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Title: Contemporary strategy analysis / Robert M. Grant.
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To Liam, Ava, Finn, Evie, Max, Lucy, and Bobby

B R I E F C O N T E N T S

Author Biography xiv
Preface to Tenth Edition xv

PART I INTRODUCTION 1

1 The Concept of Strategy 3

PART II THE TOOLS OF STRATEGY ANALYSIS 31

2 Goals, Values, and Performance 33

3 Industry Analysis: The Fundamentals 59

4 Further Topics in Industry and Competitive Analysis 83

5 Analyzing Resources and Capabilities 107

6 Organization Structure and Management Systems:
The Fundamentals of Strategy Implementation 131

PART III BUSINESS STRATEGY AND THE QUEST FOR
COMPETITIVE ADVANTAGE 153

7 The Sources and Dimensions of Competitive Advantage 155

8 Industry Evolution and Strategic Change 189

9 Technology-Based Industries and the
Management of Innovation 219

PART IV CORPORATE STRATEGY 249

10 Vertical Integration and the Scope of the Firm 251

11 Global Strategy and the Multinational Corporation 269

12 Diversification Strategy 297

viii BRIEF CONTENTS

13 Implementing Corporate Strategy: Managing
the Multibusiness Firm 315

14 External Growth Strategies: Mergers, Acquisitions,
and Alliances 340

15 Current Trends in Strategic Management 360

CASES TO ACCOMPANY CONTEMPORARY STRATEGY
ANALYSIS, TENTH EDITION

Glossary 637
Index 643

Author Biography xiv
Preface to Tenth Edition xv

PART I INTRODUCTION 1

1 The Concept of Strategy 3

Introduction and Objectives 4
The Role of Strategy in Success 4
The Basic Framework for Strategy Analysis 9
A Brief History of Business Strategy 11
Strategy Today 14
How is Strategy Made? The Strategy Process 20
Strategic Management of Not-For-Profit Organizations 24
Summary 26
Self-Study Questions 28
Notes 28

PART II THE TOOLS OF STRATEGY ANALYSIS 31

2 Goals, Values, and Performance 33

Introduction and Objectives 34
Strategy as a Quest for Value 35
Profit, Cash Flow, and Enterprise Value 39
Putting Performance Analysis into Practice 42
Beyond Profit: Values and Corporate Social Responsibility 49
Beyond Profit: Strategy and Real Options 53
Summary 56
Self-Study Questions 57
Notes 57

3 Industry Analysis: The Fundamentals 59

Introduction and Objectives 60
From Environmental Analysis to Industry Analysis 60
Analyzing Industry Attractiveness 62
Applying Industry Analysis to Forecasting Industry Profitability 71
Using Industry Analysis to Develop Strategy 74
Defining Industries: Where to Draw the Boundaries 75
From Industry Attractiveness to Competitive Advantage:

Identifying Key Success Factors 77

C O N T E N T S

x CONTENTS

Summary 80
Self-Study Questions 81
Notes 81

4 Further Topics in Industry and Competitive Analysis 83

Introduction and Objectives 84
The Limits of Industry Analysis 84
Beyond the Five Forces: Complements, Ecosystems, and Business Models 86
Competitive Interaction: Game Theory and Competitor Analysis 91
Segmentation and Strategic Groups 98
Summary 103
Self-Study Questions 103
Notes 104

5 Analyzing Resources and Capabilities 107

Introduction and Objectives 108
The Role of Resources and Capabilities in Strategy Formulation 108
Identifying Resources and Capabilities 112
Appraising Resources and Capabilities 119
Developing Strategy Implications 123
Summary 128
Self-Study Questions 129
Notes 130

6 Organization Structure and Management Systems:
The Fundamentals of Strategy Implementation 131

Introduction and Objectives 132
Strategy Formulation and Strategy Implementation 133
The Fundamentals of Organizing: Specialization,

Cooperation, and Coordination 136
Developing Organizational Capability 139
Organization Design 142
Summary 150
Self-Study Questions 150
Notes 151

PART III BUSINESS STRATEGY AND THE QUEST
FOR COMPETITIVE ADVANTAGE 153

7 The Sources and Dimensions of Competitive Advantage 155

Introduction and Objectives 156
How Is Competitive Advantage Established? 156
How Is Competitive Advantage Sustained? 162
Cost Advantage 166
Differentiation Advantage 173
Can Firms Pursue Both Cost and Differentiation Advantage? 184

CONTENTS xi

Summary 185
Self-Study Questions 186
Notes 186

8 Industry Evolution and Strategic Change 189

Introduction and Objectives 190
The Industry Life Cycle 191
The Challenge of Organizational Adaptation and Strategic Change 198
Managing Strategic Change 204
Summary 215
Self-Study Questions 215
Notes 216

9 Technology-Based Industries and the
Management of Innovation 219

Introduction and Objectives 220
Competitive Advantage in Technology-Intensive Industries 221
Strategies to Exploit Innovation: How and When to Enter 227
Standards, Platforms, and Network Externalities 232
Implementing Technology Strategies: Internal and External

Sources of Innovation 238
Implementing Technology Strategies: Organizing for Innovation 242
Summary 245
Self-Study Questions 246
Notes 246

PART IV CORPORATE STRATEGY 249

10 Vertical Integration and the Scope of the Firm 251

Introduction and Objectives 252
Transaction Costs and the Scope of the Firm 252
The Benefits and Costs of Vertical Integration 256
Designing Vertical Relationships 263
Summary 266
Self-Study Questions 266
Notes 267

11 Global Strategy and the Multinational Corporation 269

Introduction and Objectives 270
Implications of International Competition for Industry Analysis 271
Analyzing Competitive Advantage in an International Context 273
Internationalization Decisions: Locating Production 276
Internationalization Decisions: Entering a Foreign Market 278
Multinational Strategies: Global Integration versus

National Differentiation 281
Implementing International Strategy: Organizing the

Multinational Corporation 287

xii CONTENTS

Summary 293
Self-Study Questions 294
Notes 295

12 Diversification Strategy 297

Introduction and Objectives 298
Motives for Diversification 299
Competitive Advantage from Diversification 303
Diversification and Performance 307
The Meaning of Relatedness in Diversification 309
Summary 311
Self-Study Questions 312
Notes 312

13 Implementing Corporate Strategy: Managing the Multibusiness
Firm 315

Introduction and Objectives 316
The Role of Corporate Management 316
Managing the Corporate Portfolio 317
Managing Linkages Across Businesses 319
Managing Individual Businesses 323
Managing Change in the Multibusiness Corporation 329
Governance of Multibusiness Corporations 333
Summary 337
Self-Study Questions 338
Notes 338

14 External Growth Strategies: Mergers, Acquisitions,
and Alliances 340

Introduction and Objectives 341
Mergers and Acquisitions 342
Strategic Alliances 351
Summary 357
Self-Study Questions 357
Notes 358

15 Current Trends in Strategic Management 360

Introduction 361
The New Environment of Business 361
New Directions in Strategic Thinking 365
Redesigning Organizations 369
The Changing Role of Managers 371
Summary 372
Notes 373

CONTENTS xiii

CASES TO ACCOMPANY CONTEMPORARY STRATEGY
ANALYSIS, TENTH EDITION

1 Tough Mudder Inc.: Building Leadership in Mud Runs 375

2 Kering SA: Probing the Performance Gap with LVMH 384

3 Pot of Gold? The US Legal Marijuana Industry 393

4 The US Airline Industry in 2018 403

5 The Lithium-Ion Battery Industry 415

6 Walmart Inc. in 2018: The World’s Biggest Retailer Faces
New Challenges 428

7 Harley-Davidson, Inc. in 2018 442

8 BP: Organizational Structure and Management Systems 455

9 Starbucks Corporation, March 2018 462

10 Eastman Kodak’s Quest for a Digital Future 475

11 The New York Times: Adapting to the Digital Revolution 492

12 Tesla: Disrupting the Auto Industry 503

13 Video Game Console Industry in 2018 515

14 Eni SpA: The Corporate Strategy of an International
Energy Major 527

15 Zara: Super-Fast Fashion 546

16 Manchester City: Building a Multinational Soccer Enterprise 554

17 Haier Group: Internationalization Strategy 566

18 The Virgin Group in 2018 577

19 Google Is Now Alphabet—But What’s the Corporate Strategy? 587

20 Restructuring General Electric 600

21 Walt Disney, 21st Century Fox, and the Challenge of New Media 617

22 W. L. Gore & Associates: Rethinking Management 629

Glossary 637
Index 643

AU T H O R B I O G R A P H Y

Robert M. Grant is Professor of Strategic Management at Bocconi University, Milan,
Italy and a Visiting Professor at Cass Business School, London. He was born in Bristol,
England and has taught at Georgetown University, London Business School, Univer-
sity of British Columbia, California Polytechnic, UCLA, Insead, and University of South
Africa. His business experience includes making tires (Firestone) and meat pies (Kraft
Foods) and strategy consulting at American Express, Eni, BP, and other companies.

Contemporary Strategy Analysis equips managers and students of management with
the concepts and frameworks needed to make better strategic decisions. My goal is
a strategy text that reflects the dynamism and intellectual rigor of this fast-developing
field of management and takes account of the strategy issues that companies face today.

Contemporary Strategy Analysis endeavors to be both rigorous and relevant. While
embodying the latest thinking in the strategy field, it aims to be accessible to students
from different backgrounds and with varying levels of experience. I achieve this acces-
sibility by combining clarity of exposition, concentration on the fundamentals of value
creation, and an emphasis on practicality.

This tenth edition maintains the book’s focus on the essential tasks of strategy: iden-
tifying the sources of superior business performance and formulating and implement-
ing a strategy that exploits these sources of superior performance. At the same time,
the content of the book has been revised to reflect recent developments in the business
environment and in strategy research.

Distinctive features of the tenth edition include:

● More explicit guidance on how to apply the tools of strategy to analyze strategic
situations and develop strategy recommendations. See, in particular: “Applying
Strategy Analysis” in Chapter 1, “Putting Performance Analysis into Practice”
in Chapter 2, “Using Industry Analysis to Develop Strategy” in Chapter 3, and
“Developing Strategy Implications” [from the analysis of resources and capabil-
ities] in Chapter 5.

● Increased emphasis on strategy making under conditions of technological
change—especially in digital markets where strategy analysis must take account
of complements, network externalities, platform-based competition, and the
application of innovative business models to complex business ecosystems (see
Chapters 4, 8, and 9).

● Integration of stakeholder interests and corporate social responsibility within a
view of the firm as an institution for creating value (Chapter 2).

● An updated approach to strategy implementation. While maintaining an
integrated approach to strategy formulation and strategy implementation,
Chapters 6, 8, and 13 offers a systematic approach to strategy execution that
the role of organizational capabilities and capability development in guid-
ing resource allocation, and the design of organizational structures and
management systems.

My thanks to my editorial and production team at Wiley, especially to Lise Johnson,
Judy Howarth, and S. Indirakumari; and to Mary Fogarty and Nitish Mohan for their

P R E FA C E T O
T E N T H E D I T I O N

xvi PREFACE TO TENTH EDITION

assistance. This tenth edition of Contemporary Strategy Analysis has benefitted hugely
from feedback and suggestions from users—both instructors and students. I thank you
and look forward to continuing my engagement with you. Please feel free to contact me at
[email protected]

Robert M. Grant

I
INTRODUCTION

1 The Concept of Strategy

1

Strategy is the great work of the organization. In situations of life or death, it is the Tao
of survival or extinction. Its study cannot be neglected.

—SUN TZU, THE ART OF WAR

To shoot a great score you need a clever strategy.

—RORY MCILROY, GOLF MONTHLY, MAY 19, 2011

Everybody has a plan until they get punched in the mouth.

—MIKE TYSON, FORMER WORLD HEAVYWEIGHT BOXING CHAMPION

The Concept of Strategy

◆ Introduction and Objectives

◆ The Role of Strategy in Success

◆ The Basic Framework for Strategy Analysis

● Strategic Fit

◆ A Brief History of Business Strategy

● Origins and Military Antecedents

● From Corporate Planning to Strategic Management

◆ Strategy Today

● What Is Strategy?

● Why Do Firms Need Strategy?

● Where Do We Find Strategy?

● Corporate and Business Strategy

● Describing Strategy

◆ How Is Strategy Made? The Strategy Process

● Design versus Emergence

● Applying Strategy Analysis

◆ Strategic Management of Not-For-Profit
Organizations

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

4 PART I INTRODUCTION

The Role of Strategy in Success

Strategy Capsules 1.1 and 1.2 describe the careers of two individuals, Queen Elizabeth
II and Lady Gaga, who have been outstandingly successful in leading their organiza-
tions. Although these two remarkable women operate within vastly different arenas,
can their success be attributed to any common factors?

For neither of them can success be attributed to overwhelmingly superior resources.
For all of Queen Elizabeth’s formal status as head of state, she has very little real power
and, in most respects, is a servant of the democratically elected British government.
Lady Gaga is clearly a creative and capable entertainer, but few would claim that
she entered the music business with outstanding talents as a vocalist, musician, or
songwriter.

Introduction and Objectives

Strategy is about achieving success. This chapter explains what strategy is and why it is important to
success, for both organizations and individuals. We will distinguish strategy from planning. Strategy is
not a detailed plan or program of instructions; it is a unifying theme that gives coherence and direction
to the actions and decisions of an individual or an organization.

The principal task of this chapter will be to introduce the basic framework for strategy analysis that
underlies this book. This framework comprises two components of strategy analysis: analysis of the
external environment of the firm (mainly industry analysis) and analysis of the internal environment
(primarily analysis of the firm’s resources and capabilities). We shall then examine what strategy is, how it
has developed over time, how to describe the strategy of a business enterprise, and how organizations
go about making strategy.

Since the purpose of strategy is to help us to win, we start by looking at the role of strategy in success.

By the time you have completed this chapter, you will be able to:

◆ Appreciate the contribution that strategy can make to successful performance and rec-
ognize the essential components of an effective strategy.

◆ Comprehend the basic framework of strategy analysis that underlies this book.

◆ Recognize how strategic management has evolved over the past 60 years.

◆ Identify and describe the strategy of a business enterprise.

◆ Understand how strategy is made within organizations.

◆ Recognize the distinctive features of strategic management among not-for-profit orga-
nizations.

CHAPTER 1 THE CONCEPT Of STRATEgy 5

Nor can their success be attributed either exclusively or primarily to luck. Both have
experienced difficulties and setbacks at different stages of their careers. Central to their
success, however, has been their ability to respond to events—whether positive or neg-
ative—with flexibility and clarity of direction.

My contention is that, common to both the 60-year successful reign of Queen Eliza-
beth II and the short but stellar career of Lady Gaga, is the presence of a soundly for-
mulated and effectively implemented strategy. While these strategies did not exist as
explicit plans, for both Queen Elizabeth and Lady Gaga we can discern a consistency
of direction based upon clear goals and an ability to bend circumstances toward their
desired outcomes.

Elizabeth Windsor’s strategy as queen of the UK and the Commonwealth countries
is apparent in the relationship she has created between herself and her people. As
queen she is figurehead for the nation, an embodiment of its stability and continuity, a
symbol of British family and cultural life, and an exemplar of service and professional
dedication.

Lady Gaga’s remarkable success during 2008–18 reflects a career strategy that uses
music as a gateway to celebrity status, which she has built by combining the generic
tools of star creation—shock value, fashion leadership, and media presence—with a
uniquely differentiated image that has captured the attention and loyalty of teenagers
and young adults throughout the world.

What do these two examples tell us about the characteristics of a strategy that are
conducive to success? In both stories, four common factors stand out (Figure 1.1):

● Goals that are consistent and long term: Both Queen Elizabeth and Lady
Gaga display a focused commitment to career goals that they have pursued
steadfastly.

● Profound understanding of the competitive environment: The ways in
which both Elizabeth II and Lady Gaga define their roles and pursue their
careers reveal a deep and insightful appreciation of the external environ-
ments in which they operate. Queen Elizabeth has been alert both to the
changing political environment in which the monarchy is situated and to the
mood and needs of the British people. Lady Gaga’s business model and stra-
tegic positioning show a keen awareness of the changing economics of the
music business, the marketing potential of social networking, and the needs
of Generation Y.

● Objective appraisal of resources: Both Queen Elizabeth and Lady Gaga have
been adept at recognizing and deploying the resources at their disposal, and
also building those resources—for the Queen, this has included her family, the
royal household, and the recipients of royal patronage; for Lady Gaga, it com-
prises the creative talents of her Haus of Gaga.

● Effective implementation: Without effective implementation, the best-laid strat-
egies are of little use. Critical to the success of Queen Elizabeth and Lady Gaga
has been their effectiveness coordinating and leading “ecosystems” of sup-
portive individuals and organizations.

These observations about the role of strategy in success can be made in relation
to most fields of human endeavor. Whether we look at warfare, chess, politics, sport,
or business, the success of individuals and organizations is seldom the outcome of a

6 PART I INTRODUCTION

purely random process. Nor is superiority in initial endowments of skills and resources
typically the determining factor. Strategies that build on these four elements almost
always play an influential role.

Look at the “high achievers” in any competitive area. Whether we review the
world’s political leaders, the CEOs of the Fortune 500, or our own circles of friends
and acquaintances, those who have achieved outstanding success in their careers
are seldom those who possessed the greatest innate abilities. Success has gone to
those who managed their careers most effectively, typically by combining these
four strategic factors. They are goal focused; their career goals have taken pri-
macy over the multitude of life’s other goals—friendship, love, leisure, knowledge,
spiritual fulfillment—which the majority of us spend most of our lives juggling and
reconciling. They know the environments within which they play and tend to be
fast learners in terms of recognizing the paths to advancement. They know them-
selves well in terms of both strengths and weaknesses. Finally, they implement

STRATEGY CAPSULE 1.1

Queen Elizabeth II and the House of Windsor

By late 2018, Elizabeth Windsor had been queen for 66

years—longer than any of her predecessors.

At her birth on April 21, 1926, 45 other countries were

hereditary monarchies. By 2018, the forces of democracy,

modernity, and reform had reduced these to 26—mostly

small autocracies such as Bahrain, Qatar, Oman, Kuwait,

Bhutan, and Lesotho. Monarchies had also survived in

Denmark, Sweden, Norway, the Netherlands, and Bel-

gium, but these royal families had lost most of their

wealth and privileges.

By contrast, the British royal family retains con-

siderable wealth—the Queen’s personal net worth

is about $500 million—not including the $10 billion

worth of palaces and other real estate owned by the

nation but used by her and her family. Queen Eliza-

beth’s formal status is head of state of the UK and 15

other Commonwealth countries (including Canada and

Australia), head of the Church of England, and head of

the British armed forces. Yet none of these positions

confers any decision-making power—her influence

comes from the informal role she has established for

herself. According to her website, she “has a less formal

role as Head of Nation” where she “acts as a focus for

national identity, unity and pride; gives a sense of sta-

bility and continuity; officially recognises success and

excellence; and supports the ideal of voluntary service”

(www.royal.gov.uk).

How has Queen Elizabeth been able to retain not

just the formal position of the monarchy but also its

status, influence, and wealth despite so many chal-

lenges? These include wrenching social and political

changes and the trials of leading such a famously

dysfunctional family—including the failed marriages

of most of her children and the controversy that sur-

rounded the life and death of her daughter-in-law,

Diana, Princess of Wales.

At the heart of Elizabeth’s sustaining of the British

monarchy has been her single-minded devotion to what

she regards as her duties to the monarchy and to the

nation. In cultivating her role as leader of her nation, she

has preserved her political neutrality—even when she

has disagreed with her prime ministers (notably with

CHAPTER 1 THE CONCEPT Of STRATEgy 7

their career strategies with commitment, consistency, and determination. As the
management guru Peter Drucker observed: “we must learn how to be the CEO of
our own career.”1

There is a downside, however. Focusing on a single goal may lead to outstanding
success but may be matched by dismal failure in other areas of life. Many people who
have reached the pinnacles of their careers have led lives scarred by poor relationships
with friends and families and stunted personal development. These include Howard
Hughes and Jean Paul Getty in business, Richard Nixon and Joseph Stalin in politics,
Elvis Presley and Marilyn Monroe in entertainment, Tiger Woods and Boris Becker
in sport, and Bobby Fischer in chess. For most of us, personal fulfillment is likely to
require broad-based rather than narrowly focused goals.2

These same ingredients of successful strategies—clear goals, understanding the
competitive environment, resource appraisal, and effective implementation—form the
key components of our analysis of business strategy.

Margaret Thatcher’s “socially divisive” policies and Tony

Blair’s sending troops to Iraq and Afghanistan).

Through her outreach activities she promotes British

influence, British culture, and British values within the

wider world. She has made multiple visits to each of the

54 Commonwealth nations, including 27 to Canada and

16 to Australia.

The growing unacceptability of hereditary privilege

and the traditional British class system has required her

to reposition the royal family from being the leader of

the ruling class to embodying the nation as a whole. To

make her and her family more inclusive and less socially

stereotyped she has cultivated involvement with

popular culture, with ordinary people engaged in social

service and charitable work, and she has endorsed the

marriage of her grandsons William and Harry—the first

members of the royal family to marry outside the ranks

of the aristocracy.

Elizabeth has been adept at exploiting new media

for communicating both with her subjects and with a

wider global audience: initially through television, more

recently using the web, Twitter, and Facebook. Her press

and public relations staff comprises top professionals

who report to her private secretary.

While respecting tradition and protocol, she adapts

in the face of pressing circumstances. The death of her

daughter-in-law, Diana, created difficult tensions bet-

ween her responsibilities as mother and grandmother

and her need to show leadership to a grieving nation.

In responding to this crisis she recognized the need to

depart from established traditions.

Elizabeth has made effective use of the resources

available to her—especially the underlying desire of

the British people for continuity and their inherent

distrust of their political leaders. By positioning

herself above the political fray and emphasizing her

lineage—including the prominent public roles of her

mother and her children and grandchildren—she

reinforces the legitimacy of herself, her family, and the

institution they represent. She has also exploited her

powers of patronage, using her formal position to cul-

tivate informal relationships with both political and

cultural leaders.

The success of Elizabeth’s 66-year reign is indicated

by the popular support for her personally and for the

institution of the monarchy. Outside of Northern Ireland

and Quebec, republicanism is weak throughout the

British Commonwealth.

8 PART I INTRODUCTION

STRATEGY CAPSULE 1.2

Lady gaga and the Haus of gaga

Stefani Joanne Angelina Germanotta, better known as

Lady Gaga, is one of the most successful popular enter-

tainers of the 21st century. Since her first album, The

Fame, in 2008, all four of her albums have topped the Bill-

board charts; she has also topped Forbes Celebrity 100 list,

and generated $560 million in ticket sales from her five

concert tours between 2009 and 2017.

Since dropping out of NYU’s Tisch School of the Arts

in 2005, Germanotta has shown total commitment to

advancing her musical career, first as a songwriter, and

then developing her Lady Gaga persona.

Gaga’s music is a catchy mix of pop and dance, well

suited to dance clubs and radio airplay. It features good

melodies, Gaga’s capable vocals, and her reflections on

society and life, but it is hardly exceptional or innovative:

music critic Simon Reynolds described it as: “ruthlessly

catchy, naughties pop glazed with Auto-Tune and under-

girded with R&B-ish beats.”

However, music is only one element in the Lady Gaga

phenomenon—her achievement is not so much as a

singer or songwriter as in establishing a persona which

transcends pop music. Like David Bowie and Madonna

before her, Lady Gaga is famous for being Lady Gaga.

To do this she has created a multimedia, multifaceted

offering that comprises multiple components including

music, visual appearance, newsworthy events, a distinc-

tive attitude and personality, and a set of values with

which fans can identify.

Key among these is visual impact and theatricality.

Her hit records are promoted by visually stunning music

videos that have won Grammy awards and broken

records for numbers of YouTube downloads. Most striking

of all has been Lady Gaga’s dress and overall appearance,

which have set new standards in eccentricity, innovation,

and impact. Individual outfits—her plastic bubble dress,

meat dress, and “decapitated-corpse dress”—together

with weird hair-dos, extravagant hats, and extreme foot-

wear—are as well-known as her hit songs. The range of

visual images she projects means that her every appear-

ance creates a buzz of anticipation.

Lady Gaga has developed a business model adapted

to the post-digital world of entertainment. Like Web 2.0

pioneers such as Facebook and Twitter, Gaga has fol-

lowed the model: first build market presence, and then

think about monetizing that presence. By 2012, her

YouTube views, Facebook likes, and Twitter followers

had made her the “most popular living musician online.”

Her networking with fans includes Gagaville, an interac-

tive game developed by Zynga, and The Backplane, a

music-based social network.

Her emphasis on visual imagery takes account of the

means through which media popularity is converted

into revenues. While music royalties are important, con-

certs are her primary revenue source. Other revenue

sources—endorsements, product placement in videos

and concerts, merchandizing deals, and media appear-

ances—also link closely with her visual presence.

A distinctive feature of Gaga’s market positioning

is her relationship with her fans. The devotion of her

fans—her “Little Monsters”—is based less on their desire

to emulate her look as upon empathy with her values

and attitudes: Gaga’s images are social statements of

non-conformity rather than fashion statements. In com-

municating her experiences of alienation and bullying at

school and her values of individuality, sexual freedom,

and acceptance of differences, she has built a global fan

base of unusual loyalty and commitment. The sense of

belonging is reinforced by gestures and symbols such as

the “Monster Claw” greeting and the “Manifesto of Little

Monsters.” As “Mother Monster,” Gaga is spokesperson

and guru for this community.

Lady Gaga’s showmanship and theatricality are sup-

ported by The Haus of Gaga, a creative workshop modeled

on Andy Warhol’s “Factory.” It comprises a creative director

who coordinates a team of choreographers, fashion

designers, hair stylists, photographers, set designers, song-

writers, musicians, and marketing professionals.

Sources: M. Sala, “The Strategy of Lady Gaga,” BSc thesis Boc-
coni University, Milan, June 2011; http://www.biography.com/
people/lady-gaga-481598, accessed August 24, 2017.

CHAPTER 1 THE CONCEPT Of STRATEgy 9

The Basic Framework for Strategy Analysis

Figure 1.2 shows the basic framework for strategy analysis that we shall use throughout
the book. The four elements of a successful strategy shown in Figure  1.1 are recast
into two groups—the firm and the industry environment—with strategy forming a
link between the two. The firm embodies three of these elements: goals and values
(“simple, consistent, long-term goals”), resources and capabilities (“objective appraisal
of resources”), and structure and systems (“effective implementation”). The industry
environment embodies the fourth (“profound understanding of the competitive envi-
ronment”) and is defined by the firm’s relationships with competitors, customers, and
suppliers.

This view of strategy as a link between the firm and its industry environment has
close similarities with the widely used SWOT framework. However, as I explain in
Strategy Capsule 1.3, a two-way classification of internal and external forces is superior
to the four-way SWOT framework.

The task of business strategy, then, is to determine how the firm will deploy its
resources within its environment and so satisfy its long-term goals and how it will orga-
nize itself to implement that strategy.

Profound
understanding of the

competitive environment

Objective
appraisal

of resources

EFFECTIVE IMPLEMENTATION

Clear, consistent,
long-term

goals

Successful
strategy

FIGURE 1.1 Common elements in successful strategies

STRATEGY

THE FIRM

• Goals and Values
• Resources and
Capabilities
• Structure and
Systems

THE INDUSTRY
ENVIRONMENT

• Competitors
• Customers
• Suppliers

FIGURE 1.2 The basic framework: Strategy as a link between the firm and its environment

10 PART I INTRODUCTION

Strategic Fit

Fundamental to this view of strategy as a link between the firm and its external envi-
ronment is the notion of strategic fit. This refers to the consistency of a firm’s strategy,
first, with the firm’s external environment and, second, with its internal environment,
especially with its goals and values and resources and capabilities. A major reason for
companies’ decline and failure is a strategy that lacks consistency with either the internal
or the external environment. The woes of the Italian airline, Alitalia, may be attributed to
a strategy that failed to respond to competition from budget airlines such as Ryanair and
EasyJet. Other companies struggle to align their strategies to their internal resources and
capabilities. A critical issue for Nintendo will be whether it possesses the financial and
technological resources to continue to compete head-to-head with Sony and Microsoft
in the market for video game consoles.

The concept of strategic fit also relates to the internal consistency among the differ-
ent elements of a firm’s strategy. An effective strategy is one in which all the decisions
and actions that make up the strategy are aligned with one another to create a con-
sistent strategic position and direction of development. This notion of internal fit is
central to Michael Porter’s conceptualization of the firm as an activity system. Porter

STRATEGY CAPSULE 1.3

What’s Wrong with SWOT?

Distinguishing between the external and the internal

environment of the firm is common to most approaches

to strategy analysis. The best-known and most widely

used of these is the “SWOT” framework, which classifies

the various influences on a firm’s strategy into four cat-

egories: Strengths, Weaknesses, Opportunities, and

Threats. The first two—strengths and weaknesses—

relate to the internal environment of the firm, primarily its

resources and capabilities; the last two—opportunities

and threats—relate to the external environment.

Which is better, a two-way distinction between

internal and external influences or the four-way SWOT

taxonomy? The key issue is whether it is sensible and

worthwhile to classify internal factors into strengths

and weaknesses and external factors into opportu-

nities and threats. In practice, these distinctions are

problematic.

Was Zlatan Ibrahimovic a strength or a weakness for

Manchester United? As the team’s top scorer during the

2016–17 season and ranking among the world’s top-10

players, he was a strength. But as a player whose best

days were behind him and whose dominant presence

intimidated his younger team-mates, he was a weakness.

Is global warming a threat or an opportunity for the

world’s automobile producers? By encouraging higher

taxes on motor fuels and restrictions on car use, it is a threat.

By encouraging consumers to switch to fuel-efficient and

electric cars, it offers an opportunity for new sales.

The lesson here is that classifying external factors

into opportunities and threats, and internal factors into

strengths and weaknesses, is arbitrary. What is important

is to carefully identify the external and internal forces that

impact the firm, and then analyze their implications.

In this book, I will follow a simple two-way classification

of internal and external factors and avoid any premature

categorization into strengths or weaknesses, and oppor-

tunities or threats.

Note: For more on SWOT see: T. Hill and R. Westbrook, “SWOT
Analysis: It’s Time for a Product Recall,” Long Range Planning, 30
(February 1997): 46–52; and M. Venzin, “SWOT Analysis: Such
a Waste of Time?” (February 2015) http://ideas.sdabocconi.it/
strategy/archives/3405.

CHAPTER 1 THE CONCEPT Of STRATEgy 11

states that “Strategy is the creation of a unique and differentiated position involving a
different set of activities.”3 The key is how these activities fit together to form a consis-
tent, mutually reinforcing system. Ryanair’s strategic position is as Europe’s lowest-cost
airline providing no-frills flights to budget-conscious travelers. This is achieved by a
set of activities that fit together to support that positioning (Figure 1.3).

The concept of strategic fit is one component of a set of ideas known as
contingency theory. Contingency theory postulates that there is no single best
way of organizing or managing. The best way to design, manage, and lead an orga-
nization depends upon circumstances—in particular, the characteristics of that orga-
nization’s environment.4

A Brief History of Business Strategy

Origins and Military Antecedents

Enterprises need business strategies for much the same reason that armies need mili-
tary strategies—to give direction and purpose, to deploy resources in the most effec-
tive manner, and to coordinate the decisions made by different individuals. Many
of the concepts and theories of business strategy have their antecedents in military
strategy. The term strategy derives from the Greek word strategia, meaning “general-
ship.” However, the concept of strategy predates the Greeks: Sun Tzu’s classic, The Art
of War, from about 500 BC is regarded as the first treatise on strategy.5

Military strategy and business strategy share a number of common concepts and
principles, the most basic being the distinction between strategy and tactics. Strategy
is the overall plan for deploying resources to establish a favorable position; a tactic
is a scheme for a specific action. Whereas tactics are concerned with the maneu-
vers necessary to win battles, strategy is concerned with winning the war. Strategic
decisions, whether in military or business spheres, share three common characteristics:

● They are important.

● They involve a significant commitment of resources.

● They are not easily reversible.

Low operating costs

Secondary
airports

Point-to-point routes

25-min
turnaround

High aircraft
utilization

No-frills product
offering

High labor
productivity

Low prices;
separate charging

for additional
services

Single class; no
reserved seating

No baggage
transfer

Internet-only
check-in

Job
f lexibility

Direct
sales
only

Boeing
737s only

FIGURE 1.3 Ryanair’s activity system

12 PART I INTRODUCTION

Many of the principles of military strategy have been applied to business situations.
These include the relative strengths of offensive and defensive strategies; the merits of
outflanking over frontal assault; the roles of graduated responses to aggressive initia-
tives; the benefits of surprise; and the benefits of deception, envelopment, escalation,
and attrition.6 At the same time, there are major differences between business compe-
tition and military conflict. The objective of war is (usually) to defeat the enemy. The
purpose of business rivalry is seldom so aggressive: most business enterprises seek to
coexist with their rivals rather than to destroy them.

Despite parallels between military and business strategy, we lack a general theory
of strategy. The publication of Von Neumann and Morgenstern’s Theory of Games in
1944 gave rise to the hope that a general theory of competitive behavior would emerge.
Since then, game theory has revolutionized the study of competitive interaction, not
just in business but in politics, military studies, and international relations as well.
Yet, as we shall see in Chapter 4, game theory has achieved only limited success as a
broadly applicable general theory of strategy.7

From Corporate Planning to Strategic Management

The evolution of business strategy has been driven more by the practical needs of
business than by the development of theory. During the 1950s and 1960s, senior exec-
utives experienced increasing difficulty in coordinating decisions and maintaining con-
trol in companies that were growing in size and complexity. While new techniques of
discounted cash flow analysis allowed more rational choices over individual investment
projects, firms lacked systematic approaches to their long-term development. Corpo-
rate planning (also known as long-term planning) was developed during the late-
1950s to serve this purpose. Macroeconomic forecasts provided the foundation for
the new corporate planning. The typical format was a five-year corporate planning
document that set goals and objectives, forecasted key economic trends (including
market demand, the company’s market share, revenue, costs, and margins), established
priorities for different products and business areas of the firm, and allocated capital
expenditures. The new techniques of corporate planning proved particularly useful for
guiding the diversification strategies that many large companies pursued during the
1960s.8 By the mid-1960s, most large US and European companies had set up corpo-
rate planning departments. Strategy Capsule 1.4 provides an example of this formalized
corporate planning.

By the early 1980s, confidence in corporate planning had been severely shaken. Not
only did diversification fail to deliver the anticipated synergies, but the oil shocks of
1974 and 1979 ushered in a new era of macroeconomic instability, while Western com-
panies came under increasing pressure from Japanese, Korean, and Southeast Asian
competitors. Companies could no longer plan their investments and actions five years
ahead—they couldn’t forecast that far.

The result was a shift in emphasis from planning a company’s growth path to
positioning the company so that it could best exploit available opportunities for
profit. This transition from corporate planning to what became called strategic
management involved a focus on competition as the central characteristic of the
business environment and on performance maximization as the primary goal of
strategy.

This emphasis on strategy as a quest for performance directed attention to the
sources of profitability. At the end of the 1970s, Michael Porter pioneered the applica-
tion of industrial organization economics to analyzing the profit potential of different

CHAPTER 1 THE CONCEPT Of STRATEgy 13

industries and markets.9 Other studies examined how strategic variables—notably
market share—determined how profits were distributed between the firms within an
industry.10

During the 1990s, the focus of strategy analysis shifted from the sources of profit in
the external environment to the sources of profit within the firm. The resource-based
view of the firm identified the resources and capabilities of the firm as its main
source of competitive advantage and the primary basis for formulating strategy.11 This
emphasis on internal resources and capabilities has encouraged firms to identify how
they are different from their competitors and to design strategies that exploit these
differences.

During the 21st century, new challenges have continued to shape the princi-
ples and practice of strategy. Digital technologies have had a massive impact on
the competitive dynamics of many industries, creating winner-take-all markets
and standards wars.12 Disruptive technologies13 and accelerating rates of change
have meant that strategy has become less and less about plans and more about
creating options of the future,14 fostering strategic innovation,15 and seeking the
“blue oceans” of uncontested market space.16 The complexity of these challenges
has meant that being self-sufficient is no longer viable for most firms—alliances and
other forms of collaboration are an increasingly common feature of firms’ strategies.

The 2008–2009 financial crisis triggered closer scrutiny of purpose of business. Dis-
illusion with the excesses and unfairness of market capitalism has renewed interest in
corporate social responsibility, ethics, sustainability, and the legitimacy of profit as the
dominant goal of business.17

Figure 1.4 summarizes the main developments in strategic management since the
mid-20th century.

STRATEGY CAPSULE 1.4

Corporate Planning in a Large US Steel Company, 1965

The first step in developing long-range plans was to

forecast the product demand for future years. After cal-

culating the tonnage needed in each sales district to pro-

vide the “target” fraction of the total forecast demand, the

optimal production level for each area was determined.

A computer program that incorporated the projected

demand, existing production capacity, freight costs, etc.

was used for this purpose.

When the optimum production rate in each area was

found, the additional facilities needed to produce the

desired tonnage were specified. Then, the capital costs

for the necessary equipment, buildings, and layout were

estimated by the chief engineer of the corporation and

various district engineers. Alternative plans for achiev-

ing company goals were also developed for some areas,

and investment proposals were formulated after consid-

ering the amount of available capital and the company

debt policy. The vice president who was responsible for

long-range planning recommended certain plans to the

president, and, after the top executives and the board

of directors reviewed alternative plans, they made the

necessary decisions about future activities.

Source: H. W. Henry, Long Range Planning Processes in 45
Industrial Companies (Englewood Cliffs, NJ: Prentice-Hall,
1967): 65.

14 PART I INTRODUCTION

1950
1960

• Operational budgeting
• DCF capital budgeting

Financial Budgeting:

1970

Corporate Planning:
• Corporate plans based on medium-term
economic forecasts

1980
Emergence of Strategic Management:

• Industry analysis and competitive positioning
1990

The Quest for Competitive Advantage:
• Emphasis on resources and capabilities
• Shareholder value maximization

2000
2018

• Refocusing, outsourcing, delayering, cost
cutting

Adapting to Turbulence:
• Adapting to and exploiting digital technology
• The quest for flexibility and strategic innovation
• Strategic alliances
• Social and environmental responsibility

FIGURE 1.4 Evolution of strategic management

Strategy Today

What Is Strategy?

In its broadest sense, strategy is the means by which individuals or organizations
achieve their objectives. Table  1.1 presents a number of definitions of the term
strategy. Common to most definitions is the notion that strategy involves setting goals,
allocating resources, and establishing consistency and coherence among decisions
and actions.

Yet, as we have seen, the conception of firm strategy has changed greatly over
the past half-century. As the business environment has become more unstable and
unpredictable, so strategy has become less concerned with detailed plans and more
about guidelines for success. This is consistent with the introductory examples to
this chapter. Neither Queen Elizabeth nor Lady Gaga appears to have articulated any
explicit strategic plan, but the consistency we discern in their actions suggests both
possessed clear ideas of what they wanted to achieve and how they would achieve
it. This shift in emphasis from strategy as plan to strategy as direction does not imply
any downgrading of the role of strategy. The more turbulent the environment, the
more strategy must embrace flexibility and responsiveness. But it is precisely under
these conditions that strategy becomes more, rather than less, important. When the
firm is buffeted by unforeseen threats and where new opportunities are constantly
appearing, then strategy becomes the compass that can navigate the firm through
stormy seas.

CHAPTER 1 THE CONCEPT Of STRATEgy 15

Why Do Firms Need Strategy?

This transition from strategy as plan to strategy as direction raises the question of
why firms (or other types of organization) need strategy. Strategy assists the effective
management of organizations, first, by enhancing the quality of decision-making, sec-
ond, by facilitating coordination, and, third, by focusing organizations on the pursuit
of long-term goals.

Strategy as Decision Support Strategy is a pattern or theme that gives coher-
ence to the decisions of an individual or organization. But why can’t individuals
or organizations make optimal decisions in the absence of such a unifying theme?
Consider the 1997 “man versus machine” chess epic in which Garry Kasparov was
defeated by IBM’s “Deep Blue” computer. Deep Blue did not need strategy. Its phe-
nomenal memory and computing power allowed it to identify its optimal moves
based on a huge decision tree.18 Kasparov—although the world’s greatest chess
player—was subject to bounded rationality: his decision analysis was subject to the
cognitive limitations that constrain all human beings.19 For him, a strategy offered
guidance that assisted positioning and helped create opportunities. Strategy improves
decision-making in several ways:

● It simplifies decision-making by constraining the range of decision alternatives
considered and acting as a heuristic—a rule of thumb that reduces the search
required to find an acceptable solution to a decision problem.

● The strategy-making process permits the knowledge of different individuals to
be pooled and integrated.

● It facilitates the use of analytic tools—the frameworks and techniques that we
will encounter in the ensuing chapters of this book.

Strategy as a Coordinating Device The central challenge of management is
coordinating the actions of multiple organizational members. Strategy acts as a com-
munication device to promote coordination. Statements of strategy are a means by

TABLE 1.1 Some definitions of strategy

● Strategy: a plan, method, or series of actions designed to achieve a specific goal or effect.
—Wordsmyth Dictionary (www.wordsmyth.net)

● The determination of the long-run goals and objectives of an enterprise, and the adoption of
courses of action and the allocation of resources necessary for carrying out these goals.

—Alfred Chandler, Strategy and Structure
(Cambridge, MA: MIT Press, 1962)

● Strategy: “a cohesive response to an important challenge.”
—Richard Rumelt, Good Strategy/Bad Strategy

(New York: Crown Business, 2011): 6.

● Lost Boy: “Injuns! Let’s go get ’em!”
John Darling: “Hold on a minute. First we must have a strategy.”
Lost Boy: “Uhh? What’s a strategy?”
John Darling: “It’s, er … it’s a plan of attack.”

—Walt Disney’s Peter Pan

16 PART I INTRODUCTION

which the CEO can communicate the identity, goals, and positioning of the company
to all organizational members. The strategic planning process provides a forum in
which views are exchanged and consensus developed; once formulated, strategy can
be translated into goals, commitments, and performance targets that ensure that the
organization moves forward in a consistent direction.

Strategy as Target Strategy is forward looking. It is concerned not only with how
the firm will compete now, but also with what the firm will become in the future.
A forward-looking strategy establishes direction for the firm’s development and sets
aspirations that can motivate and inspire members of the organization. Gary Hamel
and C. K. Prahalad use the term strategic intent to describe this desired strategic
position: “strategic intent creates an extreme misfit between resources and ambitions.
Top management then challenges the organization to close the gap by building new
competitive advantages.”20 The implication is that strategy should embrace stretch and
resource leverage and not be overly constrained by considerations of strategic fit.21
Jim Collins and Jerry Porras make a similar point: US companies that have been sector
leaders for 50 years or more have all generated commitment and drive through setting
“Big, Hairy, Ambitious Goals.”22 Striving, inspirational goals are found in most organiza-
tions’ statements of vision and mission. One of the best known is that set by President
Kennedy for NASA’s space program: “before this decade is out, to land a man on the
moon and return him safely to earth.” However, goals on their own do not constitute
a strategy. Unless an organization’s goals are backed by guidelines for their attainment,
they are likely to be either meaningless or delusional.23

Where Do We Find Strategy?

Strategy has its origins in the thought processes of organizational leaders. For the entre-
preneur, the starting point of strategy is the idea for a new business. Until the new
business needs to raise finance, there is little need for any explicit statement of strategy.
At that point, the entrepreneur articulates the strategy in a business plan. In large
companies, strategy formulation is an explicit management process and statements of
strategy are found in board minutes and strategic planning documents, which are inva-
riably confidential. However, most companies—public companies in particular—see
value in communicating their strategy to employees, customers, investors, and business
partners. Collis and Rukstad identify four types of statement through which companies
communicate their strategies:

● The mission statement describes organizational purpose; it addresses “Why
we exist.”

● A statement of principles or values outlines “What we believe in and how we
will behave.”

● The vision statement projects “What we want to be.”

● The strategy statement articulates the company’s competitive game plan, which
typically describes objectives, business scope, and advantage.24

These statements can be found on the corporate pages of companies’ websites. More
detailed statements of strategy—including qualitative and quantitative medium-term
targets—are often found in top management presentations to analysts, which are
typically included in the “for investors” pages of company websites. Strategy Capsule
1.5 shows statements of strategy by McDonalds and Twitter.

CHAPTER 1 THE CONCEPT Of STRATEgy 17

STRATEGY CAPSULE 1.5

Statements of Company Strategy: McDonald’s and Twitter

McDONALD’S CORPORATION

Our goal is to become customers’ favorite place and

way to eat and drink by serving core favorites such

as our World Famous Fries, Big Mac, Quarter Pounder

and Chicken McNuggets.

The strength of the alignment among the

Company, its franchisees and suppliers (collectively

referred to as the “System”) has been key to McDonald’s

success. By leveraging our System, we are able to iden-

tify, implement and scale ideas that meet customers’

changing needs and preferences.

McDonald’s customer-focused Plan to Win (“Plan”)

provides a common framework that aligns our global

business and allows for local adaptation. We con-

tinue to focus on our three global growth priorities

of optimizing our menu, modernizing the customer

experience, and broadening accessibility to Brand

McDonald’s within the framework of our Plan. Our

initiatives support these priorities, and are executed

with a focus on the Plan’s five pillars—People, Prod-

ucts, Place, Price and Promotion—to enhance our

customers’ experience and build shareholder value

over the long term. We believe these priorities align

with our customers’ evolving needs, and—combined

with our competitive advantages of convenience,

menu variety, geographic diversification and System

alignment—will drive long-term sustainable growth.

Source: www.mcdonalds.com.

TWITTER, INC.

We have aligned our growth strategy around the

three primary constituents of our platform:

Users. We believe that there is a significant oppor-

tunity to expand our user base…

◆ Geographic Expansion. We plan to develop a

broad set of partnerships globally to increase rele-

vant local content … and make Twitter more acces-

sible in new and emerging markets.

◆ Mobile Applications. We plan to continue to

develop and improve our mobile applications…

◆ Product Development. We plan to continue to

build and acquire new technologies to develop

and improve our products and services…

Platform Partners. We believe growth in our

platform partners is complementary to our user

growth strategy…

◆ Expand the Twitter Platform to Integrate More

Content. We plan to continue to build and acquire

new technologies to enable our platform partners

to distribute content of all forms.

◆ Partner with Traditional Media  …  to drive more

content distribution on our platform…

Advertisers… [I]ncrease the value of our platform

for our advertisers by enhancing our advertising

services and making our platform more accessible.

◆ Targeting. We plan to continue to improve the tar-

geting capabilities of our advertising services.

◆ Opening our Platform to Additional Advertisers.

We believe that advertisers outside of the United

States represent a substantial opportunity…

◆ New Advertising Formats.

Source: Twitter, Inc. Amendment no. 4 to Form S-1, Registration
Statement, SEC, November 4, 2013.

18 PART I INTRODUCTION

All these are intentions and, as we shall see, strategic intent is not necessarily real-
ized. Ultimately, strategy is realized as action. Hence, strategy is observable in where
and how a firm chooses to compete. For example, information on a firm’s business
scope (products and its markets) and how it competes within these markets can be
found in a company’s annual reports. For US corporations, the description of the
business that forms Item 1 of the 10-K annual report to the Securities and Exchange
Commission (SEC) is particularly informative about strategy.

Checking a company’s pronouncements about strategy against its decisions and
actions may reveal a gap between rhetoric and reality. As a reality check upon gran-
diose and platitudinous sentiments of vision and mission, it is useful to ask:

● Where is the company investing its money? Notes to financial statements
provide detailed breakdowns of capital expenditure by region and by
business segment.

● What technologies is the company developing? Identifying the patents that a
company has filed (using the online databases of the US and EU patent offices)
indicates the technological trajectory a firm is pursuing.

● What new products have been released, major investment projects initiated, and
top management hired? These strategic decisions are typically announced in
press releases and reported in trade journals.

To identify a firm’s strategy it is necessary to draw upon multiple sources of
information in order to build an overall picture of what the company says it is doing
matches what it is actually doing. We will return to this topic when we discuss compet-
itive intelligence in Chapter 4.

Corporate and Business Strategy

Strategic choices can be distilled into two basic questions:

● Where to compete?

● How to compete?

The answers to these questions define the two major areas of a firm’s strategy: cor-
porate strategy and business strategy.

Corporate strategy defines the scope of the firm in terms of the industries and mar-
kets in which it competes. Corporate strategy decisions include choices over diver-
sification, vertical integration, acquisitions, and new ventures, and the allocation of
resources between the different businesses of the firm.

Business strategy is concerned with how the firm competes within a particular
industry or market. If the firm is to prosper within an industry, it must establish a
competitive advantage over its rivals. Hence, this area of strategy is also referred to as
competitive strategy.

The distinction between corporate strategy and business strategy corresponds to the
organizational structure of most large companies. Corporate strategy is the responsi-
bility of corporate top management. Business strategy is primarily the responsibility of
the senior managers of divisions and subsidiaries.

This distinction between corporate and business strategy also corresponds to the pri-
mary sources of superior profit for a firm. To survive and prosper over the long term,

CHAPTER 1 THE CONCEPT Of STRATEgy 19

a firm must earn a rate of return on its capital that exceeds its cost of capital. There are
two possible ways of achieving this. First, by locating within industries that offer attrac-
tive rates of profit (corporate strategy). Second, by establishing a competitive advantage
over rivals within an industry (Figure 1.5). This distinction may be expressed even more
simply. The basic question facing the firm is “How do we make money?” This prompts
the two basic strategic choices we identified above: “Where to compete?” and “How
to compete?”

As an integrated approach to firm strategy, this book deals with both business and
corporate strategy. However, our primary emphasis will be on business strategy. This
is because the critical requirement for a company’s success is its ability to establish
competitive advantage. Hence, issues of business strategy precede those of corporate
strategy. At the same time, these two dimensions of strategy are intertwined: the scope
of a firm’s business has implications for the sources of competitive advantage, and the
nature of a firm’s competitive advantage determines the industries and markets it can
be successful in.

Describing Strategy

These same two questions—“Where is the firm competing?” and “How is it com-
peting?”—also provide the basis upon which we can describe the strategy that a firm
is pursuing. The where question has multiple dimensions. It relates to the products the
firm supplies, the customers it serves, the countries and localities where it operates,
and the vertical range of activities it undertakes. The how question relates to the nature
of the firm’s competitive advantage: Is it seeking a cost advantage or a differentiation
advantage? How is the firm using its distinctive resources and capabilities to establish
a competitive advantage?

