Chapter 3

Internal Capabilities
What Does Internal Analysis Tell Us?
Internal analysis provides a comparative look at
a firm’s capabilities

• what are the firm’s strengths?

• what are the firm’s weaknesses?

• how do these strengths & weaknesses compare

to competitors?

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Why Does Internal Analysis Matter?

Internal analysis helps a firm:

• determine if its resources and capabilities are

likely sources of competitive advantage

• establish strategies that will exploit any sources

of competitive advantage

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The Theory Behind Internal Analysis

The Resource-Based View

• Developed to answer the
question: Why do some firms
achieve better economic
performance than others?
• Used to help firms achieve
competitive advantage and
superior economic
performance
• Assumes that a firm’s
resources and capabilities are
the primary drivers of
competitive advantage and
economic performance
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The Resource-Based View
Resources and Capabilities
Resources:
• tangible and intangible assets of a firm
» tangible: factories, products intangible: reputation

• used to conceive of and implement strategies

Capabilities:
• a subset of resources that enable a firm to
take full advantage of other resources
» marketing skill, cooperative relationships

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The Resource-Based View
Resources and Capabilities
Are these resources
Firm Assets: or capabilities?

Machinery ?

Collective Product Design Skill ?

Recruiting Skill ?

Engineering Skill of Individuals ?

Mineral Deposits ?

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The Resource-Based View

Four Categories of Resources

• Financial (cash, retained earnings)

• Physical (plant & equipment, geographic location)

• Human (skills & abilities of individuals)

• Organizational (reporting structures, relationships)

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The Resource-Based View

Two Critical Assumptions of the RBV

• Resource Heterogeneity
» different firms may have different resources

• Resource Immobility

» it may be costly for firms without certain

resources to acquire or develop them
» some resources may not spread from firm to
firm easily
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The Resource-Based View

What do these assumptions really mean?

• if one firm has resources that are valuable
and other firms don’t, and…

• if other firms can’t imitate these resources

without incurring high costs, then…

• the firm possessing the valuable resources

will likely gain a sustained competitive advantage

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The Resource-Based View

Resource Heterogeneity

• heterogeneity of resources typically occurs as the

result of ‘bundling’ the resources and capabilities
of a firm

• managers of a firm could take resources that seem

homogeneous and ‘bundle’ them to create
heterogeneous combinations

• competitive advantage typically stems from several

resources and capabilities ‘bundled’ together

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Application: The Internal Analysis Tool

The VRIO Framework

Four Important Questions:

• Value

• Rarity

• Imitability

• Organization

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The VRIO Framework

If a firm has resources that are:

• valuable,
• rare, and
• costly to imitate, and…
• the firm is organized to exploit these resources,
then the firm can expect to enjoy a sustained
competitive advantage.

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VRIO Application

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The VRIO Framework

Applying the Tool

• a resource or bundle of resources is subjected to

each question to determine the competitive
implication of the resource

• each question is considered in a comparative

sense (competitive environment)

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Applying the VRIO Framework

The Question of Value

• in theory: Does the resource enable the firm

to exploit an external opportunity or neutralize
an external threat?

• the practical: Does the resource result in an

increase in revenues, a decrease in costs, or
some combination of the two? (Levi’s reputation
allows it to charge a premium for its Docker’s pants)

3-16
Applying the VRIO Framework

The Question of Rarity

• if a resource is not rare, then perfect competition
dynamics are likely to be observed (i.e., no
competitive advantage, no above normal profits)
• a resource must be rare enough that perfect
competition has not set in

• thus, there may be other firms that possess the

resource, but still few enough that there is scarcity
(several pharmaceuticals sell cholesterol-lowering
drugs, but the drugs are still scarce—look at prices)
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Applying the VRIO Framework

Valuable and Rare

If a firm’s resources are: The firm can expect:

Not Valuable Competitive Disadvantage

Valuable, but Not Rare Competitive Parity

Competitive Advantage
Valuable and Rare
(at least temporarily)

3-18
Applying the VRIO Framework

The Question of Imitability

• the temporary competitive advantage of valuable

and rare resources can be sustained only if
competitors face a cost disadvantage in imitating
the resource
» intangible resources are usually more
costly to imitate than tangible resources
(Harley-Davidson’s styles may be easily
imitated, but its reputation cannot)

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Applying the VRIO Framework

The Question of Imitability

• if there are high costs of imitation, then the firm

may enjoy a period of sustained competitive
advantage
» a sustained competitive advantage will last
only until a duplicate or substitute emerges

 if a firm has a competitive advantage, others

will attempt to imitate it (Razor scooters
were a big hit and others quickly imitated them)

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Applying the VRIO Framework

The Question of Imitability

Costs of Imitation

Unique Historical Conditions (Caterpillar)

• first mover advantages

• path dependence

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Applying the VRIO Framework

The Question of Imitability

Costs of Imitation

Causal Ambiguity (Southwest Airlines – HR)

• causal links between resources and
competitive advantage may not be
understood
• bundles of resources fog these causal
links

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Applying the VRIO Framework

The Question of Imitability

Costs of Imitation

Social Complexity (WordPerfect)

• the social relationships entailed in

resources may be so complex that
managers cannot really manage them
or replicate them

