prosperity. such as capital. Strategy also faces internal threats stemming from inefficiencies in the firmʼs own execution and operations. from suppliers into products and services. where environment is made up of both the industry as well as society at large. and converts those resources into products that consumers value. Stuart.. as being greater than $X. we say the firm is competitively advantaged and benefiting from a strategy that is protecting the firmʼs returns from being contracted towards zero economic profit. But to be precise. We will often refer to the monetary difference between WTP and C as the “wedge. Threats to returns exist in the firmʼs external environment. Value created is the difference between the buyerʼs willingness to pay (WTP) and the firmʼs cost of bringing the output to the buyer (C). Value Creation5 Value creation is the key purpose for businesses to exist. Adam M. capture and/or sustain higher economic profits if it operated in more markets? Value Creation Firms convert resources. WTP is the buyerʼs perception of the utility (measured in monetary terms) that the firmʼs output delivers to the buyer. and to sustain those profits over time. we need to examine how market interactions lead to a particular price (P). To better understand value creation. 1996. firms cannot create this prosperity without the help of customers—indeed customers are the ones who perceive the value of the firmʼs output to be greater than the cost of producing that output (including the cost of inputs). If a firm is able to sustain economic profits (profits that are in excess of all of costs. as shown in Figure 1. and raw materials. the capture of some portion of that value by the enterprise in the form of economic profits. Value-Based Business Strategy. labor. and the sustainability of these profits over time.
In uncontested markets (markets with more demand relative to capacity). however. the firm may quickly face substantial competition. if the firm creates value in an imitable way. Entrepreneurs (inside existing or pioneering new firms) find innovative ways to combine inputs from suppliers to satisfy the needs and wants of buyers. while the firmʼs position and the activities it chooses to add value are responses to market conditions and perceived opportunities. but C decreases. If the cost of inputs is lower than the price paid by buyers. the wedge between WTP and C is divided such that both the firm and buyers benefit. Figure 1 Buyer Surplus WTP: Buyers Willingness-to-Pay Per Unit TOTAL ECONOMIC VALUE CREATED P: Unit Price of Good or Service Firm Surplus C: Unit Production Cost Quantity/Market Share This may suggest that the market conditions in which the firm operates are exogenous (externally caused). However. with markets and firms reacting to each other.as well as on the dynamics of the market in which the firm operates. the firm gains share (all else equal). very little of the wedge accrues to the firm as economic profits over time. that reality is much more complex. the firmʼs margin increases. Markets fall along a continuum from uncontested—those with considerable scarcity of firmsʼ output. to contested—those characterized by heavy competition. If the firm maintains the gap between WTP and P. 9 . Keep in mind that if the gap between WTP and P increases. Typically. firms can attempt to capture value through pricing. firms must add value by increasing the wedge between WTP and C. the entrepreneurs have created value. In this case. the firm makes more on each sale. An example is when Under Armour commands a premium price and acquires market share by designing a new line of sweat absorbent sportswear. directly moving P. We will see. In contested markets (many firms competing).
11 . with it operations in many markets. (We might conclude): While profits of home security firms will still vary across markets based on cost differences and differences in penetration rates.TOTAL ECONOMIC VALUE CREATED Buyer Surplus WTP: •Customer perception of need – same as before •Reputation – same as before or slightly increased •Features of the security system – same as before •Service features – same as before P: (our conjectures): For now. and do not face direct price competition Producer Surplus C: Cost of Inputs (our conjectures) Organizational slack – same Operational choices – same Technology choices—same Optimality of firm boundaries – improved so costs decrease. will offer firms an opportunity to outsource an activity that represents a high share of cost. Profits of SAFE’s clients will likely increase in the short run. SAFE offers efficiency and quality to all firms who contract with it. firms still enjoy geographic monopolies. SAFE.
Defining Willingness to Pay A buyerʼs WTP measures in monetary terms the subjective value (the utility) of goods or services. In general, WTP and P are separable; the extent that buyers value their goods or derive utility from those goods ought to be evaluated separately from the price they pay. WTP must be measured in relation to the internal (and unobservable) desires of buyers, but P and C are easily observed during transactions. For example, the after-thefact rebate of the original Apple iPhone for $100 did not affect the perceived value of the iPhone (WTP), even though it clearly reduced what consumers spent (P). Over time, P can come to affect what buyers perceive is their utility or WTP. Focus group outcomes aside, WTP and P are conceptually separate. An exception is of products for which P is a signal of unobservable attributes, such as wine for which price is taken by some drinkers as a signal of quality. The consumer might reason that price is an indicator of quality. In cases such as these, P can influence demand by altering the consumerʼs perception that the product has highly desirable features or functions. For example, WTP and P are dependent for certain luxury goods, where part of the perceived value is exclusivity, a function of P. iPhone users paid $999 for a small application icon that displayed the phrase “I am rich!” This icon had no functionality beyond declaring the consumer wealthy (among other questionable attributes). To be clear, cases where P and WTP are intertwined are more the exception than the rule. In the majority of cases, WTP is conceptually and actually separable from P, even if the consumer him or herself comes to believe that their WTP is equivalent to P. So what is WTP? Brandenburger and Stuart (1996) on buyersʼ WTP: Imagine that the buyer is first simply given this quantity of product free of charge. The buyer must find this situation preferable—typically, in fact, strictly preferable—to the original status quo. Now start taking money away from the buyer. If only a little money is taken away, the buyer will still gauge the new situation (product minus a little money) as better than the original status quo.
But as more and more money is taken away, there will come a point at which the buyer gauges the new situation as equivalent to the original status quo. (Beyond this amount of money, the buyer will gauge the new situation as worse.) The amount of money at which equivalence arises is the buyerʼs willingness-to-pay for the quantity of product in question. The willingness-to-pay of an industrial buyer for a piece of capital equipment may come down to the savings in the buyerʼs operating costs that installation of the new equipment would afford. Assessing the willingness-to-pay of consumers for household products is often harder [than for products/services that have quantifiable benefits to the user] (p. 8)6. Firms ultimately want to maintain a gap between P and C over a share of the market, maximizing profits in the process. We define profits as V*(P−C) or (Volume)*(Margin). The firmʼs approach to earning profits will vary with market conditions, but will generally fall into one of two broad categories: value capture and added value. In weakly contested or uncontested markets, firms can apply pressure on P. Directly affecting P is a value capture strategy. This approach “hurts” buyers or competitors (moving P around is a zero-sum game). By contrast, in highly contested markets, firms cannot effectively alter market prices or market costs. When competitive market conditions make direct movements of P challenging, firms will focus on influencing P by increasing the gap between P and WTP. By creating additional value in the chain (raising WTP) while maintaining the allocation of value to suppliers and buyers (holding P−C), they
For numerical examples of the WTP concept, see Creating Competitive Advantage, by Pankaj Ghemawat and Jan W. Rivkin.
but sometimes a firm reduces C through negotiations empowered by suppliersʼ lack of outside options. As shown in Figure 2. producing considerable profits. Movements of C are trickier to categorize: sometimes a firm increases efficiency. Price adjustments that push value capture are dictated by two factors: industry elasticity of demand. two situations provide healthy opportunity for value capture through pricing strategy. 15 . High quality product design in the market for MP3 players allowed Apple to price above competition without suffering share loss. but all things considered. Consider Dellʼs precipitous growth in the past. reducing C without taking surplus from suppliers (added value). Note that total value creation remains fixed -. Value Capture When firms produce unique goods and therefore have power in their pricing strategy. Firms that indirectly affect P by raising WTP like this employ an added value strategy. and enjoy considerable share gains. they can capture considerable value. WTP parity is a fair stance. 7 Consumers perceived their WTP for Dell to be approximately the same as for other branded PCs. One could argue that customization options increased Dell’s WTP. and the firmʼs source of advantage. Firms with cost advantages in industries with high price elasticity should price below their competition. A low cost manufacturing processes in the home PC market combined with WTP parity7 allowed Dell to under-price competition and dominate the market.firms use pricing to capture value. Firms with product advantages in industries with low price elasticity should charge premium prices. producing considerable profits for a number of years. or perhaps that its initially weaker brand diminished WTP and it caught up. which will cause only modest share loss.increase the value accumulated by the firm (WTP−P). which reduces supplier surplus (value capture).
and the longer the firm can sustain those profits. profit capture and sustainability depend on whether the firmʼs process for creating added value is proprietary. In these markets. 8 While firms can earn returns above cost in the absence of added value. firms cannot simply adjust their prices irrespective of the prices of other firms. The more of the wedge the firm can capture as profits. the greater the market value of the firm. Should one of these firms disappear. The value of an enterprise is best measured by the extent to which suppliers and/or buyers would miss that enterprise if it were absent—the more missed the enterprise. We expect entry and/or rivalry among undifferentiated sellers to drive returns down to “normal” or cost inclusive of opportunity costs. we don’t expect this to be a long-run equilibrium.Figure 2 Some firms can premium price and capture value from buyers WTP: Buyers Willingness-to-Pay P’: Price of Goods or Services Price Increase BIG PRICE HIKE LOSES LITTLE MARKET SHARE MODEST PRICE CUT GAINS CONSIDERABLE MARKET SHARE Other firms can underprice and capture value from competitors Buyer Surplus TOTAL ECONOMIC VALUE CREATED Buyer Surplus TOTAL ECONOMIC VALUE CREATED WTP P Price Cut P P’ Firm Surplus C: Cost of Inputs Loss of Market Share Firm Surplus C Gain of Market Share INTITIAL MARKET SHARE INITIAL MARKET SHARE Added Value In markets where buyers perceive that firms produce fairly homogenous goods. suppliers and buyers would simply switch to competitors with little perceived loss or pain. As indicated above. firms have little room to sustain value capture above costs8. 16 . the more is its added value.
Firms in under-served markets should incur higher costs and add features. or increase WTP with relatively small increases in C. Added value represents the upper boundary on how much value the firm can capture. while firms in over-served markets should cut costs by removing features. firms can take one of two approaches to add value: cut C with only marginal losses to WTP. 17 .Only by adding value to increase the gap between WTP and C in an inimitable way can firms expect to sustain value capture. Typically. These are shown in Figure 3.
for example. These firms eliminated features whose costs were greater than their value to buyers. WTP increases because the “net user cost” falls). by selling the product through more channels or by changing the packaging to increase convenience (single serving vs. The Apple retail store. But only so much cost cutting can be achieved through pure efficiencies—sometimes real features must go as well. Methods to raise WTP are shown in the following diagram: 18 . Costs fall much more than WTP. Benefits can be derived from tangible attributes. so P does not fall as much as C. In the underserved markets. Firm Surplus ultimately increases as a result of the WTP−C gap widening. or improved speed. Adding Value By Raising WTP To increase WTP. For example. or both. These feature improvements directly make the product better. the perceived benefits of the firmʼs output must be improved. Firms can also improve WTP by making the product less costly to use (that is. creates the opportunity to increase some combination of price and market share—that is. entrepreneurial firms can add value by becoming differentiators. bulk) the consumer incurs less costs in acquiring and/or consuming the good. quantity (Q). Consumers craved more variety and more of a coffee house experience. These firms add features that cost less than the perceived value to the buyer.Starbucks recognized the coffee shop market was under-served at the time it entered. such as improved sound quality. creating incremental surplus for the firm. where firms sell products with unused or unnecessary features. where firms sell products that are missing highly desirable features. increase price (P). Benefits can also be derived from intangible attributes. improved flavor. Note that Buyer Surplus is fixed (because the firm operates in a competitive market). In the over-served markets. offers benefits through an improved shopping experience. entrepreneurial firms can add value by becoming low cost operators. Increases in WTP. such as improved image or improved prestige. The flat panel TV market recently minted some millionaires who secured distribution deals and then delivered super-low-priced TVs produced by contract manufacturers from all over the globe.
Methods to Enhance Willingness to Pay 19 .
say. such as offering flexible work schedules to employees who are willing to sacrifice some costly benefit. Easy to Imitate Increase scale or accumulate experience by “buying share” through lower prices Introduce new products that utilize shared facilities Enter new geographies to increase capacity utilization 9 Outside option refers to the inputs next best alternative. Methods to lower C are shown below: Methods to Lower C (1) Drive cost reductions through product market activities. Other strategies may require structural adjustment. If the input is. Adding value by lowering C means that C fall by more than WTP. In fact. wheat.9 enabling the firm to negotiate lower C. the firm should reduce features (which would drop WTP only a little since the features were not valued) and costs would fall proportionately more. if the firm discovers it is “over-serving” its customer (providing too many product features relative to the customerʼs need). wheat input could be sold to other firms or employees could work at other firms. These strategies require the firm to face a lower cost structure than their suppliers.Adding Value By Lowering C To lower C. If the input is labor. a firm might absorb transport costs (in the case of wheat inputs) or provide attractive benefits (in the case of labor inputs. for example. In this section. then the outside option is that laborer’s next most attractive employment opportunity. The inputs the firm uses to produce output normally have outside options. These activities may have first mover advantages. Input costs reductions can be accomplished by reducing the relative attractiveness of an inputʼs outside options. though they are generally easy to imitate. firms must reduce the costs of critical inputs or gain efficiency in production. we continually compare the input’s currently opportunity to its next best alternative or outside options. then the outside option is the next most attractive selling opportunity for the owner of the wheat. for insurance benefits. For example. in the above examples as a result of economies of scale for transport. To reduce the perceived value of outside options of physical inputs. say health insurance). or by pooling risk. 20 .
Competitive advantage is created by the discrete set of activities companies perform. 21 . finance. 10 Being on the “productivity frontier” means the firm is efficient—and efficient means it is not possible to reduce costs without eliminating valued product/service attributes. By analyzing a firm as a set of activities. is a taxonomy of all the firmʼs activities undertaken to create value. Here strategy meets operations. managers can identify ways to widen the WTP−C gap. marketing. If this were a meal. Each box contributes something to a buyerʼs WTP and something to a firmʼs C. The value chain depicts the execution of value creation and (hopefully) added value.” 10Operating inefficiently increases the likelihood that the firm suffers resource constraints and under-invests (partially or completely) in its strategy. added value would be the main course of strategy: strategy is all about the firm being different and moving away from price competition. We now consider the value chain. The sources of a firmʼs advantage reside in some combination of primary activities and secondary activities. Easy to Imitate Reallocate production within existing facilities Reallocate facilities to regions with lower input costs Input substitutions (labor for capital or vice versa) Enhance worker productivity with incentive systems Outsource major cost centers Eliminate work force redundancies Difficult to Imitate Improve material yields Reduce product operation complexities (reduce SKUs) Alter product design to improve manufacturability Reduce inventories and improve asset management Enhance worker productivity with organizational change Earlier we considered value creation and then distinguished between value capture via market power versus added value. shown in Figure 4. and management. Value Chain The firmʼs value chain. Benchmarking or relative cost analysis is the practical alternative to the unobservable “productivity frontier.(2) Control cost drivers within the firmʼs activities. Most firm strategies can be related to the general approaches outlined above for reducing C and increasing WTP.
FIG 4: VALUE CHAIN / ACTIVITY ANALYSIS A firm’s activities are divided into two areas FUNCTIONAL ACTIVITIES CORPORATE OVERHEAD ACTIVITIES INBOUND LOGISTICS COST PRICE WTP FIRM INFRASTRUCTURE COST OPERATIONS PRICE WTP COST PRICE WTP HUMAN RESOURCES OUTBOUND LOGISTICS COST COST PRICE WTP PRICE WTP Every individual activity has some contribution to customer’s WTP and firm’s cost MARKETING & SALES COST TECHNOLOGY DEVELOPMENT WTP PRICE COST PRICE WTP AFTER-SALES SERVICES INPUT PROCUREMENT WTP COST COST PRICE PRICE WTP MARGINS Activities sum to the firm’s total WTP & cost COST PRICE WILLINGNESS TO PAY ©EFM Design LLC 22 .
Primary activities include inbound logistics. a firm can compare its actual activity costs to the 23 . The goal of activity analysis is to understand the specific WTP−C implications of each box in the value chain. a firmʼs activities are divided into primary activities and support activities.Activity Analysis Activity analysis informs managers about the cost of its activities. relative to competitors. Competitive cost analysis requires understanding the cost drivers of each of a firmʼs activities—those factors that make the cost of an activity rise or fall. a firm can adjust activities to maximize its overall WTP−C gap and the firm can seek or preserve added value. The firm can then explicitly consider how much WTP it produces by undertaking its activities in a particular way. and input procurement. technology development. Second. Ghemawat and Rivkin (2006) focus on the WTP−C gap. the analyst and/or the managers of a firm catalog the firmʼs activities. these activities must be analyzed. Support activities include firm infrastructure. Armed with this understanding. Third. Another goal is to identify opportunities for increased efficiency. Step 1: Catalog Activities Using the Value Chain as a guide. Step 2: Understand C by Activity Next. outbound logistics. There are several possible goals of activity analysis. and they analyze differences in activities to examine how and why customers are willing to pay more or less for the goods or services of rivals. the managers examine the costs associated with each activity. and after-sales service. they assess how each activity generates customer willingness to pay. operations. and they use differences in activities to understand how and why their costs diverge from those of competitors. Many management-consulting projects begin with or culminate in an activity cost analysis. the managers evaluate alternatives in the firmʼs activities. in terms of C and WTP. By linking cost drivers numerically to activities. Finally. Efficiency means that the only way for the firm to cut costs is to reduce WTP—that is. there is no way to perform an activity for less money without sacrificing some attributes valued by consumers. human resource management. One goal is to benchmark the productivity of a firm to its competitors. Below we describe the goals and outline the structure of this four-step analysis. marketing and sales. The objective is to identify changes that will widen the wedge between costs and willingness to pay. First. describing a four-step process of activity analysis based on the value chain.
In some cases this requires looking at activity costs on an individual product basis. Linking individual activities to WTP is more complex than linking them to C. 24 . This analysis should emphasize an industryʼs largest costs to ensure overall relevance. A firm participates in one or more industries through its products. and linking activities to WTP of different customer segments. industries. These relationships create a vertical chain of industries. costs. and WTP without defining which firms should be treated as competitors. weʼve referenced our competitorsʼ strategies. Change falls into two classes: (1) opportunities to raise WTP at relatively low cost increases and (2) activities that generate considerable reductions in C.estimated activity costs of its competitors. the full value chain activity analysis leads to unexpected activities where changes can increase the WTP−C wedge. such as speed of delivery. These activities should be defined narrowly enough to highlight applicable differences. Consider how the purchase and delivery experience at a car dealership affects the buyerʼs overall initial ownership experience and WTP. They must also understand which competitors enjoy relative success in satisfying different customer needs. However. availability of credit. Firms that fundamentally understand competitorsʼ strategies can isolate critical activities that they themselves do not fully exploit. activities are associated with different contributions to WTP. and quality of presale advice. Often. Industries are related through the inputs necessary for the product—each product serves as an input to a subsequent industry. It is critical to focus on differences in individual activities instead of total cost. activities associated with reducing costs to purchase also generate considerable WTP. Firms focus on cost drivers to better estimate the unobservable costs of competitor activities. although in other cases activity costs on a product group are sufficient. physical product attributes and product image tend to have the strongest effects. activities. but little change in WTP. While any activity in the value chain can affect WTP. As customers become varied. Differences in WTP usually account for more observed variation in profitability among competitors than disparities in cost levels. and the vertical chain. Figure 5 provides a conceptual model for the relationships between a firmʼs productʼs value chain. especially for larger companies. because firms may face different internal cost structures even though total costs are comparable. particularly with support activities. Step 3: Understand WTP by Activity Just as activities are associated with different C for different firms. In each of these steps. this process requires effective segmentation. Step 4: Identify Activity Changes Identifying activity changes is the final step of activity analysis. Firms must first understand who the customers are and what they desire.
and each industry has attributes that constrain profit opportunities and attributes that. Figure 5 EACH INDUSTRY HAS ITS OWN VALUE CHAIN NATURAL GAS ETHANE STYRENE POLYSTYRENE CARTONS RESTAURANT 25 . Firms sit in one or more industries along the vertical chain from raw materials to final goods. if exploited.Each box of the vertical chain is an industry. yield high returns.
• • • Understanding this competitive situation is crucial for firms. Competition in an industry continually works to drive down the rate of return on invested capital toward the…return that would be earned by the economistʼs “perfectly competitive” industry. Consider these quotes from Michael Porterʼs Competitive Strategy (1998. suppliers. Below we will discuss two vantage points for performing an industry analysis. The goal of competitive strategy for a business unit in an industry is to find a position in the industry where the company can best defend itself against these competitive forces or can influence them in its favor. we will ask how each of the four constituents (buyers. 26 . From this standpoint. Here we will outline industry features that increase the likelihood that the industry will face opportunities or constraints. substitutes. 3−5): • The essence of formulating competitive strategy is relating a company to its environment. [The Five Forces are] concerned with identifying the key structural features of industries that determine the strength of the competitive forces and hence industry profitability. One. Porterʼs Five Forces Framework The Five Forces framework provides a systematic way to catalogue the competitive situation a firm will face in its industry (see Figure 6). Industry analysis is helpful in understanding the constraints a typical firm in an industry faces in developing and/or defending its added value. Two. we will suggest that intense rivalry is analogous to the “commoditization” of an industry.…the key aspect of the firmʼs environment is the industry or industries in which it competes. and entrants) might drive commoditization (the situation where customers perceive that firmsʼ outputs are nearly indistinguishable) into the industry.Industry Analysis Porterʼs Five Forces is a framework to understand the opportunities and constraints in the competitive context of an industry of firms. we will look at the framework from an industry attractiveness standpoint. pp.
the attractiveness of an industry has to do with the extent to which price is 27 .FIG. we keep two questions in mind: (1) Does the underlying structure of this industry indicate that competitive forces will be strong or weak? Bottom line. is there some strategy that firms might employ to influence the forces in their own favor? Ultimately. 6: PORTER’S FIVE FORCES Buyer Power Buyer Power tra Pressure from En nts Pressure from Substitute Industries Supplier Power ©EFM Design LLC When we do a Five Forces analysis for any industry. is the industry attractive or unattractive? (2) If the competitive forces in the industry are strong.