However, strategy is not simply about “competing for today”; it is also concerned
with “competing for tomorrow.” This dynamic aspect of strategy involves establishing
objectives for the future and determining how they will be achieved. Future objectives
relate to the overall purpose of the firm (mission), what it seeks to become (vision),
and how it will meet specific performance targets.

These two dimensions of strategy—the static and the dynamic—are depicted
in Figure  1.6. As we shall see in Chapter  8, reconciling these two dimensions of

CORPORATE
STRATEGY

BUSINESS
STRATEGY

COMPETITIVE
ADVANTAGE

How to
compete?

INDUSTRY
ATTRACTIVENESS

Where to compete?RATE OF PROFIT
ABOVE THE COST

OF CAPITAL

How do we
make money?

FIGURE 1.5 The sources of superior profitability

20 PART I INTRODUCTION

strategy—what Derek Abell calls “competing with dual strategies”—is one of the central
dilemmas of strategic management.25

How is Strategy Made? The Strategy Process

How companies make strategy and how they should make strategy are among the most
hotly debated issues in strategic management. The corporate planning undertaken by
large companies during the 1960s was a highly formalized approach to strategy mak-
ing. Strategy may also be made informally: emerging through adaptation to circum-
stances. In our opening discussion of Queen Elizabeth and Lady Gaga, I discerned
a consistency and pattern to their career decisions that I identified as strategy, even
though there is no evidence that either of them engaged in any systematic process of
strategy formulation. Similarly, successful companies are seldom the products of grand
designs. The rise of Apple Inc. to become the world’s most valuable company (in terms
of stock market capitalization) has often been attributed to a brilliant strategy of inte-
grating hardware, software, and design aesthetics to create electronic products that
offered a unique consumer experience. Yet, there is little evidence that Apple’s incred-
ible success since 2004 was the result of an explicit strategy. Apple’s huge success with
its iPod, iPhone, and iPad was the outcome of a set of strategic decisions that combined
Steve Job’s penetrating insight into consumer preferences and technological trends with
Apple’s capabilities in design, marketing, the integration of hardware and software, and
the management of an ecosystem of partners.

So, what does this mean for strategy making by companies and other organizations?
Should managers seek to formulate strategy through a rational systematic process, or
is the best approach in a turbulent world to respond to events with opportunism and
creativity?

Design versus Emergence

Henry Mintzberg is a leading critic of rational, analytical approaches to strategy design.
He distinguishes intended, emergent, and realized strategies. Intended strategy is

COMPETING FOR THE
PRESENT

PREPARING FOR THE
FUTURE

Strategy as Direction
• What do we want to become?
-Vision statement
• What do we want to achieve?
-Mission statement
-Performance goals
• How will we get there?
-Guidelines for development
-Priorities for capital expenditure,
R & D
-Growth modes: organic growth,
M & A, alliances

Strategy as Positioning

• Where are we competing?
-Product market scope
-Geographical scope
-Vertical scope
• How are we competing?
-What is the basis of our
competitive advantage?

FIGURE 1.6 Describing firm strategy: Competing in the present, preparing for
the future

CHAPTER 1 THE CONCEPT Of STRATEgy 21

strategy as conceived of by the leader or top management team. Even here, intended
strategy may be less a product of rational deliberation and more an outcome of
inspiration, negotiation, bargaining, and compromise among those involved in the
strategy-making process. However, realized strategy—the actual strategy that is
implemented—is only partly related to that which was intended (Mintzberg suggests
only 10–30% of intended strategy is realized). The primary determinant of realized
strategy is what Mintzberg terms emergent strategy—the decisions that emerge from
the complex processes in which individual managers interpret the intended strategy
and adapt it to changing circumstances.26

According to Mintzberg, rational design is not only an inaccurate account of how
strategies are actually formulated but also a poor way of making strategy: “The notion
that strategy is something that should happen way up there, far removed from the
details of running an organization on a daily basis, is one of the great fallacies of
conventional strategic management.”27 The emergent approaches to strategy-making
permit adaptation and learning through a continuous interaction between strategy for-
mulation and strategy implementation in which strategy is constantly being adjusted
and revised in the light of experience.

The debate between those who view strategy-making as a rational, analytical pro-
cess of deliberate planning (the design school) and those who envisage strategy-making
as an emergent process (the process or learning school of strategy) has centered on the
case of Honda’s successful entry into the US motorcycle market during the early 1960s.28
The Boston Consulting Group lauded Honda for its single-minded pursuit of a global
strategy based on exploiting economies of scale and learning to establish unassailable
cost leadership.29 However, subsequent interviews with the Honda managers in charge
of its US market entry revealed a different story: a haphazard, experimental approach
with little analysis and no clear plan.30 As Mintzberg observes: “Brilliant as its strategy
may have looked after the fact, Honda’s managers made almost every conceivable mis-
take until the market finally hit them over the head with the right formula.”31

In practice, strategy-making involves both thought and action: “Strategy exists in the
cognition of managers but also is reified in what companies do.”32 Top-down rational
design is combined with decentralized adaptation:

● The design aspect of strategy comprises organizational processes through which
strategy is deliberated, discussed, and decided. These include board meet-
ings, a strategic planning process, and informal participative events, such as
strategy workshops. I will discuss processes of strategic planning more fully in
Chapter 6.

● The enactment of strategy through decisions and actions being taken throughout
the organization is a decentralized process where middle managers play a central
role. These emergent processes are typically viewed as occurring when formal
strategic plans are being implemented. However, these emergent processes may
come first. Intel’s historic decision to abandon memory chips and concentrate on
microprocessors was initiated in the operational decisions of business unit and
plant managers and subsequently adopted as strategy by top management.33

I refer to this process of strategy-making that combines design and emergence as
“planned emergence.”34 The balance between the two depends greatly upon the sta-
bility and predictability of the organization’s business environment. The Roman Catholic
Church and La Poste, the French postal service, inhabit relatively stable environments;
they can plan activities and resource allocations in some detail quite far into the future.

22 PART I INTRODUCTION

For WikiLeaks, the Somali Telecom Group, and Islamic State, strategic planning will
inevitably be restricted to a few guidelines; most strategic decisions must be responses
to unfolding circumstances.

As the business environment becomes more turbulent and less predictable, so
strategy-making becomes less about detailed decisions and more about guidelines
and general direction. Bain & Company advocates the use of strategic principles—
“pithy, memorable distillations of strategy that guide and empower employees”—to
combine consistent focus with adaptability and responsiveness.35 McDonald’s strategy
statement in Strategy Capsule 1.5 is an example of such strategic principles. Similarly,
Southwest Airlines encapsulates its strategy in a simple statement: “Meet customers’
short-haul travel needs at fares competitive with the cost of automobile travel.”
For fast-moving businesses, strategy may be reduced to a set of “simple rules.” For
example, Lego evaluates new product proposals by applying a checklist of rules:
“Does the product have the Lego look?” “Will children learn while having fun?” “Does
it stimulate creativity?”36

Applying Strategy Analysis

Despite the criticisms leveled at rational, analytical approaches to strategy formulation,
the emphasis of this book will be the application of analytical tools to strategy issues.
This is not because I wish to downplay the role of intuition, creativity, or spontaneity—
these qualities are essential ingredients of successful strategies. Nevertheless, whether
strategy formulation is formal or informal, deliberate or emergent, systematic analysis
leads to better decisions and helps protect strategic decision-making from power battles,
whims, fads, and wishful thinking. Concepts, theories, and analytic tools are comple-
ments to, and not substitutes for, intuition and creativity, and they provide a framework
for organizing discussion, processing information, and developing consensus.

We must also recognize limitations of strategy analysis. Unlike many of the analytical
techniques in accounting, finance, market research, or production management, strategy
analysis does not offer algorithms or formulae that tell us the optimal strategy to adopt.
The purpose of strategy analysis is not to provide answers but to help us to probe
the relevant issues. By providing a framework that allows us to examine the factors
that influence a strategic situation and organize relevant information, strategy analysis
places us in a superior position to a manager who relies exclusively on experience
and intuition. Finally, to the extent that our analytic tools are not specific to individual
businesses or situations, they can improve our flexibility as managers. The concepts
and frameworks we shall cover are not specific to particular industries, companies, or
situations. Hence, they can help increase our confidence and effectiveness in under-
standing and responding to new situations and new circumstances.

So, how do we go about applying our tools of strategy analysis in a systematic and
productive way that allows us to make sound strategy recommendations? Developing a
strategy for a business typically involves four main stages. These are shown in Figure 1.7.37

1. Setting the strategic agenda. Any strategy-making exercise must begin by iden-
tifying the important issues that the strategy must address. For an existing
company, this involves assessing whether the current strategy is working, which
requires that we:

● Identify the current strategy. A vital preliminary step is to establish consensus
around what the current strategy is. The above sections on Where Do We Find
Strategy? and Describing Strategy offer guidance in this.

CHAPTER 1 THE CONCEPT Of STRATEgy 23

● Appraise performance. How well is the current strategy performing? In
the next chapter, we shall how to apply financial analysis to assess firm
performance.

2. Analyzing the situation

● Diagnose performance. Having determined the level and trend of the firm’s
performance, the next challenge is diagnosis: In the case of poor performance,
what are the sources of unsatisfactory performance? In the case of good
performance, what are the factors driving this? Chapter 2 offers guidance on
performance. Dick Rumelt puts it even more succinctly: the core question in
most strategy situations is, “What’s going on here?”38

● Industry analysis. To determine whether the current strategy needs to be
changed, we need to look not just at how it is currently performing, but how
it will perform in the future. This requires looking at the likely changes in the
firm’s industry and their implications. Chapters 3 and 4 address industry
analysis.

● Analysis of resources and capabilities. Having established likely external
changes, what do these mean for the firm’s competitive position? This
requires analysis of the firm’s resources and capabilities—which we address
in Chapter 5.

3. Formulating strategy. Performance diagnosis, industry analysis, and resource
and capability analysis provide a basis for generating strategic options, the most
promising of which can be developed into a recommended strategy. Recom-
mended strategies tend to avoid precise specifications of what is to be done, they
are more likely to articulate the primary basis for a firm’s competitive advantage
and what this means for how it will compete. Chapter 7 discusses how the inter-
section of internal strengths and external success factors create the basis for a
firm’s competitive advantage.

4. Implement strategy. Without action, a strategy is merely an idea expressed
in words. Implementing strategy requires allocating resources and moti-
vating people. As we shall see in Chapter 6, this requires putting in place the
organizational structure and management systems within which action can
take place.

Setting the
strategic agenda

Analyzing the
situation

Formulating
strategy

Implementing
strategy

Identify the
current

strategy

Appraise
performance

Diagnose
performance

Industry
analysis

Analysis of
resources and
capabilities

Formulate
strategy

Implement
strategy

FIGURE 1.7 Applying strategy analysis

24 PART I INTRODUCTION

Strategic Management of Not-For-Profit Organizations

When strategic management meant top-down, long-range planning, there was little dis-
tinction between business corporations and not-for-profit organizations: the techniques
of forecast-based planning applied equally to both. As strategic management has become
increasingly oriented toward the identification and exploitation of sources of profit, it has
become more closely identified with for-profit organizations. So, can the concepts and
tools of corporate and business strategy be applied to not-for-profit organizations?

The short answer is yes. Strategy is as important in not-for-profit organizations as it is in
business firms. The benefits I have attributed to strategic management in terms of improved
decision-making, achieving coordination, and setting performance targets (see the section
“Why Do Firms Need Strategy?” above) may be even more important in the nonprofit sec-
tor. Moreover, many of the same concepts and tools of strategic analysis are readily appli-
cable to not-for-profits—albeit with some adaptation. However, the not-for-profit sector
encompasses a vast range of organizations. Both the nature of strategic planning and the
appropriate tools for strategy analysis differ among these organizations.

The basic distinction here is between those not-for-profits that operate in com-
petitive environments (most nongovernmental, nonprofit organizations) and those
that do not (most government departments and government agencies). Among the
not- for-profits that inhabit competitive environments, we may distinguish between

TABLE 1.2 The applicability of the concepts and tools of strategic analysis to
different types of not-for-profit organizations

Organizations
in competitive
environments that
charge users

Organizations
in competitive
environments that
provide free services

Organizations
sheltered from
competition

Examples Royal Opera House
Guggenheim Museum
Stanford University

Salvation Army
Habitat for Humanity
Greenpeace Linux

UK Ministry of Defence,
European Central
Bank, New York Police
Department, World
Health Organization

Analysis of goals
and performance

Identification of mission, goals, and performance indicators and establish-
ing consistency between them is a critical area of strategy analysis for all
not-for-profits

Analysis of the
competitive
environment

Main tools of competitive
analysis are the same as
for for-profit firms

Main arena for compe-
tition and competitive
strategy is the market
for funding

Not important.
However, there is
interagency competi-
tion for public funding

Analysis of
resources and
capabilities

Identifying and exploiting distinctive resources and
capabilities critical to designing strategies that confer
competitive advantage

Analysis of resources
and capabilities
essential for deter-
mining priorities and
designing strategies

Strategy
implementation

The basic principles of organizational design, performance management, and
leadership are common to all organizational types

CHAPTER 1 THE CONCEPT Of STRATEgy 25

those that charge for the services they provide (most private schools, non profit-making
private hospitals, social and sports clubs, etc.) and those that provide their services
free—most charities and NGOs (nongovernmental organizations). Table  1.2 summa-
rizes some key differences between each of these organizations with regard to the
applicability of the basic tools of strategy analysis.

Among the tools of strategy analysis that are applicable to all types of not-for-profit
organizations, those that relate to the role of strategy in specifying organizational goals
and linking goals to resource-allocation decisions are especially important. For busi-
nesses, profit is always a key goal since it ensures survival and fuels development. But
for not-for-profits, goals are typically complex. The mission of Harvard University is to
“create knowledge, to open the minds of students to that knowledge, and to enable
students to take best advantage of their educational opportunities.” But how are these
multiple objectives to be reconciled in practice? How should Harvard’s budget be

STRATEGY CAPSULE 1.6

The Strategic Plan of the International Red Cross

The International Federation of Red Cross and Red

Crescent Societies (IFRC) coordinates activities of 190

National Red Cross and Red Crescent Societies. “Strategy

2020 provides the basis for the strategic plans of National

Societies.” It included the following:

Fundamental
Principles

Humanity, Impartiality, Neutrality, Independence, Voluntary service, Unity, Universality

Vision To inspire, encourage, facilitate and promote at all times all forms of humanitarian
activities by National Societies, with a view to preventing and alleviating human
suffering, and thereby contributing to the maintenance and promotion of human
dignity and peace in the world.

Strategic
Aims

1. Save lives, protect
livelihoods, and strengthen
recovery from disasters
and crises

2. Enable healthy and
safe living

3. Promote social
inclusion and a culture
of non violence and
peace

Enabling Actions Build strong National Red
Cross and Red
Crescent Societies

Pursue humanitarian
diplomacy to prevent
and reduce vulnerability
in a globalized world

Function effectively
as the IFRC

Expected Impact Expanded sustainable
national and local capacities
of National Societies
A stronger culture of
voluntary service and
participation in National
Societies.
Scaled-up services for the
most vulnerable people

Greater access to help
people who are vulnerable
and earlier attention to
causes of vulnerability
Deeper public,
government,
and partner support
More resources to address
vulnerabilities
Stronger recognition of
community perspectives

Stronger cooperation,
coordination and support
arrangements
Improved accountability
for IFRC activities
Greater IFRC contribution
to meeting vulnerability
needs at global, national
and local levels

Source: International Federation of Red Cross and Red Crescent Societies, Strategy 2020 (Geneva, 2010).

26 PART I INTRODUCTION

allocated between research and financial aid for students? Is Harvard’s mission better
served by investing in graduate or undergraduate education? The strategic planning
process of not-for-profits needs to be designed so that mission, goals, resource allo-
cation, and performance targets are closely aligned. Strategy Capsule 1.6 shows the
10-year strategic planning framework for the International Red Cross.

Similarly, most of the principles and tools of strategy implementation—especially in
relation to organizational structure, management systems, techniques of performance
management, and choice of leadership styles—are common to both for-profit and
not-for-profit organizations.

In terms of the analysis of the external environment, there is little difference bet-
ween the techniques of industry analysis applied to business enterprises and those
relevant to not-for-profits that inhabit competitive environments and charge for their
services. In many markets (theaters, sports clubs, vocational training), for-profits and
not-for-profits may be in competition with one another. Indeed, for these types of
not-for-profit organizations, the pressing need to break even in order to survive may
mean that their strategies do not differ significantly from those of for-profit firms.

In the case of not-for-profits that do not charge users for the services they offer
(mostly charities), competition does not really exist at the final market level: differ-
ent homeless shelters in San Francisco cannot really be said to be competing for
the homeless. However, these organizations compete for funding—raising donations
from individuals, winning grants from foundations, or obtaining contracts from fund-
ing agencies. Competing in the market for funding is a key area of strategy for most
not-for-profits.

The analysis of resources and capabilities is important to all organizations that
inhabit competitive environments and, hence, must deploy their resources and capa-
bilities to establish a competitive advantage. However, even for those organizations
that are monopolists—such as government departments and other public agencies—
performance is enhanced by aligning strategy with internal strengths in resources and
capabilities.

Summary

This chapter has covered a great deal of ground—I hope that you are not suffering from indigestion. If
you are feeling a little overwhelmed, not to worry: we shall be returning to the themes and issues raised
in this chapter in the subsequent chapters of this book.

The key lessons from this chapter are:

◆ Strategy is a key ingredient of success both for individuals and organizations. A sound strategy
cannot guarantee success, but it can improve the odds. Successful strategies tend to embody four
elements: clear, long-term goals; profound understanding of the external environment; astute
appraisal of internal resources and capabilities; and effective implementation.

◆ The above four elements form the primary components of strategy analysis: determination of goals,
industry analysis, analysis of resources and capabilities, and strategy implementation.

CHAPTER 1 THE CONCEPT Of STRATEgy 27

◆ Strategy is no longer concerned with using forecasts as the basis for detailed planning; it is increas-
ingly about direction, identity, and exploiting the sources of superior profitability.

◆ To describe the strategy of a firm (or any other type of organization), we need to recognize where the
firm is competing, how it is competing, and the direction in which it is developing.

◆ Developing a strategy for an organization requires a combination of purpose-led planning (rational
design) and a flexible response to changing circumstances (emergence).

◆ The principles and tools of strategic management have been developed primarily for business enter-
prises; however, they are also applicable to the strategic management of not-for-profit organizations,
especially those that inhabit competitive environments.

Our next stage is to delve further into the basic strategy framework shown in Figure  1.2. The
elements of this framework—goals and values, the industry environment, resources and capabil-
ities, and structure and systems—are the subjects of the five chapters that form Part II of the book.
We then deploy these tools to analyze the quest for competitive advantages in different industry
contexts (Part III), and then in the development of corporate strategy (Part IV ). Figure 1.8 shows the
framework for the book.

I. INTRODUCTION

Ch. 1 The Concept of Strategy

III. BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE
Ch. 7 The Sources and Dimensions of Competitive Advantage
Ch. 8 Industry Evolution and Strategic Change
Ch. 9 Technology-based Industries and the Management of Innovation

IV. CORPORATE STRATEGY
Ch. 10 Vertical Integration and the Scope of the Firm

Ch. 11 Global Strategy and the Multinational Corporation

Ch. 12 Diversif ication Strategy

Ch. 13 Implementing Corporate Strategy: Managing the Multibusiness Firm

Ch. 14 External Growth Strategies: Mergers, Acquisitions, and Alliances

Ch. 15 Current Trends in Strategic Management

II. THE TOOLS OF STRATEGY ANALYSIS

Analysis of the Firm Analysis of Industry and Competition

Ch. 2 Goals, Values, and Performance Ch. 3 Industry Analysis:
The Fundamentals Ch. 5 Analyzing Resources and Capabilities

Ch. 6 Organization Structure and Management Systems:
The Fundamentals of Strategy Implementation

Ch. 4 Further Topics in Industry and
Competitive Analysis

FIGURE 1.8 The structure of the book

28 PART I INTRODUCTION

Self-Study Questions

1. In relation to the four characteristics of successful strategies in Figure 1.1, assess the US gov-
ernment’s Middle East strategy since the invasion of Iraq in 2003.

2. What is your career strategy for the next five years? To what extent does your strategy fit with
your long-term goals, the characteristics of the external environment, and your own strengths
and weaknesses?

3. The discussion of the evolution of business strategy (see the section “From Corporate Planning
to Strategic Management”) established that the characteristics of a firm’s strategic plans and its
strategic planning process are strongly influenced by the volatility and unpredictability of its
external environment. On this basis, what differences would you expect in the strategic plans
and strategic planning processes of Coca-Cola Company and Spotify SA, the Swedish-based
music streaming service?

4. I have noted that a firm’s strategy can be described in terms of the answers to two questions:
“Where are we competing?” and “How are we competing?” Applying these two questions, pro-
vide a concise description of Lady Gaga’s career strategy (see Strategy Capsule 1.2).

5. Using the framework of Figure 1.6, describe the strategy of the university or school you attend.

6. Your business school is considering appointing as dean someone whose entire career has
been spent in business management. What challenges might the new dean face in applying
her strategic management skills to a business school?

Notes

1. P. F. Drucker, “Managing Oneself,” Harvard Business
Review (March/April 1999): 65–74.

2. Stephen Covey (in The Seven Habits of Highly Effective
People, New York: Simon & Schuster, 1989) recommends
that we develop lifetime goals based on the multiple roles
that we occupy: in relation to our career, partner, family,
friends, and spiritual quest.

3. M. E. Porter, “What Is Strategy?” Harvard Business Review
(November/December 1996): 61–78.

4. See A. H. Van De Ven and R. Drazin, “The Concept of
Fit in Contingency Theory,” Research in Organizational
Behavior 7 (1985): 333–365.

5. Sun Tzu, The Art of Strategy: A New Translation of Sun
Tzu’s Classic “The Art of War,” trans. R. L. Wing (New
York: Doubleday, 1988).

6. W, Pietersen, “Von Clausewitz on War: Six Lessons for
the Modern Strategist,” Columbia School of Business
(February 2016); and E. Clemons and J. Santamaria,
“Maneuver Warfare,” Harvard Business Review (April
2002): 46–53.

7. On the contribution of game theory to business strategy
analysis, see F. M. Fisher, “Games Economists Play: A Non-
cooperative View,” RAND Journal of Economics 20 (Spring
1989): 113–124; C. F. Camerer, “Does Strategy Research

Need Game Theory?” Strategic Management Journal 12
(Winter 1991): 137–152; A. K. Dixit and B. J. Nalebuff,
The Art of Strategy: A Game Theorist’s Guide to Success in
Business and Life (New York: W. W. Norton, 2008).

8. H. I. Ansoff, “Strategies for Diversification,” Harvard
Business Review (September/October, 1957): 113–124.

9. M. E. Porter, Competitive Strategy (New York: Free
Press, 1980).

10. See Boston Consulting Group, Perspectives on Experience
(Boston: Boston Consulting Group, 1978) and studies
using the PIMS (Profit Impact of Market Strategy) data-
base, for example R. D. Buzzell and B. T. Gale, The PIMS
Principles (New York: Free Press, 1987).

11. R. M. Grant, “The Resource-based Theory of Compet-
itive Advantage: Implications for Strategy Formula-
tion,” California Management Review 33 (Spring 1991):
114–135; D. J. Collis and C. Montgomery, “Competing
on Resources: Strategy in the 1990s,” Harvard Business
Review ( July/August 1995): 119–128.

12. E. Lee, J. Lee, and J. Lee, “Reconsideration of the Winner-
Take-All Hypothesis: Complex Networks and Local Bias,”
Management Science 52 (December 2006): 1838–1848;
C. Shapiro and H. R. Varian, Information Rules (Boston:
Harvard Business School Press, 1998).

CHAPTER 1 THE CONCEPT Of STRATEgy 29

13. C. Christensen, The Innovator’s Dilemma (Boston:
Harvard Business School Press, 1997).

14. P. J. Williamson, “Strategy as Options on the Future,”
Sloan Management Review 40 (March 1999): 117–126.

15. C. Markides, “Strategic Innovation in Established Com-
panies,” Sloan Management Review ( June 1998): 31–42.

16. W. C. Kim and R. Mauborgne, “Creating New Market
Space,” Harvard Business Review ( January/February
1999): 83–93.

17. See, for example, N. Koehn, “The Brain—and Soul—of
Capitalism,” Harvard Business Review (November 2013);
and T. Piketty, Capital in the Twenty-First Century (Cam-
bridge, MA: Harvard University Press, 2014).

18. “Strategic Intensity: A Conversation with Garry Kasparov,”
Harvard Business Review (April 2005): 105–113.

19. The concept of bounded rationality was developed by
Herbert Simon (“A Behavioral Model of Rational Choice,”
Quarterly Journal of Economics 69 (1955): 99–118.

20. G. Hamel and C. K. Prahalad, “Strategic Intent,” Harvard
Business Review (May/June 1989): 63–77.

21. G. Hamel and C. K. Prahalad, “Strategy as Stretch and
Leverage,” Harvard Business Review (March/April
1993): 75–84.

22. J. C. Collins and J. I. Porras, Built to Last: Successful Habits
of Visionary Companies (New York: HarperCollins, 1995).

23. R. Rumelt, Good Strategy/Bad Strategy: The Difference and
Why It Matters (New York: Crown Business, 2011): 5–6.

24. D. J. Collis and M. G. Rukstad, “Can You Say What Your
Strategy Is?” Harvard Business Review (April 2008): 63–73.

25. D. F. Abell, Managing with Dual Strategies (New York:
Free Press, 1993).

26. H. Mintzberg, “Patterns of Strategy Formulation,”
Management Science 24 (1978): 934–948; “Of Strategies:
Deliberate and Emergent,” Strategic Management Journal
6 (1985): 257–272.

27. H. Mintzberg, “The Fall and Rise of Strategic Planning,”
Harvard Business Review ( January/February
1994): 107–114.

28. The two views of Honda are captured in two Harvard
cases: Honda [A] and [B] (Boston: Harvard Business
School, Cases 384049 and 384050, 1989).

29. Boston Consulting Group, Strategy Alternatives for the
British Motorcycle Industry (London: Her Majesty’s Statio-
nery Office, 1975).

30. R. T. Pascale, “Perspective on Strategy: The Real Story
Behind Honda’s Success,” California Management Review
26, no. 3 (Spring 1984): 47–72.

31. H. Mintzberg, “Crafting Strategy,” Harvard Business Review
( July/August 1987): 70.

32. G. Gavetti and J. Rivkin, “On the Origin of Strategy: Action
and Cognition over Time,” Organization Science 18
(2007): 420–439.

33. R. A. Burgelman and A. Grove, “Strategic Dissonance,”
California Management Review 38 (Winter 1996):
8–28.

34. R. M. Grant, “Strategic Planning in a Turbulent
Environment: Evidence from the Oil and Gas Majors,”
Strategic Management Journal 14 ( June 2003):
491–517.

35. O. Gadiesh and J. Gilbert, “Transforming Corner-office
Strategy into Frontline Action,” Harvard Business Review
(May 2001): 73–80.

36. K. M. Eisenhardt and D. N. Sull, “Strategy as Simple
Rules,” Harvard Business Review ( January 2001):
107–116.

37. A similar, but more detailed, approach is proposed in
M. Venzin, C. Rasner, and V. Mahnke, The Strategy Process:
A Practical Handbook for Implementation in Business
(London: Cyan, 2005).

38. Rumelt, op cit., 79.

II
THE TOOLS

OF STRATEGY
ANALYSIS

2 Goals, Values, and Performance

3 Industry Analysis: The Fundamentals

4 Further Topics in Industry and Competitive Analysis

5 Analyzing Resources and Capabilities

6 Organization Structure and Management Systems: The
Fundamentals of Strategy Implementation

2

The strategic aim of a business is to earn a return on capital, and if in any particular case
the return in the long run is not satisfactory, then the deficiency should be corrected
or the activity abandoned for a more favorable one.

—ALFRED P. SLOAN JR., PRESIDENT AND THEN CHAIRMAN OF GENERAL MOTORS, 1923 TO 1956.

Profits are to business as breathing is to life. Breathing is essential to life, but is not the
purpose for living. Similarly, profits are essential for the existence of the corporation,
but they are not the reason for its existence.

—DENNIS BAKKE, FOUNDER AND FORMER CEO, AES CORPORATION

Goals, Values,
and Performance

◆ Introduction and Objectives

◆ Strategy as a Quest for Value

● Value Creation

● Value for Whom? Shareholders versus Stakeholders

◆ Profit, Cash Flow, and Enterprise Value

● Types of Profit

● Linking Profit to Enterprise Value

● Enterprise Value and Shareholder Value

◆ Putting Performance Analysis into Practice

● Appraising Current and Past Performance

● Performance Diagnosis

● Using Performance Diagnosis to Guide Strategy
Formulation

● Setting Performance Targets

◆ Beyond Profit: Values and Corporate Social
Responsibility

● Values and Principles

● Corporate Social Responsibility

◆ Beyond Profit: Strategy and Real Options

● Strategy as Options Management

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

34 PART II THE TOOLS OF STRATEGY ANALYSIS

Introduction and Objectives

Our framework for strategy analysis (Figure 1.3) comprises four components: the firm’s goals and
values, its resources and capabilities, its structure and management systems, and its industry environ-
ment. The chapters that form Part II of this book develop these four components of strategy analysis.
We begin with goals and values of the firm and, by extension, the performance of the firm in attaining
its goals.

As the opening quotations to this chapter indicate, there is fierce debate over the appropriate
goals for business enterprises. In this chapter, we will consider whether the firm should pursue the
interests of its owners only or of all its stakeholders, including society as a whole. Our approach will
be pragmatic. While acknowledging that firms pursue multiple goals and that each firm chooses
a particular purpose, we focus upon a single goal: the creation of value. This I interpret as the pur-
suit of profit over the lifetime of the firm. Hence, the focus of our strategy analysis is upon con-
cepts and techniques that are concerned with identifying and exploiting the sources of profitability
available to the firm. Our emphasis on profitability and value creation allows us to draw upon the
tools of financial analysis for the purposes of performance appraisal, performance diagnosis, and
target setting.

Although profitability is the most useful indicator of firm performance, we shall acknowledge that
firms are motivated by goals other than profit. Indeed, the pursuit of these alternative goals may be
conducive to a superior generation of profit. Profit may be the lifeblood of the enterprise, but it is not a
goal that inspires organizational members to outstanding achievement. Moreover, for a firm to survive
and generate profit over the long run requires responsiveness and adaptability to its social, political, and
natural environments.

By the time you have completed this chapter, you will be able to:

◆ Recognize that, while every firm has a distinct purpose, the common goal for all firms is
creating value, and appreciate how the debate over shareholder versus stakeholder goals
involves different definitions of value creation.

◆ Understand how profit, cash flow, and enterprise value relate to one another.

◆ Use the tools of financial analysis to appraise firm performance, diagnose the sources of
performance problems, and set performance targets.

◆ Appreciate how a firm’s values, principles, and pursuit of corporate social responsibility
can help define its strategy and support its creation of value.

◆ Understand how real options contribute to firm value and how options thinking can con-
tribute to strategy analysis.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 35

Strategy as a Quest for Value

There is more to business than making money. For the entrepreneurs who create
business enterprises, personal wealth appears to be a less important motivation than
the wish for autonomy, desire for achievement, and lust for excitement. Almost 90
years ago, the economist Joseph Schumpeter observed: “The entrepreneur–innovator’s
motivation includes such aspects as the dream to found a private kingdom, the will to
conquer and to succeed for the sake of success itself, and the joy of creating and get-
ting things done.”1 Business enterprises are creative organizations that offer individuals
unsurpassed opportunity to make a difference in the world. Certainly, making money
was not the goal that inspired Henry Ford to build a business that precipitated a social
revolution:

I will build a motor car for the great multitude . . . It will be so low in price that no
man making good wages will be unable to own one and to enjoy with his family
the blessing of hours of pleasure in God’s great open spaces . . . When I’m through,
everyone will be able to afford one, and everyone will have one.2

Each entrepreneur is inspired by a goal that is personal and unique—family cars
for the multitude (Henry Ford), bringing the power of personal computing to the
individual (Steve Jobs), reducing deaths from infection after surgery ( Johnson & John-
son), or revolutionizing vacuum cleaning ( James Dyson). A business purpose is a
feature of established companies as well as entrepreneurial start-ups: Cynthia Mont-
gomery argues that “forging a compelling organizational purpose” is the ongoing job
of company leaders and the “crowning responsibility of the CEO.”3 Organizational
purpose is articulated in companies’ mission statements:

● Twitter’s mission is “To give everyone the power to create and share ideas and
information instantly, without barriers.”

● Nike’s mission is “To bring inspiration and innovation to every athlete* in the
world. (*If you have a body, you are an athlete.)”

● The Lego Group’s mission is “To inspire and develop the builders of tomorrow.”

Value Creation

Within this multiplicity of organizational purposes, there is a common denominator: the
desire, and the need, to create value. Value is the monetary worth of a product or asset.
Hence, we can generalize by saying that the purpose of business is to create value for
customers. However, if the firm is to survive and prosper, it is essential that it is able to
appropriate some of this customer value in the form of profit.

Value can be created in two ways: by production and by commerce. Production cre-
ates value by physically transforming products that are less valued by consumers into
products that are more valued by consumers—turning coffee beans and milk into cap-
puccinos, for example. Commerce creates value not by physically transforming prod-
ucts but by repositioning them in space and time. Trade involves transferring products
from individuals and locations where they are less valued to individuals and locations
where they are more valued. Similarly, speculation involves transferring products from
a point in time where a product is valued less to a point in time where it is valued
more. Thus, commerce creates value through arbitrage across time and space.4

36 PART II THE TOOLS OF STRATEGY ANALYSIS

How do we measure the value created by a firm? It is the value of the firm’s output
that is received by customers in excess of the real cost of producing that output:

Value creation Total customer value Real costs of producti– oon

So, is value creation the same as profit (where Profit = Revenue − Cost)? No, because
the value received by customers is typically greater than the amount they pay. Total
customer value is measured by their willingness to pay, not what they actually pay. The
difference is called consumer surplus. Similarly, the real cost of production is usu-
ally less than the firm’s accounting costs, since the owners of productive inputs (par-
ticularly employees) typically receive more than the minimum they needed in order
to supply their inputs. Producer surplus is comprised of the profits that accrue to the
owners of the firm together with earnings by input owners in excess of the minimum
they require. (We can also include taxes paid to government as part of this producer
surplus.) Figure 2.1 shows these relationships.

Consider Google (now a subsidiary of Alphabet Inc.), the total customer value it
creates far exceeds its revenue since most of its output—notably its search engine,
Gmail, and YouTube videos—are offered free. Similarly, its accounting costs exceed its
real production costs to the extent that its employees (including its managers) receive
pay and benefits in excess of would be needed to keep them working at Google. For
example, its software engineers are paid an average of about $160,000 compared to a
US average of about $95,000.

Value for Whom? Shareholders versus Stakeholders

As Figure 1.5 shows, the value created by firms is distributed among different
parties: customers receive consumer surplus, owners receive profits, government
receives taxes, and employees and the owners of other factors of production receive

$

Units of output

A. Value created:
total customer
value less real
cost of
production

Value
created

Real cost
of

production

Real cost
of

production

Price paid by
customers

Consumer
surplus

Pro�t
Taxes

Surplus to
input providers

Producer
surplus

B. Value created:
consumer
surplus plus
producer
surplus

Units of output

Accounting
cost

FIGURE 2.1 Value creation

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 37

remuneration in excess of the minimum needed for them to supply their inputs. So,
whose interests should the firm consider when considering which component of
value to pursue?

There are two answers to this question:

● Stakeholder value maximization. Stakeholder theory proposes that the firm
should operate in the interests of all its constituent groups (including society
as a whole), which implies that the goal of the firm should be to maximize
total value creation (i.e., the sum of consumer and producer surplus, including
external benefits to society as well).5

● Shareholder value maximization. Shareholder capitalism is based
upon two principles, first, that firms should operate in the interests of their
owners (who wish to earn profit); second, that the effectiveness of the
market economy is dependent upon firms responding to profit incentives
(the so-called “invisible hand”). Hence, the interests of both shareholders
and society are best served by firms maximizing profits.

The idea that the corporation should balance the interests of multiple stakeholders
has a long tradition, especially in Asia and continental Europe. By contrast, most
English-speaking countries have endorsed shareholder capitalism, where companies’
overriding duty is to produce profits for owners. These differences are reflected in
international differences in companies’ legal obligations. In the United States, Canada,
the United Kingdom, and Australia, company boards are required to act in the inter-
ests of shareholders. In most continental European countries, companies are legally
required to take account of the interests of employees, the state, and the enterprise
as a whole.6

The debate as to whether companies should operate exclusively in the inter-
ests of their owners or should pursue the goals of all stakeholders has yet to be
resolved. During the late 20th century, “Anglo-Saxon” shareholder capitalism was
in the ascendant—many continental European and Asian companies changed their
strategies and corporate governance to give primacy to shareholder interests.
However, during the 21st century, shareholder value maximization has become
tainted by its association with short-termism, financial manipulation, excessive CEO
compensation, and the failures of risk management that precipitated the 2008–09
financial crisis.

Clearly, companies have legal and ethical responsibilities to employees, customers,
society, and the natural environment, but should companies go beyond these respon-
sibilities and manage their businesses in the interests of these diverse stakeholders?
Pursuing the interests of all stakeholders is inherently appealing, yet, in practice the
stakeholder approach encounters two serious difficulties:

1 Measuring performance. Pursuing stakeholder interests means maximizing
total value creation and ensuring its equitable distribution among stakeholders.
In practice, estimating the components of value creation—consumer surplus,
producer surplus, and social externalities—is near impossible.7 Alternatively,
it may be possible to establish distinct goals for each stakeholder group, but
establishing tradeoffs among them is exceptionally difficult. As Michael Jensen
observes: “multiple objectives is no objective.”8

38 PART II THE TOOLS OF STRATEGY ANALYSIS

2 Corporate governance. If top management is to pursue and balance the inter-
ests of different stakeholders, how can management’s performance be assessed
and by whom? Must boards of directors comprise the representatives of every
stakeholder group? The resulting conflicts, wrangling, and vagueness around
performance objectives would make it easy for top management to substitute its
own interests for those of stakeholders.

To provide simplicity and clarity to our analysis of firm strategy, I make the assump-
tion that the primary goal of strategy is to maximize the value of the enterprise through
seeking to maximize profits over the long term. Having extolled the virtues of business
enterprises as creative institutions, how can I rationalize this unedifying focus on
money-making? I have three justifications:

● Competition: Competition erodes profitability. As competition increases,
the interests of different stakeholders converge around the goal of survival.
To survive a firm must, over the long term, earn a rate of profit that
covers its cost of capital; otherwise, it will not be able to replace its assets.
When weak demand and fierce international competition depress return
on capital, few companies have the luxury of sacrificing profits for
other goals.

● Threat of acquisition: Management teams that fail to maximize the profits of
their companies tend to be replaced by teams that do. In the “market for corpo-
rate control,” companies that underperform financially suffer a depressed share
price. This attracts acquirers—both other public companies and private equity
funds. Despite the admirable record of British chocolate maker Cadbury in
relation to employees and local communities, its dismal return to shareholders
between 2004 and 2009 meant that it was unable to resist acquisition by Kraft
Foods. Subsequently, both Kraft and Heinz were acquired by private equity
firm, 3G Capital, which imposed an even more rigorous focus on profit genera-
tion.9 Even without acquisition, activist investors—both individuals and institu-
tions—can pressure boards of directors to dismiss CEOs who fail to create value
for shareholders.10

● Convergence of stakeholder interests: There is likely to be more community of
interests than conflict of interests among different stakeholders. Profitability over
the long term requires loyalty from employees, trusting relationships with sup-
pliers and customers, and support from governments and communities. Indeed,
the instrumental theory of stakeholder management argues that pursuit of stake-
holder interests is essential to creating competitive advantage, which in turn
leads to superior financial performance.11 Empirical evidence shows that firms
that take account of a broader set of interests, including that of society, achieve
superior financial performance.12

Hence, the issue of whether firms should operate in the interests of shareholders
or of all stakeholders matters more in principle than in practice. According to Jensen:
“enlightened shareholder value maximization … is identical to enlightened stakeholder
theory.” We shall return to this issue later in this chapter when we consider explicitly
the social and environmental responsibilities of firms.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 39

Profit, Cash Flow, and Enterprise Value

Thus far, I have referred to firms’ quest for profit in general terms. It is time to look
more carefully at what we mean by profit and how it relates to value creation.

Profit is the surplus of revenues over costs available for distribution to the owners
of the firm. But if profit maximization is to be a realistic goal, the firm must know
what profit is and how to measure it. What is the firm to maximize: total profit or rate
of profit? Over what period? With what kind of adjustment for risk? And what is profit
anyway—accounting profit, cash flow, or economic profit? These ambiguities become
apparent once we compare the profit performance of companies. Table  2.1 shows
that ranking companies by profitability depends critically on what profitability mea-
sure is used.

Types of Profit

Accounting Profit is measured at different levels:

● Gross profit is sales revenue less the cost of bought-in materials and
components.

● Operating profit (or operating income) is the gross profit less operating
expenses, before deduction of interest and taxes.

● Net profit (or net income) is profit after the deduction of all expenses
and charges.

TABLE 2.1 Profitability measures for some of the world’s largest companies, 2017

Company

Market
capitalizationa

($ billion)
Net income

($ billion)
ROSb

(%)
ROEc

(%)
ROAd

(%)

Return to
shareholderse

(%)

Apple 824 48.4 26.9 39.0 16.3 +46.8

Amazon 689 3.0 2.3 9.6 3.1 +27.4

Alibaba 480 6.2 29.8 21.9 9.1 +94.1

JPMorgan Chase 397 24.4 50.2 9.5 1.4 +24.6

ExxonMobil 358 19.7 5.2 11.8 5.7 −5.8

Wal mart 310 13.6 4.1 14.9 11.9 +45.2

Toyota 204 15.8 7.6 13.2 4.1 +5.8

Notes:
aShares outstanding × closing price of shares on February 02, 2018.
bReturn on sales = Operating profit as a percentage of sales revenues.
cReturn on equity = Net income as a percentage of year-end shareholder equity.
dReturn on assets = Operating income as a percentage of year-end total assets.
eDividend + share price appreciation during 2017.

40 PART II THE TOOLS OF STRATEGY ANALYSIS

STRATEGY CAPSULE 2.1

Economic Value Added (EVA) at diageo plc.

At Guinness-to-Johnny-Walker drinks giant Diageo, EVA

transformed the way in which Diageo measured its

performance, allocated its capital and advertising expen-

ditures, and evaluated its managers.

Taking account of the costs of the capital tied up

in slow-maturing, vintage drinks such as Talisker and

Lagavulin malt whisky, Hennessey cognac, and Dom

Perignon champagne showed that these high-margin

drinks were often not as profitable as the company

had believed. The result was that Diageo’s advertising

expenditures were reallocated toward Smirnoff vodka,

Gordon’s gin, Baileys, and other drinks that could be sold

within weeks of distillation.

Once managers had to report profits after deduc-

tion of the cost of the capital tied up in their businesses,

they took measures to reduce their capital bases and

make their assets work harder. At Diageo’s Pillsbury food

business, the economic profit of every product and every

major customer was scrutinized. The result was the elim-

ination of many products and efforts to make marginal

customers more profitable. Ultimately, EVA analysis

resulted in Diageo selling Pillsbury to General Foods. This

was followed by the sale of Diageo’s Burger King chain to

Texas Pacific, a private equity group.

Value-based management was extended throughout

the organization by making EVA the primary determinant

of the incentive pay earned by 1400 Diageo managers.

Sources: John McGrath, “Tracking Down Value,” Financial Times
Mastering Management Review (December 1998);
www.diageo.com.

Economic Profit is pure profit. A major problem of accounting profit is that it
combines two types of returns: the normal return to capital, which rewards investors
for the use of their capital, and economic profit, which is the surplus available after
all inputs (including capital) have been paid for. Economic profit is a purer mea-
sure of profit that measures more precisely the surplus value a firm generates. To
distinguish it from accounting profit, economic profit is often referred to as rent or
economic rent.

Economic profit is calculated by deducting the cost of capital from operating profit
(where the cost of capital is: capital employed multiplied by the weighted average cost
of capital).

Economic profit has two main advantages over accounting profit as a performance
measure. First, it is a more realistic performance indicator. At many capital-intensive
companies, seemingly healthy profits disappear once cost of capital is taken into
account. McKinsey & Company calculated that among the world’s top 3000 companies,
47% were earning negative economic profit.13 Second, it improves the allocation of
capital between the different businesses of the firm by taking account of the real costs
of more capital-intensive businesses. The consulting firm Stern Stewart has popularized
the use of a particular measure of economic profit, economic value added, for allo-
cating capital (see Strategy Capsule 2.1).

Cash Flow shows the firm’s flows of cash transactions: operating cash flow is the
cash generated by the firm’s operations; free cash flow is operating cash flow less capital
investment. As a performance indicator, cash flow has the merit of being relatively
immune from accounting manipulation. Its main usefulness is in discounted cash flow

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 41

(DCF) calculation of the value of a business. Earnings before interest, taxes, deprecia-
tion, and amortization (EBITDA) provide a proxy for operating cash flow.

Linking Profit to Enterprise Value

There is also the problem of time. Once we consider multiple periods of time, then
profit maximization means maximizing the net present value of the stream of profits
over the lifetime of the firm.

Hence, profit maximization translates into maximizing the value of the firm. The
value of the firm is calculated in the same way as any other asset: it is the net present
value (NPV) of the returns that the asset generates. The relevant returns are the cash
flows to the firm. Hence, firms are valued using the same discounted cash flow (DCF)
methodology that we apply to the valuation of investment projects. Thus, the value of
an enterprise ( )V is the sum of its free cash flows ( )C in each year t, discounted at the
enterprise’s cost of capital. The relevant cost of capital is the weighted average cost of
capital (WACC) that averages the cost of equity and the cost of debt:

V
t

t
t

C

1 WACC

In practice, valuing companies by discounting economic profit gives the same result
as by discounting net cash flows. The difference is in the treatment of the capital con-
sumed by the business. The cash flow approach deducts capital at the time when the
capital expenditure is made; the economic profit approach follows the accounting
convention of charging capital as it is consumed (depreciation).

The difficulties of forecasting cash flows far into the future have encouraged the
search for approximations to DCF valuation. One approach is to estimate cash flows
over a 5-to-10-year horizon, then estimate a terminal value for the firm.14 Another is
proposed by McKinsey consultants who show that cash flow can be disaggregated into
return on capital employed (ROCE) and growth of revenue, both of which are easier
to forecast than free cash flow.15

Enterprise Value and Shareholder Value

How does maximizing the value of the firm (enterprise value) relate to the much-lauded
and widely vilified goal of maximizing shareholder value? At the foundation of modern
financial theory is the principle that the net present value of a firm’s profit stream is
equal to the market value of its securities—both equity and debt.16 Hence:

Enterprise value Market capitalization of equity Market vallue of debt17

Therefore, for the equity financed firm, maximizing the present value of the firm’s
profits over its lifetime also means maximizing the firm’s current market capitalization.

If maximizing profits over the life of the firm also means maximizing the stock
market value of the firm, why is it that shareholder value maximization has attracted so
much criticism in recent years? The problems arise from the fact that the stock market
cannot see the future with much clarity; hence, its valuations of companies are strongly
influenced by short-term and psychological factors. The danger is that top management
focuses upon boosting their firm’s stock market value rather than increasing profits
over the lifetime of the firm. For example, if stock markets are myopic, management

42 PART II THE TOOLS OF STRATEGY ANALYSIS

may be encouraged to maximize short-term profits to the detriment of long-run profit-
ability. This in turn may tempt top management to boost short-term earnings through
financial manipulation rather than by growing the firm’s operating profits. Such manip-
ulation may include adjustments to financial structure, earnings smoothing, and asset
sales that lift reported profits.

To avoid some of the criticisms that shareholder value maximization has attracted,
my emphasis will be on maximizing enterprise value rather than on maximizing share-
holder value. This is partly for convenience: distinguishing debt from equity is not
always straightforward, due to the presence of preference stock, convertible debt, and
junk bonds. More importantly, focusing on the value of the enterprise as a whole helps
emphasize the fundamental drivers of firm value over the distractions and distortions
that result from a preoccupation with stock market value.

Putting Performance Analysis into Practice

Our discussion so far has established that every business enterprise has a distinct
purpose. Yet, for all businesses, the profit earned over the life of the business—
enterprise value—is a sound indicator of a business’s success in creating and capturing
value. Long-term profitability also offers a sound criterion for selecting the strategy
through which the firm achieves its business purpose.

So, how do we apply these principles to appraise and develop business strategies?
There are four key areas where our analysis of profit performance can guide strategy:
first, in appraising a firm’s (or business unit’s) performance; second, in diagnosing the
sources of poor performance; third, in selecting strategies on the basis of their profit
prospects; and, finally, setting performance targets.

Appraising Current and Past Performance

The first task of any strategy formulation exercise is to assess the current situation.
This means identifying the current strategy of the firm and assessing how well that
strategy is doing in terms of the performance of the firm. The next stage is diagnosis—
identifying the sources of unsatisfactory performance. Thus, good strategic practice
emulates good medical practice: first, assess the patient’s state of health, and then
determine the causes of any sickness.

Forward-Looking Performance Measures: Stock Market Value If our goal is
to maximize profit over the lifetime of the firm, then to evaluate the performance of
a firm we need to look at its stream of profit (or cash flows) over the rest of its life.
The problem, of course, is that we can only make reasonable estimates of these a
few years ahead. For public companies stock, market valuation represents the best
available estimate of the NPV of future cash flows (net of interest payments). Thus, to
evaluate the performance of a firm in value creation, we can compare the change in
the market value of the firm relative to that of competitors over a period (preferably
several years). In the market for package and freight delivery, United Parcel Services,
Inc. (UPS) had a market capitalization and enterprise value that exceeded that of its
rival FedEx Corp. (see Table  2.2). This indicates that UPS is expected to generate a
higher cash flow than FedEx in the future (principally, because of its greater size and

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 43

higher profitability). However, over the period 2012–17 the gap has closed: FedEx has
created more value than UPS–as indicated by UPS’s higher total shareholder return
over the five-year period. Clearly, stock market valuation is an imperfect performance
indicator—it is vulnerable to disequilibrium, swings in market psychology, and mis-
interpretation of new information—but, as an indicator of a company’s risk-adjusted
profit stream over its lifetime, it is the best we have.

Backward-Looking Performance Measures: Accounting Ratios Because of
the volatility of stock market values, assessments of firm performance for the pur-
poses of appraising the current strategy or evaluating management effectiveness tend
to use accounting measures of performance. These are inevitably historical: finan-
cial reports appear at least three weeks after the period to which they relate. That
said, many firms offer earnings guidance—forecasts of profit for the next 12 months
(or longer).