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Applying the VRIO Framework

The Question of Imitability

Costs of Imitation

Patents
• patents may be a two-edged sword
• offer a period of protection if the firm is
able to defend its patent rights
• required disclosure may actually decrease
the cost of imitation, and the timing

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Applying the VRIO Framework

Value, Rarity, & Imitability

If a firm’s resources are: The firm can expect:

Valuable, Rare, but Temporary

not Costly to Imitate Competitive Advantage

Sustained
Valuable, Rare, and
Competitive Advantage
Costly to Imitate
(if Organized appropriately)

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Applying the VRIO Framework

The Question of Organization

• a firm’s structure and control mechanisms
must be aligned so as to give people ability
and incentive to exploit the firm’s resources
• examples: formal and informal reporting structures,
management controls, compensation policies,
relationships, etc.
• these structure and control mechanisms complement
other firm resources—taken together, they can help a
firm achieve sustained competitive advantage
(3M Company)
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 The VRIO Framework
Costly to Exploited by Competitive
Valuable? Rare? Imitate? Organization? Implications

No No Disadvantage

Yes No Parity

Temporary
Yes Yes No Advantage

Sustained
Yes Yes Yes Yes
Advantage

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3-29
Competitive Dynamics

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 Competitive Dynamics of Resource Imitation

Competitive Dynamics:
• the strategic decisions and actions of firms in
response to the strategic decisions and actions
of other firms
Firm B’s Possible Responses

Firm A No Response
(strategy decisions
Change Tactics
lead to competitive
advantage) Change Strategy

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Competitive Dynamics

“No Action” Response (Rolex Casio)

A firm may decide to take no action because:

• the other firm is serving a different market

• a response may hurt its own competitive
advantage
• it does not have the resources and capabilities
to mount an effective response
• it wants to reduce or manage rivalry in the
market through tacit collusion
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Competitive Dynamics

“Change” Responses
Tactics (Tide) Strategy (Monsanto)
• specific actions • a fundamental change
» tweaking product in a firm’s theory
characteristics may be necessary if
• usually imitated so current strategy
quickly that there is becomes obsolete
no advantage • a mimetic change may
• a ‘leap frog’ move achieve parity, but not
may create advantage advantage
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 Competitive Dynamics

Similar strategies may lead to competitive advantage

• some firms can achieve competitive advantage even
if they are second movers
Price
Focal Firm
Offering
» higher quality/ Competitor
lower cost Offerings
offering may
lead to advantage Customer
Needs
Quality
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Internal Analysis
Assumes:

• determinates of economic performance are

firm-level characteristics (resources & capabilities)

» firms may be different (heterogeneity)

» differences may be enduring (immobility)

• competitive advantage stems from resources

and capabilities that meet the VRIO criteria

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3-37
How to find resources

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 Assessing a Company’s Resources and
Capabilities: The Case of Ole Miss
RESOURCES Importance UM’s relative CAPABILITIES Importance UM’s Relative
strength Strength
R1. Finances 6 6 C1. Student 9 4
recruitment
R2. Location 7 5 C2 Course 7 5
development
R3. Brands 8 8 C3 Teaching 7 9
C4 Student 8 4
placement
C5 Alumni 6 9
relations
C6 Corporate 4 4
Both scales range from 1 to 10 relations
(1= very low, 10= very high)
C7 Research 7 4
C8 4 8
Administration
Note: Don’t get all defensive on any of these numbers, they are drawn at random 3-39
Appraising UM’s Resources and Capabilities
(Hypothetical only)

10 Key Strengths
Superfluous Strengths
C3
R3
Relative Strength

C8

R1
5 R2 C2
C6 C5 C4 C1 C7

Zone of Irrelevance Key Weaknesses

1
1 5 10
Strategic Importance
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Appraising the Capabilities of a Business
School (illustrative only)

IMPORTANCE
- +
+ Superfluous Key strength
strength R1, R3, C3
C8

RELATIVE
Inconsequential Key weaknesses
STRENGTH weaknesses C1, C4, C5, C7
C6

-
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 The Evolution of Honda Motor Company
Honda
Technical 4-cylinder 1st gasoline-powered
Competes in Civic Hybrid
Research 750cc car to meet US Low
Isle of Man TT (dual gasoline/
Institute motorcycle Emission Vehicle Standard
motorcycle electric)
founded
races
Portable Power products: Civic GS
generator ground tillers, marine
1 motorcycle:
st (natural
engines, generators, gas
98cc, 2-cycle
405cc pumps, chainsaws powered)
Dream D
motor snowblowers
cycle

1946 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Acura Car
N360 mini
4 cycle division Home co-
car
engine The 50cc generation
Supercub 1000cc system
Honda Goldwing
Civic touring
motor cycle Enters Indy
Enters Formula 1 car racing
First product: Gran Prix racing
Model A Honda FCX
clip-on engine fuel cell
for bicycles car

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Internal Analysis
Tells us:
• what the firm should do, given the relative
strengths and weaknesses of resources and
capabilities

Managers’ Job:

• bundle resources and capabilities to

achieve competitive advantage

VRIO Framework Helps Managers Recognize

Sources of Competitive Advantage
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