Getting the industry definition right. To be clear. The importance of geography varies widely by industry. In reality. If any of these forces are strong. Buyer power. and all the other forces point to it. It is often valuable to perform industry analysis based on a variety of industry definition. Rivalry is in the center of the five forces schematic. supplier power. and implementing the five forces analysis well. then the “muddled middle” in the above picture indicates that the end game is rivalry. Defining the Industry/Market It is critical to carefully define the market or industry in question. will produce valuable information. since firms located far from each other may not sell to the same set of customers.what is bad for firms is often good for customers. If buyer/supplier power and threat of substitutes/entry contribute to the outcome whereby firms continually make price and nonprice moves that reduce the profit contribution of each sale. Firms are considered competitors if consumers are willing to use their products for the same purpose. We label an industry as one of the “boxes” along a vertical chain. Porterʼs five forces turns the US antitrust laws on their heads – Antitrust authorities take the customerʼs perspective -. The quality of the analysis depends on framing the industry: too broad a definition (for example. Rivals In Porterʼs framework. The diagram above visually demonstrates the relationship among the five forces. Two common ways to define markets are in terms of products and in terms of geography. we seek to identify a set of close competitors—a group of firms that customers and suppliers see as reasonably close alternatives to each other. “beverages”) or too narrow a definition (such as “colas”) tends to yield few useful insights.the single or among a few key criteria that determine from whom the customer buys. Rivalry results in price competition that drives away profits. Therefore. In defining an industry. industry definition is more an art than a science. Geography matters as well. 28 . threat of substitutes and threat of entry can play roles in making price an increasingly central part of the customerʼs decision regarding from whom to buy. free delivery) without raising price enough to cover additional costs. rivalry refers to any firms operating in the same industry or market. even without buyer/supplier power or threat of substitutes/entry – “bad behavior” among firms could lead to competition and reduced industry profitability– always keep in mind. product similarity is the most common way that a market is defined. Rivalry is outright competition among firms – firms compete in price or they compete by adding features (ie. The other forces describe the competitive strength of less-direct competitors. rivalry inevitably becomes stronger as well.
Labor is often a very powerful supplier because it can legally form unions to collectively bargain for prices. Under the right circumstances. there may be considerable surplus for the firm to earn. buyers may be able to capture a larger share of the surplus. Buyer power is caused by a number of factors: • Buyers purchase large volumes of firm output • Firm output represents a significant fraction of buyersʼ costs • Buyer industry is more concentrated than firm industry • Buyers purchase a standard or undifferentiated product from firms • Buyers face few switching costs between firms • Buyers pose a credible threat of backward integration • Firm output is unimportant to the quality of buyersʼ product • Buyers have full information Suppliers Supplier power emerges in industries where firms are fungible intermediaries for suppliers whose scarce or differentiated inputs ultimately satisfy end user needs. Consider the fact that patients want doctors when they go to a hospital. doctors can be powerful suppliers. This information often has the effect of reducing negotiations to a pure price dimension.There are many sources of rivalry within an industry—firms may: • Face numerous competitors • Face equally-balanced competitors • Exist in a slow growth industry • Have high fixed costs or storage costs • Lack differentiation • Augment capacity in large increments • Face high exit barriers • Easily adjust prices • Have easily observable prices and terms Buyers Under some conditions. Even when other forces are weak. the buyers receive the surplus. The price conditions that lead buyers to behave this way are discussed in the section on commoditization. When conditions tempt firms to compete on price. The conditions below all result from a context in which buyers are motivated to invest in information about what they are buying. Suppose an industry has little rivalry. If suppliers have power. 29 . which they may not recover in their own prices. as a hospital without doctors cannot deliver very much. Even if the possibility of new entrants and substitute products does not pose a substantial competitive threat. Many patients perceive hospitals as “low added value” intermediaries of doctor services. leaving little for the firms. they can force price increases (or quality reductions) onto buyers. firms may face competitive pressures from their suppliers.
entry can put upward pressure on input prices. as well as on the entrantʼs access to potentially scarce but necessary resources. All firms in an industry are. Substitutes often come rapidly into play if some development 30 . If the entrant has to be relatively large to operate at an efficient scale. the firms in the given industry will be worse off.” and doing better in the market. while noncarbonated beverages might be classified as a substitute for cola. in a broad sense. When substitute products are more plentiful. Furthermore. The risk of entry is determined by the relationship between the overall size of the market and the scale of operation necessary to achieve cost parity. capacity and output increase putting downward pressure on prices. we expect new firms to attempt to join the market. entry is daunting due to factors such as capital requirements and the need to steal a lot of market share to amortize the cost of entering. Identifying substitute products is a matter of searching for other products that can perform the same function for consumers as the product of the industry. Barriers to entry that limit new entrants include: • Economies of scale • Product differentiation • Capital requirements • Access to distribution channels • Government policy and regulations • Proprietary product technology • Favorable access to raw materials or locations • Considerable learning/experience curve Substitutes Substitute products are those that can perform the same (or some of the same) function for consumers as the industryʼs product. Pepsi and Coke are direct competitors. Firms may be protected from competitive threats when barriers to entry hinder potential entrants from gaining traction in the industry. closer in “product space. If entry occurs.Supplier power is caused by a number of factors: • Firmʼs industry is an unimportant customer of supplierʼs industry • Supplier industry is more concentrated than firm industry • Few other substitute products available to the firmʼs industry • Firms face switching costs between suppliers • Suppliers pose a credible threat of forward integration • Supplierʼs product is an important input to the firmʼs business • Firms have little information on suppliers New Entrants When firms generate healthy profits. We might debate whether particular firms and products are direct competitors or substitutes. competing with substitute products. but conceptually it is clear that competitors and substitutes fall along a continuum.
or service that uses a “disruptive. to price (p. This occurs in “over served” industries. xxiii). Christensen. New products (disruptive products) targeted at different segments (usually lower price markets) become substitutes when consumer expectations grow more slowly than increases in product quality. A disruptive technology is a technological innovation. then to convenience and ultimately.increases competition in their industry. writes: When the performance of two or more competing products has improved beyond what the market demands. to overturn the existing dominant technologies or status quo products in a market. customers can no longer base their choice on which is the higher performing product.” rather than an “evolutionary” or “sustaining” strategy. The basis of product choice often evolves from functionality to reliability. product. causing price reduction or product improvement. PERFORMANCE Sustaining Technology Disruptive Technology Demand for Performance t0 t* TIME 31 . Disruptive Technologies Here we will apply [HBS] Professor Clayton Christensenʼs concept of disruptive technology to fully explore the threat to an industry from substitute products. in The Innovatorʼs Dilemma. shown in Figure 7. The insight brought out by Porterʼs analysis of substitutes and Christensenʼs analysis of competition among technology products is that technically superior products can be at risk of losing sales to technically inferior products when the buyer deems the inferior product to be sufficient for their needs.
In considering substitutes. Some factors include: • Antitrust laws that limit concentration • Government purchasing contracts • Labor policy • Trade policy • Tax policy • Environmental regulation • Financial securities regulation • Advertising regulation • Product safety regulation • Production subsidies 32 . we consider a “sustaining technology” such as the mainframe industry. which in this case is the personal computer industry. When a firmʼs product is dependent on another industryʼs product. eventually the mainframe industry faces competitive pressure from the substitute product (the disruptive technology). Note that at t* the mainframe is over serving its customers. the performance of the PC is below the level of performance consumers are demanding. The government is also a force on industry. At this point. Other Forces Many consider two other important industry forces: complements and the government. For example. complementary industries can affect rivalries through price shocks. complementary industries such as airline travel can be forced to increase short-term price competition because of relatively fixed capacity. At time t=0. This is the point when the industry (mainframes) feels strong pricing pressure from the substitute industry (PCs). The mainframeʼs performance is so far ahead of demand for performance that the customer likely has little WTP for it. In this scenario. Complementary industries can have significant impact on value creation in the firmʼs industry. but this assumption is not critical). Given this situation. We see that. When oil prices rise. both the mainframe and the PC improve over time (the assumption here is that they improve at the same rate.In the above diagram. the critical assumption is that demand for performance increases at a lower rate than the substitute product improves. that other industry is considered a complementary industry. there will be a time (t*) when the substitute satiates the consumer. At t* the mainframe has trouble monetizing its research and development investments. the mainframe industry does not perceive much of a threat from the PC because consumers of the mainframe are unsatisfied by PCs.
To be most effective. a firmʼs strategy will outline offensive or defensive actions designed to create a defendable position that exploits the opportunities and neutralizes the constraints found among the five forces.Template for Analysis Equipped with this analysis. Refer to this template as an example rather than as the best possible template imaginable. a firm has a much more comprehensive picture of how profitable operating in this industry is likely to be. 33 . Below we provide a template that may be used to have an initial dialogue about the structural attractiveness of an industry.
FACTORS AFFECTING BUYER POWER 35 .
assemblers will create demand for information and for infrastructure that will enable them to easily shop and compare microprocessors from various firms and sources. 36 . if the industryʼs output is reasonably low stakes (for example. as well as emerging competitors and substitute firms all benefit from an industryʼs commoditization. while subsets of these industries are un-commoditized through astute entrepreneurial acts. but still a high share of COGS. assemblers are strongly incentivized to keep themselves highly informed about virtually every aspect of the microprocessor business. consider the microprocessor industryʼs output is high stakes to their customers. Porterʼs Five Forces framework builds around rivalry because when a group of firms become rivals and compete on price. suppliers. the microprocessor is a reasonably high share of the assemblerʼs overall COGS. a commodity market is one in which leverage through a unique value proposition is not possible. Technically. Furthermore. This motivation to be informed gives rise to informed transactions based on salient product attributes rather than based on brands or other “quick and dirty” signals of quality and performance. Understanding how and under what conditions industries are commoditized is the source for ideas to resist it. Suppliers of critical and/or branded inputs (such as Intel in microprocessors) may also extract surplus by forcing up input prices or driving competition in the industry they supply to so as to create demand for themselves. In fact. it is reasonable to say the industry has been commoditized. We will consider two cases to demonstrate this path: the industry sells something that is “high stakes” and a high share of its customersʼ COGS. Buyers. Through the “gale of creative destruction.Resisting Commoditization When close competitors vie for customers using price as the key distinguishing feature.” industries are inevitably commoditized. Buyer Power Path to commoditization: If the industry sells an input that is a high share of its customersʼ cost of goods sold (COGS). In this case. For the first case. PC assemblers. and the case where the industry sells something that is “low stakes” and a high share of COGS. as the microprocessor performance is critical. It is critical to trace how each of the four outer forces can drive commoditization on an industry. the tin can is not the most compelling aspect of a canned vegetable). Alternatively. profits are quickly dissipated. Buyers are unimpressed with non-price differences among firms and force down product prices. the customers will almost certainly pave a path to commoditization of the industry under consideration.
” the PC assembly business becomes focused on prices competition—that is. price shoppers. Next. With more entrants coming in. The higher quantity sold results in greater profits for suppliers. the industry becomes commoditized. The difference between the cases of high stakes and low stakes is that in the former case. and more consumers focused on “Intel on the Inside. This fact suggests the suppliers may seek opportunities to “cram down” price competition on the industries they supply. the more the industry which it supplies competes on price. The effect on Intel is positive. Suppliers of these critical inputs benefit from price competition in the industries they serve.the customer will be inclined to experiment with various firms and alternatives.” and diet drinks sweetened with Splenda and restaurants that serve Coke or Pepsi. This experimentation will give rise to a group of customers who are highly informed and who are. From the perspective of the supplier. consider that there are suppliers whose inputs are seen as critical to end-users— these suppliers provide inputs that make the final product most appealing or functional to final consumers. consider Intelʼs decision to sell motherboards. ultimately. 37 . Intelʼs choice to produce motherboards ultimately reduced the entry costs to the PC manufacturing industry. We like computers with “Intel on the Inside. Since demand curves slope downward. By performing much of the complex assembly and handing it over to assemblers. In the latter case. the customer may go directly to experimentation and this willingness to experiment “commoditizes” the industry under consideration. As an example. the more final goods prices in the industry fall. Intel faces higher demand. and this drives up volume for the powerful supplier. more firms could enter the assembly business. Shown in Figure 8. the customer must become informed before that customer can credibly threaten the industry with “cost plus” demands. the lower prices drive up the quantity sold. as PC assembly becomes commoditized. Supplier Power Path to commoditization: Supplier profits increase as the industry in question competes on price (see figure below).
Figure 8 PRICE Competition among firms making PCs results in a movement DOWN the demand curve for PCs Quantity increases and price decreases Demand for Performance QUANTITY QUANTITY PRICE The movement DOWN the demand curve for PC’s results in a SHIFT RIGHTWARD for the demand curve for microproccessors Demand for Microprocessors Demand for Microprocessors QUANTITY 38 .
If the mode of production and/or the nature of demand are in flux. Firms that make 39 . ex post. preemption (reducing the odds of entry) becomes difficult when relatively rapid change discourages firms from coming in big enough to discourage future entrants. As previously discussed having to be large relative to the market. incumbents leave no room for entrants. or having to secure particular inputs will create entry barriers. entry leads to increased capacity and downward pressure on price (commoditization).New Entrants Path to commoditization: As discussed above. to be incorrect. In this setting. This suggests that there are settings in which entry is preempted by firms who move first and “fill up” the industry with the capacity needed to satisfy demand—that is. Firms fear their investments will be nearly worthless if their guess about production and/or demand turn out. Here we probe into the factors that ultimately enable entry. “staging” investments (making the investment as the firm becomes informed) reduces the odds of superfluous big fixed investments. Another context in which entry is a factor is an environment of rapid change either in buyer tastes or in the optimal configuration of production facilities. it is difficult and unattractive to make large capital investments in an effort to stake a claim on a large portion of the market. One factor that may enable entry is innovation. which may make it possible for entrants to at least match the incumbentʼs value proposition or productivity while operating at a reduced scale or with available resources. On the other hand.
customers may choose to pay less to get less once the substitute reaches some threshold of performance. they price closer to par with “disruptive” firms. there were many computer assemblers who preceded Apple and IBM.incorrect bets end up unable to preempt future entry. If we look back on the computer industry. firms. price becomes more important—and commoditization has set in. Customers switch to the “substitute” and the firms in the industry must compete for revenues to recover expenditures in research and development (which are also the source of both costs and features which over-serve buyers). their investments in production capacity did not. Unable to extract a premium. and activities 40 . which each contribute to the firmʼs total WTP−C wedge Each activity makes some contribution to WTP and some contribution to C Value creation varies significantly across industries. dissuade subsequent entrants. made up of few or many firms Each firm may sit in one or more industries Each industry faces opportunities and constraints based on Five Forces effects Each firmʼs value chain is made up of activities. ultimately. Understanding Value Summary: Refer to Figure 9 • • • • • • • The vertical chain is production from materials (natural gas) to goods (restaurants) Each box in the vertical chain is a single industry. If the industry over-serves customers. since their bets on production technology and demand attributes were incorrect. However. Substitutes (Distant Competitors) Path to commoditization: When customers view a substitute or “distant competitor” satisfactory.
and gender. 11 This section is based on and summarizes Michael Porter’s Industry Segmentation and Competitive Advantage. in the candy industry. Segmentation should reflect differences in effects of Porterʼs Five Forces.. In most industries. We suggested that intense rivalry is equivalent to the commoditization of an industry -. a variety of products have emerged to satisfy the range of customer wants. Firms are actively positioning when they configure their value chain to neutralize industry constraints and exploit industry opportunities.positioning. pp. market segmentation is used to market them to their target audience. entrants and competitors themselves can drive commoditization. Segmentation11 Industry segmentation involves creating an industry within an industry that targets the needs and wants of a given group of customers. Chewy candy production. For luxury cars. Market segmentation identifies the specific group or groups to which the firm has competitive advantage and can achieve a high penetration rate within the target luxury car market. there will likely be many more firms that make crunchy candy than make chewy candy. many crunchy candy makers will “fit” in the market. we examined features that affect the likelihood that firms face opportunities or constraints in a given market. Hence. the luxury car market). When we describe a strategy process or a firm behaving strategically. For example. we have mainly paid attention to the attractiveness of the industry as a central exercise in strategic analysis. substitutes. overnight shipping for small businesses). Within each industry there is a range of products and a distribution of customer types with varying wants and needs. We now turn to the application of what we learn from doing a good analysis of an industry -.Positioning Up to now. A chapter in Competitive Advantage: Creating and Sustaining Superior Performance (1998 edition). suppliers. Buyers of luxury cars exhibit considerable variety in terms of tastes. Under each of the five forces. but considerable economies of scale in producing chewy candy (of course. 42 .g. income. An industry segment can be based on a particular variety of product (e. Positioning involves segmenting an industry to find a defensible position in that industry. on the other hand. The reason is. we mean the firm understands the opportunities and constraints inherent in its industry and responds by seeking a “position” that is more attractive than the industry is on average –in a sense a strategy is the pursuit of an attractive position. As a result.g. firms can make crunchy candy and achieve minimum efficient scale (the level of output at which costs get as low are they will go given the technology) at a low level of output.buyers. 231-272. this is totally made up!). there may be no economies of scale in producing crunchy candy. or it can be based on customers (e.
industry. rural vs. education Lifestyle: vegetarian. retail store. Buyer type: age. purchase size. marriage status. etc. etc. bulk box Product age: new vs. crunchy and chewy may be meaningful segments of the overall candy market. There are value chain based segmentations possible if product or customer type alters: • • • • The cost of the firmʼs activity on its part of the value chain The uniqueness of the firmʼs activity on its part of the value chain The configuration of the firmʼs activity on its part of the value chain The buyerʼs own value chain.g. birthday cards 43 . urban. convenience store) Bundles: season passes vs. or performance focused Technology: halogen bulbs vs. gas station vs. replacement or antique Primacy: product vs. Buyer location: country.. Chanel vs. etc.. with competitive advantage coming from different activities along the value chain. income. Distribution channel: catalog.g. age. there would be too much chewy candy relative to demand). single event tickets Buyer Type Segments (Consumer) • • • • Demographics: family size. This means a firm has to make a lot of candy before reaching minimum efficient scale—hence. zip code. fewer chewy candy makers “fit” in the market (if lots of firms entered and made candy until they got to scale. vegan. Hence. incandescent bulbs Packaging: individually-wrapped vs. gender. ancillary services (e. Product Variety Segments • • • • • • • • Physical size: TVs can be segmented by screen size Price level: fashion is often segmented by price level (e.demonstrates economies of scale. There are four observable classes of industry segmentation that capture differences among firms: • • • • Product variety: discrete product differences that do or could potentially exist. Kmart) Features: automobiles may be safety focused. when the buyer is using the firmʼs output as an input Firms in the same industry compete in different segments. organic Language: particularly for education services Purchase occasion: Hallmarkʼs seasonal vs. internet.
nonexclusive outlets Geographic Segments • • • Localities. Typically. retail Distributors vs. constant flow Distribution Channel Segments • • • • Direct vs. We can use a variety of statistical processes and techniques to eliminate redundant variables and simplify segmentation. regions. private may affect willingness to spend frivolously Financial strength: will affect demand for credit alongside product Order pattern: quick-turnover vs.Buyer Type Segments (Commercial) • • • • • • • • • • Buyer industry: indicates price sensitivity Buyer strategy: high quality vs. packagers who sell downstream Vertical integration: less information is available on more integrated firms Purchase process: computer purchases by IT department vs. distributors Direct mail vs. Finalizing the industry segmentation matrix involves trying a number of different segmentation schemes that reveal the industryʼs most important product and buyer differences. brokers Exclusive vs. segmenting by age effectively segments by height. low quality producers Technological sophistication: grammar schools vs. we want one axis to represent combined product variables. for example. Ultimately. up to adulthood. segmentation variables are correlated. or countries Weather zones Economic development stage (for countries) Relationships among variables must be examined to identify the most meaningful segmentation pattern. universities Buyer stage: direct users of firmʼs product vs. and one axis to represent combined c 44 . non-specialists Size: will effect value of costly sales activity Structure: public vs.
Segment Selection Effective segmentation is based on meaningful differences among product and customer segments. or they can focus on a single segment. Porter describes three generic strategies that are responses to industry conditions: cost leadership. Firms can attempt to serve several segments at once. Below we describe these three strategies in some detail because the generic strategies have become part of the strategy vernacular. There are advantages and disadvantages to each approach. particularly on scale/scope economies Generic Strategies Positioning reflects a firmʼs choices in response to industry opportunities and constraints. firms who serve several segments may reduce costs for customers through one-stop-shopping. Segment attractiveness is a function of several factors: • Low structural risk of Five Forces pressure • Large size and high growth • Segment interrelationships. while focused firms may have more volatile earnings since their fortunes are tied to one segment. Firms should select which segments to serve based on segment attractiveness. While segments reflect underlying realities that firms seek to discover. while they should determine the breadth of segments to serve based on segment relationships. and focus. Focusers usually get cost advantages or stronger differentiation than firms who try to serve several segments. differentiation. 45 . However. positions are choices to serve specific segments. Diversified firms—those that choose to serve multiple segments—may face cost disadvantages.