Return on capital employed (ROCE) or closely-related measures, such as return on
equity (ROE) and return on assets (ROA), are the most useful indicators of a firm’s
effectiveness in generating profits from its assets. Indeed (as we saw on page 41),
the McKinsey valuation framework uses projections of ROCE, together with growth
and cost of capital, to estimate enterprise value. However, it is important to be aware
of the limitations and biases inherent in any particular profitability measure. Multiple
measures of profitability can be used to build a more balanced picture of a company’s
performance. Table 2.3 lists some widely used profitability indicators.

Interpreting probability ratios requires benchmarks. Comparisons over time tell
us whether performance is improving or deteriorating. Interfirm comparisons tell us
how a firm is performing relative to a competitor, relative to its industry average, or
relative to firms in general (e.g., relative to the Fortune 500, S&P 500, or FT 500).
Another key benchmark is cost of capital. ROCE should be compared with WACC,
and ROE compared with the cost of equity capital. Table 2.2 shows that, during 2013–
17, UPS earned an operating margin, ROE, ROCE, and ROA that exceeded those of
FedEx. UPS’s greater market capitalization and enterprise value reflects expectations
that UPS’s superior profit performance will be sustained into the future.

TABLE 2.2 The comparative performance of UPS and Federal Express

Company

Market
capitalization,

end 2017
($ billion)

Enterprise
value,

end 2017a
($ billion)

Return to
shareholders,
2015–2017b

(%)

Operating
margin,

2015–2017c
(%)

ROE,
2013–
2017d

(%)

ROCE,
2015–
2017e

(%)

ROA,
2015–
2017f

(%)

UPS 102.7 117.0 12.1 11.2 237.6 47.2 16.7

FedEx 66.9 82.1 50.8 6.3 13.1 12.4 7.6

Notes:
aMarket capitalization + Book value of long-term debt.
bPercentage increase in share price + Dividend yield.
cOperating income/Sales revenue.
dNet income/Shareholders’ equity.
eOperating income/(Shareholders’ equity + long-term debt).
fOperating income/Total assets.

44 PART II THE TOOLS OF STRATEGY ANALYSIS

TABLE 2.3 Profitability ratios

Ratio Formula Comments

Return on capital
employed (ROCE)

Operating profit (or EBIT)
Total assets current liabilless iities

ROCE is also known as return on invested capital
(ROIC). The denominator can also be measured as
shareholders’ equity plus long-term debt.

Return on
equity (ROE)

Net income
Shareholders’ equity

ROE measures a firm’s ability to use equity capital
to generate profits that can be returned to share-
holders. Net income may be adjusted to exclude
discontinued operations and special items.

Return on
assets (ROA)

Operating profit (or EBIT or EBITDA)
Total assets

The numerator should correspond to the return on
all the firm’s assets—e.g., operating profit, EBIT (earn-
ings before interest and tax), or EBITDA.

Gross margin Sales Cost of bought-in goods and services
Sales

Gross margin measures the extent to which a firm
adds value to the goods and services it buys in.

Operating margin Operating profit
Sales

Operating margin and net margin measure a firm’s
ability to extract profit from its sales.

Net margin Net income
Sales

Margins are useful to compare the performance of
firms within the same industry, but are not useful for
comparing firms in different industries because mar-
gins depend on an industry’s capital intensity (see
Table 2.1).

Notes:
Few accounting ratios have standard definitions; hence, it is advisable to be explicit about how you have calculated the ratio you are using.
A general guideline for rate of return ratios is that the numerator should be the profits that are available to remunerate the owners of the
assets in the denominator.
Profits are measured over a period of time (typically over a year). Assets are valued at a point of time. Hence, in rate of return calculations,
assets, equity, and capital employed should to be averaged between the beginning and end of the period.

Performance Diagnosis

If profit performance is unsatisfactory, we need to identify the sources of poor
performance so that management can take corrective actions. The main tool of diagnosis
is disaggregation of return on assets (or return on capital employed) in order to iden-
tify the fundamental value drivers. A starting point is to disaggregate return on assets
into sales margin and asset turnover (i.e., profit/assets = profit/sales x sales/assets).
We can then further disaggregate both sales margin and asset turnover into their com-
ponent items (Figure  2.2). This points us toward the specific activities that are the
sources of poor performance.

Strategy Capsule 2.2 disaggregates the return on assets for UPS and FedEx so that we can
begin to pinpoint the sources of UPS’s superior profitability. If we supplement the financial
data with the qualitative data on the two companies’ business strategies, operations, and
organization together with information on conditions within the industry in which the two
companies compete, we can gain insight into why UPS has outperformed FedEx.

Using Performance Diagnosis to Guide Strategy Formulation

A probing diagnosis of a firm’s recent performance—as outlined in Strategy
Capsule 2.2—provides a useful input into strategy formulation. If we can establish why a
company has been performing badly, then we have a basis for corrective actions. These

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 45

corrective actions are likely to be both strategic (with a medium- to long-term focus)
and operational (focused on the short term). The worse a company’s performance the
greater the need to concentrate on the short term. For companies teetering on the brink
of bankruptcy, long-term strategy takes a back seat; survival is the dominant concern.

For companies that are performing well, financial analysis allows us to understand the
sources of superior performance so that strategy can protect and enhance these deter-
minants of success. For example, in the case of UPS (see Strategy Capsule 2.2), financial
analysis points to the efficiency benefits that arise from being market leader and having
an integrated system of collection and delivery that optimizes operational efficiency. The
superior profitability of UPS’s international business points to its ability to successfully
enter foreign markets and integrate overseas operations within its global system.

However, analyzing the past only takes us so far. The world of business is one of
constant change and the role of strategy is to help the firm to adapt to change. The
challenge is to look into the future and identify factors that threaten performance or
create new opportunities for profit. In making strategy recommendations to UPS, our
financial analysis can tell us some of the reasons why UPS has been doing well up until
now, but the key to sustaining UPS’s performance is to recognize how its industry envi-
ronment will be changing in terms of customer requirements, competition, technology,
and energy costs and to assess UPS’s capacity to adapt to these new conditions. While
financial analysis is inevitably backward-looking, strategic analysis allows us to look for-
ward and understand some of the critical factors impacting a firm’s success in the future.

COGS/Sales

Turnover of other items
of working capital

Creditor Turnover
(Sales/Accounts receivable)

Inventory Turnover
(Sales/Inventories)

Fixed Asset Turnover
(Sales/PPE)

SGA expense/Sales

Depreciation/Sales Sales Margin

Sales/Assets

ROA

FIGURE 2.2 Disaggregating return on assets

Notes:
ROA: Return on assets.
COGS: Cost of goods sold.
PPE: Property, plant, and equipment.
For further discussion, see T. Koller et al., Valuation, 5th edn (Chichester: John Wiley & Sons, Ltd., 2010).

46 PART II THE TOOLS OF STRATEGY ANALYSIS

STRATEGY CAPSULE 2.2

diagnosing Performance: uPS versus FedEx

Between 2013 and 2017, United Parcel Service (UPS)

has earned more than double the return on assets as its

closest rival, FedEx Corporation. What insights can finan-

cial analysis offer into the sources of this performance

differential?

Disaggregating the companies’ return on capital

employed into operating margin and capital turnover

shows that differences in ROCE are due to UPS’s superior

operating margin and higher capital turnover (See

Figure 2.3).

Probing UPS’s higher operating margin highlights

major differences in the cost structure of the two com-

panies: UPS is more labor intensive with a much higher

ratio of employee costs to sales (however, UPS’s average

compensation per employee is much lower than

FedEx’s). FedEx has higher costs of fuel, maintenance,

depreciation, and “other.” UPS’s higher capital turnover is

mainly due to its higher turnover of fixed assets (prop-

erty, plant, and equipment).

These differences reflect the different composition

of the two companies’ businesses. UPS is more heavily

involved in ground transportation (UPS has 103,000 vehi-

cles; FedEx has 55,000), which tends to be more labor

intensive. FedEx is more oriented toward air transporta-

tion (UPS has 620 aircraft; FedEx has 650). Express delivery

services tend to be less profitable than ground delivery.

However, the differences in business mix do not appear

to completely explain the wide discrepancy in fuel, main-

tenance, and other costs between FedEx and UPS. The

likelihood is that UPS has superior operational efficiency.

Cash turnover
U: 9.51 F: 15.5

Receivables turnover
U: 10.23 F: 6.8

Labor costs/Sales
U: 54.8% F: 36.3%

Fuel costs/Sales
U: 7.5% F: 5.8%

Maintenance/Sales
U: 2.3% F: 4.2%

Operating
margin

U: 11.2%
F: 6.3%

Sales/Assets
U: 1.49
F: 1.21

ROA
U: 16.7%
F: 7.6%

U = UPS
F = FedEx

Depreciation/Sales
U: 3.4% F: 5.2%

Other costs/Sales
U: 21.4% F: 42.5%

PPE turnover
U: 3.02 F: 2.03

FIGURE 2.3 Analyzing why UPS earns a higher return on assets (ROA) than FedEx

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 47

Setting Performance Targets

We noted in Chapter  1 that an important role for strategic planning systems is to
translate strategic goals into performance targets and then monitor the performance
achieved against these targets. To be effective, performance targets need to be con-
sistent with long-term goals, linked to strategy, and relevant to the tasks and respon-
sibilities of individual organizational members. Translating goals into actionable
performance targets presents major problems for the stakeholder-focused firm. Even
for the shareholder-focused firm, the goal of maximizing the value of the firm offers
little guidance to the managers entrusted with that goal. The three main approaches to
setting performance targets are as follows:

Financial Disaggregation If the goal of the firm is to maximize profitability, we
can use the same financial disaggregation in Figure 2.2 to cascade targets down the
organization. Thus, for the top management team, performance goals might include
maximizing ROCE on existing assets while investing in new projects whose return
on capital exceeds their cost of capital. For functional vice presidents, performance
targets might include maximizing sales and market shares (for marketing and sales),
minimizing raw material and component costs (for purchasing), minimizing produc-
tion costs (for operations), maximizing inventory turns (for logistics/supply chain),
and minimizing the cost of capital (for finance). These functional goals can be further
disaggregated to the department level (e.g., plant maintenance is required to minimize
machine downtime in order to increase capacity utilization, the customer accounts
department is required to minimize the number of days of outstanding receivables,
and so on).

The dilemma with any system of performance management is that the performance
goals are long term (e.g., maximizing profits over the lifetime of the company), but
to act as an effective control mechanism performance targets need to be monitored
over the short term. For financial targets, there is the ever-present danger that pursuing
short-term profitability undermines long-term profit maximization.

Balanced Scorecards One solution to this dilemma is to combine financial targets
with strategic and operational targets. The most widely used method for doing this is
the balanced scorecard developed by Robert Kaplan and David Norton.18 The bal-
anced scorecard methodology provides an integrated framework for balancing finan-
cial and strategic goals and cascading performance measures down the organization to
individual business units and departments. The performance measures included in the
balanced scorecard derive from the answers to four questions:

● How do we look to shareholders? The financial perspective is composed of
measures such as cash flow, sales and income growth, and return on equity.

● How do customers see us? The customer perspective comprises measures such
as goals for new products, on-time delivery, and defect and failure levels.

● What must we excel at? The internal business perspective relates to internal
business processes such as productivity, employee skills, cycle time, yield rates,
and quality and cost measures.

● Can we continue to improve and develop? The innovation and learning per-
spective includes measures related to new product development cycle times,
technological leadership, and rates of improvement.

48 PART II THE TOOLS OF STRATEGY ANALYSIS

By balancing a set of strategic and financial goals, the scorecard methodology
allows the strategy of the business to be linked with the creation of shareholder
value while providing measurable targets to guide this process. Moreover, because
the balanced scorecard allows explicit consideration of the goals of customers,
employees, and other interested parties, scorecards can also be used to implement
stakeholder-focused management. Figure 2.4 shows the balanced scorecard for a US
regional airline.

Strategic Profit Drivers Financial value drivers and balanced scorecards are
systematic techniques of performance management based upon the notion that, if
overall goals can be disaggregated into precise, quantitative, time-specific targets, each
member of the organization knows what is expected of him or her and can be incen-
tivized toward achieving the targets set. However, a mounting body of evidence points
to the unintended consequences of performance targets.

In relation to profit maximization, setting profit targets may induce behavior that
undermines that goal’s attainment. Thus, many of the firms that are most successful at
creating shareholder value are those that emphasize purpose over profit. Conversely,
many of the firms most committed to profit and maximizing shareholder value—Enron,
BP, and Lehman Brothers for example—have been spectacularly unsuccessful in real-
izing these goals.19 The experiences of Boeing illustrate this problem (see Strategy
Capsule 2.3).

The problem of translating goals into targets is vividly illustrated by performance
management in the public sector. In Soviet shoe factories, quantitative monthly targets
would be met by producing low-quality shoes of a single size.20 In the British National
Health Service, the target of eight-minute ambulance response times was achieved by

Increase
Profitability

Lower
Cost

On-time
Flights

More
Cust-

omers

Low
Prices

Improve
turnaround

time

Align
Ground
Crews

Increase
Revenue

Simplified Strategy
Map

Financial

Customer

Internal

Learning

Performance
Measures

• Market Value
• Seat Revenue
• Plane Lease Cost

• FAA on-time
arrival rating

• First in industry
• 98% satisfaction
• % change

• Quality management
• Customer loyalty
program• Customer ranking

• On Ground Time

• % Ground crew
stockholders

• <25 Minutes

• Stock
ownership plan

• Cycle time
optimization program

• 25% per year • Optimize routes
• Standardize planes• 20% per year

• 5% per year

Targets Initiatives

• No. customers

• On-Time Departure

• % Ground crew trained

• Year 1, 70%
• Year 4, 90%
• Year 6, 100%

• 93%

• Ground crew training

FIGURE 2.4 Balanced scorecard for a regional airline

Source: Reproduced from www.balancedscorecard.org with permission.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 49

replacing regular ambulance crews with single paramedics (or volunteers) in cars—no
progress was met in improving survival rates from heart attacks and strokes.21

The solution to this problem is what John Kay calls “obliquity”: pursuing goals indi-
rectly.22 In the case of firm profitability, this implies establishing targets around the stra-
tegic factors that drive profit, rather than profitability itself. This focus on the drivers of
profit is the core theme of this book. Once we have identified the primary sources of
profit available to the firm we have a basis, first, for formulating a strategy to exploit
these sources of profit and, second, for implementing that strategy through performance
guidelines and targets based upon those strategic variables. This approach can also
bring clarity to the complex and contentious issue of the corporate social responsibility.

Beyond Profit: Values and Corporate Social Responsibility

At the beginning of this chapter, I argued that, while every company has a distinct
organizational purpose, a common goal for every business enterprise is to create value,
and the best indicator of value creation is profit over the lifetime of the company—or,
equivalently, maximizing enterprise value. Although the corporate scandals of the 21st
century have discredited the pursuit of profit and shareholder value maximization,
I have justified long-run profit maximization as an appropriate and practical goal for
the strategic management of firms.

STRATEGY CAPSULE 2.3

The Pitfalls of Pursuing Shareholder Value: Boeing

Boeing was one of the most financially successful mem-

bers of the Dow Jones Industrial Index between 1960

and 1990. Yet Boeing gave little attention to financial

management. CEO Bill Allen was interested in building

great planes and leading the world market with them:

“Boeing is always reaching out for tomorrow. This can only

be accomplished by people who live, breathe, eat and

sleep what they are doing.” At a board meeting to approve

Boeing’s biggest ever investment, the 747, Allen was

asked by non-executive director Crawford Greenwalt for

Boeing’s financial projections on the project. In response

to Allen’s vague reply, Greenwalt buried his head in his

hands. “My God,” he muttered, “these guys don’t even

know what the return on investment will be on this thing.”

In 1997, Boeing acquired McDonnell Douglas and a

new management team of Harry Stonecipher and Phil

Condit took over. Mr Condit talked proudly of taking the

company into “a value-based environment where unit

cost, return on investment, and shareholder return are

the measures by which you’ll be judged.”

The result was lack of investment in major new civil

aviation projects and diversification into defense and sat-

ellites. Under Condit, Boeing relinquished market lead-

ership in passenger aircraft to Airbus, while faltering as

a defense contractor due partly to ethical lapses by key

executives. When Condit resigned on December 1, 2003,

Boeing’s stock price was 20% lower than when he was

appointed.

Sources: John Kay, “Forget How the Crow Flies,” Financial Times
Magazine (January 17, 2004): 17–27; R. Perlstein, The Stock Ticker
and the Superjumbo (Prickly Paradigm Press, 2005).

50 PART II THE TOOLS OF STRATEGY ANALYSIS

This justification rests upon the overall alignment between profits and the interests
of society as a whole (Adam Smith’s notion of the “invisible hand” of profit guiding
firms to serve the needs of consumers) and the convergence of stakeholder and share-
holder interests. But what about situations when the pursuit of profit conflicts with the
social good or with widely held ethical principles? How are such inconsistencies and
conflicts to be managed? Milton Friedman’s answer was clear:

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, which is to say, engage in open and free competition without deception
or fraud.23

Under this doctrine, it is the role of government to intervene in the economy where
the pursuit of profit conflicts with the interest of society, using taxes and regulations
to align profit incentives with social goals and legislation to criminalize unethical
behavior. Others have argued that business enterprises should take the initiative to
establish principles and values that extend beyond the limits of the law, and pursue
strategies that are explicitly oriented toward the interests of society. Let us discuss each
of these areas in turn.

Values and Principles

A sense of purpose—as articulated in statements of mission and vision—is often
complemented by beliefs about how this purpose should be achieved. These orga-
nizational beliefs typically comprise a set of values—in the form of commitments
to certain ethical precepts and to different stakeholder interests—and a set of
principles to guide the decisions and actions of organizational members. Strategy
Capsule 2.4 displays the values statement of Accenture plc, the world’s biggest con-
sulting company.

At one level, statements of values and principles may be regarded as instruments
of companies’ external image management. Yet, to the extent that companies are con-
sistent and sincere in their adherence to values and principles, these ideals can be a
critical component of organizational identity and an important influence on employees’
commitment and behavior. When values are shared among organizational members,
they form a central component of corporate culture.

The evidence that commitment to values and principles influences organizational
performance is overwhelming. McKinsey & Company places “shared values” at the
center of its “7-S framework.”24 Jim Collins and Jerry Porras argue that “core values” and
“core purpose” unite to form an organization’s “core ideology,” which “defines an orga-
nization’s timeless character” and is “the glue that holds the organization together.”25
They argue that when core ideology is put together with an “envisioned future” for
the enterprise the result is a powerful sense of strategic direction that provides the
foundation for long-term success.

Corporate Social Responsibility

The debate over the social responsibilities of companies has been both contentious
and confused. Underlying the debate are different ideas about what a company

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 51

is: “the property conception” views the company as a set of assets owned by the
shareholders; the “social entity conception” views it as a community of individuals
sustained and supported by its social, political, economic, and natural environ-
ment.26 While the “firm as property” view implies that management’s sole responsi-
bility is to operate in the interests of shareholders, the “firm as social entity” implies
a responsibility to maintain the firm within its overall network of relationships and
dependencies.

Yet, from a practical viewpoint, both these conceptions are problematic. The view
that the sole purpose of the business enterprise is to make profit fails to recognize
that to survive and prosper, any organization must maintain social legitimacy. The
near-elimination of investment banks during the financial crisis of 2008–09—including
the transformation of Goldman Sachs and Morgan Stanley into commercial banks—was
caused less by their commercial failure than by a collapse of legitimacy. The phone
hacking scandal that caused the closure of a British newspaper owned by Rupert Mur-
doch’s News Corporation represented less than 1% of News Corp’s revenues. However,
in the five weeks after the scandal broke in July 2011, News Corp’s market capitaliza-
tion declined by 25%—a loss of $11 billion.

The argument that the primary responsibility of business enterprises should be
the pursuit of social goals is similarly untenable. To extend Adam Smith’s observation

STRATEGY CAPSULE 2.4

Accenture: Our Core Values

Since its inception, Accenture has been governed by

its core values. They shape the culture and define the

character of our company. They guide how we behave

and make decisions.

◆ Stewardship Fulfilling our obligation of building a
better, stronger and more durable company for future

generations, protecting the Accenture brand, meet-

ing our commitments to stakeholders, acting with an

owner mentality, developing our people and helping

improve communities and the global environment.

◆ Best People Attracting, developing and retaining the
best talent for our business, challenging our people,

demonstrating a “can-do” attitude, and fostering a

collaborative and mutually supportive environment.

◆ Client Value Creation Enabling clients to become
high-performance businesses and creating long-term

relationships by being responsive and relevant and

by consistently delivering value.

◆ One Global Network Leveraging the power of
global insight, relationships, collaboration and

learning to deliver exceptional service to clients

wherever they do business.

◆ Respect for the Individual Valuing diversity and
unique contributions, fostering a trusting, open and

inclusive environment and treating each person in a

manner that reflects Accenture’s values.

◆ Integrity Being ethically unyielding and honest and
inspiring trust by saying what we mean, matching

our behaviors to our words and taking responsibility

for our actions.

Source: http://www.accenture.com/us-en/company/overview/
values/Pages/index.aspx, accessed July 20, 2015.

52 PART II THE TOOLS OF STRATEGY ANALYSIS

that it “is not from the benevolence of the butcher, the brewer or the baker, that
we expect our dinner, but from their regard to their own interest,”27 it is likely that
if the butcher becomes an animal rights activist, the brewer joins the Temperance
League, and the baker signs up to Weight Watchers, none of us has much hope of
getting dinner!

Somewhere between these two conceptions lies a middle ground of viability where
business enterprises are aligned with the needs of their social and natural environment,
but remain committed to their business purpose and the generation of profit. Several
contributions to the management literature offer guidance as to how firms can recon-
cile their commercial and social responsibilities.

The efficacy argument for corporate social responsibility (CSR) emphasizes the
evolutionary fitness of the firm. The firm is embedded within natural and social eco-
systems to which it must adapt and sustain. Thus, according to former Shell executive
Arie de Geus, long-living companies are those that build strong communities, have
a strong sense of identity, commit to learning, and are sensitive to the world around
them. In short, they recognize they are living organisms whose life spans depend upon
effective adaptation to a changing environment.28

This view of the firm jointly pursuing its own interests and those of its ecosystem
has been developed by Michael Porter and Mark Kramer into a pragmatic approach
to CSR.29 They offer three reasons why CSR might also be in the interests of a
company: the sustainability argument—CSR is in firms’ interests due to a mutual
interest in sustaining the ecosystem; the reputation argument—CSR enhances a
firm’s reputation with consumers and other third parties; and the license-to-operate
argument—to conduct their businesses firms need the support of the constitu-
encies upon which they depend. The critical task in selecting which CSR initiatives
firms should pursue is to identify specific intersections between the interests of
the firm and those of society (i.e., projects and activities that create competitive
advantage for the firm while generating positive social outcomes)—what they term
strategic CSR.

At the intersection between corporate and social interests is what Porter and Kramer
refer to as shared value: “creating economic value in a way that also creates value for
society.”30 It is not about redistributing value, but expanding the total pool of value. For
example, fair trade redistributes value by paying farmers a higher price for their crops—
in the case of Ivory Coast cocoa growers, it increases their incomes by 10–20%. By con-
trast, efforts by cocoa buyers to improve the efficiency of cocoa growing can increase
growers’ incomes by 300%, while lowering the cost of cocoa beans for chocolate
manufacturers. Creating shared value involves reconceptualizing the firm’s boundaries
and its relationship with its environment from a transactional to a co-dependency
viewpoint. This offers three types of opportunity for shared value creation: reconceiv-
ing products and markets, redefining productivity within the value chain, and building
local clusters of suppliers, distributors, and related businesses at the places where the
firm does business. Unilever’s Sustainable Growth Plan exemplifies this approach (see
Strategy Capsule 2.5).

This notion of shared value is embedded in bottom of the pyramid initiatives—the
potential for multinational companies to simultaneously create profitable business and
promote social and economic development.31 The key is a switch of perception: view-
ing the poor as consumers, workers, and entrepreneurs rather than as victims or charity
recipients.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 53

Beyond Profit: Strategy and Real Options

So far, we have identified the value of the firm with the net present value (NPV) of its
profit earnings (or, equivalently, free cash flows). But conventional approaches to cal-
culating NPV ignore an important feature of our uncertain world: the simple idea that
an option—the choice of whether to do something or not—has value. In recent years,
the principles of option pricing have been extended from valuing financial securities to
valuing investment projects and companies. The resulting field of real option analysis
has emerged as vitally important both for investment decisions and for strategy formu-
lation. The technical details of valuing real options are complex. However, the under-
lying principles are intuitive. Let me outline the basic ideas of real options theory and
what they mean for strategy analysis.

STRATEGY CAPSULE 2.5

unilever’s Sustainable Living Plan

Since launching its Sustainable Living Plan in November

2010, Unilever—the Anglo-Dutch multinational supply-

ing over 400 brands of food, personal care, and household

products—has become a world leader in environment

sustainability. According to the Economist, Unilever is “reck-

oned to have the most comprehensive strategy of enlight-

ened capitalism of any global firm.” The program—with

its goals of reducing Unilever’s environmental footprint,

increasing its positive social impact, doubling sales, and

increasing long-term profitability—has been the cen-

terpiece of CEO Paul Polman’s strategy for the company.

Unilever has embedded its sustainability program within its

strategic, operational, and human resource management:

the plan is overseen by the board and incentive bonuses

are linked to quantitative targets for emissions and waste

reduction and energy and water conservation.

While Polman emphasizes that Unilever’s commit-

ment to sustainability is because it is “the right thing to

do,” he is also clear that the primary motivation is the fact

that the Sustainable Living Plan is in the long-term inter-

ests of Unilever itself. In an interview with McKinsey and

Company, Polman noted that the benefits to Unilever

included improved access to raw materials, greater

employee commitment, a stronger drive toward innova-

tion throughout the company, greatly increased numbers

of applications for jobs at Unilever, and improvement in

efficiency in Unilever plants and throughout its supply

chain. Shareholders appear to have benefitted as well:

in the five years following the launch of the Sustainable

Living Plan, Unilever’s share price rose by 40%, well ahead

of rivals Procter & Gamble and Nestlé.

However, when Polman announced, en route for the

January 2015 Davos meetings, that he planned to “use the

size and scale of Unilever” to lobby global leaders for a

binding agreement on climate change and poverty erad-

ication, some wondered whether he was putting global

interests ahead of Unilever’s—especially given Unilever’s

disappointing sales performance during 2014. When Uni-

lever survived a hostile takeover bid from Kraft Heinz in

2017, Polman shifted his attention towards cost reduction

and asset sales.

Sources: McKinsey & Company, “Committing to
sustainability: An interview with Unilever’s Paul Polman,”
http://www.mckinsey.com/videos/video?vid=3564008886001&
plyrid=2399849255001&Height=270&Width=480, accessed July
20, 2015; “Unilever: In search of the good business,” Economist,
August 9, 2014.

54 PART II THE TOOLS OF STRATEGY ANALYSIS

Consider the investments that Royal Dutch Shell is making in joint-venture
development projects to produce hydrogen for use in fuel cells. The large-scale use of
fuel cells in transportation vehicles or for power generation seems unlikely within the
foreseeable future. Shell’s expenditure on these projects is small, but almost certainly
these funds would generate a higher return if they were used in Shell’s core oil and gas
business. So, how can these investments—indeed, all of Shell’s investments in renew-
able energy—be consistent with shareholder interests?

The answer lies in the option value of these investments. Shell is not developing a
full-scale fuel cell business, and nor is it developing commercial-scale hydrogen pro-
duction plants: it is developing technologies that could be used to produce hydrogen
if fuel cells become widely used. By building know-how and intellectual property in
this technology, Shell has created an option. If economic, environmental, or political
factors restrict hydrocarbon use and if fuel cells advance to the point of technical and
commercial viability, then Shell could exercise that option by investing much larger
amounts in commercial-scale hydrogen production.

In a world of uncertainty, where investments, once made, are irreversible, flexibility
is valuable. Instead of committing to an entire project, there is virtue in breaking the
project into a number of phases, where the decision of whether and how to embark on
the next phase can be made in the light of prevailing circumstances and the learning
gained from the previous stage of the project. Most large companies have a “phases
and gates” approach to product development in which the development process is
split into distinct “phases,” at the end of which the project is reassessed before being
allowed through the “gate.” Such a phased approach creates the options to continue
the project, to abandon it, to amend it, or to wait. Venture capitalists clearly recognize
the value of growth options. By August 2017, Hyperloop One had raised $160 million
to develop commercial hyperloop transportation systems. Will these systems ever be
completed, let alone make a profit? It is doubtful. Investors—which include General
Electric, Dubai Ports, and SNCF, the French rail system, as well as several venture
capital firms—are making small bets on the initial development of a technology that
just might revolutionize transportation.32 The emphasis that venture capitalists place on
scalability—the potential to scale up or replicate a business should the initial launch be
successful—similarly acknowledges the value of growth options. Strategy Capsule 2.6
addresses the calculation of real option values.

Strategy as Options Management

For strategy formulation, our primary interest is how we can use the principles of option
valuation to create enterprise value. There are two types of real option: growth options
and flexibility options. Growth options allow a firm to make small initial investments in
a number of future business opportunities but without committing to them. Flexibility
options relate to the design of projects and plants that permit adaptation to different
circumstances—flexible manufacturing systems allow different product models to be
manufactured on a single production line. Individual projects can be designed to intro-
duce both growth options and flexibility options. This means avoiding commitment
to the complete project and introducing decision points at multiple stages, where the
main options are to delay, modify, scale up, or abandon the project. Merck, an early
adopter of option pricing, notes, “When you make an initial investment in a research
project, you are paying an entry fee for a right, but you are not obligated to continue
that research at a later stage.”33

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 55

In developing strategy, our main concern is with growth options. These might include:

● Platform investments. These are investments in core products or technologies
that create a stream of additional business opportunities.34 3M’s investment in
nanotechnology offers the opportunity to create new products across a wide

STRATEGY CAPSULE 2.6

Calculating Real Option Value

Application of real option value to investment projects

and strategies has been limited by the complexity of

the valuation techniques. Yet, even without getting into

the mathematics needed to quantify option values, we

can use the basic principles involved to understand the

factors that determine option values and to recognize

how projects and strategies can be designed in order to

maximize their option values.a

The early work on real option valuation adapted the

Black–Scholes option-pricing formula developed for val-

uing financial options to the valuation of real investment

projects. Black–Scholes comprises six determinants of

option value, each of which has an analogy (~) in the val-

uation of a real option:

1 Stock price ~ The NPV of the project: a higher NPV

increases option value.

2 Exercise price ~ Investment cost: the higher the

cost, the lower the option value.

3 Uncertainty ~ for both financial and real options,

uncertainty increases option value.

4 Time to expiry ~ for both financial and real options,

the longer the option lasts, the greater its value.

5 Dividends ~ Decrease in the value of the investment

over the option period: lowers option value.

6 Interest rate ~ a higher interest rate increases option

value by making deferral more valuable.b

However, the dominant methodology used for real

option valuation is the binomial options pricing model.

By allowing the sources of uncertainty and key decision

points in a project to be modeled explicitly, the tech-

nique offers a more intuitive appreciation of the sources

of option value. The analysis involves two main stages:

1 Create an event tree that shows the value of the

project at each development period under two dif-

ferent scenarios.

2 Convert the event tree into a decision tree by iden-

tifying the key decision points on the event tree,

typically the points where commitments of new

funds to the project are required, or where there

is the option to defer development. Incremental

project values at each stage can then be calcu-

lated for each decision point by working back

from the final nodes of the decision tree (using a

discount factor based upon the replicating port-

folio technique). If the incremental project value

at the initial stage exceeds the initial investment,

proceed with the first phase, and similarly for each

subsequent phase.c

Notes:
aSee: L. Trigeorgis and J. J. Reuer, “Real Options Theory in Strategic
Management” Strategic Management Journal 38 (2017): 42–63.
bSee: K. J. Leslie and M. P. Michaels, “The Real Power of Real
Options,” McKinsey Quarterly Anthology: On Strategy (Boston:
McKinsey & Company, 2000); A. Dixit and R. Pindyck, “The Options
Approach to Capital Investment,” Harvard Business Review (May/
June 1995): 105–115.
cThis approach is developed in T. Copeland and P. Tufano, “A
Real-World Way to Manage Real Options,” Harvard Business Review
(March 2004). See also T. Copeland, “Developing Strategy Using
Real Options” (Monitor Company, October 2003).

56 PART II THE TOOLS OF STRATEGY ANALYSIS

range of its businesses, from dental restoratives and drug-delivery systems to
adhesives and protective coatings. Snapchat, the image messaging service, sup-
ports a growing array of applications including news, payments, image augmen-
tation, sponsored stories, collaborative stories, and original video entertainment.35

● Strategic alliances and joint ventures are limited investments that provide a
development stage for creating a new business or new strategy.36 Virgin Group
has used joint ventures as the basis for creating a number of new businesses. A
joint venture may be a preliminary to a full acquisition. In July 2017, Starbucks
announced the acquisition of its partners’ shareholdings in its highly successful
Chinese joint venture.

● Organizational capabilities can also be viewed as options that offer the potential
to create competitive advantage across multiple products and businesses.37 Fuji-
film’s thin-film coating capabilities developed in its photographic business have
provided Fuji with the option to diversify into magnetic recording materials,
cosmetics, and industrial coatings.

Summary

Chapter 1 introduced a framework for strategy analysis that provides the structure for Part II of this book.
This chapter has explored the first component of that framework—the goals, values, and performance
of the firm.

We have explored in some depth the difficult, and still contentious, issue of the appropriate goals
for the firm. While each firm has a specific business purpose, common to all firms is the desire, and
the necessity, to create value. How that value is defined and measured distinguishes those who argue
that the firms should operate primarily in the interests of owners (shareholders) from those who argue
for a stakeholder approach. Our approach is pragmatic: shareholder and stakeholder interests tend to
converge and, where they diverge, the pressure of competition limits the scope for pursuing stake-
holder interests at the expense of profit; hence, my conclusion that long-run profit—or its equivalent,
enterprise value—is appropriate both as an indicator of firm performance and as a guide to strategy for-
mulation. We explored the relationships between value, profit, and cash flow and saw how the failings
of shareholder value maximization resulted more from its misapplication than from any inherent flaw.

The application of financial analysis to the assessment of firm performance is an essential component
of strategic analysis. Financial analysis creates a basis for strategy formulation, first, by appraising overall
firm performance and, second, by diagnosing the sources of unsatisfactory performance. Combining
financial analysis and strategic analysis allows us to establish performance targets for companies and
their business units.

Finally, we looked beyond the limits of our useful, yet simplistic, profit-oriented approach to firm
performance and business strategy. We looked, first, at how the principles of corporate social responsi-
bility can be incorporated within a firm’s strategy to enhance its creation of both social and shareholder
value. Second, we extended our analysis of value maximization to take account of the fact that strategy
creates enterprise value not only by generating profit but also by creating real options.

CHAPTER 2 GOALS, VALuES, ANd PERFORmANCE 57

Notes

1. J. A. Schumpeter, The Theory of Economic Development
(Cambridge, MA: Harvard University Press 1934).

2. “Henry Ford: The Man Who Taught America to Drive,”
Entrepreneur (October 8, 2008), www.entrepreneur.com/
article/197524, accessed July 20, 2015.

3. C. A. Montgomery, “Putting Leadership Back into Strategy,”
Harvard Business Review ( January 2008): 54–60.

4. In this chapter, I use the term value in two distinct senses.
Here I am referring to economic value, which is worth
as measured in monetary units. I shall also be discussing
values as moral principles or standards of behavior.

5. T. Donaldson and L. E. Preston, “The Stakeholder Theory
of the Corporation,” Academy of Management Review 20
(1995): 65–91.

6. In several countries, company law has been amended to
allow companies to pursue explicit social goals. In the US,
these “benefit corporations” (or B-corporations) include the

outdoor apparel company, Patagonia. See J. Surowiecki,
“Companies with Benefits,” The New Yorker, August 4, 2014.

7. M. B. Lieberman, N. Balasubramanian, and R. García-
Castro outline a method for estimating changes in value
creation over time (“Measuring Value Creation and Appro-
priation in Firms: The VCA Model,” Strategic Management
Journal 38 ( June 2017): 1193–1211).

8. M. C. Jensen, “Value Maximization, Stakeholder Theory,
and the Corporate Objective Function,” Journal of Applied
Corporate Finance 22 (Winter 2010): 34.

9. “The Lean and Mean Approach of 3G Capital,” Financial
Times (May 7, 2017).

10. “Activist Investors Have a New Bloodlust: CEOs,” Wall
Street Journal (May 16, 2017).

11. T. M. Jones, “Instrumental Stakeholder Theory: A Syn-
thesis of Ethics and Economics,” Academy of Management
Review 20 (1995): 404–437.

Self-Study Questions

1. Since long-run profitability requires that a firm is sensitive to the interests of its customers,
employees, suppliers, and society-at-large, whether a firm is run in the interests of its share-
holders or its stakeholders makes no real difference. Do you agree? Are there situations where
shareholder and stakeholder interests diverge?

2. Table 2.1 compares companies according to different profitability measures.

a. Which two of the six performance measures do you think are the most useful indicators
of how well a company is being managed?

b. Is return on sales or return on equity a better basis on which to compare the performance
of the companies listed?

c. Several companies are highly profitable yet delivered very low returns to their share-
holders during 2017. How is this possible?

3. With regard to Strategy Capsule 2.2, what additional data would you seek and what additional
analysis would you undertake to investigate further the reasons for UPS’s superior profit-
ability to FedEx?

4. The CEO of a chain of pizza restaurants wishes to initiate a program of CSR to be funded by
a 5% levy on the company’s operating profit. The board of directors, fearing a negative share-
holder reaction, is opposed to the plan. What arguments might the CEO use to persuade the
board that CSR might be in the interests of shareholders, and what types of CSR initiatives
might the program include to ensure that this was the case?

5. Nike, a supplier of sports footwear and apparel, is interested in the idea that it could increase
its stock market value by creating options for itself. What actions might Nike take that might
generate option value?

58 PART II THE TOOLS OF STRATEGY ANALYSIS

12. M. Orlitzky, F. L. Schmidt, and S. L. Rynes, “Corporate
Social and Financial Performance: A Meta-Analysis,” Orga-
nization Studies 24 (Summer 2003): 403–441.

13. See www.sternstewart.com. See also J. L. Grant, Founda-
tions of Economic Value Added, 2nd edn (New York: John
Wiley & Sons, Ltd, 2003).

14. See: “Five Ways to Estimate Terminal Values,” http://
onlinelibrary.wiley.com/doi/10.1002/9781118273166.
app13/pdf. Accessed August 27, 2017.

15. T. Koller, M. Goedhart, D. Wessels, Valuation: Measuring
and Managing the Value of Companies, 5th edn
(Hoboken, NJ: John Wiley & Sons, Inc., 2010).

16. F. Modigliani and M. H. Miller, “The Cost of Capital,
Corporation Finance, and the Theory of Investments,”
American Economic Review 48 (1958): 261–297.

17. Some calculations of enterprise value deduct the balance
sheet value of a firm’s cash and marketable securities
from the market value of its equity and debt in order to
value only the business itself.

18. R. S. Kaplan and D. P. Norton, “The Balanced Scorecard:
Measures That Drive Performance,” Harvard Business
Review ( January/February 1992): 71–79; R. S. Kaplan and
D. P. Norton, “Using the Balanced Scorecard as a Strategic
Management System,” Harvard Business Review ( January/
February 1996): 75–85.

19. S. Chatterjee, “Enron’s Incremental Descent into Bank-
ruptcy: A Strategic and Organizational Analysis,” Long
Range Planning 36 (2003): 133–149.

20. P. C. Roberts and K. LaFollett Meltdown: Inside the Soviet
Economy (Washington, DC: Cato Institute, 1990).

21. G. Bevan and C. Hood, “What’s Measured Is What
Matters: Targets and Gaming in the English Public
Health Care System,” Public Administration 84 (2006):
517–538.

22. J. Kay, Obliquity (London: Profile Books, 2010).
23. M. Friedman, Capitalism and Freedom (Chicago: Univer-

sity of Chicago Press, 1963).
24. L. Bryan, “Enduring Ideas: The 7-S Framework,” McKinsey

Quarterly (March 2008).

25. J. Collins and J. Porras, “Building Your Company’s
Vision,” Harvard Business Review (September/October
1996): 65–77.

26. W. T. Allen, “Our Schizophrenic Conception of the
Business Corporation,” Cardozo Law Review 14
(1992): 261–281.

27. A. Smith, An Inquiry into the Nature and Causes of the
Wealth of Nations, 5th edn (London: Methuen & Co.,
1905), Chapter 2.

28. A. de Geus, “The Living Company,” Harvard Business
Review (March/April 1997): 51–59.

29. M. E. Porter and M. R. Kramer, “Strategy and Society:
The Link between Competitive Advantage and Corporate
Social Responsibility,” Harvard Business Review (Decem-
ber 2006): 78–92.

30. M. E. Porter and M. R. Kramer, “Creating Shared Value,”
Harvard Business Review ( January 2011): 62–77.

31. C. K. Prahalad and S. L. Hart, “The Fortune at the
Bottom of the Pyramid,” strategy + business 26 (2002):
54–67; T. London and S. L. Hart, “Reinventing Strat-
egies for Emerging Markets: Beyond the Transnational
Model,” Journal of International Business Studies 35
(2004): 350–370.

32. “Hyperloop One hits 309km/h in latest test,” Wired
(August 2, 2017).

33. N. Nichols, “Scientific Management at Merck: An Inter-
view with CFO Judy Lewent,” Harvard Business Review
( January/February 1994): 89–105.

34. B. Kogut and N. Kulatilaka, “Options Thinking and
Platform Investments: Investing in Opportunity,”
California Management Review (Winter 1994):
52–69.

35. “Snapchat: An Abridged History,” Fortune (February
4, 2017). http://fortune.com/2017/02/04/snapchat-
abridged-history/

36. T. Chi, “Option to Acquire or Divest a Joint Venture,”
Strategic Management Journal 21 (2000) 665–687.

37. B. Kogut and N. Kulatilaka, “Capabilities as Real Options,”
Organization Science 12 (2001) 744–758.

3

When a management with a reputation for brilliance tackles a business with a rep-
utation for poor fundamental economics, it is the reputation of the business that
remains intact.

—WARREN BUFFETT, CHAIRMAN, BERKSHIRE HATHAWAY

The reinsurance business has the defect of being too attractive-looking to new
entrants for its own good and will therefore always tend to be the opposite of, say, the
old business of gathering and rendering dead horses that always tended to contain
few and prosperous participants.

—CHARLES T. MUNGER, CHAIRMAN, WESCO FINANCIAL CORP

Industry Analysis:
The Fundamentals

◆ Introduction and Objectives

◆ From Environmental Analysis to Industry Analysis

◆ Analyzing Industry Attractiveness

● Porter’s Five Forces of Competition Framework

● Competition from Substitutes

● Threat of Entry

● Rivalry between Established Competitors

● Bargaining Power of Buyers

● Bargaining Power of Suppliers

◆ Applying Industry Analysis to Forecasting Industry
Profitability

● Identifying Industry Structure

● Forecasting Industry Profitability

◆ Using Industry Analysis to Develop Strategy

● Strategies to Alter Industry Structure

● Positioning the Company

◆ Defining Industries: Where to Draw the Boundaries

● Industries and Markets

● Defining Industries and Markets: Substitution in
Demand and Supply

◆ From Industry Attractiveness to Competitive
Advantage: Identifying Key Success Factors

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

60 PART II THE TOOLS OF STRATEGY ANALYSIS

From Environmental Analysis to Industry Analysis

The business environment of the firm consists of all the external influences that impact
its decisions and its performance. Given the vast number of external influences,
how can managers hope to monitor, let  alone analyze, environmental conditions?
The starting point is some kind of system or framework for organizing information.
Environmental influences can be classified by source, for example, PEST analysis
considers the political, economic, social, and technological factors that impact a firm.

Introduction and Objectives

In this chapter and the next, we explore the external environment of the firm. In Chapter 1, we observed
that profound understanding of the competitive environment is a critical ingredient of a successful
strategy. We also noted that business strategy is essentially a quest for profit. The primary task for this
chapter is to identify the sources of profit in the external environment. The firm’s proximate environment
is its industry; hence, industry analysis will be our focus.

Industry analysis is relevant both to corporate-level and business-level strategies.

◆ Corporate strategy is concerned with deciding which industries the firm should be engaged in and
how it should allocate its resources among them. Such decisions require assessment of the attrac-
tiveness of different industries in terms of their profit potential. The main objective of this chapter is
to understand how the competitive structure of an industry determines its profitability.

◆ Business strategy is concerned with establishing competitive advantage. By analyzing customer
needs and preferences and the ways in which firms compete to serve customers, we identify the
general sources of competitive advantage in an industry—what we call key success factors.

By the time you have completed this chapter, you will be able to:

◆ Appreciate that the firm’s industry forms the core of its external environment and under-
stand that its characteristics and dynamics are essential components of strategy analysis.

◆ Identify the main structural features of an industry and understand how they impact the
intensity of competition and overall level of profitability in the industry.

◆ Apply industry analysis to explain the level of profitability in an industry and predict how
profitability is likely to change in the future.

◆ Develop strategies that (a) position the firm most favorably in relation to competition and
(b) influence industry structure in order to enhance industry attractiveness.

◆ Define the boundaries of the industry within which a firm is located.

◆ Identify opportunities for competitive advantage within an industry (key success factors).

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 61

PEST analysis and similar approaches to macrolevel environmental scanning can be
useful in keeping a firm alert to what is happening in the world but may result in
information overload.

The prerequisite for effective environmental analysis is to distinguish the vital
from the merely important. Hence, we need to establish what features of a firm’s
external environment are critical to its decisions. For the firm to make a profit, it
must create value for customers. Hence, it must understand its customers. Second,
in creating value, the firm acquires inputs from suppliers. Hence, it must under-
stand its suppliers and manage relationships with them. Third, the ability to gen-
erate profitability depends on the intensity of competition among firms that vie for
the same value-creating opportunities. Hence, the firm must understand competi-
tion. Thus, the core of the firm’s business environment is formed by its relationships
with three sets of players: customers, suppliers, and competitors. This is its industry
environment.

This is not to say that macrolevel factors such as general economic trends, changes
in demographic structure, political events, and new technologies are unimportant for
strategy analysis. They may be critical determinants of the threats and opportunities
a company will face in the future. The key issue, however, is how these factors affect
the firm’s industry environment (Figure 3.1). Consider the threat of global warming.
For most companies, this is not a core strategic issue (at least, not within their normal
planning horizons). However, for those businesses most directly affected by chang-
ing weather patterns—farmers and ski resorts—and those subject to carbon taxes and
environmental regulations—electricity generators and automobile producers—global
warming is a vital issue. For these businesses, the key is to analyze the implications
of global warming for customers, suppliers, and competition within their particular
industry. For the auto makers, will consumers switch to electric cars? Will governments
mandate zero-emission vehicles or increase spending on public transportation? Will
there be new entrants into the auto industry?

If strategy is about identifying and exploiting sources of profit, then the starting
point for industry analysis is the simple question “What determines the level of profit
in an industry?”

In the last chapter, we learned that, for a firm to make profit, it must create value
for the customer. Value is created when the price the customer is willing to pay for a

THE INDUSTRY
ENVIRONMENT

• Suppliers
• Competitors
• Customers

DemographicsTechnology

Government
and political

forces

The national/
international

economy

The natural
environment

Social forces

FIGURE 3.1 From environmental analysis to industry analysis

62 PART II THE TOOLS OF STRATEGY ANALYSIS

product exceeds the costs incurred by the firm. But creating customer value does not
necessarily yield profit. The value created is distributed between customers and pro-
ducers by the forces of competition. The stronger competition is among producers,
the more value is received by customers as consumer surplus (the difference bet-
ween the price they actually pay and the maximum price they would have been wil-
ling to pay) and the less is received by producers (as producer surplus or economic
rent). A single supplier of umbrellas outside the Gare de Lyon on a wet Parisian
morning can charge a price that fully exploits commuters’ desire to keep dry. As
more and more umbrella sellers arrive, so the price of umbrellas will be pushed
closer to the wholesale cost.

However, the profit earned by Parisian umbrella sellers, or any other industry, does
not just depend on the competition between them. It also depends upon their sup-
pliers. If an industry has a powerful supplier—a single wholesaler of cheap, imported
umbrellas—that supplier may be able to capture a major part of the value created in
the local umbrella market.

Hence, the profits earned by the firms in an industry are determined by three factors:

● the value of the product to customers

● the intensity of competition

● the bargaining power of industry members relative to their suppliers and
buyers.

Industry analysis brings all three factors into a single analytic framework.

Analyzing Industry Attractiveness

Table 3.1 shows the profitability of different US industries. Some earn consistently high
rates of profit; others fail to cover their cost of capital. The basic premise that under-
lies industry analysis is that the level of industry profitability is neither random nor the
result of entirely industry-specific influences: it is determined by the systematic influ-
ences of the industry’s structure.

The underlying theory of how industry structure drives competitive behavior and
determines industry profitability is provided by industrial organization (IO) eco-
nomics. The two reference points are the theory of monopoly and the theory of per-
fect competition. In a monopoly, a single firm is protected by high barriers to entry.
In perfect competition, many firms supply a homogeneous product and there are no
entry barriers. Monopoly and perfect competition form end points of a spectrum of
industry structures. While a monopolist can appropriate as profit the full amount of
the value it creates, under perfect competition, the rate of profit falls to a level that
just covers firms’ cost of capital. Some real-world industries are close to being monop-
olies. During 1996–2002, Microsoft’s near monopoly of the market for PC operating
systems allowed it to earn a return on equity of over 30%. Niche markets may be suf-
ficiently small that they can be dominated by a single firm (see Strategy Capsule 3.1).
Other industries are close to being perfectly competitive. The US farm sector earns
a long-run return on equity of about 3%—well below its cost of capital. However,
most industries are somewhere in between: most are oligopolies—industries domi-
nated by a few major companies.

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 63

TABLE 3.1 The profitability of US industries, 2010–2016

Industry ROCE (%) Leading Companies

Tobacco 59.9 Altria, Reynolds American, Philip Morris Int.

Computer Software 29.8 Microsoft, Oracle, Salesforce

Household, Personal Care Products 25.2 Procter & Gamble, Kimberley-Clark, Colgate-Palmolive

Semiconductors 22.5 Intel, Qualcomm, Texas Instruments

Pharmaceuticals 21.3 Pfizer, Johnson & Johnson, Merck

Entertainment 20.7 Walt Disney, Time Warner, CBS

Aerospace, Defense 19.9 Boeing, Lockheed Martin, United Technologies

Beverages 19.2 Coca-Cola, Constellation Brands,

Chemicals, Specialty 18.2 PPG Industries, Monsanto, Praxair

Food Processing 18.0 Kraft Foods, General Mills, ConAgra

Medical Products 17.5 Becton Dickinson, Stryker, Boston Scientific

Engineering/Construction 16.8 Flour, AECOM, Jacobs Engineering

Restaurants, Catering 16.6 McDonalds, Darden Restaurants, Starbucks

Office Equipment & Services 15.3 Xerox, NCR, NetApp

Apparel 14.8 VF, Hanesbrands, Ralph Lauren

Furniture, Home Furnishings 13.9 Mohawk Industries, Masco, Herman Miller

Chemicals, General 13.8 Dow Chemical, DuPont, Huntsman

Electronic products 13.7 Apple, Honeywell Intl., Dell Technologies

Packaging, Containers 13.5 WestRock, Ball, Crown Holdings

Metals & Mining 12.7 Alcoa, Freeport-McMoRan, Newmont Mining

Publishing, Newspapers 12.5 News Corp, R.R. Donnelley & Sons, Gannett

Railroads 12.4 Union Pacific, CSX, Norfolk Southern

Hospitals, Healthcare Services 12.1 UnitedHealth Group, HCA Holdings, Tenet Healthcare

Paper, Forest Products 11.2 Weyerhaeuser, International Paper, Boise Cascade

Steel 9.9 Nucor, US Steel, Steel Dynamics

Investment, Asset Management 9.5 BlackRock, Charles Schwab, Franklin Resources

Telecom Services 9.5 AT&T, Verizon Communications, Comcast

Agricultural Processing 9.5 Archer Daniel Midland, Tyson Foods, CHS

Petroleum 9.2 ExxonMobil, Chevron, Valero

Insurance 9.1 State Farm Insurance, MetLife, Prudential Financial

Food Retailing 9.1 Kroger, Albertsons, Publix Super Markets

Trucking 9.1 XPO Logistics, C.H. Robinson Worldwide, J.B. Hunt

Hotels, Casinos 9.0 Marriott International, Las Vegas Sands, MGM Resorts

Motor Vehicle Parts 9.0 General Motors, Ford, Lear

Electrical Power 6.9 Exelon, Duke Energy, PG&E Corp.

Motor Vehicles 5.7 General Motors, Ford Motor, Paccar

Airlines 5.1 American Airlines, Delta Air Lines, United Continental

Notes:
ROCE = Earnings before interest and tax / (Equity + Long-term debt)

64 PART II THE TOOLS OF STRATEGY ANALYSIS

Porter’s Five Forces of Competition Framework

Michael Porter’s five forces of competition framework is the most widely used
tool for analyzing competition within industries.1 It regards the profitability of an
industry (as indicated by its rate of return on capital relative to its cost of capital)
as determined by five sources of competitive pressure. These five forces of compe-
tition include three sources of “horizontal” competition: competition from substi-
tutes, competition from entrants, and competition from established rivals; and two
sources of “vertical” competition: the power of suppliers and the power of buyers
(Figure 3.2).

The strength of each of these competitive forces is determined by a number of key
structural variables, as shown in Figure 3.3.

Competition from Substitutes

The price that customers are willing to pay for a product depends, in part, on the
availability of substitute products. The absence of close substitutes for a product, as
in the case of gasoline or cigarettes, means that consumers are comparatively insen-
sitive to price (demand is inelastic with respect to price). The existence of close sub-
stitutes means that customers will switch to substitutes in response to price increases
for the product (demand is elastic with respect to price). The Internet has provided
a new source of substitute competition that has proved devastating for a number of
established industries. Travel agencies, newspapers, and telecommunication providers
have all suffered severe competition from Internet-based substitutes.

STRATEGY CAPSULE 3.1

Chewing Tobacco, Sausage Skins, and Sports Cards: The Joys
of Niche markets

US Smokeless Tobacco Company earned an operating
margin of 62% during 2014–2017, making a major con-

tribution to the 122% return on equity earned by its par-

ent, Altria Inc., over the same period. What’s the secret

of USSTC’s profitability? It accounts for 57% of the US

market for smokeless tobacco, and its long-established

brands (including Skoal, Copenhagen, and Red Seal), its

distribution through thousands of small retail outlets, and

government restrictions on advertising tobacco prod-

ucts create formidable barriers to would-be competitors.

Devro plc, based in the Scottish village of
Moodiesburn, is the world’s leading supplier of collagen

sausage skins (“casings”). “From the British Banger to the

Chinese Lap Cheong, from the French Merguez to the

South American Chorizo, Devro has a casing to suit all

product types.” Its overall world market share is around

60%. During 2014–2017, Devro’s return on equity

exceeded 20%—about three times its cost of equity.

Panini Group, based in Modena, Italy, is the
world leader in sports trading cards and collectable

stickers. With an exclusive licence with FIFA, it domi-

nates soccer cards and, with licences to supply NBA.

NFL and NHL trading cards, it has become market

leader in the US. It is believed to have earned an

operating margin of over 20% on its 2016 revenues

of $631 million.

Sources: www.altria.com, www.devro.com, and
www.paninigroup.com/corporate/

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 65

FIGURE 3.2 Porter’s five forces of competition framework

INDUSTRY
COMPETITORS

Rivalry among
existing f irms

Bargaining power of suppliers

Threat of
new entrants

Bargaining power of buyers

Threat of
substitutes

POTENTIAL
ENTRANTS

SUBSTITUTES

SUPPLIERS

BUYERS

FIGURE 3.3 The structural determinants of the five forces of competition

Bargaining power
• Size and concentration
of buyers relative to producers
• Buyers’ switching costs
• Buyers’ information
• Buyers’ ability to
backward integrate

BUYER POWER

Price sensitivity
• Cost of product
relative to total cost
• Product
dif ferentiation
• Competition
between buyers

• Concentration
• Diversity of competitors
• Product dif ferentiation
• Excess capacity and
exit barriers
• Cost conditions

SUPPLIER POWER

• Buyers’ price sensitivity

• Capital requirements
• Economies of scale
• Absolute cost
advantages
• Product dif ferentiation
• Access to distribution
• Legal barriers
• Retaliation

SUBSTITUTE
COMPETITION

• Buyers’ propensity to
substitute
• Relative prices and
performance of
substitutes

INDUSTRY RIVALRYTHREAT OF ENTRY

• Relative bargaining power
(See Buyer Power for detail)

66 PART II THE TOOLS OF STRATEGY ANALYSIS

The extent to which substitutes depress prices and profits depends on the propen-
sity of buyers to substitute between alternatives. This, in turn, depends on their price–
performance characteristics. If city-center to city-center travel between Washington and
New York is 50 minutes quicker by air than by train and the average traveler values
time at $30 an hour, the implication is that the train will be competitive at fares of
$25 below those charged by the airlines. The more complex a product and the more
differentiated are buyers’ preferences, the lower the extent of substitution by customers
on the basis of price differences.

Threat of Entry

If an industry earns a return on capital in excess of its cost of capital, it will attract
entry from new firms and established firms diversifying from other industries. If entry
is unrestricted, profitability will fall toward its competitive level. In some industries, it
is easy to establish a new company. Beer brewing has seen a flood of new entrants in
recent years. Between 1990 and 2017, the number of breweries increased from 284 to
4269 in the US and from 241 to 892 in the UK, despite declining beer consumption in
both countries.2 Wage differences between occupations are also influenced by entry
barriers. Why is it that my wife, a psychotherapist, earns much less than our niece, a
recently qualified medical doctor? Psychotherapy, with its multiple accrediting bodies
and less restrictive licensing. has much lower barriers to entry than medical practice.

Threat of entry rather than actual entry may be sufficient to ensure competitive
price levels. An industry where no barriers to entry or exit exist is contestable: prices
and profits tend toward the competitive level, regardless of the number of firms within
the industry.3 Contestability depends on the absence of sunk costs, hence making an
industry is vulnerable to “hit and run” entry whenever established firms raise their
prices above the competitive level.

In most industries, however, new entrants must surmount barriers to entry: disad-
vantages that new entrants face relative to established firms. The size of this disadvan-
tage determines the height of a barrier to entry. The principal sources of barriers to
entry are as follows:

Capital Requirements Set-up costs can be so large as to discourage all but the larg-
est companies. The duopoly of Boeing and Airbus in large passenger jets is protected
by the huge investments needed to develop, build, and service big jet planes. In other
industries, entry costs can be modest. Intense competition in the market for smart-
phone apps reflects the low cost of developing most software applications. Across the
service sector, start-up costs tend to be low: the cost of a franchised pizza outlet starts
at $119,950 for Domino’s and $130,120 for Papa John’s.4

Economies of Scale Industries with high capital requirements for new entrants are
also subject to economies of scale. If large, indivisible investments in production,
product development, distribution or marketing are required, efficiency requires amor-
tizing these costs over a large volume of output. According to Fiat Chrysler’s late-CEO,
Sergio Marchionne, financial viability in automobiles requires producing at least six
million vehicles a year. New automobile producers must either enter with suboptimal
capacity or with scale-efficient capacity that is massively underutilized while the entrant
builds market share.

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 67

Absolute Cost Advantages Established firms may have a cost advantage over
entrants, irrespective of scale. Absolute cost advantages often result from the owner-
ship of low-cost sources of raw materials. Established oil and gas producers, such as
Saudi Aramco and Gazprom, which have access to the world’s biggest and most acces-
sible reserves, have an unassailable cost advantage over more recent entrants such as
Cairn Energy and EOG Resources. Absolute cost advantages also result from learning.
Intel’s dominance of the market for advanced microprocessors arises in part from the
benefits it derives from its wealth of experience.

Product Differentiation In an industry where products are differentiated, established
firms possess the advantages of brand recognition and customer loyalty.5 New entrants
to such markets must spend disproportionately heavily on advertising and promotion
to establish brand awareness.

Access to Channels of Distribution For many new suppliers of consumer
goods, the principal barrier to entry is gaining distribution. Limited shelf space, risk
aversion, and the costs of carrying an additional product cause retailers to be reluc-
tant to carry a new manufacturer’s product. “Slotting fees”, payments by suppliers to
supermarkets to reserve shelf space, further disadvantage new entrants. An impor-
tant consequence of the Internet has been allowing new businesses to circumvent
barriers to distribution.

Governmental and Legal Barriers Some of the most effective barriers to
entry are those created by government. In taxicabs, banking, telecommunications,
and broadcasting, entry usually requires a license from a public authority. Leg-
islation concerning intellectual properties allows the creators of inventions, art,
and brands to be protected from imitators by patents, copyrights, and trademarks.
Environmental and safety regulations may also put new entrants at a disadvan-
tage to established firms because compliance costs tend to weigh more heavily on
newcomers.

Retaliation Potential entrants may also be deterred by expectations of retaliation
by established firms. Such retaliation may take the form of aggressive price-cutting,
increased advertising, sales promotion, or litigation. The budget airlines frequently
allege predatory price cuts by the major airlines designed to deter them from new
routes.6 To avoid retaliation, new entrants may initiate small-scale entry into marginal
market segments. Toyota, Nissan, and Honda’s first entry into the US auto market
targeted small cars, a segment that had been written off by the Detroit Big Three as
inherently unprofitable.

The Effectiveness of Barriers to Entry Industries protected by entry barriers—
particularly those where capital retirements and advertising are high—tend to earn
above-average rates of profit.7 The effectiveness of barriers to entry depends on the
resources and capabilities that potential entrants possess. Barriers that are effective
against new companies may be ineffective against established firms that are diversi-
fying from other industries.8 Google’s massive web presence allowed it to challenge
the seemingly impregnable market positions of Microsoft in web browsers and Apple
in smartphones.

68 PART II THE TOOLS OF STRATEGY ANALYSIS

Rivalry between Established Competitors

In most industries, the major determinant of the overall state of competition and
the general level of profitability is rivalry among the firms within the industry. In
some industries, firms compete aggressively—sometimes to the extent that prices
are pushed below the level of costs and industry-wide losses are incurred. In other
industries, price competition is muted and rivalry focuses on advertising, innova-
tion, and other nonprice dimensions. The intensity of price competition between
established firms is the result of interactions between six factors. Let us look at
each of them.

Concentration Seller concentration refers to the number and size distribu-
tion of firms competing within a market. It is most commonly measured by the
concentration ratio: the combined market share of the leading producers. For
example, the four-firm concentration ratio (CR4) is the market share of the four larg-
est producers. In markets dominated by a single firm (e.g., Gillette in razor blades,
or FICO in consumer credit scoring), or by a small group of companies (Coca-Cola
and Pepsi in soft drinks; Bloomberg and Reuters in financial intelligence), price
competition tends to be restrained, and competition focuses on advertising, pro-
motion, and new product development. As the number of firms supplying a market
increases, coordination of prices becomes more difficult and the likelihood that one
firm will initiate price-cutting increases. In wireless telecommunications, regulators
in the United States and Europe have favored four operators in each market and
opposed mergers in the belief that three competitors is too few for effective price
competition.9 However, despite the frequent observation that the exit of a compet-
itor reduces price competition, while new entry stimulates it, there is little systematic
evidence that seller concentration increases profitability: “The relation, if any, bet-
ween seller concentration and profitability is weak statistically and the estimated
effect is usually small.”10

Diversity of Competitors The ability of rival firms to avoid price competition by
coordinating their prices depends on how similar they are in their origins, objectives,
costs, and strategies. The cozy atmosphere of the US auto industry prior to the advent
of import competition was greatly assisted by the similarities of the companies in terms
of cost structures, strategies, and top management mindsets. Conversely, the difficulties
that OPEC experiences in agreeing and enforcing output quotas among its member
countries are exacerbated by their differences in terms of objectives, production costs,
politics, and religion.11

Product Differentiation The more similar the offerings among rival firms, the
more willing are customers to switch between them and the greater is the induce-
ment for firms to cut prices to boost sales. Where the products of rival firms are
virtually indistinguishable, the product is a commodity and price is the sole basis
for competition. By contrast, in industries where products are highly differentiated
(perfumes, pharmaceuticals, restaurants, management consulting services), com-
petition tends to focus on quality, brand promotion, and customer service rather
than price.

Excess Capacity and Exit Barriers Why, especially in commodity industries, does
industry profitability tend to fall so drastically during periods of recession? The key is
the balance between demand and capacity. Unused capacity encourages firms to offer

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 69

price cuts to attract new business. Excess capacity may be cyclical (e.g., the boom–
bust cycle in the semiconductor industry); it may also be part of a structural problem
resulting from overinvestment and declining demand. In this latter situation, the key
issue is whether excess capacity will leave the industry. Barriers to exit are impedi-
ments to capacity leaving an industry. Where assets are durable and specialized, and
where employees are entitled to job protection, barriers to exit may be substantial.12
In the European auto industry, excess capacity together with high exit barriers have
devastated industry profitability. Conversely, demand growth creates capacity short-
ages that boost margins. Rising demand for lithium-ion batteries has caused shortages
of production capacity for lithium and cobalt, increasing their prices and profitability.
On average, companies in growing industries earn higher profits than companies in
slow-growing or declining industries (Figure 3.4).

Cost Conditions: Scale Economies and the Ratio of Fixed to Variable
Costs When excess capacity causes price competition, how low will prices go? The
key factor is cost structure. Where fixed costs are high relative to variable costs, firms
will take on marginal business at any price that covers variable costs. The incredible
volatility of bulk shipping rates reflects the fact that almost all the costs of operating
bulk carriers are fixed. The daily charter rates for “capesize” bulk carriers fell from
$233,998 on June 5, 2008 to $2773 six months later as world trade contracted. Similarly,
in airlines, the low additional costs of filling empty seats mean that the emergence of
excess capacity often leads to price wars and industry-wide losses. “Cyclical” industries
are characterized both by cyclical demand and high fixed costs causing fluctuations in
revenues to be amplified into much bigger fluctuations in profits.

Scale economies may also induce aggressive price competition as companies seek
the cost benefits of greater volume.

Bargaining Power of Buyers

The profit margin earned by the firms in an industry depends on the prices they
can charge their customers. These customers will do all they can to exert downward

FIGURE 3.4 The impact of growth on profitability

Im
p

ac
t

o
n

ra
te

o
f p

ro
f it

(%
)

–6% –4% –2% 0%
Rate of market growth (in real terms)

12%10%8%6%4%2%

2.5

2

1.5

1

0.5

0

–1

–1.5

–0.5

Return on investment Return on sales

Source: Based upon the PIMS multiple regression equation. See R. M. Grant Contemporary Strategy Analysis,
5th edition (Blackwell, 2005): 491.

70 PART II THE TOOLS OF STRATEGY ANALYSIS

pressure on these prices. The ability of buyers to drive down the prices they pay
depends upon two factors: their price sensitivity and their bargaining power relative to
the firms within the industry.

Buyers’ Price Sensitivity The extent to which buyers are sensitive to the prices
they are charged depends on the following.

● The greater the importance of the product as a proportion of buyers’ total cost,
the more sensitive buyers will be about the price they pay. Soft drink com-
panies are highly sensitive to the costs of aluminum cans because this is one of
their largest cost items. Conversely, most companies are not sensitive to the fees
charged by their auditors, since auditing costs are a tiny fraction of total expenses.

● The less differentiated the products of the supplying industry, the more wil-
ling are buyers to switch suppliers on the basis of price. The manufacturers of
T-shirts and light bulbs have much more to fear from Walmart’s buying power
than have the suppliers of cosmetics.

● The more intense the competition among buyers, the greater their eagerness to
obtain preferential terms from their suppliers. Intense price competition among
British supermarket chains has made them hypersensitive to the prices they pay
their suppliers.

● The more critical an industry’s product to the quality of the buyer’s product or
service, the less sensitive are buyers to the prices they are charged. Dentists
tend not to negotiate over the prices they pay the manufacturers of titanium
dental implants.

Relative Bargaining Power Bargaining power rests, ultimately, on the refusal to
deal with the other party. The balance of power between the two parties to a transac-
tion depends on the credibility and effectiveness with which each makes this threat.
The key issue is the relative cost that each party would incur in the event of a hold-out
by the counterparty, together with the relative bargaining skills of each party. Several
factors influence the bargaining power of buyers relative to that of sellers:

● Size and concentration of buyers relative to suppliers. If an industry faces
few buyers, each with large purchases, firms will be very reluctant to lose a
large buyer. Because of their size, health maintenance organizations can pur-
chase health care from hospitals and doctors at much lower costs than can
individual patients.

● Buyers’ information. The better informed are buyers about suppliers and their
prices and costs, the better they are able to bargain. Doctors and lawyers do
not normally display the prices they charge, nor do traders in the bazaars of
Marrakech or Chennai. Keeping customers ignorant of market prices is an effec-
tive constraint on their buying power. But knowing prices is of little value if the
quality of the product is unknown. In the markets for dentistry, interior design,
and management consulting, the ability of buyers to bargain over price is
limited by uncertainty over the precise attributes of the product they are buying.

● Capacity for vertical integration. Backward integration is a means through
which buyers reduce their dependence upon their suppliers. Large beer com-
panies have reduced their dependence on the manufacturers of aluminum

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 71

cans by manufacturing their own. Large retail chains introduce their own label
brands to compete with those of their suppliers. Backward integration need not
necessarily occur—a credible threat may suffice.

Bargaining Power of Suppliers

Analysis of supplier power is precisely analogous to analysis of buyer power. The only
difference is that it is now the firms in the industry that are the buyers and the pro-
ducers of inputs that are the suppliers. Again, the relevant factors are the ease with
which the firms in the industry can switch between different input suppliers and the
relative bargaining power of each party.

The suppliers of commodities tend to lack bargaining power relative to their
customers; hence, they may use cartels to boost their influence over prices (e.g.,
OPEC, the International Coffee Organization, and farmers’ marketing cooperatives).
Conversely, the suppliers of complex, technically sophisticated components may be
able to exert considerable bargaining power. The dismal profitability of the personal
computer industry during the past 30 years may be attributed to the power exer-
cised by the suppliers of key components (processors, disk drives, LCD screens)
and the dominant supplier of operating systems (Microsoft). Wireless telecom car-
riers are pressured by monopoly suppliers of spectrum: auctions of 3G licenses
raised $127 billion of governments in the OECD countries, while US 4G auctions
raised $65 billion during 2014–2017.13 Labor unions possess significant supplier
power: in automobiles, steel, and airlines, powerful unions depress industry prof-
itability.

Applying Industry Analysis to Forecasting Industry Profitability

Once we understand how industry structure determines current levels of industry prof-
itability, we can use this analysis to forecast industry profitability in the future.

Identifying Industry Structure

The first stage of any industry analysis is to identify the key elements of the industry’s
structure. In principle, this is a simple task. It requires identifying who are the main
players—the producers, the buyers, the suppliers of inputs, and the producers of sub-
stitute goods—then distinguishing the key structural characteristics of each that will
impact competition and bargaining power.

In most manufacturing industries, identifying the main groups of players is straight-
forward; in other industries, particularly in service industries, mapping the industry
can be more difficult. Figure  3.5 depicts the increased complexity of the recorded
music industry.

Forecasting Industry Profitability

We can use industry analysis to understand why profitability has been low in some
industries and high in others but, ultimately, our interest is not to explain the past

72 PART II THE TOOLS OF STRATEGY ANALYSIS

but to predict the future. Investment decisions made today will commit resources
to an industry for years—often for a decade or more—hence, it is critical that we
are able to predict what level of returns the industry is likely to offer in the future.
Current profitability is a poor indicator of future profitability: industries such as news-
papers, solar panels, and petroleum have suffered massive declines in profitability;
in other industries, such as airlines and food processing, profitability has revived.
However, if an industry’s profitability is determined by the structure of that industry,
then we can use observations of the structural trends in an industry to forecast likely
changes in competition and profitability. Changes in industry structure typically result
from fundamental shifts in customer buying behavior, technology, and firm strat-
egies which can be anticipated well in advance of their impacts on competition and
profitability.

To predict the future profitability of an industry, our analysis proceeds in three
stages:

1 Examine how the industry’s current and recent levels of competition and profit-
ability are a consequence of its present structure.

2 Identify the trends that are changing the industry’s structure. Is the industry
consolidating? Are new players seeking to enter? Are the industry’s products
becoming more differentiated or more commoditized? Will additions to industry
capacity outstrip growth of demand? Is technological innovation causing new
substitutes to appear?

3 Identify how these structural changes will affect the five forces of competition
and resulting profitability of the industry. Will the changes in industry structure
cause competition to intensify or to weaken? Rarely, do all the structural changes
move competition in a consistent direction; typically some will exacerbate com-
petitive intensity, others will cause it to abate. Hence, determining the overall
impact on profitability tends to be a matter of judgment.

Strategy Capsule 3.2 discusses the outlook for profitability in the world auto-
mobile industry.

FIGURE 3.5 Industries are becoming more complex: Recorded music

1990 2018

Recording artists, songwriters Recording artists, songwriters

Record Companies
EMI, CBS, BMG, Polygram

Record Companies (Sony BMG,
Universal Music, Warner Music)

Wholesalers

Retailers

Consumers Consumers

Retailers
(Amazon, HMV,

Shimamura)

Download
(Apple iTunes,
Amazon MP3)

Streaming
(Spotify, Apple Music,
Pandora, Google Play,

Kugou Music)

Platforms (Apple iOS,
Android, MS Windows)

Advertisers

SUPPLIERS

PRODUCERS

DISTRIBUTORS

CONSUMERS

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 73

STRATEGY CAPSULE 3.2

The Future of the World Automobile Industry

During the current decade, the world automobile industry

has recovered from the financial crisis of 2008–2009, but

competition has been fierce and profitability low. During

2013–17, the top eight producers (Toyota, VW, General

Motors, Ford, Nissan, Hyundai, Honda and Fiat Chrysler)

have earned an average operating margin of 4.7% and

an average return on capital employed of 6.1% (almost

certainly below their weighted average cost of capital).

Applying the five forces of competition framework to the

industry allows us to understand why profitability has

been low. We can then identify the current trends that are

reshaping the industry—the switch to electric vehicles

(EVs), autonomous driving, increased shared ownership

and ride sharing, internationalization by Chinese auto

producers—and show how these trends will impact the

five forces of competition in the future. In the table below,

the direction of the arrow shows the predicted impact of

each competitive force on industry profitability.

Competitive
force

Relevant
structural features

of the industry

Impact on
profitability
2013–2018

Changes in
industry structure

2019–2028

Impact on
profitability
2019–2028

Substitutes Alternative modes of
transportation (bicycles,
public transport). Also
telecommuting.

Weak Congestion and
environmental
concerns will increase
substitute competition

Increasing

New entry
● Internationalization by

domestic producers

● New producers of EVs

Moderate Increased competition
from both sources.

Increasing

Internal rivalry
● 22 companies with annual

output of >1 million cars

● Massive excess capacity

(global capacity utiliza-

tion approx. 72%)

● High fixed costs and

large-scale economies

encourage quest for

market share

Strong
● M&A to reduce no.

of producers

● Continuing excess

capacity due to exit

barriers (especially

government support)

and falling demand due

to lower personal owner-

ship of cars

Positive impact
of M&A offset by
negative impact
of new entry
and of declining
demand

Buyer power Distribution through
franchised dealers

Weak No significant change

Supplier
power

● Consolidation among

component suppliers

● Suppliers control key

technologies

Moderate Emergence of powerful
new suppliers, especially
software companies and
suppliers of batteries

Increasing

Even with potential new revenue sources (e.g., the

supply of information, entertainment, and advertising to

car occupants), it would appear that structural changes

in the industry will depress the profitability of the car

manufacturers. This negative outlook is reflected in com-

panies’ stock market capitalization: the top eight auto

makers had an average P/E ratio of 7.2 in June 2018—

less than half the average P/E of the world’s stock markets.

74 PART II THE TOOLS OF STRATEGY ANALYSIS

Using Industry Analysis to Develop Strategy

Once we understand how industry structure influences competition, which in turn
determines industry profitability, we can use this knowledge to develop firm strat-
egies. First, we can develop strategies that influence industry structure in order to
moderate competition; second, we can position the firm to shelter it from the ravages
of competition.

Strategies to Alter Industry Structure

Understanding how the structural characteristics of an industry determine the inten-
sity of competition and the level of profitability provides a basis for identifying
opportunities for changing industry structure to alleviate competitive pressures.
The first issue is to identify the key structural features of an industry that are
responsible for depressing profitability. The second is to consider which of these
structural features are amenable to change through appropriate strategic initiatives.
For example:

● Between 2000 and 2006, a wave of mergers and acquisitions among the world’s
iron ore miners resulted in three companies—Vale, Rio Tinto, and BHP Billiton—
controlling 75% of global iron ore exports. The growing power of the iron ore
producers relative to their customers, the steel makers, contributed to the 400%
rise in iron ore prices between 2004 and 2010.14

● In chemicals, depressed profitability caused by new capacity from Asian
and Middle East producers encouraged a wave of mergers among US and
European producers during 2016–17 as they sought to gain market power and
shift from commodity to specialty products. Major deals included Dow and
DuPont, Bayer and Monsanto, Clariant and Huntsman, and Sherwin-Williams,
and Valspar.15

● US airlines have deployed several strategies to change an unfavorable industry
structure. In the absence of significant product differentiation, they have used
frequent-flyer schemes to build customer loyalty. Through hub-and-spoke
route systems, they have built dominant positions at major airports: American
at Miami and Dallas/Fort Worth, Delta at Atlanta, and Southwest at Baltimore.
Mergers and alliances have reduced the numbers of competitors on most routes.
As a result, the industry’s net margin which was −1.3% during 1990–2010,
increased to 2.8% during 2010–17.16

● Building entry barriers is a vital strategy for preserving high profitability. A
primary goal of the American Medical Association has been to maintain the
incomes of its members by controlling the numbers of doctors trained in the
United States and imposing barriers to the entry of doctors from overseas.

Once we look beyond the confines of industry to consider a firm’s entire ecosystem,
then additional opportunities arise for a firm to reconfigure the system of relationships
within which it operates. Michael Jacobides argues that industries are in a state of
continual evolution and that all firms, even small ones, have the potential to influence
changes in industry structure to suit their own interests.17 We shall consider the role of
business ecosystems in the next chapter.

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 75

Positioning the Company

Recognizing and understanding the competitive forces that a firm faces within its
industry allows managers to position the firm where competitive forces are weakest.

● The recorded music industry, once reliant on sales of CDs, has been devastated by
substitute competition in the form of digital downloads, piracy, file sharing, and
streaming. Yet, not all segments of the recorded music business have been equally
affected. The old are less inclined to new technology than younger listeners are;
hence, classical music, country, and golden oldies have become comparatively more
attractive for the sale of CDs than pop and hip-hop genres. Prominent in the resur-
gence of vinyl have been albums by David Bowie, the Beatles, and Pink Floyd.

● US truck-maker Paccar has achieved superior profitability by focusing on the
preferences of independent owner-operators (e.g., by providing superior sleep-
ing cabins, higher-specification seats, a roadside assistance program) thereby
sheltering from the bargaining power of fleet buyers.18

Effective positioning requires the firm to anticipate changes in the competitive forces
likely to affect the industry. Department stores are being decimated by online retailing.
The survivors will be those able to transform the content and nature of their customers’
experiences. The British department store chain, John Lewis, is shifting floor space
from products to services—restaurants, spas, roof gardens, and shared-use office ser-
vices—and adopting new approaches to integrating “clicks-and-bricks.”19

Defining Industries: Where to Draw the Boundaries

A key challenge in industry analysis is defining the relevant industry. The Standard Industrial
Classification (SIC) is of limited use in identifying groups of firms that compete with one
another. Which industry is Ferrari a member of? Is it part of the “motor vehicles and equip-
ment” industry (SIC 371), the automobile industry (SIC 3712), or the performance car
industry? Should it see itself as part of the Italian, European, or global auto industry?

Industries and Markets

We must clarify what we mean by the term industry. Economists define an industry as
a group of firms that supplies a market. Hence, a close correspondence exists between
markets and industries. So is there any difference between analyzing industry structure
and analyzing market structure? One major difference is that industry analysis, notably
five forces analysis, looks at industry profitability being determined by competition in
two markets: product markets and input markets.

In everyday usage, the term industry tends to refer to a fairly broad sector, whereas
a market refers to the buyers and sellers of a specific product. Thus, the packaging
industry comprises several distinct product markets—glass containers, steel cans,
aluminum cans, paper cartons, plastic containers, and so on.

To define an industry, it makes sense to start by identifying the firms that compete
to supply a particular market. At the outset, this approach may lead us to question
conventional concepts of industry boundaries. For example, what is the industry com-
monly referred to as banking? Institutions called banks supply a number of different
products and services, each comprising different sets of competitors. A basic distinction

76 PART II THE TOOLS OF STRATEGY ANALYSIS

is between retail banking, corporate/wholesale banking, and investment banking. Each
of these can be disaggregated into several different product markets. Retail banking
comprises deposit taking, transaction services, credit cards, and mortgage lending.
Investment banking includes corporate finance and underwriting, trading, and advisory
services (such as mergers and acquisitions).

Defining Industries and Markets: Substitution in Demand
and Supply

The central issue in defining a firm’s industry is to establish who is competing with whom.
To do this, we need to draw upon the principle of substitutability. There are two dimen-
sions to this: substitutability on the demand side and substitutability on the supply side.

Let us consider once more the industry within which Ferrari competes. Starting with
the demand side, if customers are willing to substitute only between Ferraris and other
sports car brands on the basis of price differentials, then Ferrari is part of the performance
car industry. If, on the other hand, customers are willing to substitute Ferraris for other
mass-market brands, then Ferrari is part of the broader automobile industry.

But this fails to take account of substitutability on the supply side. If volume car pro-
ducers such as Ford and Hyundai are able to apply their production facilities and distri-
bution networks to supply sports cars, then, on the basis of supply-side substitutability,
we could regard Ferrari as part of the broader automobile industry. The same logic can
be used to define the major domestic appliances as an industry. Although consumers
are unwilling to substitute between refrigerators and dishwashers, manufacturers can
use the same plants and distribution channels for different appliances—hence we view
Electrolux, Whirlpool, and Haier as competing in the domestic appliance industry.

Similar considerations apply to geographical boundaries. Should Ferrari view itself
as competing in a single global market or in a series of separate national or regional
markets? The criterion here again is substitutability. If customers are willing and able to
substitute cars available on different national markets, or if manufacturers are willing
and able to divert their output among different countries to take account of differences
in margins, then a market is global. The key test of the geographical boundaries of a
market is price: if price differences (net of taxes) for the same product between dif-
ferent locations tend to be eroded by demand-side and supply-side substitution, then
these locations lie within a single market.

In practice, drawing the boundaries of markets and industries is a matter of judg-
ment that depends on the purposes and context of the analysis. Decisions regarding
pricing and market positioning require a microlevel approach. Decisions over invest-
ments in technology, new plants, and new products require a wider view of the rele-
vant market and industry.

The boundaries of a market or industry are seldom clear-cut. A firm’s competitive
environment is a continuum rather than a bounded space. Thus, we may view the com-
petitive market of Disneyland, Hong Kong as a set of concentric circles. The closest
competitors are nearby theme parks Ocean Park and Ma Wan Park. Slightly more dis-
tant are Shenzhen Happy Valley, Shenzhen Window of the World, and Splendid China.
Further still are Disneyland parks in Tokyo and Shanghai and alternative forms of enter-
tainment, for example, a trip to Macau or to a Lantau Island beach resort.

For the purposes of applying the five forces framework, industry definition is
seldom critical. Whether we define the “box” within which industry rivals compete
broadly or narrowly, a key merit of the five forces framework is that it takes account
of competitors outside the industry box—either as the suppliers of substitutes or as
potential entrants.20

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 77

From Industry Attractiveness to Competitive Advantage: Identifying
Key Success Factors

The five forces framework allows us to determine an industry’s potential for profit. But
how is industry profit shared between the different firms competing in that industry?
Let us look explicitly at the sources of competitive advantage within an industry. In
subsequent chapters I shall develop a more comprehensive analysis of competitive
advantage. My goal in this chapter is simply to identify an industry’s key success
factors: those factors within an industry that influence a firm’s ability to outperform
rivals.21 In Strategy Capsule 3.3, Kenichi Ohmae, former head of McKinsey’s Tokyo
office, discusses key success factors in forestry.

STRATEGY CAPSULE 3.3

Probing for Key Success Factors

As a consultant faced with an unfamiliar business or

industry, I make a point of first asking the specialists in the

business, “What is the secret of success in this industry?”

Needless to say, I seldom get an immediate answer and

so I pursue the inquiry by asking other questions from a

variety of angles in order to establish as quickly as possible

some reasonable hypotheses as to key factors for success.

In the course of these interviews, it usually becomes quite

obvious what analyses will be required in order to prove

or disprove these hypotheses. By first identifying the

probable key factors for success and then screening them

by proof or disproof, it is often possible for the strategist to

penetrate very quickly to the core of a problem.

Traveling in the United States last year, I found myself

on one occasion sitting in a plane next to a director of

one of the biggest lumber companies in the country.

Thinking I might learn something useful in the course of

the five-hour flight, I asked him, “What are the key factors

for success in the lumber industry?” To my surprise, his

reply was immediate: “Owning large forests and maxi-

mizing the yield from them.” The first of these key factors

is a relatively simple matter: purchase of forestland. But

his second point required further explanation. Accord-

ingly, my next question was: “What variable or variables

do you control in order to maximize the yield from a

given tract?”

He replied: “The rate of tree growth is the key var-

iable. As a rule, two factors promote growth: the

amount of sunshine and the amount of water. Our

company doesn’t have many forests with enough of

both. In Arizona and Utah, for example, we get more

than enough sunshine but too little water and so tree

growth is very low. Now, if we could give the trees in

those states enough water, they’d be ready in less than

15 years instead of the 30 it takes now. The most impor-

tant project we have in hand at the moment is aimed at

finding out how to do this.”

Impressed that this director knew how to work out

a key factor strategy for his business, I offered my own

contribution: “Then under the opposite conditions,

where there is plenty of water but too little sunshine—

for example, around the lower reaches of the Columbia

River—the key factors should be fertilizers to speed up

the growth and the choice of tree varieties that don’t

need so much sunshine.”

Having established in a few minutes the general

framework of what we were going to talk about, I spent

the rest of the long flight very profitably hearing from him

in detail how each of these factors was being applied.

Source: Kenichi Ohmae, The Mind of the Strategist (New York:
McGraw-Hill, 1982): 85 © The McGraw-Hill Companies Inc.,
reproduced with permission.

78 PART II THE TOOLS OF STRATEGY ANALYSIS

Like Ohmae, our approach to identifying key success factors is straightforward
and commonsense. To survive and prosper in an industry, a firm must meet two
criteria: first, it must attract customers; second, it must survive competition. Hence, we
may start by asking two questions:

● What do our customers want?

● What does the firm need to do to survive competition?

To answer the first question, we need to look more closely at the customers of the
industry and to view them, not as a source of buying power and a threat to profit-
ability, but as the raison dӐtre of the industry and its underlying source of profit. This
requires that we inquire the following: Who are our customers? What are their needs?
How do they choose between competing offerings? Once we recognize the basis
upon which customers choose between rival offerings, we can identify the factors that
confer success upon the individual firm. For example, if travelers choose airlines pri-
marily on price, then cost efficiency is the primary basis for competitive advantage in
the airline industry and the key success factors are the determinants of relative cost.

The second question requires that we examine the nature of competition in the
industry. How intense is competition and what are its key dimensions? Thus, in airlines,
it is not enough to offer low fares. To survive intense competition during recessionary
periods an airline requires financial strength; it may also require good relations with
regulators and suppliers.

A basic framework for identifying key success factors is presented in Figure  3.6.
Application of the framework to identify key success factors in three industries is out-
lined in Table 3.2.

Key success factors can also be identified through the direct modeling of profit-
ability, thereby identifying the drivers of a firm’s relative profitability within an industry.
Using the same approach as in Chapter  2 (Figure  2.2), we can disaggregate return
on capital employed into component ratios, which then point to the main drivers
of superior profitability. In some industries, there are well-known formulae that link
operating ratios to overall profitability. Strategy Capsule 3.4 disaggregates profit margin
in the airline industry to identify key success factors.

FIGURE 3.6 Identifying key success factors

What do customers
want?

KEY SUCCESS FACTORS

Prerequisites for success

How does the f irm
survive competition?

Analysis of competition
• What drives competition?
• What are the main
dimensions of competition?
• How intense is competition?
• How can we obtain a superior
competitive position?

Analysis of demand
• Who are our customers?
• What do they want?

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 79

TABLE 3.2 Identifying key success factors: Steel, fashion clothing, and supermarkets

What do customers want?
(Analysis of demand)

How do firms survive
competition? (Analysis

of competition) Key success factors

Steel Low price
Product consistency
Reliability of supply
Technical specifications

Intense price competition
results from undifferentiated
products, excess capacity,
and high fixed costs.
Survival requires cost efficiency
and financial strength

Cost efficiency requires: large-scale
plants, low-cost raw materials, rapid
capacity adjustment
Hi-tech small-scale plants viable with
flexibility and high productivity
Quality, and service can yield a
price premium

Fashion
clothing

Diversity of customer preferences
Customers will pay premium for
brand, style, exclusivity, and quality
Mass market is highly price
sensitive

Low barriers to entry and
many competitors imply
intense competition
Differentiation offers price
premium, but imitation
is rapid

Combining differentiation with low costs
Differentiation involves style,
brand appeal, quality, and market
responsiveness
Cost efficiency requires manufacture
where wages are low

Supermarkets Low prices
Convenient location
Wide product range
Quality produce, good service, ease
of parking, pleasant ambience

Intensely price competitive
Buying power essential
for low costs

Low costs require operational efficiency,
large-scale purchases, low wages
Differentiation requires large stores,
convenient location, meticulous
in-store management

STRATEGY CAPSULE 3.4

Identifying Key Success Factors by Profitability modeling: Airlines

Profitability, as measured by operating income per availa-

ble seat-mile (ASM), is determined by three factors: yield,

which is total operating revenues divided by the number

of revenue passenger miles (RPMs); load factor, which is

the ratio of RPMs to ASMs; and unit cost, which is total

operating expenses divided by ASMs. Thus:

Profit
ASMs

Revenue
RPMs

RPMs
ASMs

Expenses
ASMs

Some of the main determinants of each of these

component ratios are the following:

◆ Revenue/RPMs

● intensity of competition on routes flown

● effective yield management to permit quick price

adjustment to changing market conditions

● ability to attract business customers

● superior customer service.

◆ Load factor (RPMs/ASMs)

● competitiveness and flexibility of prices

● efficiency of route planning (e.g., through

hub-and-spoke systems)

● building customer loyalty through quality of ser-

vice, frequent-flier programs

● matching airplane size to demand for individual

flights.

◆ Expenses/ASMs

● wage rates and benefit levels

● fuel efficiency of aircraft

● productivity of employees (determined partly by

their job flexibility)

● load factors

● level of administrative cost.

80 PART II THE TOOLS OF STRATEGY ANALYSIS

The usefulness of industry-level success factors in formulating strategy has been
scorned by some strategy scholars. Pankaj Ghemawat observes that the “whole
idea of identifying a success factor and then chasing it seems to have something
in common with the ill-considered medieval hunt for the philosopher’s stone, a
substance that would transmute everything it touched into gold.”22 However, the
existence of common success factors in an industry does not imply that firms should
adopt similar strategies. In the fashion clothing business, we identified a number
of key success factors (Table  3.2), yet  all the leading companies—Inditex (Zara),
H&M, Diesel, and Mango—have adopted unique strategies to exploit these key suc-
cess factors.

Summary

In Chapter 1, we established that a profound understanding of the competitive environment is a criti-
cal ingredient of a successful strategy. Despite the vast number of external influences that affect every
business enterprise, our focus is the firm’s industry environment that we analyze in order to evaluate the
industry’s profit potential and to identify the sources of competitive advantage.

The centerpiece of our approach is Porter’s five forces of competition framework, which links the
structure of an industry to the competitive intensity within it and to the profitability that it realizes. The
Porter framework offers a simple yet powerful organizing framework for identifying the relevant features
of an industry’s structure and predicting their implications for competitive behavior.

The primary application for the Porter five forces framework is in predicting how changes in an
industry’s structure are likely to affect its profitability. Once we understand the drivers of industry profit-
ability, we can identify strategies through which a firm can improve industry attractiveness and position
itself in relation to these different competitive forces.

As with most of the tools for strategy analysis that we shall consider in this book, the Porter five forces
framework is easy to comprehend. However, real learning about industry analysis and about the Porter
framework in particular derives from its application. It is only when we apply the Porter framework to
analyzing competition and diagnosing the causes of high or low profitability in an industry that we are
forced to confront the complexities and subtleties of the model. A key issue is identifying the industry
within which a firm competes and recognizing its boundaries. By employing the principles of substitut-
ability and relevance, we can delineate meaningful industry boundaries.

Finally, our industry analysis allows us to make a first approach at identifying the sources of compet-
itive advantage through recognizing key success factors in an industry.

I urge you to put the tools of industry analysis to work—not just in your strategic management
coursework but also in interpreting everyday business events. The value of the Porter framework is as
a practical tool—it helps us to understand the disparities in profitability between industries, to predict
an industry will sustain its profitability into the future, and to recognize which strategies have the best
potential for making money. Through practical applications, you will also become aware of the lim-
itations of the Porter framework. In the next chapter, we will see how we can extend our analysis of
industry and competition.

CHAPTER 3 INduSTRY ANALYSIS: THE FuNdAmENTALS 81

Self-Study Questions

1. From Table 3.1, select a high-profit industry and a low-profit industry. From what you know
of the structure of your selected industries, use the five forces framework to explain why prof-
itability has been high in one industry and low in the other.

2. With reference to Strategy Capsule 3.1, use the five forces framework to explain why profit-
ability has been so high in the US market for smokeless tobacco.

3. The major forces shaping the business environment of the fixed-line telecom industry are
technology and government policy. The industry has been influenced by fiber optics (greatly
increasing transmission capacity), new modes of telecommunication (wireless and internet
telephony), the convergence of telecom and cable TV, and regulatory change (including the
opening of fixed-line infrastructures to “virtual operators”). Using the five forces of compe-
tition framework, predict how each of these developments has influenced competition and
profitability in the fixed-line telecom industry.

4. By 2018, the online travel agency industry had consolidated around two leaders: Expedia
(which had acquired Travelocity, Lastminute.com, Hotels.com, Trivago, and Orbitz) and Price-
line (which owned booking.com, Kayak, Rentalcars.com, and OpenTable). These two market
leaders competed with numerous smaller online travel agents (e.g., TripAdvisor, Travelzoo,
Skyscanner, Ctrip), with traditional travel agencies (e.g., Carlson Wagonlit, TUI, American
Express—all of which had adopted a “bricks ‘n’ clicks” business model), and with direct online
sales by airlines, hotel chains, and car rental companies. Amazon and Google were both
potential entrants to the market. The online travel agents are dependent upon computerized
airline reservation systems such as Sabre, Amadeus, and Travelport. Use Porter’s five forces
framework to predict the likely profitability of the online travel agency industry over the next
ten years.

5. Walmart (like Carrefour, Ahold, and Tesco) competes in several countries of the world, yet
most shoppers choose between retailers within a radius of a few miles. For the purposes of
analyzing profitability and competitive strategy, should Walmart consider the discount retailing
industry to be global, national, or local?

6. What do you think are key success factors in:

a. the pizza delivery industry?
b. the credit card industry (where the world’s biggest issuers are: Bank of America, JPMorgan

Chase, Citibank, American Express, Capital One, HSBC, and ICBC)?

Notes

1. M. E. Porter, “The Five Competitive Forces that Shape
Strategy,” Harvard Business Review 57 ( January
2008): 57–71.

2. Brewers Association, “Historical U.S. Brewery Count,”
http://www.brewersassociation.org/statistics/number-
ofbreweries/; “Good Beer Guide 2015 Shows UK has Most
Breweries,” Guardian (September 11, 2014).

3. W. J. Baumol, J. C. Panzar, and R. D. Willig, Contestable
Markets and the Theory of Industry Structure (New York:
Harcourt Brace Jovanovich, 1982). See also M. Spence,

“Contestable Markets and the Theory of Industry Struc-
ture: A Review Article,” Journal of Economic Literature
21 (1983): 981–990.

4. “Annual Franchise 500,” Entrepreneur ( January
2017).

5. Products where brand loyalty is particularly strong
include: online search, online retailing, smartphones,
video streaming, coffee, cosmetics, and cars. See: https://
brandkeys.com/portfolio/customer-loyalty-engagement-
index/, accessed September 2, 2017.

82 PART II THE TOOLS OF STRATEGY ANALYSIS

6. C. V. Oster and J. S. Strong Predatory Practices in the US
Airline Industry (Washington DC, 2001). https://ntl.bts.
gov/lib/17000/17600/17602/PB2001102478.pdf, accessed
September 5, 2017.

7. J. L. Siegfried and L. B. Evans, “Empirical Studies of Entry
and Exit: A Survey of the Evidence,” Review of Industrial
Organization 9 (1994): 121–155; D. Heger and K. Kraft,
“Barriers to Entry and Profitability,” ZEW—Centre for
European Economic Research Discussion Paper No.
08-071 (2008).

8. G. S. Yip, “Gateways to Entry,” Harvard Business Review
60 (September/October 1982): 85–93.

9. “Four is a Magic Number,” Economist (March 15, 2014):
64; “Three’s a Crowd.” Economist (February 4, 2016).

10. “OPEC Has a Deal, But Will Its Members Cheat?” Wall
Street Journal (December 11, 2016).

11. R. Schmalensee, “Inter-Industry Studies of Structure
and Performance,” in R. Schmalensee and R. D. Willig
(eds), Handbook of Industrial Organization, 2nd edn
(Amsterdam: North Holland, 1988): 976.

12. C. Baden-Fuller (ed.), Strategic Management of Excess
Capacity (Oxford: Basil Blackwell, 1990).

13. “After the Telecommunications Bubble,” OECD Economics
Department Working Papers (2003); “America’s Latest
Spectrum Auction,” Economist (February 16, 2017).

14. “Iron Ore Companies Consolidated,” International
Resource Journal (October 2014).

15. “Hunt for Earnings Growth Reshapes Chemicals Sector,”
Financial Times (May 30, 2017).

16. “Airlines in America: No choice.” https://www.economist.
com/blogs/gulliver/2015/07/airlines-america, accessed
September 5, 2017.

17. M. G. Jacobides, “Strategy Bottlenecks: How TME
Players Can Shape and Win Control of Their Industry
Architecture,” Insights 9 (2011): 84–91; M. G. Jacobides
and J. P. MacDuffie, “How to Drive Value Your Way,” Har-
vard Business Review, 91 ( July/August 2013): 92–100.

18. M. E. Porter, “The Five Competitive Forces that Shape
Strategy,” Harvard Business Review 57 ( January
2008): 57–71.

19. “John Lewis’ Paula Nickolds on reinventing the business.”
Retail Week, March 30, 2017.

20. For a concise discussion of market definition see Office of
Fair Trading, Market Definition (London: December 2004),
especially pp. 7–17. https://www.gov.uk/government/
publications/market-definition. Accessed September 5,
2017.

21. The term was coined by Chuck Hofer and Dan Schendel
(Strategy Formulation: Analytical Concepts, St Paul: West
Publishing, 1977: 77).

22. P. Ghemawat, Commitment: The Dynamic of Strategy
(New York: Free Press, 1991): 11.

4

Economic progress, in capitalist society, means turmoil.

—JOSEPH A. SCHUMPETER, AUSTRIAN ECONOMIST, 1883–1950

◆ Introduction and Objectives

◆ The Limits of Industry Analysis

● Does Industry Matter?

● Hypercompetition

● Winner-Take-All Industries

◆ Beyond the Five-Forces: Complements, Ecosystems,
and Business Models

● Complements: A Missing Force in the Porter Model?

● Business Ecosystems: Managing Value Migration

● Using Business Models to Manage the Business
Ecosystem

● Business Ecosystems: The Value Capture Model

◆ Competitive Interaction: Game Theory
and Competitor Analysis

● Game Theory

● Competitor Analysis

◆ Segmentation and Strategic Groups

● Segmentation Analysis

● Strategic Groups

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

4 Further Topics
in Industry and
Competitive Analysis

84 PART II THE TOOLS OF STRATEGY ANALYSIS

The Limits of Industry Analysis

Does Industry Matter?