As shown below in Table 4. sustaining a low-cost position is difficult. cost advantages stem from specific superior resources because in homogenous product markets. At the same time. Most firm strategies can be described by one of the three. Identifying a firmʼs position as one of the three generic strategies is unimportant relative to learning during a discussion of what position the firm is attempting to secure and serve. a low-cost strategy is focused on protecting some cost advantage the firm already enjoys. We learn more when we describe a firmʼs strategy in detail and then discuss that description with others. or by some combination of the three. all firms benefit from and should incorporate widely understood best practices. the source of a firmʼs lowcost position must not be available to rivals. simply categorizing a firmʼs strategy is not valuable on its own. Overall Cost Leadership The low-cost strategy is not simply about pursuing operational effectiveness. however. rival firms always attempt to imitate firms with the best cost positions. To qualify as the low-cost producer with a sustainable cost advantage.Not all strategy experts believe that the three generic strategies span all possibilities or even that any of them can best describe a particular firmʼs position. Without superior resources. Generally. Porterʼs generic strategies are widely used. That said. Table 4 Required Skills and Resources Sustained access to capital investment Process engineering Organizational Requirements Tight cost control Risks Technology change may nullify past investments Low cost learning by newcomers through imitation or investment Inability to see required product or marketing change Cost inflation which narrows profit margin Frequent detailed control reports Structured organization and responsibilities Incentives based on strict quantitative targets Intense labor supervision Products designed for ease in manufacture Low cost distribution 46 .
while firms may not reach as many customers. scientists. while focus entails changing 47 . For the differentiator to justify serving this segment. they can charge higher prices if they locate a meaningful segment with a higher desire for their good. product development. focus may exist without differentiated product offerings. Differentiators look to offer product varieties that approach some set of customersʼ ideal for that product. That is.Differentiation In almost every market. while differentiation identifies underserved product categories and varieties. a focus strategy identifies underserved segments of customers. The inherent trade-off of a differentiation strategy is market share for margin. differentiation entails changing product attributes. Given that each customer has some ideal product in mind. With a differentiation strategy. customers may perceive important differences. However. consumers may sacrifice features for savings Buyersʼ need for differentiation may fall as they become sophisticated Imitation may narrow perceived differences as industry matures Corporate reputation for quality or technology leadership Strong cooperation from channels to distribute products to segments Focus A pure focus strategy is a customer-centric approach in which customers have attributes different from the customers of a non-focuser. Again. Table 5 Required Skills and Resources Strong creative and marketing insights Product engineering and basic research skills Organizational Requirements Strong coordination among R&D. And even in those markets with physically similar products. A pure focus strategy is a customer-centric approach in which customers have attributes different from the customers of the firmʼs rivals. Focus can be combined with differentiation—selling particular customers a particular variety of product. A focus strategy requires tailoring activities for particular customer groups or segments. firms that offer distinct products will likely be able to receive premium prices from at least some customers. This is summarized in Table 5. and marketing Subjective measurement of incentives with qualitative focus Amenities to attract highly skilled labor. or marketers Risks If cost difference grows. there is some variation in product offerings. these customers need to be willing to pay a sufficient margin.
the focuser did not initially configure itself in an optimal way and left itself open to entry. The customers of the focuser may even be willing to pay more—as long as the net cost to the customer is lower. if the segment makes or experiences some change in its own value chain.distribution and transaction attributes to better serve clientsʼ needs. • It is also possible that the difference between the strategic target and the market as a whole narrows. Regardless of whether a firm has the potential for a true cost advantage. Jiffy Lube may charge higher prices than some options the customer has. the focuser can raise its own margin. By lowering overall transaction costs (by taking advantage of “win-win” opportunities to customize activities for the target customer) while maintaining price parity or near parity. by setting up delivery systems ideal for fast food chain customers. Jiffy Lube reduces the cost of getting an oil change. those customers would be willing to pay the firm at least as much as they were paying the competition. The effect of these changes in the customerʼs value chain may ultimately eliminate the cost advantages of serving narrow target. For some customers. the “all in” cost is much lower. cost parity is necessary. In this case. the focuser must reduce system costs. we must answer these questions: (1) Where is the firm relative to the productivity frontier? (2) Can we increase WTP by more than we increase costs? (3) Can we decrease C by more than we decrease WTP? (4) Can we organize operations in response to commoditization in industries adjacent to us to gain more than our competitors? (Do we take advantage of volume opportunities in response to commoditization in industries we sell to? Do we take advantage of cost reduction opportunities in industries we buy from?) 48 . • It is also possible that competitors find submarkets within the target and out-focus the focuser. This would put the focuser in direct competition with competitors who serve the whole market. Jiffy Lube sells the same product as many service stations—but its distribution channel is different. it can enhance its value by reducing costs. Firms will find that while cost advantages are rare. To understand where a firm stands regarding costs. or when they uniquely face a lower input cost. If the customersʼ “all in” or net costs are lower when dealing with the focuser. for example. this will have a spillover effect on the focuser. Focusing carries specific risks: • The cost difference between a value chain configured for a particular segment and one for a broader market can widen due to idiosyncratic events. That is. but for many segments. For example. Firms enjoy a cost side advantage when they own a process. Whatever a firmʼs position. Operating below the productivity frontier is the same as expending resources with no opportunity for return. Net costs take into account all costs of using the product in question. no firm should operate below the productivity frontier.
the cost. Unfortunately. reduce SKUs) • Alter product design to improve manufacturability • Push improvements in asset management such as lower inventories • Enhance worker productivity through changes in organizational architecture Preemption and Sustainability The benefits of a strategy is the ability of the firm to “own” (sustain) some position. risk. capital for labor) • Use lower-cost components • Bring economies of scope activities in house. When a firm owns its position.In an effort to create cost advantages. Think of a first mover that invests in the capacity and infrastructure necessary to serve a segment of the market. Strategies for value creation and value capture generally fall along a continuum between the two general forms of preemption described below: investing in capital-intensive assets and securing superior scarce resources. these are easy to imitate. there are groups of activities through which firms can reduce costs. while others (second grouping) are difficult to imitate: Easily Imitable: • Reallocate production within existing facilities • Relocate facilities to low input-cost regions • Input substitution (e.. • • • • “Buy” share in existing markets through low prices to increase scale “Buy” share in existing markets to accumulate experience Introduce new products to better utilize shared facilities Enter new geographies to improve capacity utilization or increase scale Below are two sets of drivers to control cost within the firmʼs activities. The firm chooses product attributes and modes of 49 . so being first is key.g. Some (first grouping) are easily imitable. These investments reduce subsequent returns on capital invested by either incumbents or new entrants.. and complexity a potential entrant would face is sufficient to discourage entry. Investing in Capital Intensive Assets The first form of preemption consists of investing in capital-intensive activities.g. but outsource major cost centers • Enhance worker productivity through formal incentive systems • Reduce work force More Difficult to Imitate: • Improve material yields • Reduce complexity of production operations (e. but nonetheless may create positional or early-mover advantages. Firms own positions and can sustain returns when followers are preempted.
The more the competitors sink into the market. In the case where investment can be staged. Here we consider a firm that has secured inputs that are not widely available to other producers. such as CD pressing or airlines. 50 . These firms have a more difficult time fragmenting investments. so an industryʼs overall return on capital is often higher. able to secure its resources for less than their value to the firm. Collectively. In other markets. by definition. how matched past capacity choices are with future demand conditions. If competition takes on the form of “winner-takes-all” (more on this below). If the firmʼs capacity is a high share of the size of the overall opportunity. a preemptive investment also delivers the firmʼs value proposition (in addition to reducing the return on subsequent capital). Consider a first-mover who identifies an attractive market opportunity but who underestimates the size of the opportunity or who simply cannot secure enough capital to satisfy the market. investments that should act as preemption may still fail in some circumstances. capacity choices tend to be more optimal. Then along comes a competitor who also believes in the market. Furthermore. In both cases. large upfront investments under more uncertainty are required to “own” markets. This is an unfortunate outcome for firms in a setting that otherwise would have lent itself to preemptive investments and attractive returns on capital. Firms that can make preemptive investments often enjoy high and sustainable returns. Upfront preemptive investments are sometimes excessive. Ideally. then the successful early mover preempts followers by “taking up the space” with their investments. If the firm employing superior resources is earning economic profits. if this were not the case. the cost of preemption was secured for a “bargain” price. Here. Sometimes firms are able to stage their investments over time. The firm employing superior scarce resources produces a superior product and/or operates more efficiently and thereby generates a higher return on capital than other firms. These investments are said to be preemptive because subsequent investments deliver lower returns than they would have without the early moverʼs investments. the cost of preemptive investments is large. while Microsoftʼs investment in developing the operating system grew to be preemptive. For example. then that firm was. they did not have to make a big bet on day one. then the economic profits would be dissipated. the more they are motivated to keep investing to preserve the value of what they have invested in already. On the other hand. competitors will escalate their investments in an attempt to secure market supremacy.production and organization. and what alternative means of satisfying demand are on the horizon. Securing Superior Scarce Resources Another preemptive approach involves securing superior scarce resources. firms often need to account for the “opportunity cost” of owning resources that ultimately revealed themselves to be more valuable than they appeared at the time of acquisition. particularly when they cannot be staged. the choices are the firmʼs position. Analysts should ask themselves how well preemptive investments will hold going forward.
assets. The resource-based view concludes that it is critical that the firmʼs resources and its investments be mutually dependent. Furthermore. and capabilities on the one hand. dependence on these complementary assets enhances the value of the resources to the firm relative to the outside option of the resources. 51 . and employment of scarce and superior resources on the other hand. We described two forms of preemption: physically taking up the space with investments in capacity. Once a firm employs superior resources.Employing scarce and superior resources that the firm secured at a cost lower than the return those resources generate is preemptive. Preemption through physical investments and preemption through locking up valuable resources are anything but mutually exclusive. The productivity of resources is enabled by firm investments and firm investments are more valuable when combined with particular resources. This is shown in Figure 10. which is described in detail later in this document. Superior resources employed in the context of complementary assets and capabilities are even more productive. the complementary assets connect the resources to the firm. This discussion anticipates some of the insights of the resource-based view of the firm. it should invest in assets and capabilities that are complementary to those resources. In other words. In the most valuable firms we find that preemption includes use of superior resources combined with preemptive physical investments in superior assets and capabilities.
Figure 11: Sustaining Resources most important Increasing Returns Advantages product performance track records & reputation installed base in a network market cumulative experience on a learning curve W I L L A DVA N TAG E B E U N D E R M I N E D BY S H I FT S I N T E C H N O L O GY O R C U S T O M E R P R I O R I T I E S ? Information Gaps Information Gaps & Complexity & Complexity “black magic” social complexity path dependance need to imitate on numerous dimensions W I L L T H E Y P R E V E N T U S F RO M R E P L I C AT I N G O U R S U C C E S S F O R M U L A A S W E G RO W ? Economies of Scale.ifa.com (http://news.html) 53 .” by Jeremy Lopez at Morningside. Market Size. almost all firms with sustained abovemarket returns have multiple moats. in order from least to most powerful. Figure 11 below outlines many types of moats. While increasing return businesses enjoy the deepest and widest moats. “Moats”)12 As firms invest in physical and nonphysical assets. which refers to Buffet’s annual letters to investors such as (http://www.morningstar. some of which are ingeniously engineered. The strength of the moat indicates how long a firmʼs competitive advantage will last. While some individual moats are strong.aspx?id=91441). “How Morningside Measures Moats.Sustainability (or in Warren Buffet speak. & Sunk Cost market big enough to support just one efficient-scale firm W I L L A DVA N TAG E B E U N D E R M I N E D A S M A R K E T G RO W S ? One-of-a-Kind Information Gaps Strategic Assets & Complexity superior locations human talent trade secrets intellectual property brand names W I L L T H E Y R E TA I N E CO N O M I C P O W E R ? G AT E WAY S T O P RO FI TA B L E G RO W T H ? least important Information Gaps Legal Barriers & Complexity superior locations human talent trade secrets intellectual property brand names W H AT D O YO U D O W H E N T H E Y E X P I R E ? W O R T H M O R E T O O T H E R FI R M S ? 12 See for instance.com/articlenet/article. and employ owned and non-owned resources.tv/Library/Buffet. Warren Buffet is credited with using the term “moat” to connote both the form of preemption and the degree of sustainability of a business. the nature of their investments and their businesses give rise to various forms of preemption with various degrees of sustainability.
Path dependent outcomes are dependent on being 54 . Yet they can be overcome when competitor firms find important and unserved segments. In the end. the consistency of U. Moreover. the sustainability is determined by the firmʼs ability to retain economic power over time without offsetting upkeep costs. The resource-based view explores the nuance associated with dependency on particular inputs (see discussion below). and brand names can be gateways to profitable growth. Economies of Scale. Alternatively. for example. competitors often “invent around” them. copyrights. Firms may enter and compensate for operating at lower scale and higher costs by differentiating. and was surprised when Microsoft emerged victorious. and Sunk Cost Economies of scale. multi-factor moats are those that are “path dependent. human talent. the market may grow and support additional firms. trade secrets. For example.” and socially or otherwise complex. with value chains now spanning many countries. While this type of moat is generally more powerful than many legal barriers. with history showing that the protection from low costs resulting from economies of scale is not the most long-lived of moats. Market Size. Patents. Finally. and operating licenses. and the breadth of protection they provide against potential competition. Their strength is determined by how long they last before expiration. innovation often enables entry at lower scale without a cost disadvantage. and enforcing intellectual property rights across national boundaries is a challenge of mind-boggling proportions. and sunk costs are moderately powerful in sustaining a firmʼs competitive advantage.Legal Barriers Legal barriers include patents. which has been a hugely valuable asset that requires no upkeep. market size. courts are notoriously unpredictable in their findings when it comes to copyright and patent infringements. Some markets are not big enough to support multiple firms at efficient scale. The courts could view what appears to be strong legal protection as weak. courts matters less and less. there are many factors to consider when the firmʼs sustainability is dependent on its continued employment of particular assets. trademarks. Compaq was able to invent around IBMʼs formidable patents when Compaq entered the personal computer industry. One-of-a-Kind Strategic Assets Assets such as superior locations. A classic example of this is the Coca-Cola formula. Apple thought its patents were foolproof when it sued Microsoft for copying the look and feel of its operating system.S. Through effective segmentation and differentiation. entrants can make inroads even if they operate without the benefits of full-scale economies. and in fact. Information Gaps and Complexity Often the most enduring. vary widely in the degree of protection they provide to the owner. when a firm is employing scarce strategic assets. Furthermore.
When time in the market matters. products that need to be imitated on numerous dimensions (e. Strategy frameworks are useful for understanding how firms such as Crown. economic profits. By definition. Here we are looking for a situation referred to as “increasing returns”—the bigger the firm gets. Coca-colaʼs brand image is an example of path dependency. reputation) enjoy powerful moats indeed. Potential entrants cannot imitate profitable opportunities 2. Coca-Cola. Nucor. Increasing Returns Advantages Under perfect competition. Disney. many firms in a diverse array of industries avoid this downward spiral. or profits in excess of all costs including the cost of capital. profits converge to the competitive level (accounting profits just sufficient to compensate for all costs). Being the first firm with a desirable product is not what the term “early-mover advantage” refers to. features. The terms “increasing returns” and “early mover advantage” should be reserved for cases in which the firmʼs time in the market is correlated with the depth of its cost and/or product advantage from the perspective of a typical customer transaction. distribution. image. the better the firm gets. 55 . This is explained in Figure 12. in terms of cost or product advantage. path dependency and complexity cannot be engineered. most first-movers fail. There is a third category of explanations for sustained competitive advantage. Google. However. Recognize that simply being the first mover into a market doesnʼt necessarily bestow any advantages on a firm. Neither of the above two explanations explicitly factor in the benefit some firms gain. Southwest Airlines. Wal*Mart. Without Cokeʼs rich and varied history. and others sustained high returns over long periods. brand. expanding capacity and output. Pepsi. Coke would not enjoy its current brand equity.developed in a particular order and in a particular context. Additionally. are ultimately dissipated. reducing prices. By definition. As any angel investor and venture capitalist will attest. due to being an established producer in the market for a long period. ultimately. the sustainability of high returns is due to: 1. and.g. Potential entrants seize the opportunity and share in these high returns by entering the market. Barriers exist that prevent the entry of potential imitators The value in learning strategy is to be able to develop thorough analyses of how either or both of these explanations for profits plays out in the case of a particular firm. Eventually. we need to factor the mechanisms through which a firm gains an “early-mover advantage” into our explanation of the firmʼs sustained returns. At a high level.. path dependency is nearly impossible to replicate.
or the firm realizes production cost reductions beyond any due to spreading of fixed costs. and fewer application developers make software for the lower share platforms. When early mover advantages are present. software developers will tend to align with a single hardware platform. Given these caveats in what is an early mover advantage. we see that the term does not apply nearly as broadly as it is used. are highly complementary with platform-specific applications. typically the most dominant system.Hardware platforms. more consumers adopt the dominant platform. This in turn reinforces the value to consumers of the dominant operating system. they could conceivably dissipate any profits they would ultimately earn. To be clear. there are very weak economies of scope for application developers to make their software cross-platform because of significant upfront knowledge creation costs. particularly operating systems. consumers derive more benefit from the product as the firmʼs time in the market increases. Furthermore. 57 . Over time. because that system has the bulk of available software applications. only in the case of early mover advantage does the cost fall and/or the benefit to the customer rise continually as the firmʼs time in the market increases. While tenure (time spent in a business) can lead a firm to higher share or to lower costs due to spreading fixed costs across more units. However. As a result. if several firms recognize the advantage of being the first mover and spend resources trying to achieve this position. This is shown in Figure 13. we do not expect Kelloggʼs Corn Flakes to taste better as its market share grows.
It may be an advantage for learning curve firms to underbid rivals for business at first. but are more commonly referred to as “congestion” (as in traffic congestion or network congestion).There is more than one source of increasing returns or early mover advantage. The experience effect is captured by the learning curve. The diagonal line represents what might be considered a “standard” market with stable market share and no network externalities. If network externalities operate. Also note that. the learning would be widely acquired and not a source of advantage. Below we describe some common increasing return or early-mover advantages Experience Effects The experience effects describe any situation in which cumulative experience in producing a product lowers a firmʼs average variable cost. However. the advantage may accrue to one or only a few firms because of how difficult learning is and/or that learning by doing is a significant cost driver—if these conditions were not present. just as in the case of scale. In cases where a learning curve is present. in a positive feedback loop. in all cases the key is that a firm will have a product and/or cost advantage in year 2 by virtue of having been operating in the market in year 1. The idea here is that when a “network” of users exists. Negative network externalities can also occur. Sales to new customers are roughly proportional to the installed base. Over time. This creates a positive network externality because each user purchases their phone for their own use and quite unintentionally creates value for other users. there is an “external” benefit to additional consumers. The more people use telephones. The idea of network externalities can be captured graphically using the “S-curve” (see figure 14). Network Effects or Installed Base Advantages A network effects (also called network externalities) describes the situation in which each user of a good or service impacts the value of that product to other users. The classic example is the telephone. in order to build up their cumulative experience. positive network effects can create a bandwagon effect as the network becomes more valuable and more people join. The expression “network effect” is applied most commonly to positive network externalities as in the case of the telephone. Note the distinction between the learning curve and economies-of-scale—an experienced firm (with learning curve economies) would have lower costs at any scale of production. this 58 . firms can gain advantage by building up sales in early periods and developing a large “installed base” of users. When network externalities are present. where more users make a product less valuable. there are usually diminishing (or potentially even negative) additional cost savings at very high levels of cumulative experience. the more valuable the telephone is to each owner.
the share of new sales is even lower. At very low levels of installed base. an even greater share of new consumers will purchase the product. this favors convergence. When the share of the installed base is high. 13 This section draws from HBS Case Number 5-807-104 (October 2. A small difference in performance between the firms produces a large difference in economic profits. Below are considerations for judging the likelihood of convergence to a single winner13 : High Network Externalities: When network effects are strong. If network effects are strong. over time. 2007) Managing Networked Businesses: Course Overview for Educators by Thomas R. and the lure is the high value of the top prize. firms with a larger market share will gradually become larger and the share of the smaller firms will dwindle. Understanding whether a networked market is likely to be served by a single standard or by multiple standards is crucial for strategy formulation. users will want access to as big a network as possible. 100 YEAR 1 MARKET SHARE 90 80 70 60 50 40 30 20 10 Unstable Equilibrium 0 0 10 20 30 40 50 60 70 80 90 100 INSTALLED BASE . Eisenmann 59 .relationship takes on an “S” shape. however.MARKET SHARE AT START OF YEAR 1 Winner-Takes-All Outcomes The presence of network externalities can be associated with outcomes where the market converges or nearly converges to a single standard (which can be supported by a single firm or by many firms who cooperate in that standard). not absolute. A standard that attracts only a subset of the market (or a situation in which the market breaks into sub-groups each on different standards) is a less attractive situation for users. As shown in the figure. performance. These outcomes are referred to as “winner-takes-all.” A winner-take-all market is one in which reward depends heavily on relative.