Porter’s five forces of competition framework has been subject to two main attacks.
Some have criticized its theoretical foundations, arguing that the “structure–
conduct–performance” approach to industrial organization that underlies it lacks rigor
(especially when compared with the logical robustness of game theory). Others have
recognized its empirical weaknesses. A firm’s industry environment is a relatively minor
determinant of its profitability. Studies of the sources of interfirm differences in profit-
ability have produced diverse results, but all acknowledge that industry factors account
for less than 20% of the variation in return on assets among firms.1

Do these findings imply that industry doesn’t matter and we relegate the analysis of
industry and competition to a minor role in our strategic analysis? Certainly not!

It is true that profitability differences within industries are greater than profitability
differences between industries: McKinsey & Company provide clear evidence of this
for US industries.2

However, the usefulness of industry analysis is not conditional upon the relative
importance of inter-industry and intra-industry profitability differences. Industry analysis
is important because, without a deep understanding of their competitive environment,
firms cannot make sound strategic decisions. Industry analysis is not just about choos-
ing which industries to locate within, it is also important for identifying competitive
threats, attractive segments, and the sources of competitive advantage. Nevertheless, it

Introduction and Objectives

The previous chapter outlined Porter’s five forces framework and demonstrated its application to ana-
lyzing competition, predicting industry profitability, and developing strategy. The Porter framework is one
of the most useful and widely applied tools of strategic analysis. It also has its limitations. In this chapter,
we shall extend our analysis of industry and competition beyond the limits of the Porter framework.

By the time you have completed this chapter, you will be able to:

◆ Recognize the limits of the Porter five forces framework, especially when industry struc-
ture is unstable and in winner-take-all industries.

◆ Extend industry analysis to include the role of complements, business ecosystems, and
business models.

◆ Understand competitive interaction, applying insights from game theory and the tools of
competitor analysis.

◆ Apply segmentation analysis and strategic group analysis in order to analyze industries at
a more disaggregated level.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 85

is important that we acknowledge the limitations of the Porter framework and, where
possible, augment our industry analysis.

Hypercompetition

The Porter’s five forces framework is based upon the assumption that industry structure
determines competitive behavior, which in turn determines industry profitability. But
competition also unleashes the forces of innovation and entrepreneurship that trans-
form industry structures. Joseph Schumpeter viewed competition as a “perennial gale
of creative destruction” in which market-dominating incumbents are challenged, and
often unseated, by rivals’ innovations.3

Schumpeter’s view of competition as a dynamic process in which industry structure
is in constant change raises the issue of whether competitive behavior should be seen
as an outcome of industry structure or a determinant of industry structure.4 The issue
here is the speed of structural change in the industry: if structural transformation is
rapid, then the five forces framework does not offer a stable basis for predicting com-
petition and profitability.

In most industries, Schumpeter’s process of “creative destruction” tends to be more
of a breeze than a gale. In established industries, new entry tends to be infrequent and
changes in industrial concentration are slow.5 One survey observed: “the picture of the
competitive process . . . is, to say the least, sluggish in the extreme.”6 As a result, both
at firm and industry levels, profits tend to be highly persistent in the long run.7

However, this stability of industry structures is being eroded by the disruptive impact
of digital technologies and intensifying international competition. Rich D’Aveni argues
that a general feature of industries today is hypercompetition: “intense and rapid
competitive moves, in which competitors must move quickly to build [new] advantages
and erode the advantages of their rivals.”8 If industries are hypercompetitive, their
structures are unstable and competitive advantage is temporary.9 According to Rita
McGrath, “Transient advantage is the new normal.”10

Despite a lack of consistent empirical evidence of growing instability of industry
structure and accelerating erosion of competitive advantage,11 casual observation sug-
gest that the rapid structural change is not restricted to the hi-tech sector—financial
services, oil and gas, and taxi services have all experienced disruptive change in recent
years. Yet, hypercompetition does not necessarily obviate Porter’s five forces frame-
work. For example, in analyzing the dramatic structural changes that have occurred in
the solar panel industry, in pharmaceuticals, in retailing, and in telecom services, the
five forces framework allows us to forecast how changes in industry structure will affect
the forces of competition, and what their impact on profitability is likely to be.

Winner-Take-All Industries

In some industries, the disparities in profitability between firms are so great as to render
irrelevant the whole notion of industry attractiveness. In mobile devices, Apple earned
a return on equity of about 30% during 2015–2017; most its competitors made losses.
Throughout the history of the video game industry, the console maker with market
leadership—typically Nintendo or Sony—has accounted for almost all of the indus-
try’s profits. In these industries, market share confers massive competitive advantage.
Often, this advantage is the result, not of conventional scale economies, but of positive
feedback loops—the most important of which are network externalities. In online auc-
tions (dominated by eBay) and social media (dominated by Facebook), users gravitate

86 PART II THE TOOLS OF STRATEGY ANALYSIS

to the firm that has the greatest number of users. More generally, a firm with market
share leadership attracts resources away from competitors. In web search, once Google
established a lead over Yahoo!, Excite, Lycos, and AltaVista, the expectations it gener-
ated allowed it to attract resources that enabled it to accelerate quality and innovation.

In these industries, the market leader may well scoop the entire profit pool. Followers
may continue to endure losses for some time—what sustains them is the possibility of
gaining market leadership should the current leader stumble. During 2017, the woes
that engulfed ride-sharing giant, Uber, were eagerly exploited by its rival, Lyft. In these
“winner-take-all” industries, analyzing the dynamics of competitive advantage— network
externalities in particular—takes precedent over conventional industry analysis. As
we shall see shortly, complementary products play a central role in creating network
externalities.

Beyond the Five Forces: Complements, Ecosystems,
and Business Models

If our industry analysis is to fulfill its potential, it needs to go beyond the confines of
the Porter five forces framework. To understand competitive behavior and the deter-
minants of profitability, we need to look more broadly at industries to include comple-
ments, extended value chains, and other participants that form part of the “business
ecosystem.” We also need to look more narrowly: disaggregating broad industry sectors
to examine competition within particular segments and among particular groups of
firms. Let’s begin by considering extensions to the Porter framework.

Complements: A Missing Force in the Porter Model?

The Porter framework considers the suppliers of substitutes as one of the forces of
competition that reduces the profit available to firms within an industry. But what about
complements? While the presence of substitutes reduces the value of a product, com-
plements increase its value: without ink cartridges my printer is useless, as is my car
without gasoline. Given the importance of complements to most products, our analysis
of the competitive environment needs to take them into account. The simplest way is
to add a sixth force to Porter’s framework (Figure 4.1).12

If complements have the opposite effect to substitutes—they increase rather than
reduce the value of an industry’s product—the key question is: how is this value shared
between the producers of the different complementary products?

● During the 1990s, Nintendo earned huge profits from its video game consoles.
Although most of the revenue and consumer value was in the software, mostly
supplied by independent developers, Nintendo’s dominance over the games
developers, through its control over its operating system and over the manufac-
ture and distribution of games cartridges, allowed it to appropriate most of the
profits of the entire system.

● In personal computers there is similar complementarity between hardware and
software, but here power has lain with the software suppliers—Microsoft in
particular. IBM’s adoption of open architecture meant that Microsoft Windows
became a proprietary standard, while PCs were gradually reduced to commodity
status. This is a very different situation from video games, where hardware sup-
pliers keep proprietary control over their operating systems.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 87

Where two products complement one another, profit accrues to the supplier that
builds the stronger market position and reduces the value appropriated by the other.
How is this done? The key is to achieve monopolization, differentiation, and short
supply of one’s own product, while encouraging competition, commoditization, and
excess capacity in complementary products.13 Apple’s domination of its complemen-
tors—especially the suppliers of applications software—has made its iPhone one of
the lucrative proprietary products of all time. Such dominance requires power over
complementors that typically require ownership of intellectual property. Apple’s own-
ership of its iOS operating system allows it to choose which apps are offered for its
iPhone and to take 30% of the revenues these apps generate. Such control is essential
whether or not the complementary products are supplied in-house or by third parties.
Gillette’s monopolization of blades for its razors and printer manufacturers’ monopo-
lization of ink cartridges rests upon their control of the technology in both the equip-
ment and the consumable. Producing the consumables in-house facilitates control—but
is not enough on its own. Nestlé supplies its own coffee capsules for its Nespresso
coffee system, but once its patents became ineffective, it was unable to prevent a flood
of new suppliers of Nespresso-compatible capsules.14

As the above examples suggest, products based on digital technologies present fas-
cinating issues of competition and profit appropriation. Many digital markets involve
systems that comprise hardware, an operating system, application software, and Inter-
net connection. In these markets, competition tends to be among rival platforms—
the interfaces that link the component parts of the system. A platform attracts
complementors—in some cases in huge numbers: Android has over 2.8 million apps;
Amazon’s online retailing platform offers over 450 million different products in the US.
The availability of complements creates a powerful network externality: complemen-
tors favor the platform with the most users; users favor the platform with the greater
number of complements. As we have already observed, network externalities are the
main source of winner-take-all markets. We shall revisit network externalities and plat-
form-based competition in Chapter 9.

COMPLEMENTS

BUYERS

POTENTIAL
ENTRANTS

Threat of

new entrants

Bargaining power of suppliers

SUPPLIERS

Bargaining power of buyers

Rivalry among
existing f irms

substitutes

Threat of

INDUSTRY
COMPETITORS

The suppliers of
complements create
value for the industry

and can exercise
bargaining power

SUBSTITUTES

FIGURE 4.1 Five forces, or six?

88 PART II THE TOOLS OF STRATEGY ANALYSIS

Business Ecosystems: Managing Value Migration

Incorporating the suppliers of complementary products is a first step in broadening
industry analysis beyond Porter’s five forces—but we can go further. Recognition that a
firm’s business environment extends beyond conventional industry boundaries has given
rise to the term business ecosystem to describe the “community of organizations, insti-
tutions, and individuals that impact the enterprise.”15 This notion of an ecosystem also
emphasizes the codependencies among its members and the continually evolution of
the system.

Michael Jacobides shows how, within business systems, value migrates between its
different parts.16 This migration is the result of external forces such as technology, reg-
ulation, and changing customer preferences, but it can also be influenced by individual
firms—even those that are not dominant players. The quest for value requires iden-
tifying potential “bottlenecks” within the ecosystems—activities that create significant
customer value and can be dominated by the firm. Jacobides and his co-authors offer
the following guidelines:

● Become the “guardian of quality.” Who controls a product’s reputation? In wine,
there is competition for control between growers grouped by location (cham-
pagne, chianti), wine makers (Krug, Chateau Margaux), importers/distributors
(Harveys of Bristol, Berry Bros. & Rudd), and critics (Wine Spectator, Decanter).
Control typically lies with players that are closest to the consumer—but not
always: Intel’s “Intel Inside” campaign showed the potential for component
suppliers to forge links with consumers.

● Become irreplaceable: The battle to capture value is won by those who can
make themselves irreplaceable. In many industries, these are the system inte-
grators. Conversely, those who contribute a tiny portion of the value chain are
easily substituted. Apple is a master of “supply chain atomization”—ensuring
that each of its suppliers occupy limited roles that can be substituted by other
companies.

● Take advantage of changing customer needs. Shifts in customer preferences
can shift value within an ecosystem. As consumers expand the range of online
payment options they are willing to use, there are growing opportunities for
payment service providers such as Adyen, Worldpay, and Square.

● Redefine the value chain. In addition to fragmenting and integrating value
chains, firms may redefine roles along it. IKEA’s building of a global value
chain for furniture has involved the transfer of furniture assembly from manu-
facturers to consumers.

Using Business Models to Manage the Business Ecosystem

Business model is a widely used but poorly understood concept—which is hardly
surprising given the variety of ways in which it has been used. A model is a simplified
description of a real thing. Hence, a business model is a simplified description of a
business—it specifies the “core logic for creating value”17 or, as David Teece explains:
“the manner by which the business enterprise delivers value to customers, entices cus-
tomers to pay for value, and converts those payments to profit.”18

There is a long-running debate over whether there is anything distinctive about the
concept of a business model, or whether business model is simply another name for a
business strategy. We will not resolve that debate here. Instead, let us focus on situa-
tions where the concept of a business model can extend our strategy analysis. One area

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 89

is in formulating strategies to exploit the opportunities within a firm’s business eco-
system. The other, which we shall address in Chapter 7, concerns strategic innovation.

The reason that business models are useful is because strategy is often viewed too
narrowly—business strategy in terms of cost or differentiation advantage, corporate
strategy in terms of selecting sectors then managing linkages between them. Business
models allow us to consider more complex business situations and envisage business
opportunities more widely.

Most approaches to the design and selection of business models identify the com-
ponents of business models and alternative ways to configure them. One widely used
framework, the Business Model Canvas, views the firm as an infrastructure (comprising
resources, activities, and partners) that is applied to customers (comprising segments,
channels, and relationships) through a value proposition that generates revenue at
a cost that permits a profit (see Figure  4.2). The firm’s business model represents
an integrated set of choices in relation to these components. By mapping the firm’s
business model on this canvas, it is possible to experiment with alternatives: How can
the firm change the components of its business model to create new configurations?19

Traditionally, most enterprises are operated with fairly simple business models. For
example, the typical business model for a consumer goods producer involves adding
value to bought-in materials and components, then supplying the finished product to
distributors. More elaborate business models involve complementary products (e.g.,
the “razors-and-blades” model favored by Gillette and suppliers of inkjet printers) or
supplying inputs rather than outputs (e.g., franchising).

Digital technologies have caused the emergence of more complex business ecosys-
tems that offer opportunities for more diverse business models. As established indus-
tries are disrupted by digital technologies, the challenge for traditional firms is to
find business models to replace those rendered obsolete by new competition. Travel
agents have transitioned from being commission-based retailers to providing custom-
ized, fee-based services to travelers; newspapers have experimented with different
online revenue models: free content/paid advertising, “freemium” (free access to basic
content; charges for premium content), metered access, or variants on these.

The more elaborate business models that exploit the opportunities available in more
complex digital ecosystems are illustrated by Google (see Strategy Capsule 4.1). How-
ever, as Strategy Capsule 4.1. shows in relation to Ryanair, many mature industries also
have complex business ecosystems that offer opportunities for business models that
exploit relationships among diverse partner organizations.

Infrastructure

Activities

Resources
Partners

Customer

Segments

Channels
Relationships

O�er

Value
Proposition

Financial viability

RevenuesCosts Pro�t

FIGURE 4.2 The Business Model Canvas

90 PART II THE TOOLS OF STRATEGY ANALYSIS

STRATEGY CAPSULE 4.1

Business Models for Complex Business
Ecosystems: Google and Ryanair

Google: At the heart of Google’s strategy is a business
model whereby free search supports paid adver-

tising—over two-thirds of the revenues of Google’s

parent, Alphabet, are generated by advertising placed

on Google’s own websites and applications. How-

ever, Google’s full business model is more extensive. It

includes the following:

◆ Using its advertising management capabilities

and relationships with advertisers to manage

advertising placements on other content pro-

viders’ websites (AdSense).

◆ Gathering huge quantities of user data that allow

more precise targeting of advertising.

◆ Protecting the availability and data-gathering

capabilities of Google’s search products by

providing its own web browser (Chrome) and

operating systems (Android, Chrome OS).

◆ Sustaining dominance of online advertising

through launching competing products against

rivals such as Apple, Facebook, and Microsoft.

Ryanair: At the core of Ryanair’s strategy is the low-cost
carrier business model developed by Southwest Air-

lines (see Figure 1.3 in Chapter 1). However, this model

has been extended by Ryanair to exploit multiple

sources of  revenue generated by a range of partners.

Elements of the Ryanair business model include the

following:

◆ Extreme unbundling. In addition to paying for

flight tickets, passengers are encouraged to pay

for services such as seat assignments, checked

baggage, priority boarding, credit card fees, and

inflight refreshments.

◆ Payments from airports and local government

authorities (incentives to Ryanair to initiate and

maintain specific routes).

◆ Commission on sales of partners’ complementary

products and services such as car hire, train and

bus services, insurance, hotels, theater, and sports

tickets—also ticket sales for other airlines (e.g.,

Air Europa).

◆ Advertising on Ryanair website, travel magazine,

and seat backs.

Sources: Allan Afuah, Business Model Innovation: Concepts, Anal-
ysis, and Cases (Routledge, 2014); Ryanair Holdings plc, Annual
Report, 2017.

Business Ecosystems: The Value Capture Model

In an approach, variously described as the “value capture model,” “value-based
strategy,” and “bi-form models,” initial work by Brandenburger and Stuart20 has been
developed into a strategy framework that combines both breadth and analytic rigor.
The framework envisages the firm within a broad network of transacting parties.
The approach then establishes boundaries for the amount of value that the firm can
appropriate. The upper limit is determined by the amount of value that the firm
creates within its current network—which is the amount by which the total value
created within the network would diminish if the firm left the network. The lower
limit is determined by the amount of value that the form could add to an alternative
business network.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 91

Within this framework, a firm’s strategic decisions are mainly about investments in
resources and capabilities that influence the value it can capture. These decisions relate
to two types of action. First, those that increase the value that is available to the firm
by increasing the maximum value the firm adds either to its existing network or to
an alternative network—these are investments with competitive intent. Second, actions
that determine how much value the members of the network are willing to give up to
the firm—these are actions with persuasive intent.21 Recent work on the value capture
model attempts to measure then value created and captured and explores strategies
through which value creation and capture occur.22

Competitive Interaction: Game Theory and Competitor Analysis

Game Theory

Central to the criticisms of Porter’s five forces framework is its failure to address
competitive interaction among firms. A fundamental feature of strategic situations is
interdependence—the decisions made by any one player are dependent on the actual
and anticipated decisions of the other players. By relegating competition to a medi-
ating variable that links industry structure with profitability, the five forces analysis
offers little insight into competition as a process of interactive decision-making by
rival firms. Game theory allows us to model this competitive interaction. In going so,
it permits:

● The framing of strategic interaction by providing a structure, a set of con-
cepts, and a terminology that allows us to characterize a competitive situation
in terms of:

○○ Who are the players?

○○ What are each player’s options?

○○ What are the payoffs from every combination of options?

○○ What is the sequence of decisions?

● Predicting the outcome of competitive situations and identifying optimal stra-
tegic choices in situations of rivalry and bargaining. In doing so, game theory
offers penetrating insights into central issues of strategy that go well beyond
pure intuition. Simple models (e.g., the prisoners’ dilemma) predict whether
outcomes will be competitive or cooperative, whereas more complex games
permit analysis of the effects of reputation,23 deterrence,24 information,25 and
commitment,26 especially within the context of multi-period games. Particu-
larly, important for practicing managers, game theory can indicate strategies for
improving the outcome of the game through manipulating the payoffs to the
different players.27

Game theory has been applied to a wide variety of competitive situations: the
Cuban missile crisis of 1962,28 rivalry between Boeing and Airbus,29 NASCAR race
tactics,30 auctions of airwave spectrum,31 the 2008 financial crisis,32 and the evolu-
tionary determinants of male bird plumage.33 In terms of business competition, game
theory points to five types of strategic behavior for influencing competitive out-
comes: cooperation, deterrence, commitment, changing the structure of the game,
and signaling.

92 PART II THE TOOLS OF STRATEGY ANALYSIS

Cooperation One of the key merits of game theory is its ability to encompass both
competition and cooperation. While the five forces framework emphasizes compet-
itive relations between firms, Adam Brandenburger and Barry Nalebuff’s concept of
co opetition recognizes the competitive/cooperative duality of business relationships.34
While some relationships are predominantly competitive (Coca-Cola and Pepsi)
and others are predominantly cooperative (Intel and Microsoft), there is no simple
dichotomy between competition and cooperation: all business relationships combine
elements of both. For all their intense rivalry, Coca-Cola and Pepsi cooperate on mul-
tiple fronts, including common policies on sales of soda drinks within schools, environ-
mental issues, and health concerns. They may also coordinate their pricing and product
introductions.35 Exxon and Shell have competed for leadership of the world’s petro-
leum industry for over a century; at the same time they cooperate in a number of joint
ventures. The desire of competitors to cluster together—antique dealers in London’s
Bermondsey Market or movie studios in Hollywood—points to the common interests
of competing firms in growing the size of their market and developing its infrastructure.
Although cooperation usually results in better outcomes for rival firms, the communi-
cation and trust needed to avoid competition are difficult to establish. The prisoners’
dilemma game not only analyzes this predicament and points to the strategic initiatives
through which a player can transform the game in order to reach a cooperative out-
come (Strategy Capsule 4.1).

Deterrence As we see in Strategy Capsule 4.1, one way of changing a game’s
equilibrium is through deterrence. The principle behind deterrence is to impose costs
on the other players for actions deemed to be undesirable. By establishing the certainty
that deserters would be shot, the British army provided a strong incentive to its troops to
participate in advances on heavily fortified German trenches during the First World War.

The key to the effectiveness of any deterrent is that it must be credible. If admin-
istering the deterrent is costly or unpleasant for the threatening party, it will lack
credibility. Threatening a potential new entrant with a price war usually lacks credibility
since it would inflict more damage on the incumbent than on the new entrant. Invest-
ing in excess capacity can be more effective in discouraging entry. Prior to the expira-
tion of its NutraSweet patents, Monsanto invested heavily in unneeded plant capacity
to deter manufacturers of generic aspartame.36

However, deterrence only works when the adversaries can be deterred. A central
weakness of President George W. Bush’s “war on terror” was that ideologically moti-
vated terrorists are not susceptible to deterrence.37

Commitment For deterrence to be credible, it must be backed by commitment. Com-
mitment involves the elimination of strategic options: “binding an organization to a
future course of action.”38 When Hernán Cortés destroyed his ships on arrival in Mexico
in 1519, he communicated, both to Montezuma and to his own troops, that there was
no alternative to the conquest of the Aztec empire. Once Airbus had decided to build its
A380 superjumbo, it was critical to signal its commitment to the project. During 2000–02,
Airbus spent heavily on advertising the plane, even before completing the design phase,
in order to encourage airlines to place orders and discourage Boeing from developing
a rival plane.

These commitments to aggressive competition can be described as hard commit-
ments. A company may also make commitments that moderate competition; these are
called soft commitments. For example, if a company commits to achieving certain target
profit levels in the coming year, this would be a soft commitment: it signals its desire
to avoid aggressive competition.

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 93

STRATEGY CAPSULE 4.2

The Prisoners’ Dilemma

The classic prisoners’ dilemma game involves a pair of

crime suspects who are arrested and interrogated sep-

arately. The dilemma is that each will rat on the other

with the result that both end up in jail despite the fact

that, if both had remained silent, they would have been

released for lack of evidence.

The dilemma arises in most competitive situations—

everyone could be better off with collusion. Consider

competition between Coca-Cola and Pepsi in Ecuador,

where each has the choice of setting a big or small

advertising budget. Figure  4.3 shows the payoffs to

each firm.

Clearly, the best solution for both firms is for each

to restrain their advertising expenditure (the upper left

cell). However, in the absence of cooperation, both firms

adopt big budgets (the lower right cell). The reason is

that each fears that any restraint will be countered by

the rival seeking advantage by shifting to a big adver-

tising budget. The resulting “maxi-min” strategy (each

company chooses the strategy that maximizes the

minimum payoff ) is a “Nash equilibrium”: no player can

increase its payoff by a unilateral change in strategy. Even

if collusion can be achieved, it will be unstable because

of the incentives for cheating—a constant problem for

OPEC, where the member countries agree quotas but

then cheat on them.

How can a firm escape from such prisoners’ dilemmas?

One answer is to change a one-period game (single trans-

action) into a repeated game. In the above example of

competition in advertising, a multiperiod perspective

allows the companies to recognize the futility of adver-

tising campaigns that merely cancel one another out.

In the case of supplier–buyer relations, where the typical

equilibrium is a low-quality product at a low price, moving

from a spot-transaction to a long-term vendor relationship

gives the supplier the incentive to offer a better-quality

product and the buyer to offer a price that reflects the

preferred quality.

A second solution is to change the payoffs through

deterrence. In the classic prisoners’ dilemma, the Mafia

shifts the equilibrium: the threat of draconian repri-

sals encourages both suspects to maintain the “code of

silence.” Similarly, if both Coca-Cola and Pepsi were to

threaten one another with aggressive price cuts should

the other seek advantage through a big advertising

budget, this could shift the equilibrium to the top-left cell.

FIGURE 4.3 Coca-Cola’s and Pepsi’s advertising budget: The prisoners’ dilemma

COCA-COLA (Payof fs in $ millions)

PEPSI
Small Advertising
Budget

Big Advertising
Budget 15

15

4

4

10
10

−2

−2

Big Advertising
Budget

In each cell,
the lower-left
number is the
payof f to Pepsi;
the upper-right
the payof f to
Coke.

Small Advertising
Budget

94 PART II THE TOOLS OF STRATEGY ANALYSIS

Changing the Structure of the Game Creative strategies can change the structure
of the competitive game. A company may seek to change the structure of its industry to
increase the industry’s profit potential or to appropriate a greater share of the available
profit. Thus, establishing alliances and agreements with competitors can increase the
value of the game by increasing the size of the market and building combined strength
against possible entrants. There may be many opportunities for converting win–lose (or
even lose–lose) games into win–win games through cooperative strategies.

In some cases, it may be advantageous for a firm to assist its competitors. When
in June 2014, Tesla Motors offered to make available its patents to competitors, it was
betting that any loss in its own competitive advantage would be offset by the benefits
of expanding the market for electric vehicles and encouraging the wider adoption of
its own technologies with regard to battery design and battery recharging systems.39 As
we shall see in Chapter 9, standards battles often involve the deliberate sacrificing of
profit margins in order to build market leadership.

Signaling Competitive reactions depend on how the competitor perceives its
rival’s initiative. The term signaling is used to describe the selective communication
of information to competitors (or customers) designed to influence their perceptions
and hence provoke or suppress certain types of reaction.40 The use of misinfor-
mation is well developed in military intelligence. In 1943, British military intelli-
gence used a corpse dressed as a marine officer and carrying fake secret documents
to convince German high command that the Allied landings would be in Greece,
not Sicily.41

Threats are credible when backed by reputation.42 Although carrying out threats is
costly and depresses short-term profitability, exercising such threats can build a repu-
tation for aggressiveness that deters competitors in the future. The benefits of building
a reputation for aggressiveness may be particularly great for diversified companies
where reputation can be transferred from one market to another.43 Hence, Procter &
Gamble’s protracted market share wars in disposable diapers and household deter-
gents established a reputation for toughness that protects it from competitive attacks
in other markets.

Signaling may also be used to communicate a desire to cooperate: preannounced
price changes can facilitate collusive pricing among firms.44

How useful is game theory? The great virtue of game theory is its rigor: it bases the
analysis of competition on sound theoretical foundations.

However, the price of theoretical rigor is limited applicability to real-world situ-
ations. Game theory provides clear predictions in stylized situations involving few
external variables and restrictive assumptions. When applied to more complex (and
more realistic) situations, game theory frequently results in either no equilibrium or
multiple equilibria, and outcomes that are highly sensitive to small changes in initial
assumptions. Overall, game theory has made limited progress in modeling real business
situations in a way that can generate clear strategy recommendations.45

Game theory is better at explaining the past than predicting the future. In diagnosing
Nintendo’s domination of the video games industry in the 1980s, Monsanto’s efforts to
prolong NutraSweet’s market leadership beyond the expiration of its patents, or Air-
bus’s wresting of market leadership from Boeing, game theory provides penetrating
insight into the competitive situation and deep understanding of the rationale behind
the strategies deployed. However, in predicting outcomes and designing strategies,

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 95

game theory has been much less impressive. For example, the application of game
theory by US and European governments to design auctions for wireless spectrum has
produced some undesirable and unforeseen results.46

So, where can game theory assist us in designing successful strategies? As with all
our theories and frameworks, game theory is useful not because it gives us answers
but because it can help us understand business situations. Game theory provides a set
of tools that allows us to structure our view of competitive interaction. By identifying
the players in a game, the decision choices available to each, and the implications
of each combination of decisions, we have a systematic framework for exploring the
dynamics of competition. Most importantly, by describing the structure of the game we
are playing, we have a basis for suggesting ways of changing the game and thinking
through the likely outcomes of such changes.

Game theory continues its rapid development—in particular, the value capture model
we discussed above, and which has considerable potential for developing a general
framework for strategy analysis, has its basis in cooperative game theory. We shall draw
upon game theory in several places in this book, especially in exploring competitive
dynamics in highly concentrated markets. However, our emphasis in strategy formula-
tion will be less on achieving advantage through influencing the behavior of competi-
tors and much more on transforming competitive situations through building positions
of unilateral competitive advantage. Game theory typically deals with competitive situ-
ations where closely matched players have strategic options (typically relating to price
changes, advertising budgets, capacity decisions, and new product introductions) and
outcomes depend upon the order of moves, signals, bluffs, and threats. Our emphasis
will be less on managing competitive interactions and more on establishing competi-
tive advantage through exploiting uniqueness.

Competitor Analysis

In highly concentrated industries, the dominant feature of a company’s competitive
environment is likely to be the behavior of its closest rivals. In household detergents,
Unilever’s industry environment is dominated by the strategy of Procter & Gamble. The
same is true in soft drinks (Coca-Cola and Pepsi), jet engines (GE, United Technologies,
and Rolls-Royce), and financial information (Bloomberg and Reuters). Similarly, in local
markets: the competitive environment of my local Costa coffee shop is dominated by
the presence of Starbucks across the road. While game theory provides a theoretical
apparatus for analyzing competitive interaction between small numbers of rivals, for
most strategic decisions, a less formal and more empirically-based approach to predict-
ing competitors’ behavior may suffice. Let us examine how information about compet-
itors can be used to predict their behavior.

Competitive Intelligence Competitive intelligence involves the systematic collec-
tion and analysis of information about rivals for informing decision making. It has three
main purposes:

● to forecast competitors’ future strategies and decisions

● to predict competitors’ likely reactions to a firm’s strategic initiatives

● to determine how competitors’ behavior can be influenced to make it more
favorable.

96 PART II THE TOOLS OF STRATEGY ANALYSIS

For all three purposes, the key requirement is to understand competitors in order to
predict their responses to environmental changes and to our own competitive moves.
To understand competitors, it is important to be informed about them. Competitive
intelligence is a growth field, with specialist consulting firms, professional associations,
and a flood of recent books.47 About one-quarter of large US corporations have spe-
cialist competitive intelligence units.

The boundary between legitimate competitive intelligence and illegal industrial espi-
onage is not always clear. The distinction between public and private information is
uncertain and the law relating to trade secrets is much less precise than that which
covers patents and copyrights. In addition to several well-publicized cases of trade
secret theft,48 more general allegations of systematic industrial espionage have been
levied against Chinese enterprises and government agencies.49

A Framework for Predicting Competitor Behavior Competitive intelligence is
not simply about collecting information. The problem is likely to be too much rather
than too little information. The key is a systematic approach that makes it clear what
information is required and for what purposes it will be used. The objective is to under-
stand one’s rival. A characteristic of great generals from Hannibal to Patton has been
their ability to go beyond military intelligence and to “get inside the heads” of their
opposing commanders. Michael Porter proposes a four-part framework for predicting
competitor behavior (Figure 4.4).

● Competitor’s current strategy: To predict how a rival will behave in the
future, we must understand how that rival is competing at present. Identi-
fying a firm’s strategy requires looking at what the company says and what it
does (see “Where Do We Find Strategy?” in Chapter 1)—and then to recon-
cile the two.

PREDICTIONS

STRATEGY

OBJECTIVES

RESOURCES AND CAPABILITIES

ASSUMPTIONS

• What strategy changes
will the competitor
initiate?
• How will the competitor
respond to our strategic
initiatives?

How is the f irm competing?

What are competitor’s current goals?
Is performance meeting these goals?

How are its goals likely to change?

What assumptions does the competitor
hold about the industry and itself?

What are the competitor’s key
strengths and weaknesses?

FIGURE 4.4 A framework for competitor analysis

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 97

● Competitor’s objectives: To forecast how a competitor might change its
strategy, we must identify its goals. Is the company driven by financial goals or
market goals? A company whose primary goal is attaining market share is likely
to be much more aggressive a competitor than one that is mainly interested
in profitability. The most difficult competitors can be those that are not sub-
ject to profit disciplines at all—state-owned enterprises in particular. The level
of current performance in relation to the competitor’s objectives determines
the likelihood of strategy change. The more performance falls short of target,
the more likely is strategic change, possibly accompanied by a change in top
management.

● Competitor’s assumptions about the industry: A competitor’s strategic decisions
are conditioned by its perceptions of itself and its environment. These percep-
tions are guided by the beliefs that senior managers hold about their industry
and the success factors within it. These beliefs tend to be stable over time and
also converge among the firms within an industry: what J.-C. Spender refers to
as “industry recipes.”50 Industry recipes may engender “blindspots” that limit the
capacity of a firm—even an entire industry—to respond to an external threat.
The failure of British and US motorcycle manufacturers to respond to emerging
Japanese competition during the 1960s reflected a belief system that failed to
acknowledge the threat posed by high-performance, lightweight motorcycles.
(Strategy Capsule 4.2).

STRATEGY CAPSULE 4.3

Motorcycle Myopia

During the 1960s, lightweight Japanese motorcycles

began to flood Britain and North America. The chairman

of BSA, Eric Turner, was dismissive of this competitive

challenge to the dominant position of his Triumph and

BSA brands:

The success of Honda, Suzuki, and Yamaha

has been jolly good for us. People start out by

buying one of the low-priced Japanese jobs.

They get to enjoy the fun and exhilaration of

the open road and they frequently end up

buying one of our more powerful and expen-

sive machines.

(Advertising Age, December 27, 1965)

Similar complacency was expressed by William

Davidson, president of Harley-Davidson:

Basically, we do not believe in the lightweight

market. We believe that motorcycles are sports

vehicles, not transportation vehicles. Even if a

man says he bought a motorcycle for transporta-

tion, it’s generally for leisure time use. The light-

weight motorcycle is only supplemental. Back

around World War I, a number of companies came

out with lightweight bikes. We came out with one

ourselves. We came out with another in 1947 and

it just didn’t go anywhere. We have seen what

happens to these small sizes.

(American Motor Cycle, September 15, 1966)

By 1980, BSA and Triumph had ceased production

and Harley-Davidson was struggling for survival. The

world motorcycle industry, including the heavyweight

segment, was dominated by Japanese companies.

98 PART II THE TOOLS OF STRATEGY ANALYSIS

● Competitor’s resources and capabilities: Evaluating the likelihood and seri-
ousness of a competitor’s potential challenge requires assessing the strength
of that competitor’s resources and capabilities. If our rival has a massive cash
pile, we would be unwise to unleash a price war. Conversely, if we direct
our competitive initiatives toward our rivals’ weaknesses, it may be difficult
for them to respond. Richard Branson’s Virgin Group has entered into music,
airlines, financial services, and wireless telecommunications using innova-
tive forms of differentiation that are difficult for established incumbents to
respond to.

Segmentation and Strategic Groups

Segmentation Analysis51

In Chapter 3, we noted the difficulty of drawing industry boundaries and the need to
define industries both broadly and narrowly according to the types of question we are
seeking to answer. Initially, it may be convenient to define industries broadly, but for a
more detailed analysis we need to focus on more narrowly drawn markets. This pro-
cess of disaggregating industries we call segmentation.

Astute choices of segment positioning can allow a firm to outperform its rivals.
During 2007–11, Nintendo’s Wii became a surprise market share leader in video game
consoles by focusing on a large and underserved market segment: casual and older
video game players. In the brutally competitive tire industry, Pirelli has achieved
superior margins by emphasizing high-performance tires for sports and luxury cars.52

The purpose of segmentation analysis is to identify attractive segments, to select
strategies for different segments, and to determine how many segments to serve. The
analysis proceeds in five stages.

1 Identify key segmentation variables: Our starting point is to determine the
basis of segmentation. Segmentation decisions are essentially choices about
which customers to serve and what to offer them: hence segmentation variables
relate to the characteristics of customers and the product (Figure 4.5). Typically,
segmentation analysis generates far too many segmentation variables; we need to
reduce these to two or three. This requires that we (a) identify the most strategi-
cally significant segmentation variables and (b) combine segmentation variables
that are closely correlated. For example, in the restaurant industry, price level,
service level, cuisine, and alcohol license tend to be closely related. We could use
a single variable, restaurant type, with three categories—full-service restaurants,
cafés/casual dining, and fast-food outlets—as a proxy for all of these variables.

2 Construct a Segmentation Matrix: Once the segmentation variables have been
selected and discrete categories determined for each, the individual segments
may be identified using a two- or three-dimensional matrix. Strategy Capsule 4.3
shows a two-dimensional segmentation matrix for the world automobile industry.
Strategy Capsule 4.4 takes an alternative approach to industry segmentation,
using the industry value chain as the basis for segmentation.

3 Analyze segment attractiveness: Profitability within an industry segment is deter-
mined by the same structural forces that determine profitability within an industry
as a whole. As a result, Porter’s five forces of competition framework is equally

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 99

effective in relation to a segment as to an entire industry. There are, however, a
few differences. Substitute competition comes not only from other industries but
also from other segments within the same industry. Similarly, entry into a seg-
ment is most likely to be from producers established in other segments within
the same industry. The barriers that protect a segment from firms located in other
segments are called barriers to mobility to distinguish them from the barriers
to entry, which protect the industry as a whole.53 As in most segments within the
auto industry, the lack of barriers to mobility results in the superior returns of
high-profit segments being quickly eroded (see Strategy Capsule 4.3).

Segmentation analysis can help identify unexploited opportunities in an
industry. Companies that have built successful strategies by concentrating
on unoccupied segments include Walmart (discount stores in small towns),
Enterprise Rent-A-Car (suburban locations), and Edward Jones (full-service
brokerage for small investors in smaller cities). This identification of unoccu-
pied market segments is one aspect of what Kim and Mauborgne refer to as
“blue ocean strategy”: the quest for uncontested market space.54

4 Identify the segment’s key success factors (KSFs): By analyzing how buyers’ pur-
chasing criteria and the basis of competition varies between segments, we can
identify KSFs for individual segments. For example, in the bicycle industry, we
can distinguish high-price enthusiasts’ bikes sold through specialist bike stores
and economy bikes sold through discount stores. KSFs in the enthusiast segment
are technology, reputation, and dealer relations. In the economy segment, KSFs
are low-cost manufacture and a supply contract with a leading retail chain.

Opportunities for
Dif ferentiation

Characteristics
of the Product

Characteristics
of the Buyers

Industrial
buyers

Household
buyers

Distribution
channel

Geographical
location

• Physical size
• Price level
• Product features
• Technology design
• Inputs used (e.g., raw materials)
• Performance characteristics
• Presales and postsales services

• Size
• Technical
sophistication
• OEM/replacement

• Demographics
• Lifestyle
• Purchase occasion

• Size
• Distributor/broker
• Exclusive/nonexclusive
• General/specialist

FIGURE 4.5 The basis for segmentation: The characteristics of buyers
and products

100 PART II THE TOOLS OF STRATEGY ANALYSIS

STRATEGY CAPSULE 4.4

Segmenting the World Automobile Industry

1 Identify key segmentation variables and categories.

Possible segmentation variables include price, size,

engine power, body style, buyer type (retail versus

fleet), and geographical market. We can reduce the

number of segmentation variables—in particular,

price, size, and engine power tend to be closely

correlated. Other variables clearly define distinct

markets (e.g., geographical regions and individual

national markets).

2 Construct a segmentation matrix. The segmentation

matrix in Figure  4.6 shows geographical regions

(columns) and product types (rows). These product

types combine multiple segmentation variables:

price, size, design, and fuel type.

3 Analyze segment attractiveness. Applying five forces

analysis to individual segments points to the attrac-

tiveness of the growth markets of Asia and Latin

America (especially for luxury cars) as compared

with the saturated, excess capacity-laden markets

of Europe and North America. In these mature mar-

kets, the hybrid and electric car segments may be

attractive due to fewer competitors and lack of

excess capacity.

4 Identify KSFs in each segment. In sports cars, tech-

nology and design aesthetics are likely to be key

differentiators. In luxury cars, quality and interior

design are likely to be essential. In family compact

and mini cars, low cost is the primary basis for com-

petitive advantage.

5 Analyze attractions of broad versus narrow seg-

ment scope. Because of the potential to share tech-

nology, design, and components across models,

all product segments are dominated by full-range

mass-manufactures. In terms of geographical seg-

ments, only in the biggest markets (primarily China)

have nationally-focused producers survived.

P
R
O
D
U
C
T
S

Luxury cars

Full-size cars

Mid-size cars

Small cars

Station wagons

Minivans

Sports cars

Sport utility

Pickup trucks

Hybrids/Plug-ins

North
America

Western
Europe

Eastern
Europe

Asia Latin
America

Australia
& NZ

Africa

REGIONS

FIGURE 4.6 A segmentation matrix of the World Automobile Market

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 101

5 Select segment scope: Finally, a firm needs to decide whether it wishes to be a
segment specialist or to compete across multiple segments. The advantages of
a broad over a narrow segment focus depend on two main factors: similarity of
KSFs and the presence of shared costs. If KSFs are different across segments, a
firm will need to deploy distinct strategies which may require different capabil-
ities for different segments. Harley-Davidson has found it difficult to expand from
its core segments of heavyweight cruiser and touring bikes into other segments
of the motorcycle industry. Conversely, in automobiles, segment specialists have
found it difficult to survive competition from broad-scope, volume producers.

STRATEGY CAPSULE 4.5

Vertical Segmentation: Profitability along the Value Chain

Segmentation is usually horizontal: markets are disaggre-

gated according to products, geography, and customer

groups. We can also segment an industry vertically by

identifying different value chain activities. Bain & Com-

pany’s profit pool analysis maps profit differences bet-

ween different vertical activities. Figure  4.7 shows the

distribution of value in the electric vehicle sector. The

area of each segment’s rectangle corresponds to the

total profit for that activity. Alternatively, stock market

capitalization can be used to identify which groups of

firms within a sector are most successful at appropri-

ating value.

25

20

10

0

Batteries
Vehicle production

15

5

Financing

Servicing
& repair

Power
generation

Charging
points

Power
management

Value added services
(e.g. entertainment,

navigation,
information)

Revenue

EB
IT

/S
al

es
(%

)

Distribution

FIGURE 4.7 A profit pool mapping for electric vehicles

Source: Adapted from Bain & Company, “Is your electric vehicle strategy shock-proof?” (January 28, 2011).

102 PART II THE TOOLS OF STRATEGY ANALYSIS

Strategic Groups

Strategic group analysis segments industries on the basis of the strategies of member
firms. A strategic group is “the group of firms in an industry following the same or a
similar strategy along the strategic dimensions.”55 These strategic dimensions might
include product range, geographical breadth, choice of distribution channels, product
quality, degree of vertical integration, choice of technology, and so on. By selecting
the most important strategic dimensions and locating each firm in the industry along
them, we can identify groups of companies that have adopted similar approaches to
competing within the industry. In some industries strategic groups are readily observ-
able, for example, airlines fall into two broad strategic groups: “legacy carriers” (such
as American, JAL, and British Airways) and “low-cost carriers” (such as Ryanair, Easyjet,
and Southwest). Other industries are more complex: Figure 4.8 shows strategic groups
within the petroleum industry.

Most empirical research into strategic groups has investigated profitability differ-
ences between groups—on the basis that mobility barriers between strategic groups
preserve profitability differentials.56 However, there is limited evidence of sustained,
systematic profitability differences between strategic groups.57 This may reflect the fact
that the members of a strategic group, although pursuing similar strategies, are not
necessarily in competition with one another. For example, within the European airline
industry, the low-cost carriers pursue similar strategies, but do not, for the most part,
compete on the same routes. Hence, strategic group analysis is mainly useful for under-
standing strategic positioning and recognizing patterns of competition; it is less useful
for analyzing interfirm profitability differences.58

SUPER MAJORS
e.g., ExxonMobil, Shell,

BP, Chevron, Total
INTEGRATED

INTERNATIONAL
MAJORS

e.g., ENI, Repsol,
Petro-Canada

INTEGRATED
NATIONAL OIL COMPANIES

e.g., Petrobras, PDVSA, CNPC,
Indian Oil, Pemex

Geographical Scope

GlobalNational

In
te

g
ra

te
d

Ve
rt

ic
al

B
al

an
ce

D
o

w
n

st
re

am
U

p
st

re
am

NATIONAL
PRODUCTION

COMPANIES
e.g., Saudi Aramco, Kuwait

Petroleum, Qatar
Petroleum

DOMESTIC-FOCUSED
DOWNSTREAM

COMPANIES
e.g., Valero, Nippon Oil,

Phillips 66

INTERNATIONAL
EXPLORATION AND PRODUCTION

COMPANIES
e.g., Conoco, Apache, Occidental,

Marathon Oil

FIGURE 4.8 Strategic groups within the world petroleum industry

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 103

Summary

The purpose of this chapter has been to go beyond the basic analysis of industry structure, competition,
and profitability presented in Chapter 3 to consider the dynamics of competitive rivalry and the internal
complexities of industries.

In terms of industry and competitive analysis, we have extended our strategy toolkit in several
directions:

◆ We have recognized the limitations of conventional industry analysis. These include: the limited
impact of industry upon firm profitability, the role of competition in transforming industries through
a process of creative destruction, and the emergence of “winner-take-all” industries.

◆ We have extended our analysis of industry and competition to take account of complementary
products—especially in industries where these complementarities give rise to network externalities,
platform-based competition, and business ecosystems.

◆ We have become familiar with two approaches to analyzing competitive interactions between close
rivals: (a) game theory which, despite its technical rigor, offers penetrating insights into competition,
bargaining, and the design of winning strategies and (b) competitor analysis which provides a less
formal approach to understanding competitors and predicting their behavior.

◆ We have examined the microstructure of industries and markets using segmentation analysis and
strategic group analysis to understand industries at a more detailed level and to select advantageous
strategic positions.

Self-Study Questions

1. Among the industries listed in Table 3.1 in Chapter 3, which would you consider to be the
most “hypercompetitive” (i.e., ones in which competitive advantage and market leadership are
frequently overturned)?

2. During 2010, the Apple iPhone replaced RIM’s Blackberry as global market leader in smart-
phones. By 2017, the world market for smartphones was dominated by Apple and Google’s
Android; RIM and Microsoft each held market shares of less than 0.1%. Why did Google suc-
ceed in this market while Microsoft and RIM failed?

3. HP, Canon, Epson, and other manufacturers of inkjet printers make most of their profits from
their ink cartridges. Why are cartridges more profitable than printers? Would the situation be
different:

a. if cartridges were manufactured by different firms from those which make printers?
b. if cartridges were interchangeable between different printers?
c. if patent and copyright restrictions did not prevent other firms from supplying ink car-

tridges that could be used in the leading brands of printer?

104 PART II THE TOOLS OF STRATEGY ANALYSIS

4. In November 2005, six of Paris’s most luxurious hotels—including George V, Le Bristol, the
Ritz, and Hotel de Crillon—were fined for colluding on room rates. Regular guests showed
little concern—noting that, whatever the listed rack rate, it was always possible to negotiate
substantial discounts. Using the prisoners’ dilemma model, can you explain why the hotels
were able to collude over their listed rates but not over discounts?

5. During 2017, Amazon made its first major foray into bricks-and-mortar retailing with the acqui-
sition of Whole Foods Market, the up-market supermarket chain. The acquisition followed
Amazon’s entry into online food retailing with Amazon Fresh. The shares of Kroger, the big-
gest supermarket chain in the United States, fell by 11% on news of the deal. How might
Kroger use the competitor analysis framework outlined in Figure  4.4 to predict Amazon’s
competitive strategy in the US grocery market?

6. How would you segment the restaurant market in your hometown? How would you advise
someone thinking of starting a new restaurant which segments might be most attractive in
terms of profit potential?

7. Consider either the North American or European markets for air travel. Can these markets be
segmented? If so, by what variables and into which categories? Can an airline be financially
viable by specializing in certain segments or must airlines seek to compete across all (or
most) segments?

Notes

1. See: R. P. Rumelt,“How much does industry matter?” Strategic
Management Journal 12 (1991): 167–185; A. M. McGa-
han and M. E. Porter, “How much does industry matter,
really?” Strategic Management Journal 18 (1997): 15–30;
V. F. Misangyi, H. Elms, T. Greckhamer, and J. A. Lepine,
“A New Perspective on a Fundamental Debate: A Multi-
level Approach to Industry, Corporate and Business Unit
Effects,” Strategic Management Journal 27 (2006): 571–590.

2. The Strategic Yardstick You Can’t Afford to Ignore,”
McKinsey Quarterly (October 2013).

3. J. A. Schumpeter, The Theory of Economic Development
(Cambridge, MA: Harvard University Press, 1934).

4. See R. Jacobson, “The Austrian School of Strategy,”
Academy of Management Review 17 (1992): 782–807;
and G. Young, K. Smith, and C. Grimm, “Austrian and
Industrial Organization Perspectives on Firm-Level Com-
petitive Activity and Performance,” Organization Science
7 (May/June 1996): 243–254.

5. R. Caves and M. E. Porter, “The Dynamics of Changing
Seller Concentration,” Journal of Industrial Economics 19
(1980): 1–15; P. A. Geroski, “What Do We Know About
Entry? International Journal of Industrial Organization
13, (December 1995): 421–440.

6. P. A. Geroski and R. T. Masson, “Dynamic Market Models
in Industrial Organization,” International Journal of
Industrial Organization 5 (1987): 1–13.

7. D. C. Mueller, Profits in the Long Run (Cambridge: Cam-
bridge University Press, 1986).

8. R. D’Aveni, Hypercompetition: Managing the Dynamics
of Strategic Maneuvering (New York: Free Press,
1994): 217–218.

9. R. A. D’Aveni, G. B. Dagnino, and K. G. Smith, “The Age
of Temporary Advantage,” Strategic Management Journal
31 (2010): 1371–1385.

10. R. G. McGrath, “Transient Advantage,” Harvard Business
Review 91 ( June 2013).

11. G. McNamara, P. M. Vaaler, and C. Devers, “Same As
It Ever Was: The Search for Evidence of Increasing
Hypercompetition,” Strategic Management Journal 24
(2003): 261–278. See also: R. R. Wiggins and T. W. Ruefli,
“Schumpeter’s Ghost: Is Hypercompetition Making the
Best of Times Shorter?” Strategic Management Journal 26
(2005): 887–911.

12. An alternative approach is offered by A. Brandenburger
and B. Nalebuff (Co-opetition, New York: Doubleday,
1996). Their value net includes complementors (together
with customers, suppliers and competitors).

13. D.B. Yoffie and M. Kwak. “With Friends Like These: The
Art of Managing Complementors.” Harvard Business
Review 84 (September 2006): 89–98.

14. “Nespresso’s Bitter Taste of Defeat?” Financial Times
(April 26, 2013).

CHAPTER 4 FURTHER TOPICS IN INDUSTRY AND COMPETITIVE ANALYSIS 105

15. D. J. Teece, “Explicating Dynamic Capabilities: The
Nature and Microfoundations of (Sustainable) Enterprise
Performance. Strategic Management Journal 28
(2007): 1325.

16. M. G. Jacobides, “Strategy Bottlenecks: How TME
Players Can Shape and Win Control of Their Industry
Architecture,” Insights, 9 (2011): 84–91; M. G. Jacobides
and J. P. MacDuffie, “How to Drive Value Your Way,”
Harvard Business Review, 91 ( July/August 2013):
92–100.

17. J. Linder and S. Cantrell, “Changing Business Models: Sur-
veying the Landscape.” Accenture Institute for Strategic
Change, May 2000.

18. D. J. Teece, “Business Models, Business Strategy and Inno-
vation”, Long Range Planning, Vol. 43 (2010): 172–194.

19. A. Osterwalder and Y. Pigneur, Business Model Genera-
tion: A Handbook for Visionaries, Game Changers, and
Challengers (Wiley, 2010).

20. A. Brandenburger and J. H. W. Stuart “Value-Based
Business Strategy,” Journal of Economics and
Management Strategy 5 (1996): 5–24.

21. M. D. Ryall, “The New Dynamics of Competition,”
Harvard Business Review 91 ( June 2013): 80–87.

22. J. Gans and M. D. Ryall, “Value Capture Theory:
A Strategic Management Review,” Strategic Management
Journal 38 (2017): 17–41.

23. K. Weigelt and C. F. Camerer, “Reputation and Corporate
Strategy: A Review of Recent Theory and Applications,”
Strategic Management Journal 9 (1988): 137–142.

24. A. K. Dixit, “The Role of Investment in Entry Deterrence,”
Economic Journal 90 (1980): 95–106.

25. P. Milgrom and J. Roberts, “Informational Asymmetries,
Strategic Behavior and Industrial Organization,” American
Economic Review 77, no. 2 (May 1987): 184–189.

26. P. Ghemawat, Commitment: The Dynamic of Strategy
(New York: Free Press, 1991).

27. See, for example: A. K. Dixit and B. J. Nalebuff, Thinking
Strategically: The Competitive Edge in Business, Politics,
and Everyday Life (New York: W. W. Norton, 1991); and
J. McMillan, Games, Strategies, and Managers (New York:
Oxford University Press, 1992).

28. G. T. Allison and P. Zelikow, Essence of Decision: Explain-
ing the Cuban Missile Crisis, 2nd edn (Boston: Little,
Brown and Company, 1999).

29. B. C. Esty and P. Ghemawat, “Airbus vs. Boeing in Super-
jumbos: A Case of Failed Preemption,” Harvard Business
School Working Paper No. 02-061 (2002).

30. D. Ronfelt, “Social Science at 190 mph on NASCAR’s
Biggest Superspeedways,” First Monday 5 (February 7,
2000).

31. “Spectrum Auction Pits Google’s Game Theorists Against
the FCC’s,” Wired (November 11, 2007).

32. John Cassidy “Rational Irrationality,” New Yorker (Octo-
ber 5, 2009).

33. J. Maynard Smith, “Sexual Selection and the Hand-
icap Principle,” Journal of Theoretical Biology 57
(1976): 239–242.

34. A. Brandenburger and B. Nalebuff, Co-opetition (New
York: Doubleday, 1996).

35. T. Dhar, J.-P. Chatas, R. W. Collerill, and B. W. Gould,
“Strategic Pricing between Coca-Cola Company and Pep-
siCo,” Journal of Economics and Management Strategy 14
(2005): 905–931.

36. Bitter Competition: Holland Sweetener vs. NutraSweet (A)
(Harvard Business School Case No. 9-794-079, 1994).

37. D. K. Levine and R. A. Levine, “Deterrence in the Cold
War and the War on Terror,” Defence and Peace Eco-
nomics 17 (2006): 605–617.

38. D. N. Sull, “Managing by Commitments,” Harvard Business
Review ( June 2003): 82–91.

39. R. M. Grant, “Tesla Motors: Disrupting the Auto Industry,”
in Contemporary Strategy Analysis: Text and Cases, 10th
edn. (Wiley, 2019).

40. For a review of research on competitive signaling, see
O. Heil and T. S. Robertson, “Toward a Theory of Com-
petitive Market Signaling: A Research Agenda,” Strategic
Management Journal 12 (1991): 403–418.

41. B. Macintyre, Operation Mincemeat: The True Spy Story
that Changed the Course of World War II (London:
Bloomsbury, 2010).

42. K. Weigelt and C. Camerer, “Reputation and Corporate
Strategy: A Review of Recent Theory and Applications,”
Strategic Management Journal 9 (1988): 443–454.

43. P. Milgrom and J. Roberts, “Predation, Reputation, and Entry
Deterrence,” Journal of Economic Theory 27 (1982): 280–312.

44. L. Miller, “The Provocative Practice of Price Signaling:
Collusion versus Cooperation,” Business Horizons ( July/
August 1993).

45. On the ability of game theory to predict almost any
equilibrium solution (the Pandora’s Box Problem) see
C. F. Camerer, “Does Strategy Research Need Game
Theory?” Strategic Management Journal, Special Issue 12
(Winter 1991): 137–152; S. Postrel, “Burning Your Britches
behind You: Can Policy Scholars Bank on Game Theory?”
Strategic Management Journal, Special Issue 12 (Winter
1991): 153–155.

46. G. F. Rose and M. Lloyd, “The Failure of FCC Spectrum
Auctions,” (Washington DC: Center for American Progress,
May 2006); P. Klemperer, “How not to Run Auctions:
The European 3G Mobile Telecom Auctions. European
Economic Review 46 (2002): 829–845.

47. For example, J. D. Underwood, Competitive Intelligence
For Dummies (Chichester: John Wiley & Sons, Ltd, 2014).

48. http://www.therichest.com/rich-list/10-of-the-most-
infamous-cases-of-industrial-espionage. Accessed Septem-
ber 11, 2017.

49. C. Roper, Trade Secret Theft, Industrial Espionage, and the
China Threat (CRC Press Book, 2013).

50. J.-C. Spender, Industry Recipes: The Nature and Sources of
Managerial Judgment (Oxford: Blackwell, 1989).

51. This section draws heavily on M. E. Porter, Competitive
Advantage (New York: Free Press, 1985): Chapter 7.

52. “Pirelli’s Bet on High-performance Tires,” International
Herald Tribune (April 2, 2005).

53. R. E. Caves and M. E. Porter, “From Entry Barriers to
Mobility Barriers: Conjectural Decisions and Contrived
Deterrence to New Competition,” Quarterly Journal of
Economics 91 (1977): 241–262.

106 PART II THE TOOLS OF STRATEGY ANALYSIS

54. W. C. Kim and R. Mauborgne, “Blue Ocean Strategy: From
Theory to Practice,” California Management Review 47
(Spring 2005): 105–121.

55. M. E. Porter, Competitive Strategy (New York: Free Press,
1980): 129.

56. A. Feigenbaum and H. Thomas, “Strategic Groups and
Performance: The US Insurance Industry,” Strategic
Management Journal 11 (1990): 197–215.

57. K. Cool and I. Dierickx, “Rivalry, Strategic Groups, and
Firm Profitability,” Strategic Management Journal 14
(1993): 47–59.

58. K. Smith, C. Grimm, and S. Wally, “Strategic Groups and
Rivalrous Firm Behavior: Toward a Reconciliation,” Stra-
tegic Management Journal 18 (1997): 149–157.

5 Analyzing Resources
and Capabilities

One gets paid only for strengths; one does not get paid for weaknesses. The question,
therefore, is first: What are our specific strengths? And then: Are they the right
strengths? Are they the strengths that fit the opportunities of tomorrow, or are they
the strengths that fitted those of yesterday? Are we deploying our strengths where
the opportunities no longer are, or perhaps never were? And finally, what additional
strengths do we have to acquire?

— PETER DRUCKER1

You’ve gotta do what you do well.

—LUCINO NOTO, FORMER VICE CHAIRMAN, EXXONMOBIL

◆ Introduction and Objectives

◆ The Role of Resources and Capabilities in Strategy
Formulation

● Basing Strategy on Resources and Capabilities

● Resources and Capabilities as Sources of Profit

◆ Identifying Resources and Capabilities

● Identifying Resources

● Identifying Organizational Capabilities

◆ Appraising Resources and Capabilities

● Appraising the Strategic Importance of Resources
and Capabilities

● Appraising the Relative Strength of a Firm’s Resources
and Capabilities

◆ Developing Strategy Implications

● Exploiting Key Strengths

● Managing Key Weaknesses

● What about Superfluous Strengths?

● The Industry Context of Resource Analysis

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

108 PART II THE TOOLS OF STRATEGY ANALYSIS

The Role of Resources and Capabilities in Strategy Formulation

Strategy is concerned with matching a firm’s resources and capabilities to the opportu-
nities that arise in the external environment. So far, our emphasis has been on identi-
fying profit opportunities in the external environment of the firm. In this chapter, our
emphasis shifts to the internal environment of the firm—specifically, with the resources
and capabilities of the firm.

There is nothing new in the idea that strategy should exploit the resource and capa-
bility strengths of a person or an organization. The biblical tale of David and Goliath
can be interpreted from this perspective (Strategy Capsule  5.1). However, in recent
decades, two factors have focused increased attention on the role of resources and
capabilities as the basis for strategy. First, as firms’ industry environments have become
more unstable, so internal resources and capabilities rather than external markets offer
a more secure basis for strategy. Second, competitive advantage rather than industry
attractiveness has emerged as the primary source of superior profitability. Let us con-
sider each of these factors.

Basing Strategy on Resources and Capabilities

During the 1990s, ideas concerning the role of resources and capabilities in coalesced
into what has become known as the resource-based view of the firm—a conceptual-
ization of the firm as a collection of resources and capabilities that form the basis of
competitive advantage and the foundation for strategy.2

Introduction and Objectives

In Chapter 1, I noted that the focus of strategy thinking has been shifted from the external environment
of the firm toward its internal environment. In this chapter, we will make the same transition. Looking
within the firm, we will concentrate our attention on the resources and capabilities that firms possess.
This provides the internal foundations for our analysis of competitive advantage (which complements
Chapter 3’s discussion of key success factors—the external foundations of competitive advantage).

I begin by explaining why a company’s resources and capabilities are so important to its strategy.

By the time you have completed this chapter, you will be able to:

◆ Appreciate the role of a firm’s resources and capabilities as a basis for formulating strategy.

◆ Identify the resources and capabilities of a firm.

◆ Evaluate the potential for a firm’s resources and capabilities to confer sustainable compet-
itive advantage.

◆ Formulate strategies that exploit internal strengths while defending against internal
weaknesses.

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 109

To understand why the resource-based view has had a major impact on strategy
thinking, let us go back to the starting point for strategy formulation: the underlying
purpose of the firm that can be answered by posing the question: “What is our business?”
Conventionally, this question has been answered in terms of the market being served:
“Who are our customers?” and “Which of their needs are we seeking to serve?” However,
in a world where customer preferences are volatile and the identity of customers and the
technologies for serving them are changing, a market-focused strategy may not provide
the stability and constancy of direction needed to guide strategy over the long term.
When the external environment is in a state of flux, the firm itself, in terms of the
bundle of resources and capabilities it possesses, may be a more stable basis on which
to define its identity.

This emphasis on resources and capabilities as the foundation of firm strategy was
popularized by C. K. Prahalad and Gary Hamel in their 1990 landmark paper “The Core
Competence of the Corporation.”3 The potential for capabilities to be the “roots of com-
petitiveness,” the sources of new products, and the foundation for strategy is exempli-
fied by Honda and 3M, among other companies (Strategy Capsule 5.2).

The greater the rate of change in a firm’s external environment, the more likely it is
that internal resources and capabilities, rather than external market focus, will provide
a secure foundation for long-term strategy. In fast-moving, technology-based industries,
basing strategy upon capabilities can help firms to outlive the life cycles of their initial
products. Microsoft’s initial success was the result of its MS-DOS operating system for
the IBM PC followed by Windows. However, its software development, marketing, and
partnering capabilities have allowed Microsoft to expand from operating systems in to
applications software (e.g., Office), Internet services (e.g., Xbox Live), and cloud-based
computing services. W. L. Gore and Associates’ distinctive capability is developing

STRATEGY CAPSULE 5.1

david and Goliath

In about 1000 bc, David, an Israeli shepherd boy, took

up the challenge of meeting Goliath, the champion of

the Philistines in single combat. Goliath’s “height was six

cubits and a span [three meters]. He had a bronze helmet

on his head and wore a coat of scale armor of bronze

weighing five thousand shekels [58 kg]; on his  legs he

wore bronze greaves, and a bronze javelin was slung on

his back.” King Saul of the Israelites offered David armor

and a helmet, but David discarded them: “‘I cannot

go in these,’ he said to Saul, ‘because I am not used to

them.’  … Then he took his staff in his hand, chose five

smooth stones from the stream, put them in the pouch

of his shepherd’s bag and, with his sling in his hand,

approached the Philistine… As the Philistine moved

closer to attack him, David ran quickly toward the battle

line to meet him. Reaching into his bag and taking out

a stone, he slung it and struck the Philistine on the fore-

head. The stone sank into his forehead, and he fell face-

down on the ground.”

David’s victory reflects a strategy based upon exploit-

ing his three core strengths: courage and self-confidence,

speed and mobility, and expertise with a sling. This

strategy allowed him to negate Goliath’s core strengths:

size, advanced offensive and defensive equipment, and

combat experience. Had he followed King Saul’s advice

and adopted a conventional strategy for armed single

combat, the outcome would almost certainly have been

very different.

Source: Holy Bible (New International Version): 1 Samuel
17: 39–49.

110 PART II THE TOOLS OF STRATEGY ANALYSIS

STRATEGY CAPSULE 5.2

basing Strategy upon Resources and Capabilities: Honda and 3M

Honda Motor Company has never defined itself either
as a motorcycle or an automobile company. As Figure 5.1

shows, since its founding in 1948, its development of

expertise in designing and manufacturing engines

(some of it honed on the race track) has taken it from

motorcycles to a wide range of products that embody

internal combustion engines.

3M Corporation (originally Minnesota Mining and
Manufacturing) has expanded from sandpaper into over

55,000 industrial, office, medical, and household prod-

ucts. Is it a conglomerate?

Certainly not, claims 3M. Its vast product range rests on

a cluster of technological capabilities that it has systemati-

cally developed for more than a century (Figure 5.2).

1946 1950 1960 1970 1980 1990 2000 2010 2017

Honda
Technical
Research
Institute
founded 405cc

motor-
cycle

Marine engines,
generators, pumps,
chainsaws, snow-

blowers, ground tillers

Model A
clip-on
bicycle
engine

N360
minicar

1000cc
Goldwing

motorcycle

Acura Car
division

Enters
motorcycle

racing

4-cylinder
750cc

motorcycle

Portable
generator

Enters
Formula 1

racing

Honda
Civic

Enters Indy
car racing

Civic
Hybrid

Home cogeneration
system

Production
of diesel
engines

Honda
business jet

GE Honda
turbofan
engine

Variable
Cylinder

Management

98cc,
2-stroke
Dream

motorcycle

50cc
Super-

cub

Fuel
cell car

FIGURE 5.1 Key initiatives at Honda Motor Company

FIGURE 5.2 The evolution of products and technical capabilities at 3M

Carborundum
mining

Sandpaper

Scotch-
tape

Road signs and
markings

Post-it notes

Audio tape

Surgical tapes
and dressings

Videotape

Acetate
f ilm

Floppy disks
and data storage

products

Pharmaceuticals

Homecare/kitchen products

Abrasives Adhesives

Coatings and thin-f ilm
technologies

PRODUCTS

TECHNICAL
CAPABILITIES

Materials sciences

Health sciences

Microreplication

Flexible
electronics

LED lighting

Drug delivery systems

Nanotechnology

Sensors
Surface modif ication

Insulation products

Display screens

Anticorrosion coatings

1902 2015

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 111

product applications for the polymer, PTFE. This has taken W. L. Gore from rainwear
fabric (Gore-Tex) to dental floss, guitar strings, cardiac implants, fiber optic cables, and
a host of other products.

Conversely, those companies that attempted to maintain their market focus in the
face of radical technological change have often experienced huge difficulties in building
the new capabilities needed to serve their customers.

The saga of Eastman Kodak is a classic example. Its dominance of the world market
for photographic products was threatened by digital imaging. Kodak invested billions
of dollars developing digital technologies and digital imaging products. Yet, in January
2012, Kodak was forced into bankruptcy. Might Kodak have been better off allowing its
photographic business to decline while developing applications of its chemical-based
capabilities to plastics, industrial coatings pharmaceuticals, and health care?4

Typewriter and office equipment makers Olivetti and Smith Corona offer similar
cautionary tales. Despite their investments in microelectronics, both failed as suppliers
of personal computers. Might Olivetti and Smith Corona have been better advised to
deploy their existing electrical and precision engineering know-how in other prod-
ucts?5 The inability of established firms to adjust to disruptive technological change
within their own industries has been examined by Harvard’s Clay Christensen.6

Resources and Capabilities as Sources of Profit

In Chapter  1, we identified two major sources of superior profitability: industry
attractiveness and competitive advantage. Of these, competitive advantage is the
more important. As we observed in the previous chapter (Figure 4.1), industry factors
account for only a small proportion of interfirm profit differentials. Hence, establish-
ing competitive advantage through the development and deployment of resources and
capabilities, rather than seeking shelter from the storm of competition, has become the
primary goal of strategy.

The distinction between industry attractiveness and competitive advantage (based
on superior resources) as sources of a firm’s profitability corresponds to economists’
distinction between two types of profit (or rent). The profits arising from market power
are referred to as monopoly rents; those arising from superior resources are Ricardian
rents, after the 19th century British economist David Ricardo. Ricardo showed that, in a
competitive wheat market, when land at the margin of cultivation earned a negligible
return, fertile land would yield high returns. Ricardian rent is the return earned by any
superior resource or capability whose supply is limited.7 Most of the $940 million of
royalties earned in 2017 by Dolby Laboratories from licensing its sound reduction tech-
nologies comprise Ricardian rents, as does most of the $125 million earned by Floyd
Mayweather for his fight with Conor McGregor in August 2017.

Distinguishing between profit arising from market power and profit arising from
resource superiority is less clear in practice than in principle. A closer look at Porter’s
five-forces framework suggests that industry attractiveness often derives from the own-
ership of strategic resources. Barriers to entry, for example, are typically the result of
patents, brands, know-how, or distribution channels, learning, or some other resource
possessed by incumbent firms. Monopoly is usually based on the ownership of a key
resource such as a technical standard or government license.

The resource-based approach has profound implications for companies’ strategy
formulation. When the primary concern of strategy was industry selection and posi-
tioning, companies tended to adopt similar strategies. The resource-based view, by

112 PART II THE TOOLS OF STRATEGY ANALYSIS

contrast, recognizes that each company possesses a unique collection of resources and
capabilities; the key to profitability is not doing the same as other firms but exploiting
differences. Establishing competitive advantage involves formulating and implementing
a strategy that exploits a firm’s unique strengths.

The remainder of this chapter outlines a resource-based approach to strategy for-
mulation. Fundamental to this approach is a thorough and profound understanding of
the resources and capabilities of a firm. This enables the firm to adopt a strategy that
exploits its resource and capability strengths, while protecting against its weaknesses.

The same principles can be applied to guiding our own careers. A sound career
strategy is one that, like David against Goliath, leverages one’s strengths while min-
imizing vulnerability to one’s weaknesses—see Strategy Capsule 5.3 for an example.
For both individuals and organizations the starting point is to identify the available
resources and capabilities.

Identifying Resources and Capabilities

Let us begin by distinguishing between the resources and the capabilities of the firm.
Resources are the productive assets owned by the firm; capabilities are what the firm
can do. On their own, individual resources do not confer competitive advantage; they
must work together to create organizational capability. Organizational capability, when
applied through an appropriate strategy, creates competitive advantage. Figure  5.3
shows the relationships between resources, capabilities, and competitive advantage.

STRATEGY CAPSULE 5.3

Capability-based Strategy: Lyor Cohen on Mariah Carey

The year 2001 was disastrous for Mariah Carey. Her first

movie, Glitter, was a flop, the soundtrack was Carey’s

worst selling album in years, she was dropped by EMI,

and suffered a nervous breakdown.

Lyor Cohen, the workaholic chief executive of Island

Def Jam records was quick to spot an opportunity: “I

cold-called her on the day of her release from EMI and I

said, I think you are an unbelievable artist and you should

hold your head up high. What I said stuck on her and she

ended up signing with us.“

His strategic analysis of Carey’s situation was con-

cise: “I said to her, what’s your competitive advantage?

A great voice, of course. And what else? You write every

one of your songs—you’re a great writer. So why did you

stray from your competitive advantage? If you have this

magnificent voice and you write such compelling songs,

why are you dressing like that, why are you using all these

collaborations [with other artists and other songwriters]?

Why? It’s like driving a Ferrari in first—you won’t see what

that Ferrari will do until you get into sixth gear.”

Cohen signed Carey in May 2002. Under Universal

Music’s Island Def Jam Records, Carey returned to her

versatile voice, song-writing talents, and ballad style.

Her next album, The Emancipation of Mimi, was the

biggest-selling album of 2005, and in 2006 she won a

Grammy award.

Sources: “Rap’s Unlikely Mogul,” Financial Times (August 5, 2002).
“A Superstar Returns with Another New Self,” New York Times
(April 12, 2005).

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 113

Identifying Resources

Drawing up an inventory of a firm’s resources can be surprisingly difficult. No such
document exists within the accounting or management information systems of most
organizations. The balance sheet provides only a partial view of a firm’s resources—
it comprises mainly financial and physical resources. Our broader view of a firm’s
resources encompasses three main types of resource: tangible, intangible, and human.

Tangible Resources Tangible resources are the easiest to identify and value:
financial resources and physical assets are valued in the firm’s balance sheet. Yet,
accounting conventions—especially historic cost valuation—typically result in tan-
gible resources being misvalued. The Walt Disney Company’s annual accounts for
2016 valued its entire movie library—based on production cost less amortization—at
a mere $1.7 billion and its total land assets (including its 28,000 acres in Florida) at a
paltry $1.2 billion.8

However, the primary goal of resource analysis is not to value a company’s tan-
gible resources but to understand their potential for generating profit. This requires
not just valuation but information on their composition and characteristics. With that
information, we can explore two main routes to create additional value from a firm’s
tangible resources:

● What opportunities exist for economizing on their use? Can we use fewer
resources to support the same level of business or use the existing resources to
support a larger volume of business?

● Can existing assets be redeployed more profitably?

Strategy Capsule 5.4 discusses how Michael Eisner’s turnaround of Walt Disney dur-
ing the mid-1980s used both these approaches.

RESOURCES

HUMAN

COMPETITIVE
ADVANTAGE

INDUSTRY KEY
SUCCESS FACTORS

TANGIBLE

• Financial (cash,
securities, borrowing
capacity)
• Physical (plant,
equipment, land,
mineral reserves)

INTANGIBLE

• Technology
(patents, copyrights,
trade secrets)
• Reputation (brands,
relationships)
• Culture

• Skills /know-how
• Capacity for
communication
and collaboration
• Motivation

ORGANIZATIONAL
CAPABILITIES

STRATEGY

FIGURE 5.3 The links between resources, capabilities, and competitive advantage

114 PART II THE TOOLS OF STRATEGY ANALYSIS

Intangible Resources For most companies, intangible resources are more valuable
than tangible resources. Yet, in companies’ balance sheets, intangible resources tend
to be either undervalued or omitted altogether. The exclusion or undervaluation of
intangible resources is a major reason for the large and growing divergence between
companies’ balance-sheet valuations (or book values) and their stock-market valua-
tions (Table 5.1). Among the most important of these undervalued or unvalued intan-
gible resources are brands. Table 5.2 values the Walt Disney brand at $52 billion; yet in
Disney’s balance sheet, its trademarks are valued at $1.2 billion.

Trademarks, together with patents, copyrights, and trade secrets, form the intellec-
tual property of the firm. The growing importance of intellectual property as a strategic
resource is evident from the legal efforts companies make to protect their patents,
copyrights, and trademarks from infringement.

A firm’s relationships can also be considered resources. They provide a firm with
access to information, know-how, inputs, and a wide range of other resources that lie
beyond the firm’s boundaries. Being embedded within an interfirm network also con-
veys legitimacy upon a firm, which can enhance its survival capacity. These interfirm
relationships have been referred to as “network resources.”9

Finally, organizational culture may also be considered an intangible resource. Orga-
nizational culture is “an amalgam of shared beliefs, values, assumptions, significant
meanings, myths, rituals, and symbols that are held to be distinctive.”10 Although diffi-
cult to identify and describe, it is clear that organizational culture is a critically important
resource in most firms: it exerts a strong influence on the capabilities an organization
develops and the effectiveness with which they are exercised.11

Human Resources Human resources comprise the skills and productive effort
offered by an organization’s employees. Human resources do not appear on the firm’s
balance sheet—the firm does not own its employees; it purchases their services under

STRATEGY CAPSULE 5.4

Resource utilization: Revival at Walt disney

In 1984, Michael Eisner became CEO of the Walt Disney

Company. Between 1984 and 1988, Disney’s net income

increased from $98 million to $570 million, and its stock

market valuation from $1.8 billion to $10.3 billion.

The key to the Disney turnaround was the mobili-

zation of Disney’s considerable resource base. With the

acquisition of Arvida, a real estate development company,

Disney’s land holdings in Florida were developed into

hotels, convention facilities, residential housing, and a

new theme park, the Disney-MGM Studio Tour.

To exploit its huge film library, Disney began selling

the Disney classics on videocassette and licensing

packages of movies to TV networks. To put Disney’s

underutilized movie studios to work, Eisner doubled the

number of movies in production and made Disney a

major producer of TV programs.

Supporting the exploitation of these tangible

resources was Disney’s critically important intangible

resource: the enduring affection of millions of people

across generations and throughout the world for Disney

and its characters. As a result, Disney’s new management

was able to boost theme park admission charges, launch

a chain of Disney Stores to push sales of Disney merchan-

dise, and replicate Disney theme parks in Europe and Asia.

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 115

employment contacts. However, the stability of employment relationships allows us to
consider human resources as part of the resources of the firm. In the United States, the
average length of time an employee stays with an employer is 4.2 years, in Europe it
is longer—8.6 years in Great Britain, 11.4 in France and 11.0 in Germany; in Japan it
is 12.1 years.12

Pronouncements that “our people are our greatest asset,” are more than a
platitude: most companies devote considerable effort to analyzing their human
resources—in hiring new employees, appraising their performance, and planning
their development. Many organizations have established assessment centers to mea-
sure the skills and attributes of employees and prospective employees. Competency

TABLE 5.1 Large companies with the highest market-to-book ratios,
September 14, 2017

Company Nationality
Market

capitalization ($ bn.)
Market-

to-book ratio

Lockheed Martin Corp. US 88 40.8

Home Depot, Inc. US 189 27.8

Netflix, Inc. US 80 26.0

Amazon.com US 472 22.8

MasterCard, Inc. US 152 22.8

AbbVie, Inc. US 140 22.0

Glaxo Smith Kline UK 96 14.9

NVIDIA Corp. US 102 14.5

PepsiCo, Inc. US 164 13.4

Novo Nordisk A/S Denmark 95 13.1

Celgene Corp. US 111 12.8

Naspers Ltd. S. Africa 100 12.4

Starbucks Inc. US 77 12.2

Tencent Holdings China 408 12.0

Accenture plc UK 88 10.5

3M Company US 125 10.5

Alibaba China 449 10.4

Roche Switzerland 175 9.1

Coca-Cola Co. US 199 8.9

Altria Inc. US 120 8.8

Note:
The table shows companies with market capitalizations exceeding $75 billion with the highest ratios of market capi-
talization to balance-sheet net asset value.
Sources: Merrill Lynch, Financial Times.

116 PART II THE TOOLS OF STRATEGY ANALYSIS

modeling involves identifying the set of skills, content knowledge, attitudes, and
values associated with superior performers within a particular job category, then
assessing each employee against that profile.13 The finding that psychological and
social aptitudes are critical determinants of superior work performance has fueled
interest in emotional and social intelligence14 Hence the growing trend to “hire for
attitude; train for skills.”

Identifying Organizational Capabilities

Resources are not productive on their own. A brain surgeon is close to useless
without a radiologist, anesthetist, nurses, surgical instruments, imaging equipment,
and a host of other resources. To perform a task, resources must work together.

TABLE 5.2 The world’s 20 most valuable brands, 2017

Rank Brand Value, 2017 ($ bn) Change from 2016

1 Google 246 +7.1

2 Apple 235 +2.7

3 Microsoft 143 +17.6

4 Amazon 139 +40.7

5 Facebook 130 +26.6

6 AT&T 115 +7.2

7 Visa 111 +10.1

8 Tencent 108 +27.5

9 IBM 102 +18.4

10 McDonald’s 98 +10.2

11 Verizon 89 −4.2

12 Marlboro 88 +4

13 Coca-Cola 78 −2.7

14 Alibaba 59 +19.9

15 Wells Fargo 58 −0.2

16 UPS 58 +17.0

17 China Mobile 57 +1.1

18 Disney 52 +5.7

19 General Electric 50 −7.2

20 Mastercard 50 +8.2

Note:
Brand values are calculated as the net present value of forecasted future earnings generated by the brand.
Source: BrandZ ranking of the world’s top brands, compiled by Kantar Millward Brown, Financial Times (June
29, 2017).

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 117

An organizational capability is a “firm’s capacity to deploy resources for a desired
end result.”15 Just as an individual may be capable of playing the violin, ice-skating,
and speaking Mandarin, so an organization may possess the capabilities needed
to manufacture widgets, distribute them globally, and hedge the resulting foreign-
exchange exposure.

The idea that organizations possess distinctive competences is long established,16 but
it was not until Prahalad and Hamel introduced the term core competences to describe
those capabilities fundamental to a firm’s strategy and performance that organizational
capability became a central concept in strategy analysis.17 The resulting flood of litera-
ture has created considerable confusion over terminology: I shall use the terms capa-
bility and competence interchangeably.18

Classifying Capabilities Before deciding which organizational capabilities are
“distinctive” or “core,” the firms need to take a systematic survey of its capabilities. For
this we need some basis for classifying and disaggregating the firm’s activities. Two
approaches are commonly used:

● A functional analysis identifies organizational capabilities within each of the
firm’s functional areas: A firm’s functions would typically include operations,
purchasing, logistics/supply chain management, design, engineering, new prod-
uct development, marketing, sales and distribution, customer service, finance,
human resource management, legal, information systems, government relations,
communication and public relations, and HSE (health, safety, and environment).

● A value chain analysis identifies a sequential chain of the main activities that
the firm undertakes. Michael Porter’s generic value chain distinguishes between
primary activities (those involved with the transformation of inputs and inter-
face with the customer) and support activities (Figure 5.4).19 Porter’s broadly
defined value chain activities can be disaggregated to provide a more detailed
identification of the firm’s activities (and the capabilities that correspond to each
activity). Thus, marketing might include market research, test marketing, adver-
tising, promotion, pricing, and dealer relations.

HUMAN RESOURCE MANAGEMENT

TECHNOLOGY DEVELOPMENT

PROCUREMENT

PRIMARY ACTIVITIES

SUPPORT
ACTIVITIES

SERVICEMARKETING
AND SALES

OUTBOUND
LOGISTICS

OPERATIONSINBOUND
LOGISTICS

FIRM INFRASTRUCTURE

FIGURE 5.4 Porter’s value chain

118 PART II THE TOOLS OF STRATEGY ANALYSIS

Exploration Capability

Geological
Capability

Seismic
Capability

Well Construction
Capability

Partnering
Capability

Directional
Drilling

Capability

Well
Logging

Capability

Hydraulic
Fracturing
Capability

Deepwater
Drilling

Capability

Well
Casing

Capability

Negotiating
Capability

Drilling
Capability

Procurement
Capability

FIGURE 5.5 Organization capabilities as a hierarchy of integration: The case of oil
and gas exploration

The problem of both approaches is that, despite providing a comprehensive view of
an organization’s capabilities, they may fail to identify those idiosyncratic capabilities that
are truly distinctive and critical to an organization’s competitive advantage. We observed
earlier that Apple’s remarkable ability to create products of unrivaled ease of use and cus-
tomer appeal results from its combining technical capabilities with design aesthetics and
penetrating market insight. This capability is not readily apparent from either a functional
or a value chain analysis. To look beyond generic capabilities to uncover those that are
unique requires insight and judgment. A careful examination of an organization’s history
can be revealing. In reviewing an organization’s successes and failures over time, do pat-
terns emerge and what do these patterns imply about the capabilities that underlie them?

The Hierarchy of Capabilities Organizational capability involves coordinated
behavior among organizational members. This is what distinguishes an organizational
capability from an individual skill. Routines and processes play a critical role in inte-
grating individual actions to create organizational capabilities (see Strategy Capsule 5.5).
Integration is also important among organizational capabilities. Hence, the capabilities
of an organization may be viewed as a hierarchical system in which lower-level capa-
bilities are integrated to form higher-level capabilities. For oil and gas companies, a key
requirement for success is the ability to find oil and gas. Figure 5.5 shows that explo-
ration capability comprises a number of component capabilities, which, in turn, can be
further disaggregated into even more specialized capabilities.

For most companies, it is these higher-level capabilities that constitute the “core compe-
tences” described by Prahalad and Hamel. Thus, Toyota’s “lean production” capability inte-
grates multiple capabilities that relate to just-in-time scheduling, total quality management,
statistical process control, flexible manufacturing, and continuous improvement.

These higher-level capabilities tend to be cross-functional. For example, new prod-
uct development capability is an upper-level capability that integrates technological
development, marketing, design, product engineering, process engineering, and finance.

Some writers have proposed that at the highest level of the capability hierarchy
are dynamic capabilities—capabilities that allow the modification and adaptation
of lower-level operational and functional capabilities.20 We shall look more closely at
dynamic capabilities in Chapter 8.

This notion of an organization’s capabilities forming a hierarchy of integration empha-
sizes their complementarity. For example, Walmart’s “everyday low prices” strategy rests
upon four mutually reinforcing capabilities: aggressive vendor management, point-of-
sale data analysis, superior logistics, and rigorous working capital management.21

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 119

Appraising Resources and Capabilities

Having identified the principle resources and capabilities of an organization, how do
we appraise their potential for value creation? There are two fundamental issues: first,
the strategic importance of the different resources and capabilities of the firm and,
second, their strength relative to those of competitors’.

Appraising the Strategic Importance
of Resources and Capabilities

Strategically important resources and capabilities are those with the potential to gen-
erate substantial streams of profit for the firm that owns them. This depends on three

STRATEGY CAPSULE 5.5

Routines and Processes: The Foundations of Organizational
Capability

Resources are combined to create organizational capa-

bilities; however, an organization’s capabilities are not

simply an outcome of the resources upon which they

are based.

In sport, resource-rich teams are often outplayed

by teams that create strong capabilities from modest

resources. In European soccer, star-studded teams (e.g.,

Chelsea, Real Madrid, and Manchester City) are frequently

humbled by those built from limited means (e.g., Borus-

sia Dortmund, Porto, and Atletico Madrid). In business

too, we see upstarts with modest resources outcom-

peting established giants: Dyson against Electrolux in

domestic appliances, Hyundai against Toyota in automo-

biles, Dollar Shave Club against Gillette in shaving prod-

ucts, ARM against Intel in microprocessors. Clearly, there

is more to organizational capability than just resources.

The academic literature views organizational capa-

bility as based upon organizational routines: “regular and

predictable behavioral patterns [comprising] repetitive

patterns of activity”a that determine what firms do, who

they are, and how they develop. Like individual skills,

organizational routines develop through learning by

doing—and, if not used, they wither. Hence, there is a

trade-off between efficiency and flexibility. A limited rep-

ertoire of routines can be performed highly efficiently

with near-perfect coordination. The same organization

may find it difficult to respond to novel situations.

Organizational capabilities do not simply emerge:

they must be created through management action:

hence in this book we shall focus on processes rather

than routines. Processes are coordinated sequences

of actions through which specific productive tasks

are performed. Not only is the term process well

understood by managers, the tools for designing,

mapping, and improving business processes are well

developed.b

However, creating and developing organizational

capabilities is not only about putting in place processes.

Processes need to be located within appropriately

designed organizational units, the individuals involved

need to be motivated, and the resources, processes,

structures, and management systems need to be aligned

with one another.c In the next chapter, we shall address

in greater detail the challenge that companies face in

developing organizational capabilities.

Notes:
aR. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic
Change (Cambridge, MA: Belknap, 1982).
bT. W. Malone, K. Crowston, J. Lee, and B. Pentland, “Tools for
Inventing Organizations: Toward a Handbook of Organizational
Processes,” Management Science 45 (1999): 425–443.
cT. Felin, N. J. Foss, K. H. Heimeriks, and T. L. Madsen, “Microfoun-
dations of Routines and Capabilities: Individuals, Processes,
and Structure,” Journal of Management Studies, 49 (2012):
1351–1374.

120 PART II THE TOOLS OF STRATEGY ANALYSIS

factors: their potential to establish a competitive advantage, to sustain that competitive
advantage, and to appropriate the returns from the competitive advantage. Each of
these is determined by a number of resource characteristics. Figure  5.6 summarizes
the key relationships. The criteria I identify for appraising the strategic importance of
resources and capabilities are similar to those included in Barney’s VRIO framework
(see Strategic Capsule 5.6).

Establishing Competitive Advantage For a resource or capability to establish a
competitive advantage, two conditions must be present:

● Relevance: A resource or capability must be relevant to the key success factors
in the market—in particular, it must be capable of creating value for customers.
British coal mines produced some wonderful brass bands, but these musical
capabilities did little to assist the mines in meeting competition from cheap
imported coal and North Sea gas. As retail banking shifts toward automated
teller machines and online transactions, so retail branches have become a less
relevant resource.

● Scarcity: If a resource or capability is widely available within the industry, it
may be essential but it will not provide a basis for competitive advantage. In oil
and gas exploration, technologies such as directional drilling and 3-D seismic
analysis are widely available—hence they are “needed to play” but they are not
“sufficient to win.”

Sustaining Competitive Advantage Once established, competitive advantage
tends to erode; three characteristics of resources and capabilities determine the sus-
tainability of the competitive advantage they offer:

THE PROFIT-EARNING
POTENTIAL

OF A RESOURCE OR
CAPABILITY

ESTABLISHING A
COMPETITIVE
ADVANTAGE

SUSTAINING A
COMPETITIVE
ADVANTAGE

APPROPRIATING A
COMPETITIVE
ADVANTAGE

Relevance

Scarcity

Durability

Transferability

Replicability

Property rights

Relative
bargaining power

Embeddedness

FIGURE 5.6 Appraising the strategic importance of resources and capabilities

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 121

● Durability: The more durable a resource, the greater its ability to support
a competitive advantage over the long term. For most resources, including
capital equipment and proprietary technology, the quickening pace of tech-
nological innovation is shortening their life spans. Brands, on the other
hand, can be remarkably resilient. Heinz sauces, Kellogg’s cereals, Guinness
stout, Burberry raincoats, and Coca-Cola have been market leaders for over
a century.

● Transferability: Competitive advantage is undermined by competitive imi-
tation. If resources and capabilities are transferable between firms—that
is, if they can be bought and sold—then any competitive advantage that is
based upon them will be eroded. Most resources—including most human
resources—are easily acquired. Other resources and most capabilities are not
easily transferred. Some resources are immobile. A competitive advantage of
the Laphroaig distillery and its 10-year-old, single malt whiskey is its spring
on the Isle of Islay, which supplies water flavored by peat and sea spray.
Capabilities, because they combine multiple resources and are embedded
in processes, are also difficult to move from one firm to another. Another

STRATEGY CAPSULE 5.6

Appraising Resources and Capabilities: Grant versus barney

The approach outlined in this chapter for apprais-

ing the strategic importance of resources is an

alternative to the more widely used VRIO framework

developed by Jay Barney. Let me compare the two

approaches so that their similarities and differences

are apparent.

GRANT: Strategic
Importance Framework

BARNEY:
VRIO Framework Comparison

Establishing competitive advantage

● Relevance ● Valuable Similar: both are concerned with
creating value for customers

● Scarcity ● Rare Identical: scarcity = rareness

Sustaining competitive advantage

● Durability — No equivalent criterion in VRIO

● Transferability ● Imitable Similar: imitating a resource or
capability requires either buying it
(i.e., transferring it) or replicating it

● Replicability

Appropriating competitive advantage

● Appropriability ● Organization Similar: being organized to
capture value implies the ability
to appropriate value

Sources: The VRIO Framework is found in J. B. Barney, “Looking Inside for Competitive Advantage,” Academy of
Management Executive 9 (1995): 49–61 and J. B. Barney and W. Hesterly, Strategic Management and Competitive
Advantage 5th edn (Pearson, 2014).

122 PART II THE TOOLS OF STRATEGY ANALYSIS

barrier to transferability is limited information regarding resource quality.
Sellers of resources are better informed about the performance character-
istics of resources than buyers—this is certainly true of human resources.
This creates a problem of adverse selection for buyers.22 Finally, resources
are complementary: they are less productive when detached from their
original home. Hence, when Chinese companies acquire European brands—
Aquascutum by YGM, Cerruti by Trinity Ltd., MG (the British sports car
marque) by SAIC, and Ferretti by Weichai Group—there is a risk that brand
equity is eroded.

● Replicability: If a firm cannot buy a resource or capability, it must build it. Tech-
nologies that are not protected by patents can be imitated easily by competitors.
Capabilities based on complex networks of interacting organizational routines
are less easy to copy. Federal Express’s national, next-day delivery service and
Singapore Airlines’ superior inflight services are complex capabilities based on
carefully-honed processes, well-developed HR practices, and unique corporate
cultures. Even when resources and capabilities can be copied, imitators are typi-
cally at a disadvantage to initiators.23

● Appropriating the returns to competitive advantage: Who gains the returns
generated by superior resources and capabilities? Typically the owner of that

STRATEGY CAPSULE 5.7

Appropriating Returns from Superior Capabilities: Employees
versus Owners

Investment banking provides a fascinating arena to

observe the struggle between employees and owners to

appropriate the returns to organizational capability. Gold-

man Sachs possesses outstanding capabilities in merger

and acquisition services, underwriting and proprietary

trading. These capabilities combine employee skills, IT

infrastructure, corporate reputation, and the company’s

systems and culture. All but the first of these are owned

by the company. However, the division of returns between

employees and owners suggests that employees have the

upper hand in appropriating rents. In 2016, total employee

compensation was $11.7 billion—an average of $338,576

per employee; net after-tax profit was $7.1 billion out of

which shareholders received $1.1 billion in dividends.

A similar situation exists in professional sport: star

players are able to exploit the full value of their contri-

bution to their teams’ performance. The $38.4 million

salary the Los Angeles Lakers will pay LeBron James for

the 2018/19 NBA season seems likely to fully exploit his

value to the Lakers.

So too CEOs: Expedia’s CEO, Dara Khosrowshahi, was

paid $94.6 million in 2014—an exceptional level of pay

when compared to Expedia’s net profit of $425 million

or to the average pay of Expedia’s 16,291 other US

employees.

The more organizational performance can be iden-

tified with the expertise of an individual employee, the

more mobile is that employee, and the more likely that

the employee’s skills can be deployed with another

firm, then the stronger is the bargaining position of

that employee.

Hence, the emphasis that many investment banks,

advertising agencies, and other professional service

firms give to team-based rather than individual skills. “We

believe our strength lies in… our unique team-based

approach,” declares audit firm Grant Thornton. However,

employees can reassert their bargaining power through

emphasizing team mobility: in August 2018, a team of

European equity analysts moved from Societe Generale

to Barclays plc.

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 123

resource or capability. But ownership may not be clear-cut. Are organizational
capabilities owned by the employees who provide skills and effort or by the
firm which provides the processes and culture? In human-capital-intensive
firms, there is an ongoing struggle between employees and shareholders as
to the division of the rents arising from superior capabilities. As Strategy Cap-
sule 5.7 describes, bargaining between star employees and owners over the
sharing of spoils is a characteristic feature of both investment banking and
professional sports. This struggle is reminiscent of Karl Marx’s description of
the conflict between labor and capital to capture surplus value. The prevalence
of partnerships (rather than shareholder-owned companies) in law, accounting,
and consulting firms is one solution to the battle for rent appropriation: the star
workers are the owners.

Appraising the Relative Strength of a Firm’s
Resources and Capabilities

Having established which resources and capabilities are strategically most important,
we need to assess how a firm measures up relative to its competitors. Appraising a
company’s resources and capabilities relative to those of its competitors’ is difficult.
Organizations frequently fall victim to past glories, hopes for the future, and their
own wishful thinking. Executives within the same company often have quite different
perceptions of their own company’s strengths and weaknesses.24 Executives may also
mistake luck for capability, creating overconfidence in their company’s capabilities.25
Royal Bank of Scotland’s successful acquisition of NatWest Bank was followed by an
acquisition binge culminating in the disastrous takeover of ABN Amro in 2007.26

Benchmarking—the process of comparing one’s processes and performance to
those of other companies—offers an objective and quantitative way for a firm to assess
its resources and capabilities relative to its competitors.27 The results can be salu-
tary: Xerox Corporation’s pioneering use of benchmarking during the 1980s revealed
the massive superiority of its Japanese competitors in cost, quality, and new product
development, providing the impetus for company-wide transformation.28 The case for
benchmarking has been reinforced by recent evidence showing that the substantial
productivity differences between firms within the same industry are primarily the result
of differences in management practices.29

Benchmarking is most useful for assessing functional capabilities. To assess idio-
syncratic capabilities—Johnson & Johnson’s ability to infuse ethics into its business
practices; Lego’s ability to inspire children across countries, cultures and generations;
Nokia’s capacity for corporate reincarnation—benchmarking needs to be supplemented
by more reflective approaches to recognizing strengths and weaknesses. As I discussed
earlier (“Identifying Organizational Capabilities”), in-depth probing of a company’ his-
tory and traits can be highly instructive.

Developing Strategy Implications

Our analysis so far—identifying resources and capabilities and appraising them in
terms of strategic importance and relative strength—can be summarized diagrammati-
cally (Figure 5.7).

124 PART II THE TOOLS OF STRATEGY ANALYSIS

Our focus is the two right-hand quadrants of Figure 5.7. How do we exploit our key
strengths most effectively? How can we address our key weaknesses in terms of both
reducing our vulnerability to them and correcting them? Finally, what about our “super-
fluous strengths”: are these really inconsequential or are there ways in which we can
deploy them to greater effect? Let me offer a few suggestions.

Exploiting Key Strengths

The foremost task is to ensure that the firm’s critical strengths are deployed to the
greatest effect:

● If some of Walt Disney’s key strengths are the Disney brand, the worldwide
affection that children and their parents have for Disney characters, and the
company’s capabilities in the design and operation of theme parks, the impli-
cation is that Disney should not limit its theme park activities to six locations
(Anaheim, Orlando, Paris, Tokyo, Hong Kong, and Shanghai); it should open
theme parks in other locations which have the market potential for year-round
attendance.

● If a core competence of quality newspapers such as the New York Times, the
Guardian (United Kingdom), and Le Monde (France) is their ability to interpret
events and identify emerging trends, can this capability be used as a basis for
creating new revenue sources such as specialized business and financial intelli-
gence, individually customized news feeds, and political consulting services?

● If a company has few key strengths, this may suggest adopting a niche strategy.
Harley-Davidson’s key strength is its brand identity; its strategy has been
to focus upon traditionally styled, technologically backward, cruiser motor-
cycles. British semiconductor company ARM is a technology leader in RISC
architecture; its strategy is highly focused: it licenses its microprocessor designs
for mobile devices worldwide.30

Managing Key Weaknesses

What does a company do about its key weaknesses? It is tempting to counter weak-
nesses with plans to upgrade existing resources and capabilities. However, converting
weakness into strength is likely to be a long-term task for most companies. In the short

Superfluous Strengths Key Strengths

Zone of lrrelevance Key Weaknesses
H

ig
h

High

RE
LA

TI
VE

S
TR

EN
G

TH
Lo

w

Low
STRATEGIC IMPORTANCE

FIGURE 5.7 The framework for appraising resources and capabilities

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 125

to medium term, a company is likely to be stuck with the resources and capabilities
that it has inherited.

The most decisive, and often most successful, solution to weaknesses in key
functions is to outsource. Companies have become increasingly selective in the activ-
ities they perform internally: concentrating on their key strengths and outsourcing
other activities. Across a range of activities specialist suppliers have developed
high-level capabilities in contact manufacture (Hon Hai Precision/Foxconn, Flextron-
ics), IT (Accenture, IBM, Capgemini), logistics (Exel, Kuehne + Nagel, UPS), and food
service (Compass, Sodexo).

Some companies may be present in relatively few activities within their value chains.
In athletic shoes and clothing, Nike undertakes product design, marketing, and overall
“systems integration,” but most other functions are contracted out. We shall consider
the vertical scope of the firm in greater depth in Chapter 11.

Clever strategy formulation can allow a firm to negate its vulnerability to key
weaknesses. Harley-Davidson cannot compete with Honda, Yamaha, and BMW on
technology. The solution? It has made a virtue out of its outmoded technology and
traditional designs. Harley-Davidson’s old-fashioned, push-rod engines, and recycled
designs have become central to its retro-look authenticity.

What about Superfluous Strengths?

What about those resources and capabilities where a company has particular strengths
that don’t appear to be important sources of sustainable competitive advantage? One
response may be selective divestment. If a retail bank has a strong but increasingly
underutilized branch network, it may be time to prune its real-estate assets and invest
in web-based customer services.

However, in the same way that companies can turn apparent weaknesses into com-
petitive strengths, so it is possible to develop innovative strategies that turn apparently
inconsequential strengths into key strategy differentiators. Edward Jones’ network of
brokerage offices and 8000-strong sales force looked increasingly irrelevant in an era
when brokerage transactions were going online. However, by emphasizing personal
service, trustworthiness, and its traditional, conservative investment virtues, Edward
Jones has built a successful contrarian strategy based on its network of local offices.31

In the fiercely competitive MBA market, business schools can also differentiate on the
basis of idiosyncratic resources and capabilities. Georgetown’s Jesuit heritage is not an
obvious source of competitive advantage for its MBA programs. Yet, the Jesuit emphasis
on developing the whole person and cultivating ethics, integrity, and emotional intel-
ligence provide a strong foundation for developing successful business leaders. Simi-
larly, Dartmouth College’s location in the woods of New Hampshire far from any major
business center is not an obvious benefit to its business programs. However, Dartmouth’s
Tuck Business School has used the isolation and natural beauty of its locale to create
close-knit MBA classes that then join a loyal and supportive alumni network.