Even if the manufacturing costs are nominal. If segments of customers or individual customers have a wide range of needs. On the other hand. a CD player). CDʼs and even LPs coexist. standards can coexist. These costs include: outlays for hardware (e. Opportunities for Product Differentiation Are Low. a very small fraction of the market uses a Non-Wintel standard. If multiple-standard association is costly (for some combination of manufacturers. quality can only be assessed by buying and consuming the product. Basically consider all the costs incurred in operating in a standard that are only useful in that standard and not useful in another standard.g. the more users prefer to converge to a single standard. costs for software (the CDs). When users simultaneously operate in both standards (they own cassettes and CDs) they incur redundant costs. firms that have built up a good reputation among experienced users will have a distinct advantage. we have to consider the increase in distribution costs if there are multiple standards. Only if the different products satisfy different needs would be expect to see coexistence. while for experience goods. Buyers have to be willing to vote with their dollars and pay for the redundant costs of multiple standards. is the differentiation between the different standards valuable to enough consumers to get them to pay enough to cover the redundant costs in the hardware and software markets? If there is little demand for particular and distinct features. the more expensive it is for consumers to support both standards. the more convergence we will see. New competitors would have to offer much lower prices in order to compensate for the higher WTP of the established products. In the case of the CD and the cassette—one had higher sound quality and one was more portable for a while.. The question here is. or distributors) convergence is more likely. and other transactions costs. For an established product—one that consumers have tried and liked—WTP increases a great deal relative to newer products. consumers benefit from industry wide standards) when the product is used in conjunction with a complementary good and it is costly to offer several configurations of the complementary good. then users will converge to a single standard. The higher these redundant costs are. The more expensive it is for the suppliers of complementary goods to produce their output in multiple configurations. Industries have an incentive to conform to a single (or very few) standards (that is. Search goods are ones for which buyers can assess quality at the time of purchase. 60 . learning costs. If buyers are uncertain about a productʼs quality. Buyer Uncertainty and Reputation Goods for which quality is an issue can be placed into two categories. we donʼt see convergence to a single standard. consumers. In many industries in which standards exist. We did see cassettes. Multiple-Standard Association Is Painful/Costly: There are costs incurred in order to “associate” with a particular standard.
outperform others in creating wealth for their owners. The RBV is a compilation of the contributions of many scholars to the fields of strategy and organizational behavior. it might be more profitable to charge higher prices and exploit the experienced users. so long as she doesnʼt switch to a competing product. buyers may face a specific cost if they want to switch suppliers.Buyer Switching Costs For certain products. A great example is producing a product that requires training to be able to use it—when the buyer purchases the product. In a consumer surplus comparison. Positioning reflects the ideal response to industry conditions and involves investing in tangible and intangible assets to secure that position. Optimal firm pricing strategy for products with switching costs can be quite tricky. even if (WTP1−P1) < (WTP2−P2). In this section. the buyer will continue to use the original supplier. Some firms must pay particular attention to relationships with internal inputs (most often.) also provided several insights that we used in this section. In some cases. in other cases. This is because getting new customers requires that (WTP1−P1−T1) > (WTP2−P2−T2). but not limited to. distribution channels. 61 . produce. David Besanko (Kellogg School of Managemen. The price that maximizes profits from established users may not be low enough to attract any new users. it may be beneficial to keep prices low to attract and “lock in” new buyers. a competing product would have to provide either a higher WTP or lower P to offset the additional cost of training to use the new product. and deliver its 14 This section is based on The Cornerstones of Competitive Advantage: A Resource-Based View by Margaret Peteraf (1993). The RBV of the firm deals with the fundamental question: “Where does competitive advantage come from?” This framework attempts to explain why some firms. Resource-Based View14 At several points in this document. As long as (WTP1−P1) > (WTP2−P2−T2). over time. Many scholars consider the paper The Cornerstones of Competitive Advantage: A Resource-Based View by Margaret Peteraf (1993) to be a comprehensive description of this work. we have referred to the resource-based view (RBV). key employees). and patents. Resources as a source of competitive advantage are different from positioning. brand names. she incurs a “training” cost that wonʼt have to be repeated. the RBV examines how firms can enjoy sustainable returns as a result of resources employed. The RBVʼs answer starts with the assumption that firms are endowed with inherently different bundles of resources. and then contrast it with the positional view. and they all contribute to the firmʼs ability to create. Here we summarize and clarify the main ideas of the RBV of strategy. By contrast. we will examine the RBV in some depth. These resources include assets such as locations.
In fact. competitive advantage?” A firm has a competitive advantage if it earns a rate of economic profit that exceeds the industry average. sustainable. “What characteristics must resources possess in order for them to serve as the basis for a wealth-creating. and by matching these resources to economically relevant environments. If firms in a particular industry are different. For this reason. The firms with superior resources are able to produce their output more efficiently than rivals 62 . these differences can be attributed to differences in the bundles of resources that firms depend upon to make and sell their products. we evaluate the firm through multiple frameworks and find that each generates some insights. As a tool for strategy formulation. These resources also include capabilities such as hiring practices. There are four foundations of a wealth-creating. sustainable competitive advantage: • Resource Heterogeneity • Ex Post Limits to Competition • Imperfect Mobility • Ex Ante Limits to Competition Resource Heterogeneity Differences among firms are necessary for competitive advantage. That advantage creates wealth for the firmʼs owners if the original costs incurred to create the advantage are less than the present value of the stream of profits that now flow from the advantage. Within these environments the firm has a competitive advantage because its resources are superior to those of competing firms. K. A firmʼs competitive advantage is sustainable if that advantage persists over a reasonably long period of time. Sustainable Competitive Advantage The primary goal outlined in Peterafʼs discussion of RBV is to provide a systematic way to answer the question. Gary Hamel and C.goods and services to consumers. quality control processes. while no one framework alone “cracks the case. Prahaladʼs notion of core competences is a well-known strategy concept that reflects the basic logic of the resource-based view of the firm. there is no single framework for the analysis of a firmʼs competitive advantage. Wealth-Creating.” The RBV is one such paradigm that helps us identify the sources of a particular firmʼs performance. However. there must be some firms whose resources are superior to others. Instead. According to the RBV. it has become one of the most important frameworks in the modern field of strategy. the RBV implies that firms should examine their resources and find environments appropriate for these resources. The RBV emphasizes that a firmʼs competitive advantage arises by owning unique resources that other firms do not possess and cannot acquire. or corporate cultures that similarly play an important role in value-creating activities.
Ricardian rents arise. Ricardian rents can occur in highly competitive markets. Suppose each wheat producer is so small in comparison to the overall size of the market that no single producer can move the market price. And when superior resources raise output quality. Wheat is wheat in this industry—there are no organic strains. a firm with superior resources might have lower costs. monopoly rents arise. Picture an industry in which many firms compete. This is demonstrated in Figure 15. Resulting from the Law of Diminishing Returns. This is the economistʼs perfectly competitive industry. such as wheat. When superior resources lower production costs. Resource heterogeneity gives rise to two kinds of rents15 . notice that the marginal cost curve (MC) is upward sloping. MC AC $ PER UNIT P*=$6 RICARDIAN RENT AC*=$3 P = MC AT THIS LEVEL OF OUTPUT OUTPUT (UNITS PER YEAR) Letʼs pause for a moment and fully understand Figure 15. or any other possible type of differentiation. The worst firm in the industry is the firm that just breaks even. 63 .(lower C). as 15 The term “rents” can be used interchangeable with economic profits – returns in excess of all costs including the opportunity cost of resources such as capital. or they can offer products that provide consumers with higher utility than the goods offered by rival firms (higher WTP). Ricardian Rents. wheat is wheat). The superior firm can capture the difference between its average cost (as below. This firm just covers its average cost of production. and perhaps some have more skill at harvesting their crops. Whatever the difference. each selling an identical commodity. Suppose that some wheat farmers are different from others. First. and so this “marginal” firmʼs cost (including opportunity costs of labor and capital) is equal to the market price. Some farmers have more fertile land than others. though still a standard product (after all. $3) and the market price ($6).
Since monopolistic firms can enjoy a gap between AC and P. this firm cannot set prices). with little care for the specific producer. However. so the 64 . which is referred to as a Ricardian rent. so the firm generates an economic surplus. Usiminas generates Ricardian rents when it sells steel on the world market at world prices. Wheat produces have virtually no control. in the view of consumers. the scarce resource may be particularly fertile land close to a river. but Microsoft has very strong control over pricing of its Windows operating system. different prices emerge. However. Steel is one of the most competitive product markets because buyers of steel can purchase identical grades of steel from a variety of different producers. and the firm begins to face a downward-sloping demand curve. Coke has some control (because Pepsi is a partial substitute). which is limited in physical size. firms select to produce quantities where the market clears at prices well above MC. while monopoly rents result from differentiated products that have no good substitutes. degrees of price inelasticity arise. In the wheat industry. This surplus results purely from more efficient cost curves (remember. When a firm makes a product that. they generate economic surplus above their actual costs and opportunity costs. the scarcity that limits the firmʼs size also prevents competing firms from replicating its cost curves and ultimately driving prices down for the entire industry. Other small stuffed animals are not perceived by small children to be comparable to Webkins. In highly competitive goods markets. Ricardian rents result from superior production efficiency. including the market cost of capital. after the British economist David Ricardo. A firm can have both Ricardian and monopoly rents. Monopoly Rents. and we are adding variable costs to generate more output. The Brazilian steel firm Usiminas is one such firm. the ability to earn the rent ultimately derives from the existence of valuable resources that a firm possesses but competitors do not. the average cost (AC) is below MC. Examples. In both cases. the incremental costs get larger and larger. and in turn AC. This economic surplus is above all actual costs and opportunity costs. notice that our cost curves indicate we have some given level of fixed costs. Typically. steel is labor intensive. including the market cost of capital. the firm is limited in expansion because its superior resource is scarce. Or it may be a skilled owner who has limited time to apply harvesting expertise. Webkins are a particularly differentiated product due to brand image. In this scenario. and has historically been one of the lowest cost producers in the world. Luckily.output increases constantly. and firms located near cheaper labor supplies face lower costs. Second. firms have increasing control over how they price their goods. As a result of consumer perceived differences. is differentiated from the products of competing firms. firms will choose to produce an output level where their MC is equal to P to maximize firm profits. As product substitutability drops. Here. we consider Ricardian rents a supply side phenomenon. and we consider monopoly rents a demand side phenomenon.
“Isolating mechanisms” are factors that prevent firms from replicating other firmsʼ superior economic rents. The maker of Webkins therefore limits output to keep prices above average costs. Imperfect Imitability. the inability of potential rivals to replicate Akamaiʼs algorithms for detecting Internet congestion is imperfect imitability. other firms would clone the high performance firmʼs resources and drive down profit margins in the industry. Though initially extremely profitable. Imperfect Mobility The third condition necessary for the firm to have a sustainable competitive advantage is imperfect mobility. Ex post limits to competition are typically driven by imperfect imitability and imperfect substitutability. Common examples of isolating mechanisms include: • • • • • • Exclusive legal franchises: these prevent overlap of market segments Patents and trademarks: rival firms cannot free-ride on intellectual property Channel crowding: rival firms cannot gain access to needed distribution channels Causal ambiguity: unobservable trade secrets are lowering costs Experience curves: resources in an industry may have to be developed over time Buyer switching costs: even perfect imitations do not draw away consumers Imperfect Substitutability. These limits are barriers that ensure resource heterogeneity is preserved over time. In practice the distinction between imperfect imitability and imperfect substitutability is a matter of degree rather than kind. Isolating mechanisms can prevent imitation of resources that allow low-cost efficiency. The Pet Rock industry is a well-known case of no ex post limits. To offer a rough distinction. imitators broke into the industry and brutal competition quickly brought down prices. This difference gives rise to monopoly rents because the maker of Webkins faces very similar production costs as other stuffed animal makers. while the inability to develop alternative technologies for high-speed Internet connections is imperfect substitutability. Ex Post Limits to Competition The second condition for a firm to enjoy a wealth-creating. Without ex post limits to competition.demand for Webkins is downward sloping. Imperfect mobility means either (i) the resource cannot be bought and sold in the marketplace (there is no market for resources such as “corporate 65 . Imperfect substitutability is the inability of would-be rivals to acquire resources that are good substitutes for the superior resources possessed by the firm. sustainable competitive advantage based on superior resources is the presence of ex post limits to competition. or prevent imitation of resources that allow differentiated end products for consumers. Whereas imperfect imitability limits direct imitation or cloning. imperfect substitutability limits firms from creating resources that substitute for or neutralize economically powerful resources.
Because of their extra-productivity. Fred gets a salary premium equal to his extra value. or (ii) the resource is more productive for one firm than others (it is “co-specialized”). Even though Fred is an extra-productive resource. Perfect Mobility. It appears that BesankOil has 16 This fictitious company is named after a mentor of mine at the Kellogg School of Management. If the resource is mobile. firms can own many resources that are openly traded in the market. the firm that possesses this resource is unable to secure a competitive advantage over other firms because Fred is perfectly mobile. Likely. 66 . Professor David Besanko. The owners of BesankOil will earn a Ricardian rent. similar to the farmer with the fertile land. Co-specialized resources are those that are more productive when used together—collective productivity would be sacrificed if these assets were separated. then competition among firms for Fredʼs services will drive his salary to $3 million a year. If the going market rate for run-of-the-mill CEOs is $1 million a year. We start by considering an example of a perfectly mobile resource. Unlike labor. and Fred is not like other CEOs. Co-specialized Resources. Now. the firm that currently employs Fred. based on bilateral negotiations. then the company can sell the tracts to rival firms who would attain the same low-cost production as BesankOil.16 which owns an especially productive tract of oil reserves. Firm A will not necessarily have to compensate Fred for his full added value to the firm. Unlike an asset such as “corporate culture” Fred can buy and sell his labor freely in the market. We can hypothesize an oil firm. He is so talented. run-of-the-mill CEOs. BesankOil. these oil reserves allow BesankOil to extract oil from the ground at a cost less than the production costs of rival firms. call it Firm A. Firm Aʼs rivals will compete to lure Fred away from his current employer by offering Fred a higher salary. Fred is perfectly mobile if Fredʼs superlative skills relative to other CEOs are not firm specific. and Fredʼs salary will be bid up to the point that he receives the full value of his additional productivity relative to ordinary. Fred and Firm A will split the economic rent. earns an economic rent. but he is unable to bring rents to other firms in the industry because Fredʼs skills perfectly complement the other top managers. while the firm ends up employing Fred will have the same profits as other firms because it must pay a premium in return for the added value that Fredʼs skills create. Fred would be an equally extraordinary manager at any firm in the industry. Fred cannot capture his full value even though he is free and willing to move to another firm. Owning Mobile Resources.culture” or “reputation”). The cospecialized resources cannot capture their individually superior production because the bundle is difficult to buy and sell in the market. and Fredʼs skills can add an extra $2 million in profitability to the firm that employs him. Suppose however that Fred has been working his magic at Firm A creating rents. Suppose that there is a CEO named Fred. The firm discovered these reserves and thus controls how they are used.
the total profit that the railroad will eventually collect [over all its years of operation] will be $20 million. because until then. it will never pay to build a second rail line into the valley. propose to build the railroad in 1900. If the railroad is built before 1900. We could also consider BesankOil as two separate value chains: tract exploration and oil extraction. Assume that if the rail line is built in 1900. Price Theory (1990): Suppose there is a certain valley into which a rail line can be built. we consider the fable recounted in David Friedmanʼs book. recognizing the full opportunity costs of BesankOil resolves this apparent contradiction. so we can ignore complications associated with discounting receipts and expenditures to a common date. suppose that all of these facts are widely known in 1870. not enough people will live in the valley for their business to support the cost of maintaining the rail line. BesankOilʼs competitive advantage lies in exploration (perhaps due to skill. Even though BesankOil is more profitable than competing oil producers. 384). The firm must be able to acquire the resources that underpin its competitive advantage at below-market rates. Lastly. In this case. it will lose $1 million a year until 1900. which is all he will get if he waits for me to build first. knowing these facts. perhaps luck). but its extraction operation is merely industry average. we assume that the interest rate is zero. The present value of the cost of acquiring the monopoly franchise (20 years 67 . However. This means that the opportunity cost incurred by BesankOil from not selling the superior resource just offsets the extra value that the resource creates. I am forestalled by someone who plans to build in 1899. Ex Ante Limits to Competition The final condition necessary for the firm to create a wealth-enhancing sustainable competitive advantage is limited competition to acquire the resources in the first place. a correct accounting of BesankOilʼs economic rent should take into account the opportunity cost it incurs by not selling the asset to the second-highest valuing user. Someone willing to build still earlier forestalls him. the race to acquire the valuable resource—the monopoly on rail transportation in the valley—competes away the economic profits that result from the monopoly. $19 million is better than nothing. To simplify the discussion. To illustrate the importance of ex ante limits to competition. Further suppose that whoever builds the rail line first will have a monopoly. I. the cash flows that the second-highest valuing user gets from the oil tracts are (by hypothesis) exactly the same as the cash flows received by BesankOil. In this fable. The railroad is built in 1880—and the building receives nothing above the normal return on his capital for building it (p.a sustainable competitive advantage even though its resource is not immobile.
the firm could not enjoy a sustainable competitive advantage. The first necessary condition for wealth-creating. firms compete up the cost to acquire the resource in the first place. The third necessary condition for wealth-creating. 68 . the advantage created no net wealth for the owners of the railroad. on balance. Chandler purchased the secret formula for Coca Cola (called Merchandise 7X) from the inventor. Now. sustainable competitive advantage is ex post limits to competition.. this represented a rate of return of 45 percent per year. But. One of the most famous examples of the implications of limited ex ante competition occurred in 1891 when Asa G. with perfect mobility) a firm that possesses the superior resource would not outperform its competitors and would thus not have a competitive advantage. The extra profit gained from possessing the superior resource is offset by the premium that it needs to pay to the owner of the resource in order to keep the resource from moving to other competing firms. sustainable competitive advantage is resource heterogeneity. due to ex ante competition. When Chandlerʼs sons sold the company in 1916. The final necessary condition for wealth creating.300. The second necessary condition for wealth-creating. Without imperfect mobility (e. sustainable competitive advantages come from.g. it would be no different from rivals in its industry. For the Chandler family. that the valuecreating potential of the resource is not widely appreciated. the resources that underpin the firmʼs competitive advantage could be imitated or substituted for. Without ex post limits. for $2. they received $25 million. Firmʼs that incurs up-front costs to acquire superior resources do not have wealth-creating sustainable competitive advantage. a firm cannot have a competitive advantage. sustainable competitive advantage is imperfect mobility. the cost of acquiring this advantage meant that. Atlanta druggist Dr.of $1 million a year losses between 1880 and 1900) exactly offsets the present value of the cash flows from possessing the monopoly franchise. If a firm does not have a unique bundle of resources. we would say that that the incumbent railroad has a sustainable competitive advantage in this particular market. Without ex ante limits to competition. if we were to look at this market in 1903 or 1907. the firm would not profit from its possession of superior resources. The key factor limiting ex ante competition is imperfect information. each year for a quarter of a century! Conclusion Recall that Peterafʼs central goal of the resource-based view is to explain where wealthcreating. and it therefore could not outperform them. John Styth Pemberton. Without a portfolio of superior resources. In the absence of ex post limits. In the absence of imperfect mobility. sustainable competitive advantage is ex ante limits to competition.
economies of scale that create room for only one firm to occupy the position the firm has staked out in the market. Meanwhile. also called the activitysystems view by Pankaj Ghemawat and Jan Rivkin (1998). Here we want to ask a related. The firmʼs competitive advantage is sustained. What is Strategy. In other words. but would add that its greatness is contingent on Southwestʼs resources. The resource-based view has a resource market orientation—competitive advantage through imperfections in resource markets that give a firm a privileged access to certain valuable resources. However. domination. when there are barriers that make it difficult or undesirable for other firms to replicate the firmʼs position. while the resource-based view emphasizes the things you have. but the resourcebased view emphasizes that competitive positions do not exist in the abstract. The positional view emphasizes the idea that competitive advantage arises from the ability of a firm to create a unique competitive position in the market in which it competes. because resources are only great if the firm can build activity systems and competitive positions that are different and better than competing firms. firms enjoy “synergy”17 among their constituent parts. the positional view of the firm. and preservation of a unique position in the firmʼs product market. 17 A synergy suggests that the interaction among two or more components of the firm produces combined value in excess of the sum of the value of the components would have produced if they operated separately. Positional View of the Firm As an explanation of competitive advantage. 69 . and instead positions are contingent on the firm possessing certain resources. the RBV would concede that Southwest has a great competitive position. Another way to draw the distinction is that the positional view emphasizes the things you do. why is the whole worth more than the sum of the parts? In cases where the firm is worth less than the sum of the parts. Relative to the resource-based view of the firm. the positional view would emphasize that unique and valuable resources do not exist in the abstract. A final distinction is that the positional view emphasizes the importance of unique and valuable competitive positions as a source of competitive advantage. These unique positions are created based on the different activities performed by rivals. but different question: Why is the enterprise itself more valuable than the cumulative value of its resources and investments? Another way to state the question is. the positional view has a product market orientation—competitive advantage through the creation. according to the positional view of strategy.Resource-Based View vs. The positional view is best summarized in the reading by Michael Porter. we ultimately expect the firm to be disassembled to unlock the value of the components. These barriers might be barriers to entry at the industry level. the RBV can be contrasted with another important perspective in strategy. most firms are valuable above and beyond their component parts. For example. or the complexity involved in executing an integrated system of activities. when it comes to the firm. Shifting Perspectives: Components of Firm Value Up to now we have mainly focused on techniques for describing how firms create and capture value.
Consider a football franchise has constituent parts – a coach, team players, the team “system,” the stadium, the brand. It is a reasonable conjecture that if we extract a component from one franchise and replace it with a component taken from another franchise, there would be some affect -- the new component would interact favorably or unfavorably with the other component parts of the franchise. Understanding the precise nature of the interaction among component parts of an enterprise is of fundamental importance. Below we will describe three sources or components of firm value that can be used to describe the total value of an enterprise, and explain how the interaction among these components gives rise to synergy. Describing the value of the firm in this way is, in some respects, redundant to describing the firmʼs position. However, understanding and evaluating the components of a firmʼs value is highly complementary to positioning analysis. When we describe a firmʼs position, we describe: • Characteristics of the firmʼs output • The segment of customers the firm serves • The suppliers with whom the firm transacts • The locations the firmʼs activities span This description of the firm is more informative and insightful if it is framed relative to the firmʼs direct competitors. The position the firm “owns,” by virtue of the firm having invested in a value chain constructed to serve that position, can be valued in monetary terms. In our discussion, we suggest that the value of the firm goes beyond the value of the firmʼs market position. Here we think of the firm as being comprised of three components: 1. The value of the firmʼs assets and capabilities (essentially the added value of the firmʼs position as described above). Here we will refer to this component as asset and capability value (ACV). Assets and capabilities are the cumulative physical and nonphysical investments made by the organization. Again, this is essentially the value of the firmʼs market position. Assets and capabilities are quite literally what the firm is doing, for whom, with whom, and where. ACV is the value of these cumulative investments. 2. The added value of the resources the firm employs but does not own. Here we mainly refer to the firmʼs human capital. While we sometimes pay attention to the nature of the human capital a firm employs when we describe its position, it is unusual to pay close attention to the factors that we will elaborate on here. We refer to this component as employed resource value (ERV). ERV is the added value of the resources used, or employed, but not owned by the firm. 3. The added value of the firmʼs internal governance and incentive structure. We refer to this component as governance value (GV). GV refers to the added value of structuring the organization such that the players actions are transparent and aligned in the interest of the firmʼs capital owners. We believe the framework presented here is in line with how investors should and often
do think about the value of a firm. A firm enters a market and operates and by doing so, chooses a market position (eventually this is becomes the ACV component). The firm employs a set of well-suited resources necessary to operate in its market position (leading to ERV), and sets up a structure of governing those resources (GV). In sum, the particulars of the firmʼs choices of how to operate, its execution choices, combine with the firmʼs position and give rise to the three components of value. The three components interact with each other and with market forces, as shown in Figure 16, thereby increasing or decreasing the total value of the firm as well as the relative shares of the three components.
g on nts Amone n p tio m ac Co r te e In hre T
Assets and Capabilities Value Consider an enterprise with all of its current non-owned inputs (such as human capital) replaced with the next best alternatives. The value of the enterprise, stripped of its nonowned resources and then replaced with the next best set of resources is the ACV of the firm. ACV is derived from assets and capabilities owned by the firmʼs shareholders or capital owners. ACV is essentially the monetary value of the firmʼs position. This is the portion of the firmʼs value that cannot be expropriated away from the firmʼs owners (or shareholders). Itʼs the component of value that is ownable. Examples of assets and capabilities are location, premises, brand, contacts with buyers and suppliers, patents, and documented organizational know-how (related to manufacturing, administering, etc.). These assets and capabilities can be acquired instantly or developed over time. ACV can be sold to other firms as itʼs the “turn-key” portion of the firm (meaning anyone can “turn the key” and derive this value). Employed Resource Value ERV is the incremental value to the firm that results from superior matching of employed resources such as human capital to its ACV. Our discussion here draws on insights from the resource based view of the firm presented above. The resource-based view suggests that co-specialization between particular resources and the whole rest of the firm was critical if the firm was to have the leverage (or bargaining power) over the value produced by the resources. If a resource is equally productive at all firms, then the resourceʼs value fully reflects that fact. On the other hand, if the resource is more productive when employed by a particular firm, then the resource is worth less to another firm. A superior choice of employed resources results in “synergies” with the firmʼs ACV relative to using the next best set of resources and these synergies are the ERV component of firm value. To retain some of the value generated by non-owned resources, such as human capital, it is necessary that the firmʼs ACV be complementary (that is, generates synergies or co-specialized) the with firmʼs employed resources. If the firmʼs ACV does not enhance the productivity of the ERV, then the resources are likely to capture their full value as compensation as their outside options are fully credible. Consider an individual who is a very gifted artist and cartoonist. Technological inputs, a group of creative peers, a process to manage the output of an animated film, and other sorts of assets and capabilities would likely enhance this individualʼs productivity. Likewise, assets and capabilities for animated filmmaking are enhanced by particularly well match human inputs. ERV is the value due to superior matching of particular resource inputs to particular ACV. For some service firms, say law firms, ERV value can be a high fraction of overall firm value. On the other hand, for a firm with a particularly strong brand and a lot of additional ACV, ERV might be a small fraction of firm value. Arguably, the value of Coca-Cola would be quite nearly fully preserved even if all human capital were replaced with the next best alternative group of employees.