The Industry Context of Resource Analysis

The results of our resource and capability appraisal depend critically upon how
broadly or narrowly we define the industry within which the firm is located. If we are
appraising the resources and capabilities of Harley-Davidson, should we view Har-
ley as located in the motorcycle industry or in the heavyweight motorcycle segment?
Clearly, our appraisal of both the strategic importance of resources and Harley’s relative
strength will differ substantially. Initially at least, it is best to define industries fairly

126 PART II THE TOOLS OF STRATEGY ANALYSIS

If the key success factor in the airline business is

providing safe, reliable transportation between city pairs

at a competitive price, we can begin by identifying the

resources and capabilities needed to achieve that goal.

We can then use the value chain to fill out more system-

atically this list of resources and capabilities. Table  5.3

and Figure 5.8 show the major resources and capabilities

required in the airline business and assess Icelandair’s

position relative to a peer group of competitors.

In terms of strategy implications, a key resource that

distinguishes Icelandair is location: Iceland’s population

of 326,000 offers a passenger and freight market that Ice-

landair can easily dominate, but is too small to support

an international airline. Hence, to achieve efficient

scale, Icelandair must (a) collaborate with other firms

and the Icelandic government to develop Iceland as a

tourist destination and (b) compete on North Atlantic

routes between European and North American cities.

For (b) to be viable, Icelandair needs to make routes

that involve a stopover at its Reykjavik hub competitive

with the point-to-point routes offered by the major US

and European airlines. This requires (a) using Icelandair’s

operational efficiency to undercut other airlines on price

and (b) exploiting Icelandair’s operational and customer

service capabilities, its human resource strengths, and

the appeal of Reykjavik/Iceland as a stopover to estab-

lish a differentiation advantage. Icelandair’s strategy is

encapsulated in its vision statement: “To unlock Iceland’s

potential as a year-round destination, to strengthen Ice-

land’s position as a connecting hub, and to maintain our

focus on flexibility and experience.”

STRATEGY CAPSULE 5.8

Resource and Capability Analysis in Action: Icelandair Group

FIGURE 5.8 Icelandair’s resource and capability profile

Superf luous Strengths

Inconsequential Weaknesses

Maintenance

General management
Human resources

Financial resources
Flight

operations
Cabin services

Marketing

Key Strengths

Brand
Landing
slots Location

/route networkFleet

Key Weaknesses

H
ig

h

High

RE
LA

TI
VE

S
TR

EN
G

TH
Lo

w

Low
STRATEGIC IMPORTANCE

broadly; otherwise, there is a risk our analysis will be constrained by the focal firm’s
existing strategic positioning, Thus, in the case of Harley-Davidson, it is useful to view
the company within the context of the motorcycle industry as a whole. That way we
can address the question of which segments Harley should be located within. We can
then go on to a more focused analysis of Harley’s resources and capabilities for the
different industry segments.

As with all strategy frameworks, we need to be alert to the limitations of resource
and capability analysis. Not only are our criteria of strategic importance and relative
strength context-dependent but also individual resources and capabilities are themselves

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 127

multidimensional aggregations. For example, a firm’s manufacturing capability might
be assessed in relation to efficiency, quality, and flexibility. Hence, the resource and
capability analysis as outlined in this chapter is likely to be a fairly crude tool for
appraising a firm’s potential for competitive advantage. However, what it does offer is
a systematic approach to describe and assess an organization’s portfolio of resources
and capabilities that can be subsequently refined.

Strategy Capsule  5.8 illustrates how the approach outlined in this chapter can be
applied to identify and appraise the resources and capabilities of the Icelandair Group
and indicate its potential to establish a competitive advantage within the airline industry.

TABLE 5.3 The resources and capabilities of Icelandair Groupa

Strategic importance [1–10] Icelandair’s relative strength [1–10]b

Resources
Fleet Planes are transferrable; main differentiator is

age of fleet [2]
Above-average age of fleet until new planes are
delivered in 2018–21 [2]

Financial resources Critical for (a) buying other resources (b) sur-
viving downturns [7]

Strong balance sheet; positive cash flow [8]

Location and
route network

Critical to market access and exploiting network
economies [9]

Tiny domestic market and inferior North Atlantic
routes [3]

Landing slots Key determinant of access to congested
airports [6]

Limited presence at the key capacity-constrained
airports of Europe and North America [3]

Brand Important indicator of quality and reliability [5] Lacks international prominence and still tainted by
former image as a “hippy airline” [4]

Human resources Human resources critical to most capabilities [8] Well-educated, well-trained, and well-motivated
employees [8]

Capabilities
Flight operations Operational capabilities are critical to cost

efficiency and user satisfaction [9]
Strong record of operational efficiency, safety, and
flexibility; cost per average seat mile below that of
US and European legacy carriers [8]

Cabin services Critically important in business class; less impor-
tant in economy class [6]

Customer reviews suggest parity in business
class and superior quality/price combination in
economy [6]

Maintenance Relevant to reliability and safety, but easily out-
sourced [3]

Safety record and reliability performance suggest
superior capability [7]

Marketing Important for building brand awareness and
stimulating demand [5]

A key element in Icelandair’s success in expanding
tourist traffic and market share of North Atlantic
market [8]

General
management

Essential for developing and maintaining opera-
tional, customer service, marketing, and support
capabilities [8]

Icelandair has a dynamic, hands-on senior
management team that supports a flexible and
committed approach to management [9]

Notes:
aThis exercise is for illustrative purposes only. The assessments provided are based upon the author’s perceptions, not upon objective
measurement.
bCompared to peer group, comprising Norwegian, SAS, Lufthansa, British Airways, American, EasyJet, and WOW Air.

128 PART II THE TOOLS OF STRATEGY ANALYSIS

Summary

We have shifted the focus of our attention from the external environment of the firm to its internal
environment. We have observed that internal resources and capabilities offer a sound basis for building
strategy. Indeed, when a firm’s external environment is in a state of flux, internal strengths are likely to
provide the primary basis upon which it can define its identity and its strategy.

In this chapter, we have followed a systematic approach to identifying the resources and capabilities
that an organization has access to; we then have appraised these resources and capabilities in terms of
their potential to offer a sustainable competitive advantage and, ultimately, to generate profit.

Having built a picture of an organization’s key resources and capabilities and having identified areas
of strength and weakness, we can then devise strategies through which the organization can exploit
its strengths and minimize its vulnerability to its weaknesses. Figure 5.9 summarizes the main stages of
our analysis.

In the course of the chapter, we have encountered a number of theoretical concepts and relation-
ships; however, the basic issues of resource and capability analysis are intensely practical. At its core,
resource and capability analysis asks what is distinctive about a firm in terms of what it can do better
than its competitors and what it cannot. This involves not only analysis of balance sheets, employee
competencies, and benchmarking data, but also insight into the values, ambitions, and traditions of a
company that shape its priorities and identity.

FIGURE 5.9 Summary: A framework for analyzing resources and capabilities

STRATEGY

RESOURCES

3. Develop strategy implications:
(a) How can strengths be exploited most
ef fectively?
(b) In relation to weaknesses:
–Which activities can be outsourced?
– Can a strategy that minimizes the
impact of weaknesses be selected?
– Can resources/capabilities be
strengthened by investment?

2. Appraise the f irm’s resources and capabilities
in terms of:
(a) strategic importance
(b) relative strength

1. Identify the f irm’s resources and capabilities

POTENTIAL FOR
SUSTAINABLE
COMPETITIVE
ADVANTAGE

CAPABILITIES

CHAPTER 5 ANALYzING RESOuRCES ANd CAPAbILITIES 129

Because the resources and capabilities of the firm form the foundation for building competitive
advantage, we shall return again and again to the concepts of this chapter. In the next chapter, we shall
consider the organizational structure and management systems through which resources and capa-
bilities are deployed. In Chapter 7, we shall look more closely at the competitive advantages that arise
when resource and capability strengths intersect with key success factors. In Chapter 8, we shall con-
sider how companies build the capabilities needed to deal with the challenges of the future.

Self-Study Questions

1. Since it was founded in 1994, Amazon has expanded its business from online book sales, to
online general retailing, to audio and video streaming, to e-readers and tablet computers, to
cloud computing. Is Amazon’s strategy based primarily upon serving a market need or pri-
marily on exploiting its resources and capabilities?

2. The world’s leading typewriter manufacturers in the 1970s included Olivetti, Underwood, IBM,
Olympia, Remington, Smith Corona, and Brother Industries. While IBM and Brother adapted
to the microelectronics revolution, most of the others failed. What strategies might these com-
panies have pursued as an alternative to producing personal computers and electronic word
processors market?

3. I have argued that the part of discrepancy between firms’ stock market value and their book
value reflects the fact that intangible resources are typically undervalued or not valued at all in
their balance sheets. For the companies listed in Table 5.1, which types of resource are likely
to be absent or undervalued in the firms’ balance sheets?

4. Many companies announce in their corporate communications: “Our people are our greatest
resource.” In terms of the criteria listed in Figure  5.7, can employees be considered of the
utmost strategic importance? For Walmart, McDonald’s, and McKinsey & Company, how impor-
tant are employees to their competitive advantages?

5. The chapter argues that Apple’s key capabilities are product design and product development
that combine hardware technology, software engineering, aesthetics, ergonomics, and
cognitive awareness to create products with a superior user interface and unrivalled market
appeal. How easy would it be for Samsung to replicate these capabilities of Apple?

6. Given the profile of Icelandair’s resources and capabilities outlined in Strategic Capsule 5.8,
how might Icelandair best exploit its resources and capabilities to (a) expand passenger num-
bers traveling to and from Iceland and (b) profitably grow its share of the North Atlantic market?

7. Apply resource and capability analysis to your own business school. Begin by identifying the
resources and capabilities relevant to success in the market for business education, appraise the
resources and capabilities of your school, and then make strategy recommendations regarding
such matters as the programs to be offered and the overall positioning and differentiation of
the school and its offerings.

130 PART II THE TOOLS OF STRATEGY ANALYSIS

Notes

1. P. F. Drucker, Managing in Turbulent Times (New York:
Harper & Row, 1990).

2. The resource-based view is described in J. B. Barney, “Firm
Resources and Sustained Competitive Advantage,” Journal
of Management 17 (1991): 99–120; and R. M. Grant,
“The Resource-based Theory of Competitive Advantage,”
California Management Review 33 (1991): 114–135.

3. C. K. Prahalad and G. Hamel, “The Core Competence of
the Corporation,” Harvard Business Review (May/June
1990): 79–91.

4. “Eastman Kodak: Failing to Meet the Digital Challenge,” in
R. M. Grant, Cases to Accompany Contemporary Strategy
Analysis 10th edn (Oxford: Blackwell, 2019).

5. E. Danneels, “Trying to Become a Different Type of
Company: Dynamic Capability at Smith Corona,” Strategic
Management Journal 32 (2011): 1–31; and E. Danneels, B.
Provera, and G. Verona, “(De-)Institutionalizing Organiza-
tional Competence: Olivetti’s Transition from Mechanical to
Electronic Technology,” Bocconi University, Milan, 2012.

6. C. M. Christensen, The Innovator’s Dilemma (New York:
Harper Business, 2000).

7. A. Madhok, S. Li, and R. L. Priem, “The Resource-Based
View Revisited: Comparative Firm Advantage, Willingness-
Based Isolating Mechanisms and Competitive Heteroge-
neity,” European Management Review 7 (2010): 91–100.

8. Walt Disney Company, 10-K report, 2014.
9. R. Gulati, “Network Location and Learning: The Influence

of Network Resources and Firm Capabilities on Alli-
ance Formation,” Strategic Management Journal 20
(1999): 397–420.

10. S. Green, “Understanding Corporate Culture and Its Rela-
tionship to Strategy,” International Studies of Management
and Organization 18 (Summer 1988): 6–28.

11. J. Barney, “Organizational Culture: Can It Be a Source
of Sustained Competitive Advantage?” Academy of
Management Review 11 1986): 656–665.

12. http://stats.oecd.org/Index.aspx?DatasetCode=TENURE_
AVE. Accessed September 13, 2017.

13. E. Lawler, “From Job-Based to Competency-Based Orga-
nizations,” Journal of Organizational Behavior 15 (1994):
3–15; L. Spencer and S. Spencer, Competence at Work:
Models for Superior Performance (New York: John Wiley &
Sons, Inc., 1993).

14. D. Goleman, Emotional Intelligence (New York: Bantam,
1995); D. Goleman, Social Intelligence (New York:
Bantam, 2006).

15. C. E. Helfat and M. Lieberman, “The Birth of Capabilities:
Market Entry and the Importance of Prehistory,” Industrial
and Corporate Change 12 (2002): 725–760.

16. P. Selznick, Leadership in Administration: A Sociological
Interpretation (New York: Harper & Row, 1957).

17. C. K. Prahalad and G. Hamel, “The Core Competence of
the Corporation,” Harvard Business Review (May/June
1990): 79–91.

18. G. Hamel and C. K. Prahalad state: “the distinction bet-
ween competencies and capabilities is purely semantic”
(letter, Harvard Business Review, May/June 1992: 164–165).

19. M. E. Porter, Competitive Advantage (New York: Free
Press, 1984).

20. D. J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabilities
and Strategic Management,” Strategic Management Journal
18 (1997): 509–533.

21. P. Leinwand and C. Mainardi, “The Coherence Premium,”
Harvard Business Review 88 ( June 2010): 86–92.

22. Adverse selection refers to the propensity for a market to
be dominated by low-quality or risky offerings as a result
of information asymmetry. This is also known as the
lemons problem. See G. Akerlof, “The Market for Lemons:
Qualitative Uncertainty and the Market Mechanism,”
Quarterly Journal of Economics 84 (1970): 488–500.

23. I. Dierickx and K. Cool (“Asset Stock Accumulation and
Sustainability of Competitive Advantage,” Management
Science 35 (1989): 1504–1513) point to two major disadvan-
tages of imitation (a) asset mass efficiencies: the incumbent’s
strong initial resource position facilitates the subsequent
accumulation of resources and (b) time compression dis-
economies: additional costs incurred by an imitator when
seeking to rapidly accumulate a resource or capability.

24. J. Denrell, N. Arvidsson, and U. Zander, “Managing
Knowledge in the Dark: An Empirical Study of the Reli-
ability of Capability Evaluations,” Management Science 50
(2004): 1491–1503.

25. D. Miller, The Icarus Paradox: How Exceptional Companies
Bring about Their Own Downfall (New York: Harper-
Business, 1990).

26. I. Martin, Making It Happen: Fred Goodwin, RBS and the
Men Who Blew Up the British Economy (London: Simon &
Schuster, 2013).

27. “What is Benchmarking?” Benchnet: The Benchmarking
Exchange, www.benchnet.com, accessed September 18,
2017.

28. G. Jacobson and J. Hillkirk, Xerox: American Samurai
(New York: Macmillan, 1986).

29. N. Bloom, J. Van Reenen, and E. Brynjolfsson, “Good
Management Predicts a Firm’s Success Better Than IT,
R&D, or Even Employee Skills,” Harvard Business Review
(April 2017); N. Bloom and J. Van Reenen, “Why Do
Management Practices Differ across Firms and Countries?”
Journal of Economic Perspectives 24 (2010): 203–224.

30. S. Ferriani, E. Garnsey, G. Lorenzoni, and L. Massa, “The
Intellectual Property Business Model: Lessons from ARM
Plc.” (CTM Working Paper, University of Cambridge,
June 2015).

31. C. Markides, All the Right Moves (Boston: Harvard Business
School Press, 1999).

6 Organization Structure
and Management
Systems: The
Fundamentals of
Strategy Implementation

Ultimately, there may be no long-term sustainable advantage other than the ability to
organize and manage.

—JAY GALBRAITH AND ED LAWLER

I’d rather have first-rate execution and second-rate strategy anytime than brilliant
ideas and mediocre management.

—JAMIE DIMON, CEO, JPMORGAN CHASE & CO.

Many people regard execution as detail work that’s beneath the dignity of a business
leader. That’s wrong. To the contrary, it’s a leader’s most important job.

—LARRY BOSSIDY, FORMER CEO, HONEYWELL

6

◆ Introduction and Objectives

◆ Strategy Formulation and Strategy Implementation

● The Strategic Planning System: Linking Strategy
to Action

◆ The Fundamentals of Organizing: Specialization,
Cooperation, and Coordination

● Specialization and Division of Labor

● The Cooperation Problem

● The Coordination Problem

◆ Developing Organizational Capability

● Processes

● Motivation

● Structure

◆ Organization Design

● The Role of Hierarchy

● Defining Organizational Units

● Alternative Structural Forms: Functional,
Multidivisional, Matrix

● Systems and Style: Mechanistic versus Organic
Organizational Forms

● Recent Trends in Organizational Design

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

132 PART II THE TOOLS OF STRATEGY ANALYSIS

Introduction and Objectives

We spend a lot of our time strategizing: pondering our next career move, making plans for a vaca-
tion; thinking about how to improve our marketability. Most of these strategies remain just wishful
thinking: if strategy is to yield results, it must be backed by commitment and translated into action.

The challenges of strategy implementation are even greater for organizations than for individuals.
Executing strategy requires the combined efforts of all the members of the organization, many of whom
will have played no role in its formulation; others will find that the strategy conflicts with their own
personal interests. Even without these impediments, implementation tends to be neglected because
it requires commitment, persistence, and hard work. “How many meetings have you attended where
people left without firm conclusions about who would do what and when?” asks super-consultant,
Ram Charan.1

In this chapter, we consider some of the fundamentals of strategy implementation. We begin by
clarifying the relationship between strategy formulation and strategy implementation. If strategy
involves translating intention into action, the basic organizational requirements are for coordination
and cooperation. We view organizational capability as the mechanism through which coordination
and cooperation effectuate action. We disaggregate organizational capability into four components:
resources, motivation, processes, and structure and go on to explore the role of each of these in strategy
implementation.

This chapter introduces only the fundamentals of strategy implementation. In subsequent chap-
ters, we shall consider strategy implementation in particular contexts, such as strategic change
(Chapter 8), innovation (Chapter 9), mature industries (Chapter 10), international business (Chapter 12),
multi business firms (Chapter  14), and mergers and acquisitions (Chapter  15). At the same time, our
consideration of strategy implementation is limited: ultimately strategy implementation embraces the
whole of management.

By the time you have completed this chapter, you will be able to:

◆◆ Understand the relationship between strategy formulation and strategy implementation
and the role of strategic planning systems in linking strategy to action.

◆◆ Recognize the role of cooperation and coordination as the basic requirements for organi-
zational effectiveness.

◆◆ Appreciate the role that resources, processes, motivation, and structure play in developing
organizational capabilities.

◆◆ Select the organizational structure best suited to a particular business context.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 133

Strategy Formulation and Strategy Implementation

The relationship between strategy formulation and strategy implementation has long
been a contentious issue. During the early years of corporate planning, strategy was
viewed as a two-stage process: first, formulation (mainly by top management), then
implementation (mainly by middle management). This conception was challenged by
Henry Mintzberg who envisaged strategy as emerging from the interaction between
the formulation and implementation (see the discussion of “How is Strategy Made? The
Strategy Process” in Chapter 1).2

From what we have learned about the nature of strategy, it is clear that we cannot
separate strategic management into self-contained formulation and implementation
stages. The intended strategy of any organization is inevitably incomplete: it com-
prises goals, directions, and priorities, but it can never be comprehensive. It is during
implementation that the gaps are filled in and, because circumstances change, the
strategy adapts. Equally, strategy formulation must take account of the conditions of
implementation. The observation “Great strategy; lousy implementation” is typically a
misdiagnosis of strategic failure: a strategy which has been formulated without taking
account of its ability to be implemented is a poorly formulated strategy. Clearly, strategy
formulation and implementation are interdependent. Nevertheless, the fact remains that
purposeful behavior requires that action must be preceded by intention, and intention
needs to be preceded by thought.

The Strategic Planning System: Linking Strategy to Action

Our outline of the development of strategic management in Chapter  1 (see “A Brief
History of Business Strategy”) indicated that companies adopted corporate planning,
not to formulate strategy but to facilitate coordination and control in increasingly large
and complex organizations.

Similarly with entrepreneurial start-ups, when Steve Jobs and Steve Wozniak founded
Apple Computer at the beginning of 1977, strategy was developed in their heads and
through their conversation. A written articulation of Apple’s strategy did not appear
until they needed to write a business plan in order to attract venture capital funding.3
However, Apple did not adopt a systematic strategic planning process until several
years later when it needed to establish capital expenditure budgets for its different
functions and product teams and link strategy to day-to-day decision-making.

Thus, Mintzberg’s claim that formalized strategic planning is a poor way to make
strategy, even if it is right, fails to recognize the real value purpose of strategic planning
systems. As we shall see, strategic planning systems provide a framework for the
strategy process which can assist in building consensus, communicating the strategy
and its rationale throughout the organization, allocating resources to support the
strategy, and establishing performance goals to guide and motivate the individuals and
groups responsible for carrying out the strategy.

The Strategic Planning Cycle Most large companies have a regular (normally
annual) strategic planning process that results in a document that is endorsed by the
board of directors and provides a development plan for the company for the next three
to five years. The strategic planning process is a systematized approach that assem-
bles information, shares perceptions, conducts analysis, reaches decisions, ensures

134 PART II THE TOOLS OF STRATEGY ANALYSIS

consistency among those decisions, and commits managers to courses of action and
performance targets.

Strategic planning processes vary between organizations. At some they are highly
centralized. Even after an entrepreneurial start-up has grown into a large company,
strategy making may remain the preserve of the chief executive. At MCI Communica-
tions, former CEO Orville Wright observed: “We do it strictly top-down at MCI.”4 How-
ever, at most large companies, the strategic planning process involves a combination of
top-down direction and bottom-up initiatives.5

Figure 6.1 shows a typical strategic planning cycle. The principal stages are:

1 Setting the context: guidelines, forecasts, assumptions. The CEO typically initiates
the process by indicating strategic priorities—these will be influenced by the
outcome of the previous performance reviews. In addition, the strategic planning
unit may provide assumptions or forecasts that offer a common basis for strategic
planning by different units within the organization. For example, the 2017–20
strategic plan of the Italian oil and gas company Eni was based upon (a) the
goal of increasing free cash flow by expanding petroleum production and selling
assets and (b) assumptions that the price of crude would rise to $60 per barrel
and the dollar/euro exchange rate would appreciate to 1.20 by 2020.6

2 Business plans. On the basis of these priorities and planning assumptions, the
different organizational units—product divisions, functional departments, and
geographical units—create strategic plans that are then presented for com-
ment and discussion to top management. This dialogue represents a critically
important feature of the strategy system: it provides a process for sharing
knowledge, communicating ideas, and reaching consensus. This process may
be more important than the strategic plans that are created. As General (later
President) Dwight Eisenhower observed: “Plans are worthless, but planning is
everything.”7

Corporate
Guidelines

Draft
Business

Plans

Discussions
with

Corporate

Revised
Business

Plans

Approval
by

Board

Corporate
Plan

Capex
Budget

Performance
Targets

Operating Plan/
Operating Budget

Performance
Review

Forecasts/
Scenarios/
Planning

Assumptions

FIGURE 6.1 The generic annual strategic planning cycle

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 135

3 The corporate plan. Once agreed, the business plans are then integrated
to create the corporate strategic plan that is then presented to the board
for approval.

4 Capital expenditure budgets. Capital expenditure budgets link strategy
to resource allocation. They are established through both top-down and
bottom-up initiatives. When organizational units prepare their business plans,
they will indicate the major projects they plan to undertake during the stra-
tegic planning period and the capital expenditures involved. When top
management aggregates business plans to create the corporate plan, it estab-
lishes capital expenditure budgets both for the company as a whole and for
the individual businesses. The businesses then submit capital expenditure
requests for specific projects that are evaluated through standard appraisal
methodologies, typically using discounted cash flow analysis. Capital expen-
diture approvals take place at different levels of a company according to
their size. Projects of up to $5 million might be approved by a business
unit head; projects of up to $25 million might be approved by divisional
top management; larger projects might need to be approved by the top
management committee; the biggest projects may require approval by the
board of directors.

5 Operational plans and performance targets. Implementing strategy requires
breaking down strategic plans into a series of shorter-term plans that pro-
vide a focus for action and a basis for performance monitoring. At the basis
of the annual operating plan are a set of performance targets derived from
the strategic plan. These performance targets are both financial (sales growth,
margins, return on capital) and operational (inventory turns, defect rates,
number of new outlets opened). In the section on “Setting Performance Tar-
gets” in Chapter 2, I outlined the basic cascading logic for goal setting: overall
goals of the organization are disaggregated into more specific performance
goals as we move down the organization. As Chapter 2 shows, this can use
either a simple financial disaggregation or the balanced scorecard method-
ology. There is nothing new about this approach: management by objectives
(the process of participative goal setting) was proposed by Peter Drucker in
1954.8 Performance targets can be built into the annual operating budget. The
operating budget is a pro forma profit-and-loss statement for the company as
a whole and for individual divisions and business units for the upcoming year.
It is usually divided into quarters and months to permit continual monitoring
and the early identification of variances. The operating budget is part fore-
cast and part target. Each business typically prepares an operating budget for
the following year that is then discussed with the top management committee
and, if acceptable, approved. In some organizations, the budgeting process
is part of the strategic planning system: the operating budget is the first year
of the strategic plans; in others, budgeting follows strategic planning. Opera-
tional planning is more than setting performance targets and agreeing budgets;
it also involves planning specific activities. As Bossidy and Charan explain:
“An operating plan includes the programs your business is going to complete
within one year … Among these programs are product launches; the marketing
plan; a sales plan that takes advantage of market opportunities; a manufac-
turing plan that stipulates production outputs; and a productivity plan that
improves efficiency.”9

136 PART II THE TOOLS OF STRATEGY ANALYSIS

The Fundamentals of Organizing: Specialization, Cooperation,
and Coordination

Translating intention into action requires organizing. To understand what organizing
involves, we must understand why firms exist.

Specialization and Division of Labor

Firms exist because of their efficiency advantages in producing goods and services that
results from the division of labor: each worker specializing in a specific task. Consider
Adam Smith’s description of pin manufacture:

One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a
fifth grinds it at the top for receiving the head; to make the head requires two or three
distinct operations; to put it on is a peculiar business, to whiten the pins is another; it
is even a trade by itself to put them into the papers.10

Smith’s pin makers produced about 4800 pins per person each day. “But if they had all
wrought separately and independently, and without any of them having been educated
to this peculiar business, they certainly could not each have made 20, perhaps not one
pin, in a day.”

However, specialization comes at a cost: dividing the production process requires
integrating the separate efforts. This involves two problems: first, the cooperation
problem, aligning the interests of individuals who have divergent goals; second, the
coordination problem, even in the absence of goal conflict, how do individuals harmo-
nize their separate efforts?

The Cooperation Problem

The economics literature analyzes cooperation problems arising from goal misalign-
ment as the agency problem.11 An agency relationship exists when one party (the
principal) contracts with another party (the agent) to act on behalf of the principal. The
problem is ensuring that the agent acts in the principal’s interest. Particular attention has
been given to agency problems arising between owners (shareholders) and managers.
The central issue of corporate governance is ensuring that managers act in the inter-
ests of shareholders. However, agency problems exist throughout the entire hierarchy:
employees tend to pursue their own interests rather than those of their organization.
Even organizational goals fragment as a result of specialization as each department
creates its own subgoals. The classic conflicts are between different functions: sales
wishes to please customers, production wishes to maximize output, R & D wants to
introduce mind-blowing new products, while finance worries about profit and loss.

Several mechanisms are available to management for achieving goal alignment
within organizations:

● Control mechanisms typically operate through hierarchical supervision: man-
agers supervise the behavior and performance of subordinates using positive
and negative incentives. The principal positive incentive is the oppor-
tunity for promotion up the hierarchy; negative incentives are dismissal
and demotion.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 137

● Performance incentives link rewards to output: they include piece rates for pro-
duction workers and profit bonuses for executives. Performance-related incen-
tives have the advantages of being “high powered”—rewards are directly related
to performance—and they avoid the need for costly monitoring and supervision
of employees. Pay-for-performance is less effective when employees work in
teams or where output is difficult to measure.

● Shared values. Some organizations achieve high levels of cooperation and
low levels of goal conflict without resorting to either punitive controls or
performance incentives. The members of churches, charities, and voluntary
organizations often share values that support common purpose. Similarly,
for business enterprises, as we saw in Chapter 2 (see pp. 52–53), shared values
among members encourage the convergence of interests and perceptions that
facilitate consensus and enhances performance.12 In doing so, shared values
can act as a control mechanism that is an alternative to bureaucratic control or
financial incentives. An organization’s values are one component of its culture.
Strategy Capsule 6.1 discusses the role of organizational culture in aligning
individual actions with company strategy.

● Persuasion. Implementing strategy requires leadership and at the heart of lead-
ership is persuasion. J.-C. Spender argues that, language is central, both to the
conceptualization of strategy and to its implementation.13 Leadership requires
influencing others, where rhetoric—the use of language for persuasion—is a
core skill. Management rhetoric is not simply about communicating strategy; it
involves changing the perceptions of organizational members, their relationships
with the organization, and, ultimately, guiding their actions to actualize the
strategy in the face of uncertainty and ambiguity.

The Coordination Problem

Willingness to cooperate is not enough to ensure that organizational members integrate
their efforts—it is not a lack of a common goal that causes Olympic relay teams to drop
the baton. Unless individuals can find ways of coordinating their efforts, production
does not happen. As we shall see in our discussion of organizational capabilities, the
exceptional performance of Disney theme parks, the Ferrari Formula 1 pit crew, and
the US Marine Corps band derives less from the skills of the individual members and
more from superb coordination among them.

Mechanisms for coordination include the following:

● Rules and directives: A basic feature of all firms is a general employment
contract under which individuals agree to perform a range of duties as required
by their employer. This allows managers to exercise authority by means of
general rules (“Secret agents on overseas missions will have essential expenses
reimbursed only on production of original receipts”) and specific directives
(“Miss Moneypenny, show Mr Bond his new toothbrush with 4G communica-
tion and a concealed death ray”).

● Mutual adjustment: The simplest form of coordination involves the mutual
adjustment of individuals engaged in related tasks. In soccer or doubles
tennis, players coordinate their actions spontaneously without direction or
established routines. Such mutual adjustment occurs in leaderless teams and
is especially suited to novel tasks where routinization is not feasible.

138 PART II THE TOOLS OF STRATEGY ANALYSIS

● Routines: Where activities are performed repeatedly, coordination becomes
routinized. As we shall see in more detail when we discuss processes,
organizational routines are “regular and predictable sequences of coordinated
actions by individuals” that provide the foundation of organizational capability.
If organizations are to perform complex activities efficiently and reliably, rules,
directives, and mutual adjustments are not enough—coordination must become
embedded in routines.

STRATEGY CAPSULE 6.1

Organizational Culture as an Integrating Device

Corporate culture comprises the beliefs, values, and

behavioral norms of the company, which influence

how employees think and behave.a It is manifest in

symbols, ceremonies, social practices, rites, vocabulary,

and dress. While shared values are effective in aligning

the goals of organizational members, culture exercises

a wider influence on an organization’s capacity for pur-

poseful action. Organizational culture is a complex

phenomenon. It is shaped by the national and ethnic

cultures within which the firm is embedded and the

social and professional cultures of organizational mem-

bers. Most of all, it is a product of the organization’s his-

tory, especially the founder’s personality and beliefs: the

corporate culture of Walt Disney Company continues to

reflect the values, aspirations, and personal style of Walt

Disney. A corporate culture is seldom homogeneous:

different cultures coexist within different functions and

departments.

Culture can facilitate both cooperation and

coordination through fostering social norms and a sense

of identity. Cultures can also be divisive and dysfunc-

tional. At the British bank NatWest during the 1990s, John

Weeks identified a “culture of complaining” which was a

barrier to top-down strategy initiatives.b A culture may

support some types of corporate action but handicap

others. Lehman Brothers (whose collapse in September

2008 triggered the global financial crisis) was renowned

for its individualistic, entrepreneurial culture whose

downside was ineffective risk management. The culture

of the British Broadcasting Corporation reflects internal

politicization, professional values, and dedication to the

public good, but a lack of customer focus.c

Cultures take a long time to develop and cannot

easily be changed. As the external environment changes,

a highly effective culture may become dysfunctional. The

police forces of some US cities have developed cultures

of professionalism and militarism, which increased their

effectiveness in fighting crime, but led to isolation and

unresponsiveness to community needs.d

Despite its power in determining how an orga-

nization behaves, culture is far from being a flexible

management tool at the disposal of chief executives. It

is a property of the organization as a whole, which is not

amenable to manipulation. CEOs inherit rather than cre-

ate the culture of their organizations. The key issue is to

recognize the culture of the organization and to ensure

that structure and systems work with the culture and not

against it. Where strategy is aligned with organizational

culture, it can act as a control device and a source of flex-

ibility: when individuals internalize the goals and princi-

ples of the organization, they can be allowed to use their

initiative and creativity in their work.

Notes:
aE. H. Schein, “Organizational Culture,” American Psychologist 45
(1990): 109–119.
bJ. Weeks, Unpopular Culture: The Ritual of Complaint in a British
Bank (Chicago: University of Chicago Press, 2004).
cT. Burns, The BBC: Public Institution and Private World (London:
Macmillan, 1977).
d“Policing: Don’t Shoot,” Economist (December 13, 2014): 37.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 139

The relative roles of these different coordination devices depend on the types of
activity being performed and the intensity of collaboration required. Rules are highly
efficient for activities where standardized outcomes are required—most quality- control
procedures involve the application of simple rules. Routines are essential for activ-
ities where close interdependence exists between individuals, be the activity a basic
production task (supplying customers at Starbucks) or more complex (performing
a heart bypass operation). Mutual adjustment works best for nonstandardized tasks
(such as problem-solving), where those involved are well informed of the actions of
their coworkers, either because they are in close visual contact (a chef de cuisine and
her sous chefs) or because of information exchange (a design team using interactive
CAD software).

Developing Organizational Capability

Translating strategy into action requires organizational capability. Hence, the develop-
ment and deployment of organizational capabilities lies at the core of strategy imple-
mentation. So far, we have said little about the determinants of organizational capability
beyond recognizing that capabilities involve combining resources to perform a task. Let
us look more closely at the structure of organizational capability in the light of our pre-
ceding discussion of the fundamentals of organizing.

Capabilities require resources, and the level of capability depends, to some degree,
upon the amount and quality of these resources. However, there is more to capa-
bility than resources alone. In sport, all-star teams can be beaten by teams that create
strong capabilities from modest resources. In 1992, the US men’s Olympic basketball
team—the “Dream Team” that included Charles Barkley, Larry Bird, Patrick Ewing,
Magic Johnson, Michael Jordan, Karl Malone, and Scottie Pippen—lost to a team of
college players in one of their practice games. In Euro 2016, the English soccer team,
with a market value of $810 million, was eliminated by Iceland, a team valued at
$30 million. Similarly, in business: upstarts with modest resources can outcompete
established giants—Dyson against Electrolux in domestic appliances, ARM against Intel
in microprocessors, Spotify against Apple in streamed music. Clearly, there is more to
organizational capability than just resources.

The effectiveness with which resources—people especially—are integrated to cre-
ate capabilities depends upon three major factors: processes, motivation, and structure.
These are depicted in Figure 6.2.

ORGANIZATIONAL
CAPABILITIES

RESOURCES

Motivation StructureProcesses

FIGURE 6.2 Integrating resources to build capability

140 PART II THE TOOLS OF STRATEGY ANALYSIS

Processes

The academic literature views organizational capability as based upon organizational
routines—“regular and predictable behavioral patterns [comprising] repetitive patterns
of activity” that determine what firms do, who they are, and how they develop.14 Like
individual skills, organizational routines develop through learning-by-doing—and, if
not used, they wither.

However, the academic literature’s emphasis on routines as an emergent phenomenon
ignores the role of management. In practice, patterns of coordination among organi-
zational members to undertake a productive task are planned by managers who use
learning-before-doing as a vital preliminary to learning-by-doing. For this reason, I
emphasize organizational processes over organizational routines, where a process is
a coordinated sequence of actions through which specific productive tasks are per-
formed. Not only is the term process well understood by managers, but there are
established tools for their design, mapping, and development.15

Motivation

Processes provide the basis for team members to coordinate their individual actions;
however, the effectiveness of the coordination depends upon the extent of their
motivation. We discussed motivation in relation to the challenge of aligning the goals
of individuals with those of the organization. Team motivation is more complex: it
depends not only on each individual’s willingness to strive in performing his/her
specific task but also on a willingness to subordinate individuals to team goals. Despite
decades of research, the determinant of exceptional team performance remains a
mystery—which is why outstandingly successful sports coaches—Alex Ferguson,
Joe Gibbs, John Wooden, Scotty Bowman—command huge fees on the corporate
lecture circuits.

Structure

The people and processes that contribute to an organizational capability need to
be located within the same organizational unit if they are to coordinate effectively.
Processes that span internal organizational boundaries rarely achieve high levels
of capability. Until the mid-1980s, European and US automakers used a sequential
system of new product development which began in marketing then went, in turn,
to styling, engineering, manufacturing, and finance. When they adopted the cross-
functional product development teams pioneered by Toyota and Honda, the time to
develop a new model of car was halved.16 As companies develop new capabilities,
so their organizational structures become more complex. Strategy Capsule 6.2 shows
the evolution of organizational structure at a management consulting company as it
developed specialist capabilities.

The design of organizational structure is a broad topic that cannot be reduced to
the simple principle of locating each organizational process within an organizational
unit. So let us consider more generally the basic issues that are involved in the design
of organizational structures.

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 141

STRATEGY CAPSULE 6.2

Capability Development and Organizational Structure
at Booz & Company

During the 1990s, Booz Allen Hamilton (now Strategy&,

a subsidiary of PwC) transitioned from a “generalist” to a

“specialist” model of management consulting. Under the

generalist model, consultants were located in one of its

28 offices throughout the world and were then assigned

to one or more consulting projects. The expectation was

that they would develop, through experience, broad-

based consulting expertise that was not specific either

to a particular management function or particular sector.

Booz’s managing partner referred to the firm as “a colony

of artists” (see Figure 6.3a).

During the 1990s, Booz recognized the need to

develop specialist capabilities in relation to individual

management functions (such as strategy, operations,

information technology, and change management) and

specific sectors (e.g., energy, telecom, financial services,

and automobiles). To develop these specialist capabilities,

Booz adopted a matrix structure comprising functional

practices and sector practices (see Figure  6.3b). Hence,

a new consultant or associate joining Booz would be

located within a particular office and assigned to one or

more client teams, but training and career development

purposes would also be part of a functional practice and

a sector practice.

FIGURE 6.3 Booz Allen Hamilton (Worldwide commercial business)

b 1998: Organizing for capabilitya 1992: “A colony of artists”

FUNCTIONAL PRACTICES

P
R
A
C
T
I
C
E
S

I
N
D
U
S
T
R
Y

NY Tokyo London

Strategy Operations IT
Financial
services

Energy

Telecom

Consumer

Engineering

Chemicals
/Pharma

P r o j e c t Te a m sP r o j e c t Te a m s

NY

Tokyo

London

Project Teams

Project Teams

Project Teams

Project Teams

Project Teams

Project Teams

142 PART II THE TOOLS OF STRATEGY ANALYSIS

Organization Design

Designing structures that can reconcile efficiency through specialization with effective
integration is a major management challenge that is informed by a substantial body of
organizational theory. Let us restrict ourselves to four issues that are especially rele-
vant to implementing strategy. We begin by acknowledging the need for hierarchy—all
organizations are hierarchical to a greater or lesser degree. We go on to consider how
to define organizational units within these hierarchies. We then examine how these
organizational units are configured within the overall structure of the company. Finally,
we look at formality within organizations and the relative merits of mechanistic and
organic structures.

The Role of Hierarchy

Hierarchy is the fundamental feature of all but the simplest organizations and the
primary mechanism for achieving coordination and cooperation. Despite the nega-
tive images that hierarchy often conveys, there are no viable alternatives for complex
organizations—the critical issue is how hierarchy should be structured and how its var-
ious parts should be linked. Hierarchy is a solution both to the problem of cooperation
and the problem of coordination.

Hierarchy as Mechanism for Cooperation: Hierarchy is system of control
through authority: each member of the organization reports to a superior and has
subordinates to supervise and monitor. Hierarchy is a core feature of bureaucracy—
a formalized administrative system devised by the Qin emperor of China in about
220BC, and deployed ever since in public administration, the military, and commerce.
For the German sociologist, Max Weber, bureaucracy was the most efficient and
rational way to organize human activity. It involves “each lower office under the con-
trol and supervision of a higher one”; a “systematic division of labor”; formalization
in writing of “administrative acts, decisions, and rules”; and work governed by stan-
dardized rules and operating procedures. Authority is based on “belief in the legality
of enacted rules and the right of those elevated to authority under such rules to issue
commands.”17

Hierarchy as Coordination: Hierarchy is a feature not only of human organiza-
tions, but of all complex systems:

● The human body comprises subsystems such as the respiratory system, nervous
system, and digestive system, each of which consists of organs, each of which is
made up of individual cells.

● The physical universe is a hierarchy with galaxies at the top, solar systems below,
planets below that, and so on, all the way down to atoms and subatomic particles.

● A novel is organized by chapters, paragraphs, sentences, words, and letters.

The basic principle here is that of modularity: dividing complex systems into hierarchi-
cally organized components.18 Modular, hierarchical structures have two major advan-
tages in coordinating productive activities:

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 143

● Economizing on coordination: Hierarchy reduces the amount of communica-
tion needed to coordinate the activities of organizational members. Suppose
that the optimal span of control is five. In a group of six individuals, there
are 15 bilateral interactions, if one member is appointed coordinator, there
are five vertical interactions. Similarly, a group of 25 involves 250 bilateral
interactions; a hierarchical system with a span of control of five requires a
three-tier hierarchy and 24 interactions. The larger the number of organiza-
tional members, the greater the efficiency benefits from organizing hierar-
chically. Complex computer software can require large development teams:
Microsoft’s Windows 8 development team comprised about 3200 software
development engineers, test engineers, and program managers. These were
organized into 35 “feature teams,” each of which was divided into a number
of component teams. As a result, each engineer needed to coordinate only
with the members of his or her immediate team. The modular structure
of the Windows 8 development team mirrored the modular structure of
the product.

● Adaptability: Hierarchical, modular systems can evolve more rapidly than uni-
tary systems. This adaptability requires decomposability: the ability of each
component subsystem to operate with some measure of independence from
the other subsystems. Modular systems that allow significant independence for
each module are referred to as loosely coupled.19 The modular structure of Win-
dows enabled a single feature team to introduce innovative software features
without the need to coordinate with all 34 other teams. The key requirement is
that the different modules must fit together—this requires a standardized inter-
face. Entire companies may be viewed as loosely coupled modular structures. At
Procter & Gamble, decisions about developing new shampoos can be made by
the Beauty, Hair, and Personal Care sector without involving P&G’s other three
sectors (Baby, Feminine, and Family Care; Fabric and Home Care; and Health
and Grooming). A modular structure also makes it easier to add new businesses
and divest others—in 2015, P&G sold its cosmetics and fragrances business
to Coty.20

Organizational capabilities can also be viewed as being organized hierarchically. In
the petroleum sector, drilling capability is composed of several specialist capabilities;
then drilling capability links with other capabilities to form overall exploration capa-
bility (see Figure 6.4). Similarly with Apple’s new product development capability, this

Negotiating
Capability

Geological
Capability

Directional
Drilling

Capability

Well
Logging

Capability

Deepwater
Drilling

Capability

Well
Casing

Capability

Hydraulic
Fracturing
Capability

Seismic
Capability

Drilling
Capability

Well Construction
Capability

Partnering
Capability

Procurement
Capability

Exploration Capability

FIGURE 6.4 The hierarchical structure of organization capabilities: The case of oil
and gas exploration

144 PART II THE TOOLS OF STRATEGY ANALYSIS

too is a higher-level capability that combines an array of lower-level capabilities such as
market insight, microelectronic capability, software engineering, design aesthetics, and
partner relations management. Because these upper-level capabilities integrate such a
broad span of specialist know-how, they are difficult for others to imitate.

Defining Organizational Units

An organizational hierarchy is composed of organizational units—but how should we
define these units? The principle we have established so far is that organizational struc-
ture should be aligned with processes: those who perform a process should be located
within the same organizational unit. The fundamental issue is intensity of coordination
needs: those individuals who need to interact most closely should be located within
the same organizational unit. In the case of McDonald’s, the store managers and crew
members undertake food preparation, cooking, and cleaning: the individual store is the
basic organizational unit. At Infosys Consulting, a client engagement may involve con-
sultants and software engineers at different Infosys offices throughout the world as well
as those at the client site: the project team is the appropriate organizational unit—even
if it is temporary and spans multiple locations. However, individuals’ organizational
roles typically involve them in multiple processes—which should take precedence
when defining organizational units? James Thompson’s answer was “Where interdepen-
dence among organizational members is most intense.”21

Alternative Structural Forms: Functional,
Multidivisional, Matrix

The same principle of defining organizational units in the basis of the intensity of
interdependence also applies to the integration of lower-level organizational units
into higher-level units. On the basis of these alternative approaches to grouping tasks
and activities, we can identify three basic organizational forms for companies: the
functional structure, the multidivisional structure, and the matrix structure.

The Functional Structure Single-business firms tend to be organized by
function. Most airlines have functional structures (see Figure 6.5). Grouping together
functionally similar tasks is conducive to exploiting scale economies, promoting
learning and capability building, and deploying standardized control systems.
Since cross- functional integration occurs at the top of the organization, functional

Finance
Legal &

Regulatory Technology
Human

ResourcesMarketingOperations

Board of Directors

CEO
Michael O’Leary

FIGURE 6.5 Ryanair Holdings plc: Organizational structure

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 145

structures are conducive to a high degree of centralized control by the CEO and top
management team.

As functionally organized companies grow and diversify, so there are pressures to
decentralize through adopting a divisional structure (see below). However, as com-
panies and their industries mature, the advantages of efficiency, centralized control,
and well-developed functional capabilities can cause companies to revert to functional
structures. General Motors, a pioneer of the multidivisional structure, integrated its
product divisions and overseas subsidiaries into a more integrated functional structure
as scale economies became its dominant strategic priority.

The Multidivisional Structure In a multidivisional corporation, the divisions are
separate businesses, defined by product or geography. The key advantage of the multi-
divisional structure is the potential for decentralized decision-making. It is a loosely
coupled, modular organization where business-level strategies and operating decisions
can be made at the divisional level, while the corporate headquarters concentrate on
corporate planning, budgeting, and providing common services.

The effectiveness of the multidivisional form depends on the ability of the corporate
center to apply a common management system to the different businesses. At ITT, Harold
Geneen’s “managing by the numbers” allowed him to cope with over 50 divisional heads
reporting directly to him. At BP, a system of “performance contracts” allowed CEO John
Browne to oversee BP’s 24 businesses, each of which reported directly to him. Divi-
sional autonomy also fosters the development of leadership capability among divisional
heads—an important factor in grooming candidates for CEO succession.

The large, divisionalized corporation is typically organized into three levels: the
corporate center, the divisions, and the individual business units, each representing a
distinct business for which financial accounts can be drawn up and strategies formu-
lated. Figure 6.6 shows General Electric’s organizational structure at the corporate and
divisional levels. Chapter 14 will look in greater detail at the management of the multi-
divisional corporation.

Matrix Structure Whatever the primary basis for grouping, all companies that
embrace multiple products, multiple functions, and multiple locations must coordinate
across all three dimensions. Organizational structures that formalize coordination and
control across multiple dimensions are called matrix structures.

Corporate Executive O�ce
Chairman & CEO

Corporate Sta�
-Business Development
-Commercial & Public Relations
-Human Resources

-Legal
-Global Research
-Finance

GE
Power

GE
Digital

GE
Health care

GE
Capital

GE
Renewable

Energy

GE
Aviation

GE Trans-
portation

Current
powered

by GE

Baker
Hughes

FIGURE 6.6 General Electric: Organizational structure, January 2018

146 PART II THE TOOLS OF STRATEGY ANALYSIS

Figure  6.7 shows the Shell management matrix (prior to reorganization in 1996).
Within this structure, the general manager of Shell’s Berre refinery in France reported
to his country manager, the managing director of Shell France, but also to his business
sector head, the coordinator of Shell’s refining sector, as well as having a functional
relationship with Shell’s head of manufacturing.

Many diversified, multinational companies, including Philips, Nestlé, and Unilever,
adopted matrix structures during the 1960s and 1970s, although in all cases one
dimension of the matrix tended to be dominant in terms of authority. Thus, in the
old Shell matrix, the geographical dimension, as represented by country heads and
regional coordinators, had primary responsibility for budgetary control, personnel
appraisal, and strategy formulation.

Since the 1980s, the matrix structure has fallen out of favor and several large corpo-
rations have claimed to have dismantled their matrix organizations: “They led to conflict
and confusion; the proliferation of channels created informational logjams as a pro-
liferation of committees and reports bogged down the organization; and overlapping
responsibilities produced turf battles and a loss of accountability.”22 Yet, any company
that operates over multiple products, multiple functions, and multiple geographical

RE
GI

ON
S

Ea
st

an
d

Au
str

ala
sia

Eu
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FIGURE 6.7 Royal Dutch Shell Group: Pre-1996 matrix structure

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 147

markets has to coordinate with each of these dimensions. So, all multifunctional, multi-
product, multinational companies are de facto matrix organizations. The problem is
over-formalization, resulting in a top-heavy corporate HQ and over-complex systems
that slow decision-making and dull entrepreneurial initiative. The trend has been for
companies to focus on formal systems of coordination and control on one dimension,
then allowing the other dimensions of coordination to be mainly informal. Thus, while
Shell claims to have dismantled its matrix and organized itself around four business sec-
tors, the reality is that it still has country heads, responsible for coordinating all Shell’s
activities in relation to legal, taxation, and government relations within each country,
and functional heads, responsible for technical matters and best-practice transfer within
their particular function.

Systems and Style: Mechanistic versus Organic
Organizational Forms

So far, we have looked just at structure—the architecture of organizations. Equally
important are the systems through which the structure operates and the management
styles through which these systems are manifest. During the first half of the 20th century,
management thought was dominated by Weber’s theory of bureaucracy and Frederick
Taylor’s rational approach to job design and employee incentives. During the 1950s, the
human relations school of management recognized the importance of social relation-
ships within organizations and adverse impact of inertia and alienation on employee
effort. “Theory X” had been challenged by “Theory Y.”23 The important issue here is
that different types of management suit different circumstances. Among Scottish engi-
neering companies, Burns and Stalker found that firms in stable environments had
mechanistic forms, characterized by formality and high degrees of job specialization;
those in less stable markets had organic forms that were less formal and more flex-
ible.24 Table 6.1 contrasts key characteristics of the two forms.