73 . Suppose this individual comes up with an idea that would enhance the operating system and increase the value of the firm by. that human capital certainly appreciates how much effort was undertaken. the more value the shareholders derive. When considering the production of ACV. Herein lies the issue—once ACV is developed. At one end of the spectrum are firms that are primarily made up of ERV.” While we cannot describe one-size fits all good governance. consistency. letʼs develop an example. thereby. Good governance displays transparency. but human capital cannot take ACV away (what human capital can take from the firm is called ERV). GE is one such “in-between” firm—but likely more ACV than ERV (although this varies by business unit). To understand how profound and central the challenge of encouraging is. equity. say. Motivating the production of ACV is the central challenge facing organizations. Consider that firms fall along a continuum. it is owned by the firm. When human capital creates ACV. Nothing is more fundamental to the value of the firm than a set of human capital driven to increase the ACV of the firm. Hence. At the other end of the spectrum are firms whose value is entirely ACV value—replacing non-owned resources entirely with the next best set would not change the value of the firm at all. and overall good sense and. informs human capital before the effort is undertaken “what is in it for them. $50 million. the firm wouldnʼt be worth much. it is easiest to consider the case of human capital. Again. scientists. Consider an individual who is a programmer for Microsoft. a number of individuals developing these ideas continually is essentially what drives the ongoing value of the firm. Most firms fall between these two extremes—but all firms are closer to one of these two types. it is reasonable for that human capital to wonder “whatʼs in it for me?” Governance is the answer to this question. come to work and they are essentially asked to drive the ACV value of the firm. Governance is about putting in place infrastructure and incentive structures that motivate the production of ACV. we can discuss two types of governance paradigms observed.Governance Value GV is incremental value to the firm that results from properly incentivizing employed resources to generate additional ACV. and distributors. The more successful these people are in their job functions. Every day. ACV cannot be taken by an individual to another firm—the firm can sell it. An example of such a firm is one that produces movie scripts—without the script writers. human capital cannot threaten to move its past contributions to another firm—it can only threaten to take future ideas—the value of past ideas is embedded in the firm. While $50 million is trivial relative to the market value of Microsoft. We doubt the value of Cameron Cookware (a firm that makes cookware for the stove top and microwave) would change much of its human capital were switched out. marketers.
it becomes challenging to find a true promotion opportunity. For example. However. the human capital finds its opportunities greatly enhanced in exchange for its contribution of ACV to a particular organization. Furthermore. Promotions enable individuals to enjoy more leverage for every hour they work—promotions mean more access to the firmʼs productive assets (plants and people). Many nonprofit organizations maintain a reputation for high standards so that quality human capital is attracted and then rewarded with outside options. The incentive to increase the value of the firm are derived from some combination of the following: the employees financial rewards are correlated with their contribution to firm profits.S. The firm can increase the human capitalʼs external visibility. In considering GE and several other ACV firms that have reputations for sound governance we can observe a commonality. the limitation is firm growth—firms can only promote as long as they are growing. This can be accomplished in a number of ways. As the firmʼs growth slows. If the individual contributes ACV and the firmʼs value appreciates.781 own?! But there is an alternative way to increase the value of human capital beyond increasing the value of the human capitalʼs stock holdings. so does the value of the individualʼs options. there is an alternative way to increase the value of human capital beyond stock options or promotions within the organization. as well as their outside options. Here. as well as for encouraging movement from GE to other organizations. firms might give individuals stock options. rapid promotion within the armed services is externally visible and opens up opportunities in the private sector. The firm can promote on the basis of ACV contributions. While being in the U. how might the firm motivate the production of ACV? Again. How much of the firm can employee number 36. Good governance for an ACV value firm entails a correlation between the human capitalʼs contribution of ACV value and an improvement in that human capitalʼs value. If the firm cannot use options or promotions. mature firms perceive even more of a need to produce ACV. but not all. we can also appreciate the limits of this approach at a large and mature company. even for worthy individuals. With higher external visibility. The employed resources must get some. The reason this is the case is that GE has an external reputation for empowering managers and enabling them to acquire strong management skills in the process. We imagine this would work well in the context of a small firm where the individualʼs wealth changed appreciably with the value of the firm. though. GE is known for imparting generally desirable skills and know-how to its managers. With more leverage the individual can be more productive and financially and professionally rewarded. armed forces may not be financially rewarding in and of itself. Opportunity to segueway out of the organization can be as motivating as opportunity to move up in a given organization. General Electric (GE) has structured its organization so it drives human capital to increase the value of the firm.Governance in ACV Firms Reputedly. the employees contribution of firm value over time increases their inside options (chances of promotion). 74 . of the value they create.
than the value the human capital derives throughout his/her career increases. good governance suggests the human capital ultimately derives value correlated with its ACV contribution. the absence of leverage to threaten the firm can under-motivate the employee to produce ACV. and overall nature of governance is not radically different for ERV firms. then the value that human capital derives from its job increases through increased leverage. In the case of ERV governance. the trick is to retain value without paying that value out in wages to human capital. there is no one-size fits all governance model for ACV type firms. technically. If the human capital owns a stake in the firm. the employee cannot credibly threaten to take the ACV away from the firm. To retain the value. the firm must retain the human capital. the “problem” the governance of an ACV firm is addressing is “under-motivation. intention. While the human capital does not directly own its ACV contribution (by the very nature of ACV. the value of the firm. While itʼs good for the firm that its ACV cannot be stolen by human capital. but there are important distinctions. the firm owns it). each time the human capital leaves the building. the question is how to maintain a balance of power between the firm and the human capital. At the beginning of this document we included the following in our definition of strategy: “A wise firm that uses its advantage judiciously will be able to sustain its position in the value chain. goes with that human capital. as they say (good news and bad news). The form. Hence. the firm promises to reward the human capital at the point where the human capital is not empowered enough to demand the reward.” Good governance of an ACV firm is an example of a “judicious” use of power. If the human capital is rewarded with outside options for its ACV contribution. If firms continually back out on their promises.” The firm is committing in advance to a set of rewards that it will bestow upon the human capital after the ACV is produced. they end up with a lot of slack effort from human capital. However. Good governance also allows for value to be of both monetary and nonmonetary nature. Governance in ERV Firms ERV firms face a situation very different from ACV firms. Some of the value has to be retained by the firm to deliver a return to invested capital. The firm will reward the human capital after the ACV is produced and securely owned by the firm—that is. One important distinction is the underlying “problem” the governance needs to address. The human capital can threaten to take the value away from the firm—in fact. then the human capitalʼs wealth increases along with its contribution of ACV. In the case of ACV firms. all good governance of ACV firms shares the idea that the value of the human capital appreciates with the ACV value of the firm. the question is what is the firm if all or most of the value resides with the human capital? 75 . This is a twin-edged sword. However.Again. In fact. If the human capital is promoted within the organization for its ACV contribution.
the structure of pay matters. Pixar offers its creative types unfathomable technology. than the best human capital will be attracted to and retained by firm A. but the grueling work positions them for many good outside options. One is that with promotion. • They realize that their odds of promotion at the organization are low. the ERV firm provides advanced technologies. capabilities. Talented minions ultimately stay in order to move up this pyramid of pay and power. Minions are somewhere in between. The ultimate employer of the human capital simply passes ERV through as wages. A cheap and productive base is critical to the financial success of those individuals higher up on the pyramid. law firms. creative agencies have to determine what assets and capabilities can be firmowned and available to the talent so the talent wants to associate with particular firms. ACV is critical as without it. Promotions have two related upsides. Consulting firms. 76 . the ERV firm needs ACV in order to retain some of the value. Once promoted to a high level. In other words. but lots of learning. and infrastructure to supply to talented human capital to enhance its productivity. One begins as one of the “minions”—underlings who get low hourly wages.The first insight of governance of ERV firms is that the firm must invest in assets that complement and enhance the productivity of the human capital. ERV firms are structured as partnerships. the human capital gets a seat at the table where the division of the firmʼs profits is decided. Talent and diligence are rewarded with promotions. Again. the human capital shops itself around to the highest bidder. It stands to reason that one of two things must be true about the minions: • They overestimate their chances of success. In addition to ACV. this is retaining ERV through ownership of ACV. the human capital gets their own minions—each hour the human capital works is now more productive and hence more financially and professionally rewarding (like promotions in the ACV firm). Often. grueling work. If the “pie” is larger for talent at firm A relative to firm B. Other employer are attracted to individuals who held position such as these because of how much the individual learned or because the individual signals they are a hard worker for having held this job. It should be clear that a critical governance tool of most ERV firms is an army of minions. long hours. It is also possible that rather than providing minions. They would not accept such a bad deal for one or two years if they realized their servitude delivered a low probability of success. Governance must focus on what assets.
77 . patents. g V PLUS THE ERV OF THE FIRM ERV: By utilizing human resources that are complementary to the firm’s assets the firm’s value is addtionally enhanced. ACV and ERV based firms can use different forms for strategic preemption. A firmʼs total value is dependent on each component. As shown in Table 6. Finally. because good structure motivates those actions that nourish the firmʼs position in superior resources. k BOOK VALUE OF THE FIRM’S ASSETS Value from ACV-ERV-GV Interactions V V V V A K While we can consider the three components in isolation. ERV is maximized by good GV. there are important interactions among them. These activities produced assets such as brand. because the matches themselves are dependent on incentive systems. superior ACV tends to attract superior ERV because good matching levers up the value of human capital (though much is captured in wages). processes. as shown in Figure 17. GV reinforces ACV. institutionalized know-how etc. f TOTAL VALUE OF THE FIRM GV: With good systems for incentivizing resources. the firm’s value is additionally enhanced. a V PLUS THE ACV OF THE FIRM ACV: The firm’s activities added incremental value over the initial capital invested. Furthermore. Imagine that fruitful interactions among the three components grow the pie—and firm choices and market conditions can grow or shrink the pie. First. At a point in time the firm is made up of three components that you can think of as slices of the pie.
Goldman Sachs • • Securing Superior Scarce Resources • • • Ex ante limits on competition Substitution and imitation Scalability Marketing and demand realization Expropriation • • • • • Technologies that depreciate or leap frog ACV stock Divisibility of investments Pricing power Demand growth potential Governance: motivating HR to make ACV investments Ex.. Pepsi Co. Mittal Steel Ex. Microsoft Ex. Law firm of “Star and Star” 78 .Table 6: Issues for the Long term Value of the Firm Form of Preemption Long Run Nature of the Firm ERV is Critical • • Investing in Capital Intensive Assets Quality of firmʼs ACV Technologies that depreciate or leap frog ACV stock Divisibility of investments Pricing Power Extent of HR cospecialization Scalability Governance: and reducing reliance on specific HR Mostly ACV • • • • • • • Quality of firmʼs ACV Technologies that depreciate or leap frog ACV stock Divisibility of investments Pricing Power Demand growth potential Reducing consonance of firmʼs offering Governance: motivating HR to make ACV investments • • • • • Ex. Disney animation. Google.
If the firm claims to have efficacious management processes.” That is. it should be evident in its selling. general and administrative expenses (SG&A) as a percent of sales ratio.Financial Metrics When we are working toward a deep understanding of how firms create. Whatever advantage the firm claims to enjoy over its rival. If a firm believes it enjoys high return because of its cumulative brand equity. should be evidenced in one or more of its financial metrics of performance shown in Figure 19.COGS) (1-tax rate) X Sales (SG & A) Sales WACC X Capital Sales X (Market Share) X (Market Size) NOPAT: Net Operating Profit After Tax WAAC: Weighed Average Cost of Capital V: Volume COGS: Cost of Good Sold SG&A: Selling General & Administrative A firmʼs strategy must be measurable via its financial footprint. evidence of that belief should be reflected in its gross margins. 79 . particular advantages show up in identifiable ways in the firmʼs financials. we have to look at the firmʼs financial performance. shown in Figure 18.(WACC x Capital) = V x (P-C) WHERE C INCLUDES THE COST OF CAPITAL = (Sales . Economic Profit = NOPAT . Any identified competitive advantage must be reflected in financial metrics. and sustain value. capture. Different types of advantages have “financial footprints.
Superior Economic Profit Higher Gross Margin Lower SG&A to Sales Ratio Lower Capital to Sales Ratio Superior Economic Profit Cost of Goods Sold (COGS) Advantage Price Premium Due to WTP Advantage Efficencies in Marketing or Administration Higher Volumes Superior Management of Working Capital Efficiencient Use of Fixed Assets WTP Advantage Lower Prices Due to Cost Advantage Ability to Dominate a Niche Competitors Cannot Serve 80 .
1% Dec-04 Dec-07 n/a Dec-07 6.7% 22.5% Dec-06 n/a Dec-07 n/a 11.9% Dec-06 9.4% 27.5% Dec-04 -10.28 Dec-06 1.06 Dec-07 0. As in the economic profit derived analysis above.5% 20.77 0.2% Dec-06 Dec-07 46.6% SG&A/Revenue Dec-03 Adjusted EBITA Margin (without operating lease adjustment) Dec-04 Dec-05 53.8% Average Net Other Assets/Revenue Dec-03 -15.1% 15.7% 11.2% Dec-03 n/a Deprecation/Revenue Dec-03 Dec-04 8.3% 20.88 Dec-04 Dec-04 Dec-05 Dec-06 Dec-07 Dec-03 n/a Dec-05 1.8% Capitalized Op.8% Dec-04 Dec-05 Average Net PP&E/Revenue Dec-03 133.3% Higher Gross Margin (without operating lease adjustment) Dec-03 Dec-03 0.92 Dec-04 n/a Dec-05 n/a Average Working Capital/Revenue Dec-03 11.1% n/a n/a Dec-04 Dec-05 16.6% Dec-07 8.4% 57.2% Dec-05 7.2% -57.0% Dec-04 Dec-05 23.5% Dec-06 7.0% Dec-06 21.2% 11. Lease/Revenue Capital Turnover (Revenue/Average Invested Capital) Dec-06 93.1% 13.0% Dec-05 10.1% 12. Dec-04 Dec-05 Dec-06 Dec-07 Dec-06 -8. shown below in Figure 20.3% 59.5% Dec-07 -9.2% 19.9% Dec-05 75.3% Dec-05 16.9% 81 .1% Dec-07 109.7% Dec-05 -5.2% -30.6% 19.6% Dec-07 Dec-03 15.0% Dec-04 9.1% 22. the ROIC tree allows for a firmʼs strategy to be disaggregated into representative metrics.4% Dec-07 19.8% Operating Tax Rate (without operating lease adjustment) Dec-03 24.7% A complementary approach to understanding the financial footprint is the Return on Invested Capital Tree.7% Dec-06 Dec-07 R&D Expense/Revenue Dec-06 n/a Dec-03 20.0% Dec-06 17.5% Pretax Return on Invested Capital (without operating lease adjustment) 8.8% 17.6% Dec-04 114. COGS/Revenue (without operating lease adjustment) Dec-03 49.
For example. Finally. This analysis allows for comparability to other firms and therefore a way for management to benchmark their strategy relative to another firm. but also customer satisfaction. productivity developments. there needs to be a translation of what drives value into metrics. and in particular employee actions. The key is taking these metrics and shaping behavior and resource utilization in a way to have value creation become a part of the very DNA of the firm. or progress by competitors in entering your markets. then in addition to simple measures such as revenue growth or cost savings. If this system were to be utilized by UPS or FedEx. At a regional or country level the focus is not just on cost control. Performance Management It clearly follows if we can disaggregate financial performance and strategy into quantifiable and clear measures then we should be able to orient the entire company towards creating value. cost per deliveries. planning and implementation.Given the objective is to generate economic profits. milestones may be developed to recognize the progress on the closing of a transaction. value capture. Firm Boundaries The term “firm boundaries” refers to the choices of activities and distinct businesses undertaken by an enterprise. the reality is these programs have not always worked in practice. While this makes sense. and preemption are in line with market dynamics. The classic problem faced by economic profit-based performance measurement is that a company must ensure the long-term health of the firm. the day-to-day measurement of strategy can in fact distract from long-term performance. The challenge for a company is to strike a balance between long-term and short-term objectives. Firms must continually judge if their plans for value creation. average time required per delivery. Evaluating the boundaries of the firm is a critical part of the continual process 82 . and. if M&A is a part of the firmʼs strategy to expand the firmʼs boundaries. For example. an approach would be to focus the performance measurement depending on the role and level within an organization. at the corporate level the board would be focused on not just the underlying drivers of economic profit created on a business unit level but also possible milestones such as progress in entering new markets. Over the years firms such as GE have developed systems around economic profit that aim to resource allocation. These may be coupled with milestones that may provide targets that are tied to less quantifiable strategic actions. Peculiarly. and capital budgeting decisions. Strategy has no finish line. the delivery level would be focused on number of deliveries. As shown in the ROIC tree. in such a way as to create value. Because the firm is focused on generating economic profits today any system must have enough flexibility to encompass long-term performance. the ROIC tree is focused on the activities underlying the firms performance.
The distinction between horizontal growth and concentric diversification is not definitive (meaning the difference can be a very thin line). shown in Table 7 and Table 8. • Horizontal: Decisions about horizontal boundaries mainly pertain to increasing scale in a given business. but not to adding products. it was a vertical move (forward integration). Pepsiʼs beverage business and its snack food business share some common inputs (print and media advertising) and many of the same distribution channels.. Leveraging Power: Using size as a source of power over suppliers and buyers • Cross Selling (Cost)—sell multiple products through common promotions. A firmʼs boundaries will affect the extent to which the firm creates value. Firm boundaries can typically be extended in the following directions: • Vertical: Decisions about vertical boundaries concern which steps in the vertical chain to conduct in-house and which to outsource. and/or the volume of consumers. paper mill located adjacent to a pulp mill) • Winery experimenting with grape growing to better match criteria for the wine being produced and demanded 2. and detailed below: 1. there was a vertical dimension—the fountain business was forward integration.of setting the firmʼs strategy. merchandise offers in credit card statements. Strategic decisions that set a firmʼs boundaries focus on the gap between the value of the whole firm and the value of its parts. When Pepsi bought restaurants. Coordination: Reducing transaction costs • Vertically related production facilities working together to coordinate product flows (e. as well as the extent to which the firm can sustainably capture value. • Conglomerate Diversification: A diversified firm is one that operates in one or more different markets. and outsource activities without synergies. The firm increases the quantity of its output. coupons for chips with soda). and/or sales force (sell a service contract with appliance sale. • Increasing concentration may reduce rivalry. • Geographic Expansion: Here the firm enters a new geography and leverages its operating expertise and/or its product mix. This may refer to adding varieties. many would consider Pepsi and Frito-Lay to be an example of concentric diversification. Firms should integrate activities with synergies. • Concentric Diversification: A diversified firm is one that operates in one or more different markets. Operating in highly related or concentric markets means the outputs are related on either or both the production and consumption side. Campbellʼs entered the business of being its own supplier.g. three groups of synergies may exist. When Pepsi bought bottlers. Operating in markets that are neither related in production nor consumption is called conglomeration. With each boundary decision. Hence. channels. Campbellʼs backward integrated into can making—that is. generating more market power and 83 .
. Expanding boundaries is often self-serving to managers by way of: • Raising their profile and compensation • Diversifying their job risk Table 7: Synergies Horizontal Coordination • Expanding into new geographies Vertical • Reduce negotiations • Timing and size of production batches • Input attributes • Over input suppliers Diversification • • • • R&D Innovation Marketing Promotions Leveraging Power • Over input suppliers • Over customers • Over input suppliers • Over customers • Strategic presence in multiple markets • Corporate overhead • Knowledge across business units Sharing Assets • Corporate overhead • Equipment • Corporate overhead • Capital budgeting 84 . 3. Sharing Assets: Reducing costs through economies of scale or scope • Plants that are capable of producing end products for multiple businesses (i.e.e. Some potential customers may eschew doing the business with the firm to avoid being a source of profits for a competitor. Note: if also sell to independent channels—potential channel conflict and negative synergy. auto assembly plants producing cars and small SUVs on the same line) • A manufacturer produces components that are used in a variety of different products (i.• higher prices. jet engines. appliances. gas turbines) It is important to note that some analysts believe that managers may have motivation to expand the firm boundaries aside from creating shareholder wealth through the exploitation of synergies. But the firm needs to consider: o Can my firm grow large enough relative to the market to have an effect? o Will too many of the benefits spillover to my competition? Manufacturer-owned distribution—use manufacturer owned distribution channels to influence market prices and as a source of information on competitors and end customers.. diesel engines used in generators and earth moving equipment) • A firm undertakes an R&D project on an enabling technology that benefits multiple businesses (GE: breakthroughs in material sciences benefit medical devices.
In short. synergies do not materialize in the expected magnitude. and infrastructure becomes strained Vertical • Loss of market pressures reduces discipline for in house production • In house activities may compete with partners. or through merger and acquisition activity in the market. Table 8: Challenges Horizontal Coordination • Low total product demand • Culture clash • Buyers and suppliers resist pressures. 19 That said. the “grow or go” philosophy is hardwired into the fabric of modern corporations. The Impetus to Grow Mckinsey studied the 100 largest companies in the U. Mehrdad Baghai 20 “How the Mighty Fall.” Patrick Viguerie. the “undisciplined pursuit of more” is supposed to be characteristic of companies in decline.” Jim Collins 85 .20 II. draining goodwill • Costs rise as firm loses ability to specialize Diversification • Transfer pricing culture emerges • Businesses are less related than hoped • Over input suppliers • Over customers • Strategic presence in multiple markets • Corporate overhead • Knowledge across business units Leveraging Power Sharing Assets Growth Through Acquisition18 I. companies with above-average revenue in the first cycle were more likely to exhibit above-average TRS in the next cycle. Types of Growth There are two types of growth: organic growth and inorganic growth. Organic growth can be broken down into two components: growth of the specific segments that the 18 Stern MBA Class of 2009 Vikram Bhaskaran prepared this M&A section of Strategy Essentials under the supervision of Professor Sonia Marciano 19 “The Granularity of Growth. overlooked challenges arise to the detriment of optimistic managers. Sven Smit.S between 1994 – 2004 (two economic cycles) across two dimensions: Total returns to shareholders (TRS) and growth. Often.Firms often try to manage risk by managing their boundaries. They found that growth matters both to company survival and to long-term survival. These firms may manage boundaries organically. Companies that exhibited growth rates lower than the GDP in the first economic cycle were five times more likely to disappear altogether than companies that grew rapidly in the first cycle. learn to respond • Firms overestimate fit. And too often.
Breakdown of CAGR 1999-2006 3. 86 . Growth through M&A Mergers and acquisitions are arguably the most popular and influential form of discretionary business investment and.35% Share Gain Source: Mckinsey granular growth database III.company operates in (portfolio momentum) and the companyʼs relative market share performance (the difference between company growth rates and relevant segment growth rates). as we have seen earlier.69% PorIolio Momentum M&A 65. Inorganic growth is typically synonymous with M&A. M&A activity takes place in waves and has historically been correlated with market growth or decline. 2007 was a record year for M&A both in terms of deal value and total number of global deals. The following diagram summarizes M&A deal flow across the last 10 years. most of this growth can be explained by portfolio momentum and M&A.1 percent per year over the period. Mckinsey studied 416 companies between 1999 and 2006 and found that the average large company in their dataset grew at 10. are integral to growth. As seen below.96% 30.
operational and financial synergies. Vertical mergers occur in different stages of production operations (e.4 98 99 00 01 02 03 04 05 06 07 08 Source: Dealogic IV. it is the increase in competitiveness and resulting cash flows beyond what the two companies are expected to accomplish independently. where the value of the combined firms is greater than the sum of the value of both firms individually.7 1. vertical or conglomerate. Broadly speaking.3 1. Expected growth and future profitability are already embedded in the share price of both businesses – adding synergy means creating value that not only does not yet exist but is not yet expected.3 1. Rationale behind M&A From an economic standpoint. Horizontal mergers involve firms operating in similar businesses (e. 21 “Mergers and Acquisitions.8 3. mergers can be horizontal.g.2 2.4 3. When acquirers pay a premium for a business they have to both meet the performance targets that the markets already expects and the even higher targets implied by the acquisition premiums. Chevron.3 2.” Sirower 87 . 1998-2008 4.Global M&A deal volume (in $trillions).g. AOL. the term is used to refer to strategic. 21 While the type of merger definitely dictates the specific rationale for M&A. 22 Below is an exhaustive list of articulated reasons for why companies partake in M&A activity through the lens of strategic. Samuel C. More simply. Time Warner) and conglomerate mergers where firms are in different business activities (Tycoʼs acquisitions).8 3. Texaco). Fred Weston. the most commonly used term that encapsulates the rationale for M&A is Synergy. operational and financial benefits that arise when a firm partakes in M&A.” J.9 2 3. Weaver 22 “The Synergy Trap.
many M&A deals allow the acquirer to eliminate future competition (increasing barriers to entry for an incumbent player) and gain a larger market share by acquiring a smaller competitor. 25 • • 23 “Intelligent M&A.as was the case with pharmaceutical companies. • • • • Operational Synergies • Economies of scale: Economies of scale refer to the reduction in unit cost achieved by producing a large volume of a product. A company that merges to diversify may acquire another company in a seemingly unrelated industry in order to reduce the impact of a particular industry's performance on its profitability. it might be able to reduce its reliance on customers or suppliers thereby increasing market power. Industry consolidation can also force companies to merge and take advantage of economies of scale/scope in order to survive and compete profitably -. allowing the acquiring firm to “leapfrog” the process of internal capability building. corporate executives oftentimes state diversification of unsystematic risk as a strategic imperative that drives M&A activity. Elimination of competition: Tempered by the regulatory constraints of monopoly rules. Beamish 88 . Diversification: Conventional wisdom states that it is better for shareholders to diversify risk. Access to customers: A firm might acquire another firm based on the attractiveness and revenue generating potential of the target firmʼs customer base.Strategic Synergies • Access to capabilities/know-how: Companies that want to compete more effectively in an existing market might lack certain capabilities to do so and might acquire another firm with the requisite set of capabilities. “ Scott Moeller. However. In the context of M&A the larger combined firm has the ability to reduce operating costs by gaining scale in areas such as production. Boeh.24 Economics of vertical integration: When a firm purchases up or down the value chain. This is an especially common stated rationale in R&D intensive and technology-centric businesses. Christopher Bra 24 ibid 25 “Mergers and acquisitions. Paul W. 23 Economies of scope: Economies of scope typically refer to demand-side efficiencies where combined firms are able to better utilize distribution channels and marketing efforts. Access to new markets: A firm might want to enter a new product /geographic market by acquiring another firm operating in that market.” Kevin K. A firm might do this to cross-sell new products to this customer base or improve on the existing customer value proposition.
Financial Synergies • Optimizing capital structure. The cost of capital may be lowered and debt capacity may be increased if a combined firm is able to avail of lower borrowing rates. Other financial synergies might include better cash management, lease terms, management of working capital etc. 26 Tax Advantages: Past losses of an acquired subsidiary can be used to minimize present profits of the parent company and thus lower tax bills. Thus, firms have a reason to buy firms that have accumulated tax losses. However, the Federal government has instituted numerous restrictions regarding tax-loss mergers and their popularity is on the decline.27
Research on M&A also focuses on the psychology of mergers where the unit of analysis is not the firm but the individual managers that drive M&A activity. Research suggests that manager hubris, empire building, status, power and remuneration are some of the underlying reasons for M&. 28 Because it is impossible to diversify human capital risk at the manager level, this school of thought also suggests that managers diversify their own risk by growing their organizations through M&A. V. M&A and Value Creation/Destruction: Evidence of Post Merger Profitability • In their research, Professors Healy, Palepu, and Ruback (1992) find that, on average, operating cash flows of merged companies drop from their pre-merger level. They also find that merged companies experience improvements in asset productivity, leading to higher cash flows relative to their peers. Hence, non-merging firms experience stronger declines in operating cash flows.
It is fair to say that the history of mergers over the past century suggests that: • Expected (or announced) synergies tend to be less than “real” potential synergies • Realized synergies tend to be less than “real” potential synergies • Mergers may not be the optimal way to achieve advanced in shareholder wealth Depending on the source, acquiring firms fail to capture value 50 % – 75% of the time while target companies get about 15%-25% of the premium on the pre-existing value of the firm. Failure is typically gleaned by comparing stock prices before and after acquisition announcements and by compiling anecdotal evidence from business executives during the process. While there is no real consensus between practitioners, consultants, academics and business executives about the exact percentage of failures,
“Valuation for M&A,” Frank C. Evans, David M. Bishop ibid 28 “M & A,” Jeffrey C. Hooke
there is some consensus about the root causes behind M&A Failure. Two schools of failure analysis exist. There is empirical performance literature that focuses onexplaining the variance in acquiring firm performance based on the premium paid and the postmerger integration literature that (largely anecdotal) that explains potential problems with integration. • Premium School. Acquisition premiums can be as high as 100% of the market value. 29 In this school of thought it is believed that the premiums companies pay to acquire other companies are systematically overstated and therefore set up acquisitions to fail. The takeover premium here is defined as the amount the acquiring firm pays for an acquisition that is above the pre-acquisition price of the target. In this worldview, the larger the premium paid for an acquisition, the worse the subsequent returns for the acquiring firms.30 Post-Merger Integration School. Most surveys of corporate executives tend to highlight post-merger integration as the dominant source of deal error. A survey of M&A Executives conducted by the Corporate Strategy Board showed that 60% of surveyed corporate development executives rank integration as the single place of value leakage. The main argument made is that the strategic intent of the acquisition is lost in integration and that integration synergies are harder to realize than expected. Within this school of thought, analysts view clashing corporate cultures as one of the most significant obstacles to post-merger integration. In fact, a cottage industry has emerged to help companies navigate the rough terrain of cultural integration. A Watson Wyatt study found that cultural incompatibility is consistently rated as the greatest barrier to successful integration but research on cultural factors are least likely to be an aspect of due diligence. 31 However, according to Wharton M&A expert Sikora, Culture integration is certainly important," he says, "but it's always the excuse when something doesn't work out." 32
VI. Integration Approaches Seasoned acquirers develop “integration playbooks” which outline specific set of processes, people and resources required at every stage integration However, conceptually, it is useful to think of integration in terms of strategic interdependence and organizational autonomy.33 More simply, the sources of value capture combined with the degree of autonomy required to capture the value will determine the size and scope of the integration efforts.
“The Synergy Trap,” Sirower ibid 31 “Mergers and Acquisitions from A-Z,” Andrew Sherman 32 http://knowledge.wharton.upenn.edu/printer_friendly.cfm?articleid=1137 33 “ Managing Acquisitions: Creating Value Through Corporate Renewal ,” David B. Jemison, Philippe C. Haspeslagh
Strategic Interdependence The degree of strategic interdependence is driven by expected value creation across a range of areas: • Resource Sharing: Value created by combining the companies at the operating level Functional Skills Transfer: Value created by moving people or sharing information, know-how and knowledge.
General Management Skill Transfer: Value created through improved insight, coordination and control. Combination benefits: Value created by leveraging cash resources, excess capacity, borrowing capacity, added purchasing power or greater market power.
Organizational Autonomy The degree of autonomy that the acquirer gives the new target firm can be determined by asking three simple questions: Is autonomy integral to preserving the strategic capability bought? If so, how much autonomy should be allowed? In which areas is autonomy important? Depending on where companies fall on both axes, four types of integration approaches emerge: Need for strategic interdependence Low High Low Preservation Holding High Symbiosis Absorption
Need for autonomy
Symbiosis. Every companyʼs leadership style can seem unique. Holding. Here the intention is not to integrate and value is created by financial transfers. risk sharing or general management capability. Attitudes about 34 “Strategic capabilities and knowledge transfer within and between organization. Thus is common when the strategic rationale for acquisition is diversification. The target firm is run as a discrete entity. VII. This typically happens when a large firm acquires a smaller competitor to gain scale. This includes the work of such governing bodies as program management steering committees. communication styles vary widely among companies.34 2. Absorption. However. This approach is positively related to the acquirer buying tangible or intangible resources which are non-people dependent. Communication Communication. and what has worked for one may not work for another. Surprisingly. This approach is positively related to the acquirer buying intangible resources that are people dependent. This is the most common type of acquisition where management must ensure simultaneous boundary preservation and boundary permeability.” Arturo Capasso. 3. Preservation. Andrea Lanza 92 . Integrations issues are compounded by competing governance structures. Companies that ignore cultural issues as they relate to leadership styles sometimes destroying much of the mergerʼs potential value in the process. Giovanni Battista Dagnino. Integration Challenges The single most cited problem during integration is cultural incompatibility. The acquirer subsumes the acquirer into its existing structure. 4. councils that oversee the work of support functions. is critical during a merger given the inherent uncertainties on the part of employees and customers. cultural issues are rarely factored in when deciding to acquire another company. corporate governance boards and even new product development committees. Senior leaders have different motivational styles and the resulting friction often creates additional risks. Governance Effective corporate governance must encompass the way decisions are made in each part of the company and across organizational boundaries.1. whereas leaders at another organization may prefer a more hands-off approach. Cultural challenges manifest themselves in the following areas: Leadership One companyʼs executives may favor a command-and-control style.
invest to gain share—an effective acquisition strategy (defined as growth through M&A at a rate higher than that of 75 percent of a companyʼs 35 “Avoiding post-merger blues. companies that acquire in bad times as well as in good outperform boom-time buyers over the long run. merger integration plans should include efforts to harmonize performance metrics and compensation systems where possible. organizations risk internal breakdowns in the quality of products and services and may provide incorrect or untimely data to customers. Timing. According to Bain & Company analysis of more than 24. 36 Mckinsey says that of the potential strategic moves companies can take to grow in a downturn—divest. can lead to morale issues. preferences for formal versus informal channels and the frequency of communications may all come into play. customers and vendors understand and accept them. undesired turnover. Thompson Financial. Bain Analysis 93 .) This finding held true regardless of industry or the size of the deal. ("Excess returns" is defined as shareholder returns from four weeks before to four weeks after the deal. insufficient or inconsistent guidance on such key issues as organizational restructuring. if overlooked. while explaining important differences when necessary. 2008 36 Thomspson Datastream. suppliers and service providers. Changes in the way companies handle these tasks require strong leadership. With employees in particular. customer relations and changes in financial policies can create unnecessary business risk. If changes in core business processes and process interdependencies are not deliberately and systematically thought through during the integration planning phase. even if not always uniform across the organization. Newly merged companies must help employees understand that their different recognition and reward systems are fair. Thus. A couple of key factors that characterize successful acquirers include: 1. 35 VIII. compared with peers. Performance Management Systems Differences in the way the acquiring and target companies evaluate and reward employee performance are important and.” Bearingpoint. updating and enforcing core business processes which must be understood and respected during the integration phase.000 transactions between 1996 and 2006. acquisitions completed during and right after the recession from 2001 to 2002 generated almost triple the excess returns of acquisitions made during the preceding boom. inconsistent performance and a decline in overall employee productivity.confidentiality. there are companies where M&A expertise and excellence has become a competitive advantage in its own right. Moreover. Successful Acquirers While failure is hard to study objectively. acquire. supported by careful and frequent communications to verify that employees. Business Processes Different companies have significantly different ways of developing.
As discussed above. M&A strategy is proactive rather than reactive. we should ask questions such as: How important is this new market? What is the current cycle in this market and how do asset prices compare to historic values? If I donʼt enter organically 37 38 39 “M&A Strategies in a Down Market. business unit executives (who are charged with integration) are not involved in the due-diligence phase of the acquisition. It is also critical to understand the market dynamics.peers) created significant value for shareholders. M&A is pursued with the intent of expanding the firm boundaries. For example. Early Involvement of Business Units. Treatment of Acquisition as a Competency. to block a competitor.37 2. For these companies. Successful acquirers such as GE and Pepsi. approach M&A as if it is a process such as supply chain management and not as a one time event. on the other hand. acquisitions are not seen as a stand-alone strategy but instead a tool to fill strategic holes (such as diversifying an asset profile or expanding a geographic footprint) that can't be filled as efficiently on an organic basis. The costs to complete a transaction and the likelihood of any synergies are important.” BCG. Many rewarded acquirers therefore say that having business units lead the entire process for a bolt-on acquisition can dramatically improve estimates of synergies — and the likelihood of capturing them. it would seem.” 3.38 4. In the post war period the rise and fall of conglomerates and the recent period of private equity have witnessed a new flurry of dealmaking. Reactive Acquisitions. M&A teams that identify synergy opportunities without significant participation by the relevant business units can engender resentment and bring about charges that the team is setting unattainable targets. it is inevitable that we will be affected by M&A in the future. Oftentimes. M&A has actively been encouraged as a healthy manifestation of the free market economy. For a firm whose objective is to create economic profits first and foremost. The connection between successful acquirers and their adherence to an overarching strategy is also borne out by the fact that none of them acquired companies for defensive purposes — that is. During an upturn. If our careers have not been touched by M&A to date. M&A often arises because of a companyʼs belief that organic growth is either too expensive or not sufficiently fast enough. Proactive vs.” Mckinsey Quarterly 94 . For successful acquirers. 2008 “Growing through Acquisitions. They codify their learnings across each acquisition and have a systematic and well articulated “M&A Playbook.39 Mergers and Acquisitions—A sensible strategic choice or lazy management? Mergers and acquisitions (M&A) have long been a part of our corporate life. 204 “Habits of Busiest Acquirers.” Mckinsey Quarterly. divestments created slightly more value than acquisitions did.
95 . Joint-ventures and alliances have been created by companies as ways to create a position in a market. CSR is concerned with the negative spillovers. considerations of how to reduce externalities and manage the perception of the firmʼs activities are related to firm strategy. the underlying motivation is still monetary profits. While these impacts can be positive or negative. value can be created from options other than M&A. attending to a safe workplace. but will also generate unemployment. However. enterprise makes significant net positive contributions to society by way of the production of output valued by consumers that is in excess of the costs of inputs sacrificed in production. Overall. More broad connotations include philanthropic endeavors supported by the corporation and its employees. Perception could impact WTP (boycotts) as well as future operating costs (firm ultimately diminishes its operating context or regulators impose constraints). Although firms benefit society (without firms there would be no prosperity). Francine Blei (NYU Stern EMBA 2010) and Amad Shaikh (Wharton EMBA 2010) Why is CSR part of a strategy course? “Corporate responsibility” has many different interpretations. Loosely the term embraces ethical and fair business practices. as well as its public perception. and embracing diversity. gender blind. it is fair to ask “What is the obligation of business to the society in which it operates?” Ultimately. Some producers are “added value” producers—they produce output that is perceived to be superior to some or all consumers or they produce their output more efficiently than do other producers. but also can be valuable where a deal is either too expensive or where delaying in order to gain more information is valuable. Externalities and CSR This section was prepared with significant insight and assistance from Scott Osman (NYU Stern EMBA 2009).what will my competition do? Can I create value from this transaction? What is the maximum I can pay and what are the likely synergies? Alternative to Mergers and Acquisitions When organic growth is a challenge. a more polluting process might come at a lower cost. Generally. strategic corporate responsibility brings the term to a heightened level of “doing good and doing well”. shifting from a labor intensive to a capital intensive process could increase margins. every activity in the value chain will affect social factors in the locations where the company operates. Alternatively. The externalities of firms engaging in profit maximizing affects the firmʼs net contribution. These structures are usually legally complex. Frequently. Firms can also enhance profitability by engaging in behavior that amounts to expropriation – for example the “hidden fees” of cellular or banking services. Hence. firms can enhance profits by “shifting costs” to society—for example. not altruism.
” is that which both enhances society as well as firm profits. which is to say.” 96 . corporations find themselves dealing with an increasingly well informed public. “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game. Figure 21 CAUSE As firm grows and matures. engages in open and free competition without deception or fraud. Some of this CSR attempts to directly mitigate the harm done by the firm (“junk food” maker reduces its fat content). nonetheless. the firmʼs net benefit to society does not necessarily increase directly with profits. palpable externalities. I have called it [social responsibility] a “fundamentally subversive doctrine” in a free society. Few would disagree that firms should be constrained from engaging in value destruction. Economists would argue that some production decisions are not “first-best”—society loses more than the firm gains in profits as a result of some choices. Firms engage in CSR to address that social feedback. Public scrutiny often means that corporations that cause externalities face the risk of social feedback. maximizing profits entails cost cutting vigilance Social externalities confound firm’s brand or public perception Firm faces boycotts and government action Firm creates a CSR agenda to address feedback EFFECT Remedial CSR Milton Friedman is often credited for making the most incisive case that the obligation of firms is to focus exclusively on profits.Why should firms be concerned with CSR when their net contribution to society is positive? While society benefits from profitable enterprise. sometimes a lot). which hurts financial performance. in my book Capitalism and Freedom. or outright incompetent behavior. Particularly intriguing CSR. In the age of internet and instant communication. This is certainly plausible when the firm engages in fraudulent. referred to below as “strategic. or offset the harm by contributing something positive (“junk food” maker supports athletic programs). The more challenging discussion is about what to do in the case of activities that generate profits while also producing smaller but. In a 1970 essay in The New York Times Magazine Friedman wrote: That is why. deceptive. and have said that in such a society. These examples of “remedial” CSR tend to increase the firmʼs operating costs (sometimes a little.
To what performance metric would we hold management accountable if management is charged with serving the whole of society? That said. Does erring on the side of caution mean that management be vigilant in protecting the firmʼs reputation and exposure to future liability? Or. CSR responds to factors such as the internet (increased odds of detection) and taste shifts (more constituents express concern). Oil companies clean up their oil spills. the rules themselves have become increasingly blurred and complex. On the other hand. the very rules and regulations that govern their activities. Companies now perceive more of an obligation to not only “stay within the rules of the game. and chemical companies that harm the public health make contributions to medical research efforts (in addition to satisfying legal claims). The current mood is that the vague and ambiguous threats posed by the firmʼs own externalities on the firmʼs reputation and ultimate liability are not windmills. operations which subject the firm to peril in the long-run) has been a driver of CSR activism. Many cheap labor markets have arguably lax labor regulations and subject workers to standards the firmsʼ home markets would not tolerate.Would Friedman suggest that remedial CSR was “fundamentally subversive” or a means to defend profits by preserving/enhancing the firmʼs reputation? In the quote. Managers donʼt have a parallel universe against which they can measure shareholder wealth derived from various levels and approaches to CSR. and social activists for causing a number of negative externalities: 97 . The choice firms currently face (cheap labor to remain competitive vs. What about the case of a firm operating within the “rules of the game” but at the same time imposing externalities on society? It is fair to suggest that Friedman would be supportive of CSR as long as shareholders were among the beneficiaries in the long run. Firms themselves are often directly involved with setting. by extension. or lobbying for. does caution mean that management err on the side of spending shareholder wealth sparingly so it can fight vague and ambiguous threats that loom somewhere in the future? Is CSR akin to “tilting at windmills”? In general. the principle that shareholders be among the beneficiaries of CSR hardly diminishes the challenge of developing a CSR agenda.” but to take remedial action to balance harms they create. Firms find themselves being vigorously blamed by citizens. combined with profit enhancing choices (like outsourcing)—opening firms up to accusations of negative externalities. Friedman clearly disavows profitable but fraudulent. many corporations have been shifting production abroad to benefit from lower cost labor. In order to remain competitive. The position taken here is that CSR at the expense of shareholder wealth is a slippery slope. blatantly incompetent enterprise. governments. Staying within the rules when the rules are unpalatable and/or influenced by the firms themselves will hardly deflect accusations of corporate irresponsibility. He also disavows corporate philanthropy— management giving at its own discretion. as many interpret Friedman. firms are increasing their attention to CSR. deceptive and.
Appeasement measures may include publicity campaigns. Measuring returns on CSR would subject the firm to accusations that its motives were disingenuous. governments have employed a wide range of responses.• Structural unemployment caused by laid-off workers with industry-specific skills • Lowly paid workers who become reliant on socially financed assistance • Traffic congestion caused by heavy usage of public roads Organized groups can exert influence through exclusion. It is possible that the firmʼs costs and the negative externality decline together.automobiles). but this outcome is not the norm. thereby. In recent times. Appeasement is distinct from “pure philanthropy” as the basis is some return to shareholders. to industry-specific taxes.” which is discussed below) if it reduces profits but raises the firms profile as a “concerned producer” and. However. Furthermore. preserves the firmʼs reputation and. not much attention has been historically paid to whether or not this premise is correct. remedial. philanthropic contributions. and. such as selling environmentally friendly products in addition to traditional products (e. for example. help much either. what some call. Here firms address problems directly. Solidly remedial CSR is likely to raise 98 . the firm can point out and ponder the customerʼs own propensity to express concerns about social issues while making purchases that suggest otherwise. sponsorship of community events.g. privatization. from regulation and restriction. companies may not want to offset the potential efficacy of these activities by appearing self-serving. Unfortunately. companies have been held responsible for a widening range of issues. The benefit of moving towards the middle and higher end of the remedial CSR spectrum is that measurement is often not as confounded. in fact. appeasement doesnʼt hurt much but it doesnʼt. In sum. without direct ties to financial metrics. It is reasonable and straightforward for a firm to measure the profitability of a product offering. appeasement may often fall outside of the scope of pure profit-maximization. In the middle of the remedial CSR spectrum are programs that are. or encouraging employees to donate time or their own money. in extreme cases. such as boycotting products from the “offending” firm. On the substantive end of the spectrum are solidly remedial activities. by installing filters that reduce the polluting effects of smoke-stacks. in all likelihood. “token-bribe-charity” initiatives by firms often fail to deflect criticism. the dollars devoted to these activities tend not to be big enough to provoke much of Friedmanʼs (ghostʼs) ire. This CSR qualifies as “remedial” (rather than “strategic. in the course of participating in a market for “socially responsible” products.” Furthermore. Furthermore. its “license to operate. On the other hand.. But as constituents and feedback mechanisms have become more sophisticated. Remedial CSR agendas fall along a spectrum between topical appeasement and substantive redress. and activists have become more sophisticated in generating awareness and mobilizing action through the media.
both of which provide a student trainee program which potentially can feed the company with new employees already oriented to their work standard. managers answer the question. Patagonia. benefits. The return to shareholders comes in the form of reducing the firmʼs future liability and/or preserving or enhancing its reputation. Wal-Mart. The Body Shop. at the least. Work conditions – safety. While doing nothing is off the table. and report social performance. These organizations act as information verification bodies (like the auditing function of accounting firms) that allow private self-regulation.substandard 99 . Climate Change/Carbon Footprint. and/or Community-oriented efforts. Starbucks. “do we err on the side of preserving the firmʼs reputation or the firmʼs return on capital?” quite differently. ranging from: Supply Chain Code of Conduct.g. it was surprising that many of the above topics related to legally required policies. a tacit admission of guilt. Ben and Jerryʼs Whole Foods.” or “Itʼs right for our customers. nondiscriminatory practices. The “cognitive dissonance” of customers is a perpetual problem—consumers indicate concerns but are not willing to “vote with their dollars. others seem to introduce programs reactively. and some companies have a separate Division of Corporate Responsibility. remedial CSR issues are tabled because future liability is uncertain. A survey of many corporate websites reveals that numerous companies devote a section on “Corporate Responsibility”.” The firm devoting resources to remedial CSR needs to be cognizant of “crowding out” higher return projects and/or raising its costs of operating thereby weakening the firmʼs competitive position. But when the firm has matured. faces tremendous scrutiny for labor practices that are not uncommon in the retail industry. We observe a good deal of variance among managers in terms of their perception of what it means to have a “conservative” CSR policy. not only is growing more difficult. enabling the corporation to extract benefit from its outlays. as damage control against negative publicity (e. Once firms embrace CSR it is difficult to “put the genie back in the bottle. yet the content varied greatly. perquisite. They claim “Weʼre not the only ones.” These activities are. When the future segment leader is early in its life cycle. However. Sometimes companies deal with mediating organizations that monitor. Environment/Sustainability. Firms increasingly face global competitors. for example. experience suggests that remedial CSR matters disproportionately to the largest or most high profile firms in a given industry.” Challenges aside. Strategies to maintain a “Context Focused” CSR profile include Marriott Corporation and Cisco Systems. many of whom are not under pressure to be socially responsible. so should be “tilting at windmills. As information technology reduces the frictions of mobilizing social movements. While companies define themselves by “socially responsible” behavior as the backbone of their company – examples are Tomʼs Shoes. rank. outsourcing to countries having cheaper labor +/.” but liability is thrust on them nonetheless.the firmʼs costs. but externalities are more recognized. not altruistic or particularly strategic policies. firms are increasingly forced to move towards substantive redress. so the firm faces higher risks of social feedback. Several companies have a Corporate Responsibility Reporting section integrated into their annual reports.
Nonetheless. in an effort to garner good will and attract/maintain a consumer base. 100 . with increased access to internet and “real time” events. etc. for some companies.working conditions. negative exposure can quickly reverse a companyʼs successes. The Corporate Responsibility Officer Organization (CRO) publishes an annual “Best Corporate Citizens List”. and strategic corporate responsibility. etc. “Cause-related Marketing” is popular however it sustainability other than providing a veil of “social correctness” is unclear. however. Intrinsic to the company one expects diversity. consumers could be better served to donate directly to these causes and receive their own tax benefit from doing so.). thus not taking advantage of developing countriesʼ labor force and economies. In fact. And in fact. that there is a blurry line between ethical corporate governance. With globalization. It appears. corporate social responsibility. many firms pride themselves in maintaining a proper social image. oil spills. safety. the expectation is that these business practices will be universal. which. This “Crisis Prevention” is a more a form of damage control. pollution. provides a “seal of approval.
g. Diamonds) MARGINS 101 .g. printing ink) • Procurement Practices • Supply Chain Issues AFTER-SALES SERVICES INPUT PROCUREMENT (Child Labor. Job Training • Working Conditions • Hiring Diversity • Healthcare • Disposal of Obsolete Products • Handling of Consumables (motor oil.Figure 22: Links with Social Factors FUNCTIONAL ACTIVITIES • Transporation Impacts (congestion) CORPORATE OVERHEAD ACTIVITIES INBOUND LOGISTICS • Financial Reporting Practices • Government Lobbying Practices • Product Safety • Product Recycling • Product Disposal • University Relationships • Ethical Research Practices (animal testing. to children) • Marketing practices (e. Conflict. genetic modification) FIRM INFRASTRUCTURE OPERATIONS • Process Pollution • Process Recycling • Energy Use • Hazardous Materals HUMAN RESOURCES OUTBOUND LOGISTICS • Packaging Disposal • Energy Use • Marketing practices (e. to poor) • Privacy MARKETING & SALES TECHNOLOGY DEVELOPMENT • Education.
What is different here? The key difference is the overtly “socially positive” aspect of the investment. and the community. . companies increasingly measure financial returns of CSR activities. stated “the enlightened corporation should try to create value for all of its constituencies. customer happiness is an end in itself. Regardless. We began this section asserting that the net contribution of enterprise to society is positive. . and each perspective is valid and legitimate. and Seventh Generation. “the most successful businesses put the customer first. the purpose of the business is to maximize profits. customer happiness is merely a means to an end: maximizing profits. In the profit-centered business. employees. and governments. John Mackey (CEO of Whole Foods). passion. suppliers. In the customer-centered business. Patagonia. consumers. in “Putting Customers Ahead of Investors”. . efforts can reap financial dividends through the effect of this CSR on employees. Motivations for strategic CSR investments will range considerably. and then ask themselves how to garner value from those investments. Some household name companies. while not “crowding out” or coming at the expense of businesses devoted to maximizing shareholder wealth.” 102 .” Highly visible examples include Ben and Jerryʼs.Strategic CSR While remedial CSR is concerned with defending shareholder value. investors. Some companies will start from the premise that they are socially-bound to make CSR investments. From an investor's perspective. ahead of the investors. have also made firm-wide decisions that social enterprise is worthwhile for them. a point-counterpoint to Friedman. In terms of the case for strategic CSR. strategic CSR wonders about the possibility of the firm engaging in investments that have clear social benefits while also producing positives returns to capital. Others simply have a broad view of profitmaximization. and examine CSR activities just like any other—measuring the bottom line. Each of those groups will define the purpose of the business in terms of its own needs and desires. Without a doubt. firms and customers in western economies are expressing interest in businesses whose outputs produce clear social benefits. and will be pursued with greater interest. Strategic CSR is the essence of the often-used phrase “doing well by doing good. and empathy than the profit-centered business is capable of. such as SC Johnson and DuPont. But that's not the purpose for other stakeholders--for customers.
Maak) discuss “Corporate Integrity vs. and that “consistent and systematic criteria for evaluating corporate performance must be applied. content. it is possible to creatively incorporate which do not undermine the companyʼs value. nearly 2/3 of G250 companies engage with their stakeholders in a structured way. some companies (e. 103 . concludes that the definition of CSR is not uniform. emphasizing safe working conditions. He states that CSR may be initiated to attract customers (e.g. In a study from a major business school. to attract investors. safe.Several corporations have soundly demonstrated that in addition to “bottom line” targets. context. Over 60% of new employees consider this in the choosing the company they would work for [citation??]. consistency. Furthermore. Whole Foods) have shown that corporate philanthropy can be good for business – an example is setting aside five days throughout the year where the store donates 5% of total sales to philanthropy – up front publicity of these events “usually brings hundreds of new or lapsed customers into our stores. and >50% of the worldʼs largest 250 companies publicly disclose new business growth opportunities and/or the financial value of corporate responsibility. 2008 2(2):261‐275. to encourage employee loyalty and goodwill. up from 33 percent in 2005. suggest an underlying framework of ʻʻ7 Csʼʼ of integrity: commitment.g. In fact. conduct.g. (2) increasing retention and thereby reducing overall training costs. Whitehead. over 85% of employees expect their company to make a positive contribution [citation??]. coherence. PR. However. graduating MBA students were willing to 40 Portnoy. generating returns by (1) serving as non-financial forms of compensation. Corporate Responsibility”. environmentally sound. According to studies. “75% of the largest 250 companies worldwide have a corporate responsibility strategy that includes defined objectives. and to promote Community goodwill. Review of Environmental Economics and Policy. and/or “politically correct” product sourcing). Companies that make CSR investments can increase the morale in their workforce. There is evidence that employees are aware/interested in the contributions to society made by the company they work for. The (Not So) New Corporate Social Responsibility: An Empirical Perspective. and continuity as the underpinnings of true CSR. a requirement that is undermined by the adoption of differing definitions of CSR and the use of alternative terms such as CR. Employees Employees are aware of a corporationʼs social impact.” Other authors (e. many of whom then become regular shoppers” According to the KPMG International Survey of Corporate Responsibility Reporting 2008. and (3) increasing labor productivity. in a survey of CSR practices.” Portnoy40 and others review motivations behind firms that “rebrand to get even more mileage from their beyond compliance endeavors” CSR. consumer choices are influenced by the philosophies endorsed by the corporation. recent data suggests that at least for certain segments of the population.
would be examples of the latter. where companies explore ways to serve the underserved market of the worldʼs exceptionally poor. Corporate Social Responsibility: CSR Doesn't Pay. One dramatic example of this is what is called Bottom of the Pyramid (BoP). David Vogel Forbes. The quality of a companyʼs CSR activity is perceived by employees as contributing to a positive work experience. 10/06/08.com. spanning from the promise to make a contribution to a charity based on a purchase. Why corporate responsibility is a survivor. which then results in a significant bottom-line impact. or a statement that a contribution of some amount will be made to a charity by a retailer for an in store purchase are examples of the former. the result is increased productivity and loyalty from the employees. April 20 2009. companies are either saving money or the changes are “cost-neutral”. others report that through certain CRSR (e. "Ethical" products are a niche market: Virtually all goods and services continue to be purchased on the basis of price. increase willingness-to-pay. it is generally understood by companies that these are incentives to increase consumer willingness to choose the product.42 The concept of a “contribution” on the part of a company in the mind of the consumer is very broadly defined here. M. Companies can increase returns by (1) generating brand loyalty.ft. the consumer is willing to pay considerably more for the product to encourage and reward the good intentions of the company. and enabling premium pricing. D. While there is insufficient hard data to support the financial returns of CSR.com. The most exciting. 104 . and (2) accessing new previously underserved markets. and dramatic impact of CSR efforts may come from new business opportunities. There is a growing catalog of examples where sustainability efforts end up saving the company money. In the best of these circumstances.”41 On the other hand. and is a consideration in retention. Consumers Consumers may also be aware of a corporationʼs social impact.g. A box of cereal emblazoned with a pink ribbon. certain consumer segments (most prominently college age) do exert willingness to pay for products from companies sharing their political or social viewpoints. which results in lower costs and higher profits for the company.accept a 10% lower salary if the company was noted for its good work [citation??]. or to make a purchase. In the case of the contribution. to products created with a “good” pedigree. www. “green”) initiatives. fair trade harvested coffee beans or dishtowels made from fair trade cotton. can be a factor in better relationships between employees. In the case of fair trade coffee. convenience and quality. hardest to predict. The BoP program by Unilever reached 110 million rural 41 42 Vogel. One sees publications purporting “CSR Doesnʼt Pay” . Skapinker .“Part of the reason why CSR does not necessarily pay is that only a handful or consumers know or care about the environmental or social records of more than a handful of firms.
but also can be aligned with managementʼs fiduciary obligation of driving shareholder returns. they regularly make public appeals to enhance their good name. Numerous “sustainability” indices exist within stock markets around the world. about one out of every nine dollars under professional management in the United States can be attributed to socially responsible investing—that represents 11 percent of the $25. Given that these firms face unique industry-specific government oversight. This suggests that socially responsible investing can have an impact. Investors Investors too are aware of a corporationʼs social impact. Increasingly and with the help of such indices. In recent years. lowering the firmʼs cost-of-capital. on a firmʼs cost-of-capital. albeit small. firms can (jointly if necessary) make CSR investments to reduce “public enemy” status. The company is not only profiting from this activity. Governments Finally. soap consumption increased by 15%. Awareness of germs increased by 30% and soap use increased among 79% of parents and among 93% of children in the areas targeted. Closing Thoughts It is feasible for many firms to discover that social responsibility is not just a cost center.1 trillion in total assets under management tracked in Nelson Informationʼs Directory of Investment Managers. As of 2007. the Rockefeller Foundation provides consulting practices to other organizations who want to deploy their investing resources in ways that further organizational goals.Indians since it began in 2002. Unilever discovered that it could create a dramatic health impact on the lives of millions of people by teaching them about cleanliness and making soap products available at affordable costs. While this often manifests itself at the industry level. governments are responsive to the wider publicʼs view of various companiesʼ social impacts. Many of these challenges were discussed above: • What should guide managementʼs philosophy of what “conservative” CSR means? • What are the looming threats of under-investing in CSR? • What principles enable management to navigate trade-offs among constituents? 105 . foundations representing enormous amounts of invested capital are committing themselves to mission-related investing. it is building brand in a new market because improved sanitary conditions provide a key link in lifting people out of poverty. There are substantial challenges to developing an effective and appropriate CSR agenda. Companies that make CSR investments can increase firm value by increasing the investor base. thereby increasing access to the political process and reducing the likelihood of reactive regulation or taxes. As a result. In fact. oil companies and defense contractors have gone to great lengths to win public trust.
They also believe that the resulting product will be more durable (as well as have other positive product attributes. 106 . government. 3. Firms will have to face the significant challenge of developing new value chains to make the production and distribution of CSR more cost effective as well as transparent to consumers. distribute. They believe the resulting textile would be in the cost zone of their current costs. Firm also is strategic in choosing local organizations to sponsor and support to maximize the purchase of “goodwill”. and social activists. CSR is a different attribute than most firms are experienced in selling. Unquestionably. Potential Examples of CSR I am interested in your thoughts about the NPV of the following CSR initiatives. Additionally. consumers say they want corporations to behave responsibility. but have not shown consistent willingness to “vote with their dollars. Firm seeks to drive WTP and C directly while addressing a social concern: A clothing company wants to invest in a process to convert recycled materials into textiles. with a few limitations – but a net better textile).” This consumer behavior might be indicative of the failure of firms to effectively produce. 2. Firm perceives an “empathy” correlation between its target and a particular cause (“cause marketing” such as Avon and breast cancer): Firmʼs CSR takes the form of “matching” – customer makes a sale and firm contributes some share of proceeds to the cause. Which would you advocate and why? 1.• What metrics of CSR efficacy are accurate? These are some of the challenges faced by proponents of CSR. Your firm operates its largest plant in town X: CSR in your organization is focused on impact of the plant on the constituents of X. Firm works to minimize environmental impact. and market the “CSR attributes” of their output.
that fact didn’t make it into the reporter’s story. the CEO meets the Police Chief and engages in integrative bargaining to arrive at win-win solutions* that will help alleviate the drain on police as well as help SAFE. The CEO also freezes all police hiring. who will have a natural affinity to SAFE for future work opportunities. an externality that threatens the company’s future growth and reputation. that the local paper runs a story with the Police Chief bemoaning how he is losing good officers to SAFE and he is unable to keep up with the attrition. When the news hit. They both agree that SAFE should fund a new department at the local technical college that will have SAFE-scholarships to encourage police recruitment and training. SAFE sees the ROI as follows: 1. preempting any “bad blood” as officers leave SAFE. Remedial CSR: Under this remedy-driven mode. which is largely dependent on hiring security professionals from within the police force. In the process. SAFE establishes good-will with new recruits. No “juicy” quotes from the Chief for a news reporter against SAFE! 2. SAFE’s growth has led to an unintended consequence. SAFE’s own employees get retrained. Eventually enough police officers leave. SAFE decides to seek CSR strategies that provide a return on its social investments. What if SAFE had done it differently? Here comes “Strategic CSR”… (One year before story would have otherwise hit): Under this proactive mode. this freeze could become permanently disabling to SAFE. 107 . essentially putting at stake the company’s growth and reputation. 3. it will have its own security staff (ex police officers themselves) do some of the training.Application to the SAFE case: As SAFE gets larger and larger. Before the situation worsens. saving resources and costs for continuous training. In other words. SAFE’s CEO rushes to make amends by announcing that it is going to be making a significant contribution towards the construction of the new police station. Furthermore. *By “win-win” we mean that the firm does not sacrifice profits to make society better off. and offers more lucrative salaries. SAFE gets a commitment from the Chief that as part of the curriculum. SAFE is caught completely off-guard by the news. even as they may have more choices if and when new entrants enter the SAFE-type business model. police-officers start leaving the line of duty for a “less-dangerous” and more lucrative job at SAFE. New ties are created with the Police Chief. depending on how long the public’s ire lasts. The firm can sell the socially beneficial product for a profit. While SAFE is a solid contributor to the local United Way. The reporter then makes the sensationalist leap that the city is becoming less safe because of this large corporation. quipping that it is ironically called SAFE. SAFE’s CEO recognizes that SAFE’s growth is causing a drain on the police force.
the type of labor you will hire. because not doing so can lead to a situation where neither tactics nor strategy is effective. Tactics without strategy is the noise before defeat. which is the return based on the risk of pizza shop in that strip. and sustains value (earns profits long enough to monetize ALL costs). on the other hand. It is important that the strategist demarcate strategy from tactics. using imported and highest-quality ingredients with the goal of maximizing profit with premium pricing. In other words. Economic Profits Before you decide to open that pizza parlor and sink the required capital. What will be the enterpriseʼs “it”? Strategy is means the enterprise creates value (drives a wedge between costs and customer valuation of the output). captures value (drives a wedge between revenues and costs). etc. Tactics. then you can be quite sure that you will earn what economists call the “competitive return”—a return equal to the opportunity costs of the capital. will be the means and ways that you will achieve your strategy: the machines that you will use. you put your shop in a strip mall with three other pizza shops and you all sell exactly the same type of pizza.Encapsulation of Core Concepts This section was prepared with significant input and assistance from Amad Shaikh (Wharton EMBA Student Graduating in 2010) Strategy To think strategically is to think about long-term goals and objectives: what do you want to be when you grow up. Strategy will revolve around how you can make more money on your pizza than your competitors (better quality pizza or lower cost of production compared to the competitors). and sustaining it. less opportunity cost) will be zero.” [Sun Tzu] Letʼs suppose that you are interested in starting a pizza parlor. cash profit. your economic profit (accounting profit i. Youʼll have to decide what kind of pizza parlor you want to have: the parlor that sells (a) the cheapest pizza in town through innovative means of cheap production and maximizing profitability on volume OR (b) deluxe “custom” pizza. If you entered a market that is perfectly competitive. your choice of suppliers.e. Strategy is not the same as Tactics “Strategy without tactics is the slowest route to victory. for example. you would contrast the returns you expect from the pizza parlor to other potential uses of that capital available to you. This is strategy. 108 .
” Youʼll set your pizza price (call it “P”) somewhere in this wedge. Although the firm will likely lose some customers. The consumer is willing to pay a certain amount for your pizza (call it “WTP” or willingness to pay). in this case. then by lowering price below competitors. WTP−P is the consumerʼs piece of the pie. all of which will vary with your choice of production methods (capital and labor inputs). WTP−P is the consumerʼs surplus (because he is willing to pay more than the price). Multiply P−C by volume and you get profit. etc. you could gain share at the expense of your competitors. C includes the appropriate risk adjusted return for the capital you tied up in the business. Thus. you are creating value that is equal to WTP−C. WTP−P shrinks). and P−C is your producerʼs surplus or your margin. C includes the opportunity cost of the capital—that is. If the pizza is distinctly good. A price 109 . P−C is the firmʼs piece—this is a measure of how much of the value created the firm is capturing. number of toppings. Earning more on each customer retained will more than offset the revenues lost by losing some customers.? Then there is YOUR cost (call it “C”) in making those pizzas. In contrast. Firms that make output that some consumers determine is better can capture more of the value they create by raising price. Since your WTP has to be greater than C for you to be in a viable business. price is critical to the decision to purchase process). the more of the value created the firm could capture. Value Addition Letʼs think of WTP−C as a pie. etc. thereby discouraging most of the firmʼs customers from using price as the primary driver of their decision to purchase). The goal of strategy is to convert a portion of this wedge into your profits. raw-materials. and sustain it over some period of time. costs ranging from fixed costs to operating costs.Value Letʼs assume that you went ahead and jumped into the pizza business.. Superior firms capture more of the value created (buyer surplus shrinks when firmʼs raise price—WTP is the same. are you using high quality ingredients. and you can gain many more customers by dropping price a little bit (high price elasticity/high price sensitivity—since pizzas are about the same. which we refer as to the “wedge. Where you set P depends on many market factors. The more distinctly good the pizza is. the firm may be able to raise price and increase value capture. etc. Value Capture vs. depending on some generic factors such as size. Economists would say that firms can capture more when the firm faces a low price elasticity (low price sensitivity—which is. if your pizza is about as good as the othersʼ. Here lowering price below competitors is the approach to value. but the consumerʼs WTP also depends on attributes of quality and taste and delivery options. is a result of the pizza being distinctly good. with such distinctly good pizza. the firm will retain most of its customers. Are you preparing your own dough.
A price war also redistributes market share among firms (at least in the short run). you keep more value (P went down by $1. In this scenario you could choose to remove that special imported topping (saving yourself. but your piece of the pie just got bigger (P went up by $2. You could bundle complementary products (add a 2-liter coke bottle with the pizza to make ordering easier). because customers were willing to pay only $1 for it (so you were over-serving them). you could earn an additional $1. Customers will keep their piece of the pie same (both WTP and P went down by $1) but since you made the pie bigger. To reinforce this intuition. lower price). There are the functional or “primary activities” (rolling the dough) and there are also corporate activities—infrastructure activities or support activities such as HR. By breaking the entire value chain into discrete activities. we can analyze what each activity contributes in making the product or improving its attributes (WTP) and what each activity costs (C). Value Chain and Vertical Chain Firms that assemble ingredients into a pizza are involved in many activities—the value chain.” you can engage in “value addition. letʼs say that you could improve the pizzaʼs taste such that the consumer is willing to pay an additional $2. As opposed to “value capture. Now you could lower price by $1. at least).” Letʼs consider the “industry pie”—if competitors each work to cater to a segment of customers and work to offer their segment “distinctly” delicious pizza—the industry value creation pie grows. total value created is unchanged (in the short run. but C only went up by $1)! Value might also be created by eliminating product features. you could reduce buyer purchase cost (deliver the pizza free of charge). IT. However. purchasing. while it costs you only an additional $1 to make that happen. The consumer is still getting the same WTP−P (both WTP & P went up by $2). say $2). but C went down by $2)! How can you increase WTP in the market? You could make the product better (as we did in our pizza example). these activities lead to the final sales of the goods. each competitor has a “lock” on their particular segment by giving that segment pizza that is more satiating (to that segment) than the other competitorsʼ offerings. Theoretically.war does not alter value creation. etc. A price war increases buyer surplus (same WTP. or you could improve the reputation or image (through experiential results—more sustainable or through aggressive/creative marketing). Together. Furthermore. The sum of the WTPs and the Cs of all the pieces is 110 . The growth in value created is primarily driven by the higher WTP of each pizza buyer getting just what they want.
is completely organic.50/pizza to the productʼs WTP. You feel that you will provide an offering that is unparalleled in the market. to the pizza process. In other words. advertise heavily. in addition to being low-fat. great ingredients. to the dough production. to the delivery process. Or perhaps the reverse was true. Great taste.equal to the overall WTP and overall C for the product. In fact. We could analyze each piece of the value chain similarly and determine the cost vs.50 (not losing any customers) and save $0. and you keep adding employees in an attempt to maintain the high standards you set for your business. Industry analysis helps us organize our thoughts about the opportunities and constraints due to adjacent industries (as well as firms in our industry). many industries are involved in the production of a pizza. you start seeing your margins thin out. reduce the price by $1. the supplier of your olives. but none could match the freshness and superiority of this one huge supplier. not just the parlor. There was little you could do about this “bargaining power of suppliers.50/pizza. and find out that it is costing $2/pizza to provide this service. and non-fattening—you have reached the nirvana in pizzas! You jump into the business.” from the wheat farm. to the flour production. and that adding delivery service (if you didnʼt offer it) would increase WTP more than it would cost. and sure enough the customers start coming in droves. You sit down and start to account for what is happening and it doesnʼt take you long to realize that the Porterʼs 5 forces have you squarely cornered. You also realized that while you had started out at $25 per 111 . Industry Analysis You have decided to offer “custom-special” pizza. You are hardly able to keep up with demand. But late into your second year of booming business. the last drop of cost put into the product should be less than what it contributes to increasing the productʼs WTP (marginal cost < marginal improvement in WTP).” and you expected this olive-supplier to keep squeezing harder. Here we realize what happens in the industries we buy from and sell to impact our business (our ability to add and capture value) in significant ways. started increasing prices quite drastically. but the entire “vertical chain. while it is only adding $1. leading you to add service. WTP-benefit for each. This analysis can help uncover whether the WTP contribution of each activity is optimized for the cost it incurs. then we would conclude that it is better to shut the delivery service down. So. Only a few months ago. and to the marketing and customer process. Step back a bit and think of the pizza business. the most popular ingredient on your pizza. if we analyze the pizza delivery activity (an “outbound logistics” activity in Porterʼs Value Chain—see Figure above). which combines the best of imported ingredients. You looked around for alternatives.
Weʼll start with the “differentiation” generic strategy.” marketing organic. differentiation. Firms are actively positioning when they configure their value chain to neutralize industry constraints and exploit industry opportunities. and ultimately increasing his sales of olives. In this strategy. so that there was no room for a new entrant to come in. and it tasted almost as good as yours. You didnʼt think your loyal customers would leave you.” You also remembered that another pizza shop had opened up several blocks away. the exact scenario you wanted to avoid by going premium. another threat. You could have franchised several branches of your “premium pizza” parlors all around the city. For those who enjoyed your pizza weekly. With a differentiation strategy. Even if the pita cannibalized some of your pizza. and you just couldnʼt lose these regular customers. instead of a pizza was about to open up. you were giving in to the “bargaining power of the buyers. you could simply start offering “premium pita sandwiches” too. and focus. All these forces were making your “premium pizza” into a commodity-like item. instead of cheap. right across your parlor. high-quality pizza] will likely be able to receive premium prices from at least some customers. so that you can exert your own “buyer pressure” on this supplier. but when one customer brought you a slice of the other placeʼs pizza. it worried you a little due to the “threats of new entrants. the “threat of substitute products” was looming—a new “Pita-Stop. increasing volume. low stakes” for them. fresh ingredients in a pita bread. and you may not have had to reduce prices as much. and some did. It was too late now. Porter describing zero economic profits to you. and the supplier was more than happy to see both of you competing—lowering pizza prices. which your “premium” pizza parlor plan reflects. There are ways that you could have resisted some of this “commoditization” pressure. And as far as substitutes. pushing you towards price-based competition. “firms that offer distinct products [your organic. while firms may not reach as many customers. but at a lower price.medium pizza. and it too was serving “premium” pizza. You could also have made an alliance with all the major buyers of olives from this one olive supplier. they can 112 . low-fat.” And as you thought things couldnʼt have gotten worse. the buyers wouldnʼt have had much choice. as customers were literally demanding lower prices or they would switch. Porter describes three generic strategies that are responses to these conditions: cost leadership. you had a nightmare in which you saw Dr. Once you controlled all premium food real estate in the city. and that night after you went home and slept. so that you may have been able to preempt the pita substitute. this was starting to become “high cost. It was also getting the olives from “your” supplier. you were already down to $20. and “crowded out” entrants and substitutes. at least the profits from both went into the same pocket—yours! Positioning Positioning involves segmenting an industry to find a defensible position in that segment. The inherent trade-off of a differentiation strategy is market share for margin [as you had expected with your $25 medium-pizza price].
as well as “packaging” pieces and “topping” pieces.” This would have been the case. and at the competitive market pricing. Strategies for preemption generally fall between two general forms of preemption: capital-intensive assets and securing superior scarce resources—to be clear. when the cost. and consider industries that are highly capital-intensive. In order to be truly successful.” Finally. Sometimes. a “focus strategy” identifies underserved segments of customers. You heard Porter. which meant that only one employee had to program in the size and toppings for the pizza. sometimes they have to be all upfront. We can apply this intuition to pizza parlors…if you want to “own” the pizza market in a particular strip mall. which consumes half the energy of generic pizza ovens. “To qualify as the low-cost producer with a sustainable cost advantage. risk. if suppose. A firm can “own” (sustain) some position (operate without competitors encroaching). and be confident that no cheaper substitutes show up in the arena. by investing in so much excess capacity. With this “Focus Strategy.charge higher prices if they locate a meaningful segment with a higher desire for their good. saving retailing costs. For instance. For a truly capital-intensive preemption strategy. Firms can make choices that raise barriers to entry. Even though Reliance may not run this refinery at full capacity all the time. complexity a potential entrant would face is sufficient to discourage entry. a preemptive choice would be to build enough capacity to satisfy all the demand for pizza that strip mall faces. investments can be staged. As opposed to your current “differentiation strategy” that identifies underserved product categories and varieties. Preemption and Sustainability We already discussed the kind of preemption that you may be able to engage with your pizza business. the source of a firmʼs lowcost position must not be available to rivals. and the pizza would come out in a box! This way you needed half the employees that a regular pizza parlor would need. while taking care of the folks who would most likely pay for your premium pizza anyway. the capacity must meet or exceed demand conditions for the near long-term. you could have chosen a strategy where you only catered your premium pizza to exclusive “high-end” parties. This one refinery is essentially able to supply most of the product need in a significant region of India. these forms of preemption are NOT mutually exclusive.” The other strategy you could have employed is “cost leadership. innovative ovens that you yourself helped invent. we have to move beyond pizza parlors. you had invested in new.” you chose to serve a specific clientele. 113 . it has essentially preempted any other refineries that may have wanted to set up shop in the region. Reliance built a gigantic oil refinery in India processing nearly 42 million gallons per day of oil. you were coming ahead with the highest margin. and you could offer pizza at a lower price than anyone else.
For instance. The more people use email. and finally the highest of moats. as captured by the “learning curve. Resource-Based View The RBV examines how firms can enjoy sustainable returns as a result of resources employed. etc. which relate to a situation where each user of a good or service impacts the value of it for someone else as in the example of email. also benefit/need the network effect to be truly successful. and preservation of a unique position in the firmʼs product market. like the refinery we just talked about. So. distribution channels. The resource-based view has a resource market orientation—competitive advantage through imperfections in resource markets that give a firm a privileged access to certain valuable resources. and so many social associations that it is nearly impossible to replicate. a certain product may require training that costs a certain amount. domination. which relates to increasingly lower variable costs as the company becomes “experienced” in producing it. even when advertising the same attributes as your pizzaʼs. These moats ranged. if the olives were truly the specialty hall-mark of your pizza. This way you are preventing this “scarce” resource from being available to others. corporate cultures.” (2) network effects. (5) increasing returns advantages. that similarly create value. such as Facebook. locations. would still have to charge less in order to overcome customers experiences with your pizza). Increasing returns or early-mover advantages come from a variety of effects: (1) experience effects. switching to a competing product would have to make up for the cost of retraining on the new product. in increasing strength: (1) legal barriers (such as patents) (2) one-of-a-kind strategic assets.. that a firm gains 114 . and if there was only one or two producers of these olives. such as brand names. while the positional view emphasizes the things you do. and by matching these resources to economically relevant environments. or even quality control processes. like trade secrets.Another form of preemption is to secure scarce and superior inputs that are not widely available to other producers. back to our pizza example. (3) sunk costs and economies of scale. It is by owning these unique resources that other firms do not possess and cannot acquire. then you could either backward integrate and take over the olive producer. the positional view has a product market orientation—competitive advantage through the creation. like Cokeʼs brand image that depends on a rich and varied history. Once that training cost has been sunk. (3) buyer uncertainty and reputation. Warren Buffet talked about moats to connote both the form of preemption and their degrees of sustainability. Social networking sites. RBV starts with the assumption that firms are endowed with inherently different bundles of resources. which relate to costs that buyers would have to face in order to switch. the RBV emphasizes the things you have. which relates to building product reputation through experience and customersʼ unwillingness to switch due to it (customers like your pizza so much that the other pizza parlor. the more valuable this service is to each user. For instance. Thus. or contract with the producer to make you the only pizza parlor that it supplies its olives too. (4) information gaps and path-dependency. and finally (4) buyer switching costs.
some other parlor could offer him higher salary and if you really want to keep him.” As an example of Monopoly rents. “Ex Ante Limits” relate to a firm buying the resources that it needed to create its competitive advantage at a below-market price.” firms have different bundles of resources that they use to produce and sell their products. Under “Resources Heterogeneity. earning “Ricardian Rents” and/or (b) produce superior output (WTP) at the same cost. you hope that the other parlors donʼt come up with a way to achieve the same lower costs through another different type of production innovation (imperfect substitutability). you would own a unique resource that helps you gain Ricardian rents. If you had this. Thus. you may also raise the ante. So. and (4) Ex Ante Limits to Competition. which can produce much higher WTP (and can demand high prices). 115 . Eventually. consider a wheat-farmer who has a particularly fertile piece of land (perhaps next to the river). remember the unique pizza-oven (patented by your company) that operates at half the cost relative to other ovens. (2) Ex Post Limits to Competition.competitive advantage. While he may be worth a lot to you. this manager represents the opposite of “imperfect mobility. and thus other firms will not be able to pay him enough to extract the incremental value he is worth (because only you own the oven). if this manager was so good BECAUSE he could run your special oven better than anyone else. Under “Ex Post Limits. is the firm ahead in creating real wealth. Back to our pizza parlor example. Furthermore. than other companies in its peer industry because of the unique resources it owns. So. sustainable competitive advantage: (1) Resources Heterogeneity. His cost of production would be lower due to the resources he owns (the land). Under “Imperfect Mobility. and thus while he cannot affect the market price of wheat. then he is worth that much partly because of that oven. his value is partly from co-specialization. There are four foundations of for a wealth-creating. (3) Imperfect Mobility.” On the other hand.” As an example of Ricardian rents. earning “Monopoly Rents.” the goal is that other firms cannot buy your unique/superior resource in the marketplace or that the resource is more productive for you than your competitors (co-specialization). Firms with superior resources are able to either (a) produce at a lower cost (C) than other firms in the industry. Letʼs say you hired the best manager in the pizza world who excelled in customer service and in reducing labor turnover. he can earn more than other farmers due to his lower “C.” firms have to have barriers that ensure that resource heterogeneity is preserved. his “price” may be bid up to the point that he has extracted everything extra that he was worth. consider Microsoft. This can only happen when there is imperfect market information. your pizza-oven innovation should have a foolproof patent on it such that other pizza parlors are unable to duplicate your resource superiority (imperfect imitability). Only if the firm pays a lower cost for resources than the present value of its future cash flows that these resources are expected to create.
” 116 . However.e. then this co-specialization results in synergies that makes the two resources more valuable than their sum of their separate values. (3) GV (Governance Value): portion of value that comes from structuring the organization such that the playersʼ actions are transparent and aligned with the interest of the firmʼs capital owners. it has to be co-specialized otherwise the ERV will likely capture its full value as compensation (i. essentially the monetary value of the firmʼs position.” When the human capital is complementary to the firmʼs ACV.Shifting Perspectives: Components of Firm Value While creating and capturing value are essential in strategy. patents. then the enterprise would be dismantled to unlock componentsʼ value. consistency. brands. thereby. derived from assets and capabilities owned by the firmʼs shareholders or capital owners. and overall good sense and. Examples: location. Good governance displays transparency. etc. equity. in order for ERV to increase the firmʼs value. So. other firms will bid up its price since it will be equally productive at other firms). we also have to look at a related question: why is the whole (of the enterprise) worth more than its parts? If this wasnʼt the case. (2) ERV (Employed Resource Value): portion of value that firm employs but doesnʼt own. Remember our discussion of co-specialization under “imperfect mobility. informs human capital before the effort is undertaken “whatʼs in it for them. Governance is about putting in place the appropriate infrastructure and incentive structure that motivates the production of ACV. Here we think of the firm as being comprised of 3 parts: (1) ACV (Asset and Capabilities Value): portion of value that is “ownable” and sellable. most firms enjoy “intrinsic synergy” among their constituent parts. When considering the production of ACV. mainly the human capital. it is reasonable for that human capital to wonder “whatʼs in it for me?” Governance is the answer to this question.
GV reinforces ACV. This could include performance-based stock options. GV would refer to how well you. In this way. as the owner. the oven needs the manager. because good structure motivates those actions that nourish the firmʼs position in superior resources. superior ACV tends to attract superior ERV. Also the pay structure matters. In our pizza parlor case. brand-name that builds over time. ERV is maximized by good GV. In other words. Finally. but lots of opportunity to learn. Is he incentivized appropriately to find innovative ways to reduce delivery costs. Another way is to open up “external” options for employees. While we can consider the three components in isolation. there are important interactions among them. ERV would be our super-duper manager who can operate that special oven better than anyone in the market. incentivize the manager to keep producing more and more out of the ACV that is available. though both are limited by the firmʼs growth. because good matching levers up the value of human capital (though much is captured in wages). for which he is ultimately rewarded for and expects that reward? 117 . a firm is able to use the worldwide market of opportunities to enhance its own employeesʼ motivation. They are motivated to work because either they will move up and get their own “minions” eventually. GV in an ERV firm is a little different and involves a focus on cospecialization such that the ERVʼs full value can only be retained at this firm. long hours. and the manager needs the oven. by increasing their external visibility. promotions. because the matches themselves are dependent on incentive systems. Furthermore. special ovenʼs patent. or that they will learn so much that they will have solid external opportunities. but whose value would be no better than a regular manager without that oven.Good GV in ACV firms entails the idea that value of the human capital should appreciate with the ACV value of the firm. ACV would be the location. First. many times with structures where entry-level “minions” get low wages.
superior resources command price premiums and this presents a challenge to firms. • Positioning: Choosing a set of activities for value creation that neutralize industry constraints while exploiting industry opportunities. If the firm was sold. ACV would go to the new owner. • Mobility: The ability of inputs to be used as productively by competitor firms. • Increasing Returns Market: Markets with economies (in C or WTP) that improve with share. • • • Expropriation: Forcing a firm to accept prices at or below its average costs. Governance Value: Value generated from incentives that align human capital with financial capital. there must be some market friction. • Ex Ante Limits: Often. competitors can substitute other resources or can create new resources that are as valuable as the firm in questionʼs resources – this is a failure of ex post limits. Differentiator: Raising WTP with minimal effects on C. Resource Based View: The view that superior returns lie in superior resources. Cost Leadership: Reducing C with minimal effects on WTP. Ultimately. to pass ex ante limits. Five Forces: The industry forces that drive firms to become rivals. • Ex Post Limits: Often. Mobility suggests that the “resource” (generally human) can take (make mobile) his/her productivity – thereby creating the ability to extract the value in wages.Glossary • Assets and Capabilities Value (ACV): Value generated from superior tangible and intangible inputs that “ownable”. Employed Resource Value: Value generated from good matching of resources (mainly human) to the ACV of the firm. acquiring a superior resource at a price low enough to leave a residual economic rent requires some market friction – that is. • • • • Commoditization: When consumers shop primarily by finding the lowest price. • • Preemption: Limiting a firmʼs competitors from duplicating that firmʼs position. 118 .
119 .• • • • • • Resource Heterogeneity: That resource inputs vary across firms. Value Chain: The taxonomy of all a firmʼs activities. Added Value: Increasing firm surplus by increasing the gap between WTP and C. Value Capture: Increasing firm surplus by adjusting P. Value Creation: Generating a gap between WTP and C. Segmentation: Dividing a market based on product or customer attributes.
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