This principle that an organization’s structure, systems, and management style should
reflect the environment, in which it operates forms the basis of contingency theory—
there is no one best way to organize; it depends upon circumstances.25 Although
Alphabet (Google) and McDonald’s are both large international companies, their struc-
tures and systems are very different. McDonald’s is highly bureaucratized: high levels

TABLE 6.1 Mechanistic versus organic organizational forms

Feature Mechanistic forms Organic forms

Task definition Rigid and highly specialized Flexible and broadly defined

Coordination and control Rules and directives vertically
imposed

Mutual adjustment, common culture

Communication Vertical Vertical and horizontal

Knowledge Centralized Dispersed

Commitment and loyalty To immediate superior To the organization and its goals

Environmental context Stable with low technological
uncertainty

Dynamic with significant technological
uncertainty and ambiguity

Source: Adapted from Richard Butler, Designing Organizations: A Decision-Making Perspective (London: Routledge,
1991): 76, by permission of Cengage Learning.

148 PART II THE TOOLS OF STRATEGY ANALYSIS

of job specialization, formal systems, and a strong emphasis on rules and procedures.
Google emphasizes informality, low job specialization, horizontal communication, and
the importance of principles over rules. These differences reflect differences in strategy,
technology, human resources, and the dynamism of the business environments that
each firm occupies. In general, the more standardized are a firm’s products (beverage
cans, blood tests, or haircuts for army inductees) and the more stable its environ-
ment, the greater are the efficiency advantages of mechanistic approach with stan-
dard operating procedures and high levels of specialization. Once markets become
turbulent, or innovation becomes desirable, or buyers require customized products—
then the bureaucratic model breaks down.

Contingency also requires the functions within a company to be organized differ-
ently. At my university, admissions, student records, and accounting operate on bureau-
cratic principles; research, fund raising, and external relations are organized organically.

As the business environment has become increasingly turbulent, the trend has been
toward organic approaches to organizing, which have tended to displace more bureau-
cratic approaches. Since the mid-1980s, almost all large companies have made strenuous
efforts to restructure and reorganize to achieve greater flexibility and responsiveness.
Within their multidivisional structures, companies have decentralized decision-making,
reduced their number of hierarchical layers, shrunk headquarters staffs, emphasized
horizontal rather than vertical communication, and shifted the emphasis of control from
supervision to accountability.

However, the trend has not been one way. The financial crisis of 2008 and its after-
math have caused many companies to reimpose top-down control. Greater awareness
of the need to manage financial, environmental, and political risks in sectors such as
banking, petroleum, and mining have also reinforced centralized control and reliance on
rules. Many companies follow the cycles of centralization and decentralization that may
be a means by which they balance the trade-off between integration and flexibility.26

Developments in information and communication technology (ICT) have worked in
different directions. In some cases, the automation of processes has permitted their cen-
tralization and bureaucratization (think of the customer services at your bank or telecom
supplier). In other areas, ICT has encouraged informal approaches to coordination. The
huge leaps in the availability of information available to organizational members and
the ease with which they can communicate with one another have increased vastly the
capacity for mutual adjustment without the need for intensive hierarchical guidance
and leadership.

Recent Trends in Organizational Design

Consultants and management scholars have proclaimed the death of hierarchical struc-
tures and the emergence of new organizational forms. Two decades ago, two of Ameri-
ca’s most prominent scholars of organization identified a “new organizational revolution”
featuring “flatter hierarchies, decentralized decision-making, greater tolerance for ambi-
guity, permeable internal and external boundaries, empowerment of employees, capacity
for renewal, self-organizing units, and self-integrating coordination mechanisms.”27

In practice, there has been more organizational evolution than organizational revolu-
tion. Certainly, major changes have occurred in the structural features and management
systems of industrial enterprises, yet there is little that could be described as radical
organizational innovation or discontinuities with the past. Hierarchy remains the basic
structural form of almost all companies, and the familiar structural configurations—
functional, divisional, and matrix—are still evident. Nevertheless, within these familiar
structural features, change has occurred:

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 149

● Delayering: Companies have made their organizational hierarchies flatter. The
motive has been to reduce costs and to increase organizational responsiveness.
Wider spans of control have also changed the relationships between managers
and their subordinates, resulting in less supervision and greater decentralization
of initiative. At General Electric, Jack Welch reduced the number of hierarchical
levels from nine to five throughout most of the company. As a result, senior
executives had up to 25 subordinates directly reporting to them, forcing them to
decentralize decision-making.

● Adhocracy and team-based organization: Adhocracies, according to Henry
Mintzberg, are organizations that feature shared values, high levels of partic-
ipation, flexible communication, and spontaneous coordination. Hierarchy,
authority, and control mechanisms are largely absent.28 Adhocracies tend to exist
where problem-solving and other nonroutine activities predominate and where
expertise is prized. Team-based organizations engaged in research, consulting,
engineering, and entertainment tend to be adhocracies, as are some technology-
based startup companies.

● Project-based organizations: Consulting and construction companies are
organized around projects, the defining characteristic of which is that work
assignments have finite lives, hence the organization structure needs to be
dynamically flexible. Because every project is different and involves a sequence
of phases, each project needs to be undertaken by a closely interacting team
that is able to draw upon the know-how of previous and parallel project teams.
As cycle times become compressed across more and more activities, project-
based organization is becoming increasingly common across the business sector.

● Network structures: A major feature of the shift from formal to informal orga-
nizational structures is that coordination is determined less by hierarchical
structures and more by social networks—the patterns of interactions among
organizational members. The importance of social networks to the behavior
and performance of organizations has led several management thinkers to rec-
ommend that these informal social structures be the primary basis for orga-
nizational structure and supplant traditional, formal structures. Thus, Gunnar
Hedlund and Bartlett and Ghoshal have proposed network-based models of the
multinational corporation.29 Advances in information and communications tech-
nology have greatly enhanced the potential for coordination to occur spontane-
ously without the need for formal organizational structure.

● Permeable organizational boundaries: Network relationships are not limited by
company boundaries. As firms specialize around their core competencies and
products become increasingly complex, so these interfirm networks become
increasingly important. As we shall see when we look more closely at strategic
alliances (Chapter 15), localized networks of closely interdependent firms are
features not only of traditional industrial districts such as those of northern Italy,30
but also the high-tech clusters such as the concentration of Formula 1 construc-
tors in Britain’s “Motorsport Valley” and Israel’s medical electronics cluster.31

Common to these emerging organizational phenomena are:

● A focus on coordination rather than on control: In contrast to the command-
and-control hierarchy, these structures focus almost wholly on achieving
coordination. Financial incentives, culture, and social controls take the place of
hierarchical control.

150 PART II THE TOOLS OF STRATEGY ANALYSIS

● Reliance on informal coordination where mutual adjustment replaces rules
and directives: Central to all nonhierarchical structures is their dependence
on voluntary coordination through bilateral and multilateral adjustment. The
capacity for coordination through mutual adjustment has been greatly enhanced
by information technology.

● Individuals occupying multiple organizational roles thereby requiring informal
structures that facilitate flexibility and responsiveness.

Summary

Strategy formulation and strategy implementation are closely interdependent. The formulation of
strategy needs to take account of an organization’s capacity for implementation; at the same time, the
implementation process inevitably involves creating strategy. If an organization’s strategic management
process is to be effective then its strategic planning system must be linked to actions, commitments
and their monitoring, and the allocation of resources. Hence, operational plans and capital expenditure
budgets are critical components of a firm’s strategic management system.

Strategy implementation involves the entire design of the organization. By understanding the
need to reconcile specialization with cooperation and coordination, we are able to appreciate the
fundamental principles of organizational design.

Applying these principles, we can determine how best to allocate individuals to organizational units
and how to combine these organizational units into broader groupings—in particular, the choice bet-
ween basic organizational forms such as functional, divisional, or matrix organizations.

We have also seen how companies’ organizational structures have been changing in recent years,
influenced both by the demands of their external environments and the opportunities made available
by advances in information and communication technologies.

The chapters that follow will have more to say on the organizational structures and management sys-
tems appropriate to different strategies and different business contexts. In the final chapter (Chapter 16),
we shall explore some of the new trends and new ideas that are reshaping our thinking about organi-
zational design.

Self-Study Questions

1. Jack Dorsey, the CEO of Twitter, Inc., has asked for your help in designing a strategic planning
system for the company. Would you recommend a formal strategic planning system with an
annual cycle such as that outlined in “The Strategic Planning System: Linking Strategy to Action”
and Figure 6.1? (Note: Twitter’s strategy is summarized in Strategy Capsule 1.5 in Chapter 1.)

2. Select a persistently successful team in a professional sport with which you are familiar. To
what extent can the superior capabilities of this team be attributed to the role of processes,
motivation, and structure (as discussed in the section “Developing Organizational Capability”)?

CHAPTER 6 ORGANIZATION STRUCTURE AND MANAGEMENT SYSTEMS 151

3. Within your own organization (whether a university, company, or not-for-profit organization),
which departments or activities are organized mechanistically and which organically? To what
extent does the mode of organization fit the different environmental contexts and technol-
ogies of the different departments or activities?

4. In 2008, Citigroup announced that its Consumer business would be split into Consumer
Banking, which would continue to operate through individual national banks, and Global
Cards, which would form a single global business (similar to Citi’s Global Wealth Management
division). On the basis of the arguments relating to the “Defining Organizational Units” section
above, why should credit cards be organized as a global unit and all other consumer banking
services as national units?

5. The examples of Apple and General Motors (see “Functional Structure” section above) point
to the evolution of organizational structures over the industry life cycle. During the growth
phase, many companies adopt multidivisional structures; during maturity and decline, many
companies revert to functional structures. Why might this be? (Note: you may wish to refer to
Chapter 8, which outlines the main features of the life-cycle model.)

6. Draw an organizational chart for a business school that you are familiar with. Does the school
operate with a matrix structure (for instance, are there functional/discipline-based depart-
ments together with units managing individual programs)? Which dimension of the matrix is
more powerful, and how effectively do the two dimensions coordinate? How would you reor-
ganize the structure to make the school more efficient and effective?

Notes

1. L. Bossidy and R. Charan, Execution: The Discipline of Get-
ting Things Done (New York: Random House, 2002): 71.

2. H. Mintzberg, “Patterns of Strategy Formulation,”
Management Science 24 (1978): 934–948; “Of Strategies:
Deliberate and Emergent,” Strategic Management Journal
6 (1985): 257–272.

3. Apple Computer: Preliminary Confidential Offering Mem-
orandum, 1978. http://www.computerhistory.org/collec-
tions/catalog/102712693.

4. MCI Communications: Planning for the 1990s (Harvard
Business School Case No. 9-190-136, 1990): 1.

5. For a description of the strategic planning systems of
the world’s leading oil and gas majors, see R. M. Grant,
“Strategic Planning in a Turbulent Environment: Evidence
from the Oil Majors,” Strategic Management Journal 24
(2003): 491–518.

6. “Eni 2016 Results and 2017–2020 Strategic Plan” (Rome:
Eni, March 1, 2017).

7. D. W. Eisenhower, “Remarks at the National Defense
Executive Reserve Conference” (November 14, 1957).

8. P. F. Drucker, The Practice of Management (New York:
Harper, 1954).

9. L. Bossidy and R. Charan, Execution: The Discipline
of Getting Things Done (New York: Random House,
2002): 227.

10. A. Smith, The Wealth of Nations (London: Dent, 1910): 5.
11. K. Eisenhardt, “Agency Theory: An Assessment and Reviews,”

Academy of Management Review 14 (1989): 57–74.
12. T. Peters and R. Waterman, In Search of Excellence

(New York: Harper & Row, 1982).
13. J.-C. Spender, Business Strategy: Managing Uncertainty,

Opportunity, and Enterprise (Oxford: Oxford University
Press, 2014).

14. R. Nelson and S.G. Winter, An Evolutionary Theory of
Economic Change (Cambridge, MA: Belknap, 1982).

15. T. W. Malone, K. Crowston, J. Lee, and B. Pentland,
“Tools for Inventing Organizations: Toward a Handbook
of Organizational Processes,” Management Science 45
(1999): 425–43.

16. K. B. Clark and T. Fujimoto, Product Development
Performance (Boston: Harvard Business School Press,
1991): 29–30.

17. M. Weber, Economy and Society: An Outline of Interpretive
Sociology (Berkeley, CA: University of California Press, 1968).

18. H. A. Simon, “The Architecture of Complexity,”
Proceedings of the American Philosophical Society 106
(1962): 467–482.

19. J. D. Orton and K. E. Weick, “Loosely Coupled Systems: A
Reconceptualization,” Academy of Management Review 15
(1990): 203–223.

152 PART II THE TOOLS OF STRATEGY ANALYSIS

20. “P&G Faces Up to Mistakes in Beauty Business,” Wall Street
Journal (November 9, 2015).

21. J. D. Thompson, Organizations in Action (New York:
McGraw-Hill, 1967).

22. C. A. Bartlett and S. Ghoshal, “Matrix Management: Not
a Structure, a Frame of Mind,” Harvard Business Review
( July/August 1990): 138–145.

23. “Idea: Theories X and Y,” The Economist online extra
(October 6, 2008), www.economist.com/node/12370445,
accessed December 18, 2017.

24. T. Burns and G. M. Stalker, The Management of Innovation
(London: Tavistock, 1961).

25. L. Donaldson, “Contingency Theory (Structural),” in
R. Thorpe and R. Holt (eds.), The Sage Dictionary of
Qualitative Management Research (London: Sage, 2008).

26. J. Nickerson and T. Zenger refer to this as structural
modulation: “Being Efficiently Fickle: A Dynamic Theory
of Organizational Choice,” Organization Science 13
(2002): 547–567.

27. R. Daft and A. Lewin, “Where Are the Theories for the New
Organizational Forms?” Organization Science 3 (1993): 1–6.

28. H. Mintzberg, Structure in Fives: Designing Effective
Organizations (Englewood Cliffs, NJ: Prentice Hall, 1993):
Chapter 12.

29. G. Hedlund, “The Hypermodern MNC: A Heterarchy?”
Human Resource Management 25 (1986): 9–35; C. Bartlett
and S. Ghoshal, Managing across Borders: The Trans-
national Solution, 2nd edn (Boston, Harvard Business
School, 1998).

30. M. H. Lazerson and G. Lorenzoni, “The Firms That Feed
Industrial Districts: A Return to the Italian Source,”
Industrial and Corporate Change 8 (1999): 235–266; A.
Grandori, Interfirm Networks (London: Routledge, 1999).

31. “Motorsport Valley Looks Beyond Automotive Sectors,”
Financial Times ( July 4, 2014); “Israel’s Tech Startups Are
Giving Silicon Valley a Run for Its Money,” New York Post
(May 28, 2017).

III
BUSINESS

STRATEGY AND
THE QUEST FOR

COMPETITIVE
ADVANTAGE

7 The Sources and Dimensions of Competitive Advantage

8 Industry Evolution and Strategic Change

9 Technology-based Industries and the Management
of Innovation

7

If you don’t have a competitive advantage—don’t compete!

JACK WELCH, CEO, GENERAL ELECTRIC 1981–2001.

The Sources and
Dimensions of
Competitive Advantage

◆ Introduction and Objectives

◆ How Is Competitive Advantage Established?

● External Sources of Competitive Advantage

● Internal Sources of Competitive Advantage: Strategic
Innovation through Business Models and Blue Ocean
Strategy

◆ How Is Competitive Advantage Sustained?

◆ Cost Advantage

● The Sources of Cost Advantage

● Using the Value Chain to Analyze Costs

◆ Differentiation Advantage

● The Nature and Significance of Differentiation

● Analyzing Differentiation: The Demand Side

● Analyzing Differentiation: The Supply Side

● Bringing It All Together: The Value Chain in
Differentiation Analysis

◆ Can Firms Pursue Both Cost and Differentiation
Advantage?

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

156 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

How Is Competitive Advantage Established?

Competitive advantage refers to a firm’s ability to outperform its rivals. Most of us can
recognize competitive advantage when we see it: Walmart in discount retailing, Vestas
in wind turbines, Google in online search, and Embraer in regional jets. Yet, defining
competitive advantage is troublesome. Competitive advantage can be defined broadly
in terms of a firm’s superiority in creating value for its stakeholders, or more narrowly
in terms of profitability. Because of the difficulties in identifying and measuring total
value creation (see the section on “Strategy as a Quest for Value” in Chapter 2), I shall

Introduction and Objectives

In this chapter, we integrate and develop the elements of competitive advantage that we have analyzed
in previous chapters. Chapter 1 noted that a firm can earn superior profitability either by locating in an
attractive industry or by establishing a competitive advantage over its rivals. Of these two, competitive
advantage is the more important. As competition has intensified across almost all industries, very few
industry environments can guarantee secure returns; hence, the primary goal of a strategy is to build
competitive advantage for the firm.

Chapters 3 and 5 provided the two primary components of our analysis of competitive advantage.
The last part of Chapter  3 analyzed the external sources of competitive advantage: the determinants
of the key success factors within a market. Chapter  5 analyzed the internal sources of competitive
advantage: the potential for the firm’s resources and capabilities to establish and sustain competitive
advantage.

This chapter looks more deeply at competitive advantage. We first explore the dynamics of com-
petitive advantage, examining the processes through which competitive advantage is created and
destroyed. This gives us insight into how competitive advantage can be attained and sustained. We
then look at the two primary dimensions of competitive advantage: cost advantage and differentiation
advantage and develop systematic approaches to their analysis.

By the time you have completed this chapter, you will be able to:

◆ Identify how a firm can create competitive advantage—including the roles that anticipa-
tion, agility, business model innovation, and blue ocean strategies can play.

◆ Identify how a firm can sustain competitive advantage—including the use of different
types of isolating mechanism.

◆ Use cost analysis to identify the sources of cost advantage in an industry, assess a firm’s
relative cost position, and recommend strategies to enhance cost competitiveness.

◆ Use differentiation analysis to identify the sources of differentiation and formulate strat-
egies that create differentiation advantage.

◆ Appreciate the feasibility of pursuing both cost and differentiation advantage.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 157

take the simple approach and define competitive advantage as: a firm’s potential to
earn a higher rate of profit than its direct competitors. I emphasize the potential for
superior profitability rather than actual superior profitability to take account of the
fact that competitive advantage may not be revealed in higher profitability—a firm may
forgo current profit in favor of investing in market share, technology, customer loyalty,
or executive perks. For example, over the ten-year period, 1998–2007, Amazon earned
a net loss, despite its obvious competitive advantage in online retailing. Amazon had
foregone profit in favor of sales growth.

In viewing competitive advantage as the result of matching internal strengths to
external success factors, I may have conveyed the notion of competitive advantage
as something static and stable. In fact, as we observed in Chapter 4 when discussing
competition as a process of “creative destruction,” competitive advantage is a disequi-
librium phenomenon: it is created by change and, once established, it sets in motion
the competitive process that leads to its destruction.1 The changes that generate com-
petitive advantage can be either internal or external. Figure  7.1 depicts the basic
relationships.

External Sources of Competitive Advantage

External changes create competitive advantage when they have differential effects on
companies because of their different resources and capabilities or strategic positioning.
For example, by reducing subsidies for renewable energy, the tax bill passed by the
US Congress in December 2017, will enhance the competitive advantage of power pro-
ducers that use fossil fuels, such as Duke Energy and AEP, over wind and solar power
producers such as Terra-Gen and Caithness Energy.

The greater the magnitude of the external change and the greater the difference
in the strategic positioning of firms, the greater the propensity for external change
to generate competitive advantage, as indicated by the dispersion of profitability
among the firms within an industry. The world’s beer brewing industry has a
relatively stable external environment and the leading firms—AB Inbev, Carlson,
Heineken, and Molson Coors—pursue similar strategies with similar resources and

Resource heterogeneity
among f irms creates
winners and losers

Some f irms are faster
and more ef fective

in exploiting change

Some f irms capable of
strategic innovations (e.g.,

new business models or
locating “blue oceans”)

Internal sources
of change

How does competitive
advantage emerge?

External sources of change, e.g.,
• Changing customer demand
• Changing prices of inputs
• Technological change

FIGURE 7.1 The emergence of competitive advantage

158 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

capabilities: differences in profitability among this group tend to be small and stable.
The major toy companies (Mattel, Lego, Hasbro, Bandai Namco, and MGA Entertain-
ment), on the other hand, comprise a heterogeneous group that experience unpre-
dictable shifts in consumer preferences, resulting in wide and variable profitability
differences.

The competitive advantage that arises from external change also depends on firms’
ability to respond to change. Any external change creates entrepreneurial opportunities
that will accrue to the firms that exploit these opportunities most effectively. Entrepre-
neurial responsiveness involves one of two key capabilities:

● Anticipation. Over its 100-year history, IBM has demonstrated a remarkable
ability to renew its competitive advantage through anticipating, and then tak-
ing advantage of, many of the major shifts in the IT sector: the birth of the
mainframe, the rise of personal computing, advent of the internet, migration of
value from hardware to software and services, cloud computing, big data, and
quantum computing. Conversely, Hewlett-Packard has been less adept in recog-
nizing and responding to these changes.

● Agility. As markets become more turbulent and unpredictable, quick-response
capability has become increasingly important as a source of competitive advantage.
Quick responses require information. As conventional economic and market fore-
casting has become less effective, so companies rely increasingly on “early-warning
systems” through contact with customers, suppliers, and competitors, then com-
press their cycle times so that information can be acted upon speedily. Zara, the
retail fashion chain owned by the Spanish company Inditex, has built a vertically
integrated supply chain that cuts the time between a garment’s design and retail
delivery to under three weeks (against an industry norm of three to six months).2
This emphasis on speed as a source of competitive advantage was popularized
by the Boston Consulting Group’s concept of time-based competition3 and in the
surge of interest by consultants and academics in strategic agility.4

Internal Sources of Competitive Advantage:
Strategic Innovation through Business Models and
Blue Ocean Strategy

Competitive advantage may also be generated internally through innovation which cre-
ates competitive advantage for the innovator while undermining previously established
competitive advantages—the essence of Schumpeter’s “creative destruction.”5 Although
innovation is typically thought of as applications of new technology, our emphasis
here is strategic innovation—new approaches to serving customers and competing
with rivals.

Business Model Innovation Strategic innovation has long been recognized as an
important source of competitive advantage. Four decades ago, McKinsey & Co. drew
the distinction between “same game” strategies (“playing by the traditional rules”) and
“new game” strategies (“rewriting them completely”).6 More recently, the term business
model innovation has been used to describe the introduction of novel approaches to
creating and/or capturing value within an industry.7 Its importance in creating competi-
tive advantage is indicated by research showing business model innovation to be a more
potent profit generator than either product or process innovation.8 It has been argued that

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 159

most new companies entering the Fortune 500 between 1997 and 2007 owed their success
to innovative business models.9 While business model innovations continue to create new
corporate giants and transform entire sectors, very often these innovative business models
are a variation on a theme or the transfer of an existing business model from a different
sector (see Strategy Capsule 7.1).

Business model innovations can be classified in different ways, A study by IBM iden-
tified three generic types:

● New industry models—reconfigurations of the conventional industry value chain
such as Dell’s direct sales model for PCs or Zara’s vertically integrated fast-
fashion model.

● New revenue models—changing the value proposition, the target audience or
pricing strategy. In the 1980s, Rolls Royce introduced “Power by the Hour”:
instead of buying jet engines outright, airlines could pay usage based fees for
engines, maintenance, and spares and other support services. Virgin America
introduced a novel customer offering comprising low airfares and a differenti-
ated in-flight experience.

● New enterprise models—involve reconfiguring enterprise boundaries and
partner relationships. Apple’s iPhone with outsourced manufacture and
network of application providers created a new model of the smart-
phone business.

STRATEGY CAPSULE 7.1

Examples of Business Model Innovations

Business model innovations are typically associated with

e-commerce businesses such as Google, eBay, Facebook,

Amazon, and Spotify. Yet, many of these business models

are variants on business models established much ear-

lier. Significant business model innovations include the

following:

◆ Free content supported by paid advertising origi-

nated with US commercial radio at the beginning of

the 1920s.

◆ Platform business models. A platform is an inter-

face between two sets of platform users. The first

platform businesses were auction houses. Sotheby’s

was established in 1744, Christies in 1766.

◆ Shared-ownership models used by Airbnb, Zipcar,

Netjets, and the like have their origins in real estate

timeshares (pioneered by the Swiss company, Hapi-

mag, during the 1960s).

◆ Franchising. The system of local licensed distributors,

each with defined exclusive territories, is attributed

to the Singer Sewing Machine Company which

introduced its system in the 1880s.

◆ Consumer cooperatives. The Rochdale Society of Equi-

table Pioneers’ cooperative grocery store was not the

world’s first consumer cooperative, but created a

model for future cooperatives.

◆ Microfinance—small loans to low-income business

owners—was developed by Muhammad Yunus’s

Grameen Bank during the 1970s.

◆ Tied products (razor-and-blades) model involving

below-cost pricing of the durable item and premium

pricing of consumables, was introduced by Gillette’s

competitors during the 1910s, then copied by Gillette.

◆ Mail order. The first major mail order retailer was

Montgomery Ward, established in 1872.

160 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Conceiving of business model innovations is much easier than implementing them.
To the extent that most business model innovations are variations on existing themes,
then analogical reasoning is a powerful tool for revealing new possibilities.10 Office
products retailer, Staples, was established as the “Toys ‘R’ Us for office supplies”; can-
nabis infrastructure company, Diego Pellicer Worldwide, Inc., envisages itself as the
“Starbucks of marijuana.”

Implementing business model innovations comes up against the resistance cre-
ated by commitment to the prevailing business model. Established companies may
be reluctant to experiment with new business models because of their adherence to
current asset allocations or to senior executives ‘perceptions of the “dominant logic”
of their business.11 However, using the lexicon of business models may assist in over-
coming these barriers: business models offer a narrative that can be used, not only to
simplify cognition, but also as a communication device creating a sense of legitimacy
around the initiative.12 Moreover, adopting new business models does not necessarily
involve abandoning existing models—increasingly companies are getting used to
operating multiple models: Netflix offers both video streaming and DVDs by mail.

STRATEGY CAPSULE 7.2

Blue Ocean Strategy

Kim and Mauborgne argue that the best value-creating

opportunities for business lie not in existing industries

following conventional approaches to competing (what

they refer to as “red oceans”), but seeking uncontested

market space. These “blue oceans” may be entirely new

industries created by technological innovation (such as

artificial intelligence and nanotechnology), but are more

likely to be the creation of new market space within

existing industries using existing technologies. This

may involve:

◆ New customer segments for existing products, for

example, Tesla’s Powerwall battery for electrical

storage in the home.

◆ Reconceptualization of existing products, for

example, Mark Zuckerberg’s reconceptualization of

a printed Facebook of class members as an online,

interactive, and social platform.

◆ Novel recombinations of product attributes and

reconfigurations of established value chains that

establish new positions of competitive advantage, for

example, Dell’s integrated system for ordering, assem-

bling, and distributing PCs, which permitted unprec-

edented customer choice and speed of fulfillment.

The strategy canvas is a framework for developing

blue ocean strategies. The horizontal axis shows the differ-

ent product characteristics along which the firms in the

industry compete; the vertical axis shows the amount of

each characteristic a firm offers its customers. Starting with

the value line showing the industry’s existing offerings, the

challenge is to identify a strategy that can provide a novel

combination of attributes. This involves four types of choice:

◆ Raise: What factors should be raised well above the

industry’s standard?

◆ Eliminate: Which factors that the industry has long

competed on should be eliminated?

◆ Reduce: Which factors should be reduced well below

the industry’s standard?

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 161

Pursuing multiple business models can offer companies the benefits of both synergy
and risk spreading.13

Blue Ocean Strategy An alternative approach to identifying the potential for stra-
tegic innovation is that developed by Insead’s Kim Chan and Renee Mauborgne. Their
blue ocean strategy involves a quest for “uncontested market space.”14 Creating
untapped market space doesn’t necessarily require finding new market opportunities
well beyond existing industry boundaries, blue oceans can also be created within
existing markets. The challenge is “to create new rules of the game by breaking the
existing value/cost trade-off.”15 One approach is to combine performance attributes
that were previously viewed as conflicting. Thus, Virgin America offers the low fares
typical of budget airlines together with inflight services that are superior to those
of most legacy carriers. Indeed, common to many blue ocean strategies is offering
superior customer value through reconciling low price with differentiation. Strategy
Capsule  7.2 outlines how the concept of blue ocean strategy can help companies
pursue strategic innovation.

◆ Create: Which factors should be created that the

industry has never offered?

Figure  7.2 compares value lines for Cirque du Soleil

and a traditional circus.

Source: Based upon W. C. Kim and R. Mauborgne, Blue Ocean
Strategy: How to Create Uncontested Market Space and Make
the Competition Irrelevant (Boston: Harvard Business School
Press, 2005).

FIGURE 7.2 The strategy canvas: Value lines for Cirque du Soleil and the traditional circus

Low

High

Cirque du Soleil

Pr
ice

Pe
rfo

rm
ing

an
im

als

Hu
mo

r

Th
rill

s/d
an

ge
r

Ac
ro

ba
tic

s
Da

nc
e

Co
stu

me
s

Mu
sic

Vis
ua

l e
xp

eri
en

ce

Co
mf

or
t

At
tra

cti
ve

ve
nu

e

Ap
pe

al
to

ch
ild

ren

Ap
pe

al
to

ad
ult

s

Traditional circus

162 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Identif ication • Obscure superior performance

REQUIREMENT FOR IMITATION ISOLATING MECHANISM

Incentives for imitation
• Deterrence: signal aggressive intentions
• Preemption: exploit all available
opportunities

Diagnosis
• Use multiple sources of competitive
advantages to create causal ambiguity

Resource acquisition
• Base competitive advantage upon resources
and capabilities that are immobile and
dif f icult to replicate

FIGURE 7.3 Sustaining competitive advantage: Types of isolating mechanism

How Is Competitive Advantage Sustained?

Once established, competitive advantage is eroded by competition. The speed with
which competitive advantage is undermined depends on the ability of competitors to
challenge either by imitation or innovation. Imitation is the most direct form of compe-
tition; hence, for competitive advantage to be sustained over time, barriers to imitation
must exist. Rumelt uses the term isolating mechanisms to describe the barriers that
prevent the erosion of a business’s superior profitability.16 The tendency for profit dif-
ferences between competitors to persist for periods of a decade or more suggests that
isolating mechanisms can be very effective.17

To identify the sources of isolating mechanisms, let us examine the process of com-
petitive imitation. For one firm to successfully imitate the strategy of another, it must
meet four conditions: it must identify the competitive advantage of a rival, it must have
an incentive to imitate, it must be able to diagnose the sources of the rival’s competitive
advantage, and it must be able to acquire the resources and capabilities necessary for
imitation. At each stage, the incumbent can create isolating mechanisms to impede the
would-be imitator (Figure 7.3).

Obscuring Superior Performance A simple barrier to imitation is to obscure the
firm’s superior profitability. According to George Stalk, former managing director of the
Boston Consulting Group: “One way to throw competitors off balance is to mask high
performance so rivals fail to see your success until it’s too late.”18 One of the attractions
of private company status is avoiding disclosure of financial performance. Few food
processors realized the profitability of canned cat and dog food until the UK Monop-
olies Commission revealed that the leading firm, Pedigree Petfoods (a subsidiary of
Mars, Inc.), earned a return on capital employed of 47%.19

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 163

In order to discourage new competitors, companies may forgo maximizing their
short-term profits. The theory of limit pricing, in its simplest form, postulates that
a firm in a strong market position sets prices at a level that just fails to attract
entrants.20

Deterrence and Preemption A firm may avoid competition by persuading potential
rivals that imitation will be unprofitable. Deterrence (as we discussed in the section
on “Game Theory” in Chapter 4) involves making threats that competitive incursions
will be resisted vigorously.21 For deterrence to work, threats must be clearly signaled,
backed by commitment, and credible. Following the expiration of its NutraSweet pat-
ents in 1987, Monsanto fought an aggressive price war against the Holland Sweetener
Company. Although costly, this gave Monsanto a reputation for aggression that deterred
other would-be entrants into the aspartame market.22

A firm can also deter imitation by preemption—occupying existing and potential
strategic niches to reduce the range of investment opportunities open to the challenger.
Preemption may include:

● Proliferation of product varieties by market leaders leaving few niches for new
entrants and smaller rivals to occupy. Between 1950 and 1972, for example, the
six leading suppliers of breakfast cereals introduced 80 new brands into the
US market.23

● Investing in underutilized production capacity can be especially discouraging
to rivals and potential entrants. Part of Monsanto’s strategy to protect its NutraS-
weet business were heavy investments in aspartame plants.

● Patent proliferation can limit competitors’ innovation opportunities. In 1974,
Xerox’s dominant market position in plain-paper copiers was protected by a
wall of over 2000 patents, most of which were not used. When IBM introduced
its first copier, Xerox sued it for infringing 22 of these patents.24

Causal Ambiguity and Uncertain Imitability If a firm is to imitate the com-
petitive advantage of another, it must understand the basis of its rival’s success. For
Kmart or Target to imitate Walmart’s success in discount retailing, they must first
understand what makes Walmart so successful. Walmart does many things differ-
ently, but which of these differences are the critical determinants of superior prof-
itability?

Lippman and Rumelt identify this problem as causal ambiguity: when a firm’s com-
petitive advantage is multidimensional and is based on complex bundles of resources
and capabilities, it is difficult for rivals to diagnose the success of the leading firm. The
outcome of causal ambiguity is uncertain imitability: if the causes of a firm’s success
cannot be known for sure, successful imitation is uncertain.25

Recent research suggests that the problems of strategy imitation may run even deeper.
We observed in Chapter 5 that capabilities are the outcome of complex combinations
of resources and that multiple capabilities interact to confer competitive advantage.
Research into complementarity among an organization’s activities suggests that these
interactions extend across the whole range of management practices.26 Strategy
Capsule  7.3 describes Urban Outfitters as an example of a unique “activity system.”
Where activities are tightly linked, complexity theory—NK modeling in particular—
predicts that, within a particular competitive environment, a number of fitness peaks

164 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

will appear, each associated with a unique combination of strategic variables.27 The
implications for imitation is that to locate on the same fitness peak as another firm not
only requires recreating a complex configuration of strategy, structure, management
systems, leadership, and business processes, but also means that getting it just a little
bit wrong may result in the imitator missing the fitness peak and finding itself in an
adjacent valley.28

One of the challenges for the would-be imitator is deciding which management prac-
tices are generic best practices and which are contextual—they only work in combination
with other management practices. For example, if Sears Holdings is considering which
of Walmart’s management practices to imitate in its Kmart stores, some practices (e.g.,
employees required to smile at customers, point-of-sale data transferred direct to the cor-
porate database) are likely to be generically beneficial. Others, such as Walmart’s “everyday
low prices” pricing policy, low advertising sales ratio, and hub-and-spoke distribution are
likely to be beneficial only when combined with other practices that ensure low costs.

Acquiring Resources and Capabilities Having diagnosed the sources of an
incumbent’s competitive advantage, the imitator’s next challenge is to assemble the
necessary resources and capabilities for imitation. As we saw in Chapter  5, a firm
can acquire resources and capabilities either by buying them or by building them.

STRATEGY CAPSULE 7.3

Urban Outfitters

Urban Outfitters, Inc. was founded in Philadelphia in 1976.

By 2018, it operated 650 Urban Outfitters, Anthropologie,

and Free People stores in 14 countries. The company tar-

gets, “Well-educated, urban-minded, young adults aged

18—30 through its unique merchandise mix and compel-

ling store environment ‘creating’ a unified environment that

establishes an emotional bond with the customer. Every

element of the environment is tailored to the aesthetic pref-

erences of our target customers. Through creative design,

much of the existing retail space is modified to incorpo-

rate a mosaic of fixtures, finishes and revealed architec-

tural details. In our stores, merchandise is integrated into a

variety of creative vignettes and displays designed to offer

our customers an entire look at a distinct lifestyle.”

According to Michael Porter and Nicolaj Siggelkow,

these management practices are both distinctive and

highly interdependent. The urban-bohemian-styled

product mix, which includes clothing, furnishings, and

gift items, is displayed within bazaar-like stores, each

of which has a unique design. To encourage frequent

customer visits, the layout of each store is changed every

two weeks, creating a new shopping experience when-

ever customers return. Each practice makes little sense

on its own, but together they represent a distinctive,

integrated strategy. It may be possible to replicate

the individual elements of Urban Outfitters’ business

system; the real challenge for an imitator integrating

them into a cohesive whole.

Source: Urban Outfitters, Inc. 10-K Report to January 31, 2018;
M. E. Porter and N. Siggelkow, “Contextuality within Activity
Systems and Sustainable Competitive Advantage,” Academy of
Management Perspectives 22 (May 2008): 34–56.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 165

The imitation barriers here are limits to the transferability and replicability of resources
and capabilities (see Chapter  5, “Sustaining Competitive Advantage”). Strategy Cap-
sule 7.4 shows how the resource requirements for competitive advantage differ across
different market settings.

STRATEGY CAPSULE 7.4

Competitive Advantage in Different Market Settings

Competitive advantage arises where there are imper-

fections in the competitive process, which in turn result

from the conditions under which essential resources and

capabilities are available. Hence, by analyzing imper-

fections of competition, we can identify the sources of

competitive advantage in different types of market. We

distinguish between two types of value-creating activity:

trading and production.

In trading markets, the limiting case is efficient markets,

which correspond closely to perfectly competitive mar-

kets (e.g., the markets for securities, currencies, and com-

modity futures). If prices reflect all available information

and adjust instantaneously to new information, no

market trader can expect to earn more than any other.

It is not possible to beat the market on any consistent

basis—in other words competitive advantage is absent.

This reflects the conditions of resource availability. Both

of the resources needed to compete—finance and

information—are equally available to all traders.

Competitive advantage in trading markets requires

imperfections in the competitive process:

◆ Where there is an imperfect availability of information,

competitive advantage results from superior access

to information—hence the criminal penalties for

insider trading in most advanced economies.

◆ Where transaction costs are present, competitive

advantage accrues to the traders with the lowest

transaction costs, hence the superior returns to

low-cost index mutual funds over professionally

managed funds. Vanguard’s S&P 500 Index fund with

administrative costs of 0.07% annually has outper-

formed 90% of US equity mutual funds.

◆ If markets are subject to systematic behavioral trends

(e.g., the small firm effect or the January effect), compet-

itive advantage accrues to traders with superior knowl-

edge of market psychology or of systematic price

patterns (chart analysis). If markets are subject to band-

wagon effects, competitive advantage can be gained

in the short term by following the herd (momentum

trading) and longer term by a contrarian strategy.

Warren Buffett is a contrarian who is “fearful when

others are greedy, and greedy when others are fearful.”

In production markets, the potential for compet-

itive advantage is much greater because of the com-

plex combinations of the resources and capabilities

required, the highly differentiated nature of these

resources and capabilities, and the imperfections in their

supply. Within an industry, the more heterogeneous are

firms’ endowments of resources and capabilities, the

greater the potential for competitive advantage. In the

European electricity-generating industry, the growing

diversity of players—utilities (EDF, ENEL), gas distributors

(Gaz de France, Centrica), petroleum majors (Shell, ENI),

independent power producers (AES, E.ON), and wind

generators—has expanded opportunities for compet-

itive advantage and widened the profit differentials

between them.

Differences in resource endowments also influence the

erosion of competitive advantage: the more similar are com-

petitors’ resources and capabilities, the easier is imitation.

166 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

DIFFERENTIATION
ADVANTAGE

COST
ADVANTAGE

Sim
ilar p

rodu
ct

at lo
wer

cos
t

Price premium
from unique product

COMPETITIVE
ADVANTAGE

FIGURE 7.4 Sources of competitive advantage

Cost Advantage

A firm can achieve a higher rate of profit (or potential profit) over a rival in one of two
ways: either it can supply an identical product or service at a lower cost or it can supply
a product or service that is differentiated in such a way that the customer is willing to
pay a price premium that exceeds the additional cost of the differentiation. In the former
case, the firm possesses a cost advantage; in the latter, a differentiation advantage. In
pursuing cost advantage, the goal of the firm is to become the cost leader in its industry
or industry segment. Cost leadership requires the firm to “find and exploit all sources
of cost advantage [and] sell a standard, no-frills product.”29 Differentiation by a firm
from its competitors is achieved “when it provides something unique that is valuable to
buyers beyond simply offering a low price.”30 Figure 7.4 illustrates these two types of
advantage. By combining the two types of competitive advantage with the firm’s choice
of scope—broad market versus narrow segment—Michael Porter has defined three
generic strategies: cost leadership, differentiation, and focus (Figure 7.5).

Historically, strategic management has emphasized cost advantage as the primary
basis for competitive advantage in an industry. This focus on cost reflected the tradi-
tional emphasis by economists on price as the principal medium of competition. It also
reflected the quest by large industrial corporations during the last century to exploit
economies of scale and scope through investments in mass production and mass dis-
tribution. This preoccupation with cost advantage was reinforced during the 1970s and
1980s when the experience curve became a widely-used tool of strategy analysis (see
Strategy Capsule 7.5).

Since then, increasing low-cost competition from emerging market countries has
resulted in Western firms adopting a number of new approaches to cost reduction,
including outsourcing, offshoring, process re-engineering, lean production, and orga-
nizational delayering.

COST
LEADERSHIP

COMPETITIVE
SCOPE

Industry wide DIFFERENTIATION

FOCUSSingle segment

Low cost Dif ferentiation
SOURCE OF COMPETITIVE ADVANTAGE

FIGURE 7.5 Porter’s generic strategies

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 167

STRATEGY CAPSULE 7.5

BCG and the Experience Curve

The experience curve has its basis in the systematic

reduction in the time taken to build airplanes and

Liberty ships during World War II. In studies ranging

from bottle caps and refrigerators to long-distance calls

and insurance policies, the Boston Consulting Group

(BCG) observed a remarkable regularity in the reduc-

tions in unit costs with increased cumulative output. Its

law of experience states: the unit cost of value added to

a standard product declines by a constant percentage

(typically between 15% and 30%) each time cumulative

output doubles. (Where “unit cost of value added” is the

unit cost of production less the unit cost of bought-in

components and materials).a Figure 7.6 shows the expe-

rience curve for Ford’s Model T.

The experience curve has important implications for

strategy. If a firm can expand its output faster than its

competitors can, it can move down the experience curve

more rapidly and open up a widening cost differential.

BCG recommended that a firm’s primary strategic goal

should be driving volume growth through increasing its

market share. BCG identified Honda in motorcycles as

an exemplar of this strategy.b The benefits market share

were supported by studies showing a positive relation-

ship between profitability and market share.c However,

association does not imply causation—it is likely that

market share and profitability are both outcomes of

some other source of competitive advantage—product

innovation, or superior marketing.d

The weaknesses of the experience curve as a strategy

tool are, first, it fails to distinguish several sources of cost

reduction (learning, scale, process innovation); second,

it presumes that cost reductions from experience are

automatic—in reality they must be managed.

Notes:
a Boston Consulting Group, Perspectives on Experience (Boston:
BCG, 1970).
b Boston Consulting Group, Strategy Alternatives for the British
Motorcycle Industry (London: HMSO, 1975).
c R. Jacobsen and D. Aaker, “Is Market Share All That It’s Cracked
Up To Be?” Journal of Marketing 49 (Fall 1985): 11–22.
d R. Wensley, “PIMS and BCG: New Horizons or False Dawn?”
Strategic Management Journal 3 (1982): 147–58.

FIGURE 7.6 Experience curve for the Ford Model T, 1909–1920

0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8 4.0

$4000

$3500

$3000

$2500

$2000

$1500

$1000

$500

$0

Cumulative units of production (millions)

U
n

it
c

o
st

1909

1910

1911
1912

1913

19201918
1915

1914

Note: The figure shows an 85% experience curve, that is, unit costs declined by approximately 15% with
each doubling of cumulative volume.

168 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

The Sources of Cost Advantage

There are seven principal determinants of a firm’s unit costs (cost per unit of output)
relative to its competitors; we refer to these as cost drivers (Figure 7.7).

The relative importance of these different cost drivers varies across industries,
between firms within an industry, and across the different activities within a firm.
By examining each of these different cost drivers in relation to a particular firm, we
can analyze a firm’s cost position relative to its competitors’, diagnose the sources
of inefficiency, and make recommendations as to how a firm can improve its cost
efficiency.

Economies of Scale The predominance of large corporations in most manufacturing
and service industries is a consequence of economies of scale. Economies of scale exist
wherever proportionate increases in the amounts of inputs employed in a production
process result in lower unit costs. Economies of scale have been conventionally associ-
ated with manufacturing. Figure 7.8 shows a typical relationship between unit cost and
plant capacity. The point at which most scale economies are exploited is the minimum
efficient plant size (MEPS).

• Technical input–output relationships
• Indivisibilities
• Specialization

• Increased individual skills
• Improved organizational routines

• Process innovation
• Re-engineering of business processes

• Standardization of designs and components
• Design for manufacture

• Location advantages
• Ownership of low-cost inputs
• Non-union labor
• Bargaining power

• Ratio of f ixed to variable costs
• Fast and f lexible capacity adjustment

• Organizational slack/X-inef f iciency
• Motivation and organizational culture
• Managerial ef fectiveness

ECONOMIES OF LEARNING

PRODUCTION TECHNIQUES

PRODUCT DESIGN

INPUT COSTS

CAPACITY UTILIZATION

RESIDUAL EFFICIENCY

ECONOMIES OF SCALE

FIGURE 7.7 The drivers of cost advantage

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 169

Scale economies arise from three principal sources:

● Technical input–output relationships: In many activities, increases in output do
not require proportionate increases in input. A 10,000-barrel oil storage tank
does not cost five times as much as a 2000-barrel tank. Similar volume-related
economies exist in ships, trucks, and steel and petrochemical plants.

● Indivisibilities: Many resources and activities are “lumpy”—they are unavailable
in small sizes. Hence, they offer economies of scale as firms are able to spread
the costs of these items over larger volumes of output. In R&D, new product
development and advertising market leaders tend to have much lower costs as a
percentage of sales than their smaller rivals.

● Specialization: Increased scale permits greater task specialization. Mass pro-
duction involves breaking down the production process into separate tasks
performed by specialized workers using specialized equipment. Division of
labor promotes learning and assists automation. Economies of specialization are
especially important in knowledge-intensive industries: in investment banking,
management consulting, and legal services, large firms are able to offer a
broader array of specialized expertise.

Scale economies are a key determinant of an industry’s level of concentration.
In many consumer goods industries, scale economies in marketing have driven
industry consolidation. Figure 7.9 shows how soft drink brands with the greatest sales
volume tend to have the lowest unit advertising costs. In other industries—especially
aerospace, automobiles, software, and movie production—economies of scale arise
from the huge costs of new product development. The Boeing 747 was hugely prof-
itable because 1536 were built between 1970 and 2017. The challenge for the Airbus
A380 is whether there is sufficient worldwide demand to cover the plane’s $18 billion
development cost.

In industries where scale economies are important, small- and medium-sized com-
panies can avoid disadvantages of small scale by outsourcing activities where scale is
critical. For example, specialist car makers typically license technologies and designs
and buy in engines.

Cost per
unit of output

Units of output
per periodMinimum

Ef f icient
Plant Size

FIGURE 7.8 The long-run average cost curve for a plant

170 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Economies of Learning The experience curve has its basis in learning-by-doing. Rep-
etition develops both individual skills and organizational routines. In 1943, it took 40,000
labor-hours to build a B-24 Liberator bomber. By 1945, it took only 8000 hours.31 Intel’s
dominance of the world microprocessor market owes much to its accumulated learning
in the design and manufacture of these incredibly complex products. Learning occurs
both at the individual level through improvements in dexterity and problem solving and
at the group level through the development and refinement of organizational routines.32

Process Technology and Process Design Superior processes can be a source of
huge cost economies. Pilkington’s revolutionary float glass process gave it (and its
licensees) an unassailable cost advantage in producing flat glass. Ford’s moving assem-
bly line reduced the time taken to assemble a Model T from 106 hours in 1912 to six
hours in 1914. When process innovation is embodied in new capital equipment, diffu-
sion is likely to be rapid. However, the full benefits of new process technologies typi-
cally require system-wide changes in job design, employee incentives, product design,
organizational structure, and management controls. Between 1979 and 1986, General
Motors achieved few productivity gains from the $40 billion it spent on robotics and
other advanced manufacturing technologies. The problem was that Toyota’s system of
lean production, which GM sought to imitate, relies less on advanced automation than
on work practices such as just-in-time scheduling, total quality management, continuous
improvement (kaizen), teamwork, job flexibility, and supplier partnerships.33

Business process re-engineering (BPR) is an approach to redesigning operational
processes that became widely popular during the 1990s. “Re-engineering gurus”
Michael Hammer and James Champy define BPR as: “the fundamental rethinking and
radical redesign of business processes to achieve dramatic improvements in critical
contemporary measures of performance, such as cost, quality, service, and speed.”34
BPR recognizes that processes can evolve haphazardly, hence, BPR begins with the
question: “If we were starting afresh, how would we design this process?”

BPR can lead to major gains in efficiency, quality, and speed (Strategy Capsule 7.6),
but where business processes are complex and embedded in organizational routines,
“obliterating” existing processes and starting with a “clean sheet of paper” may endanger
organizational capabilities that have been nurtured over a long period. In recent years,
BPR has been partly superseded by business process management, where the emphasis
has shifted from workflow management to the broader application of information tech-
nology (web-based applications in particular) to the redesign and enhancement of
organizational processes.35

A
d

ve
rt

is
in

g
e

xp
en

d
it

u
re

($
p

er
c

as
e)

0.02

10

Annual sales volume (millions of cases)

0.05

0.10

0.15

0.20

20 50 100 200 500 1000

Schweppes
SF Dr. Pepper

Diet PepsiDiet 7-Up

Diet Rite
Fresca

Sprite Dr. Pepper

Seven-Up

Pepsi Coke

Tab

FIGURE 7.9 Economies of scale in advertising: US soft drinks

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 171

Product Design Design-for-manufacture—designing products for ease of pro-
duction rather than simply for functionality and esthetics—can offer substantial cost
savings, especially when linked to the introduction of new process technology. In 2014,
General Motors CEO Mary Barra announced the goal of reducing 26 global vehicle pro-
duction platforms to just four by 2015. Such a transition would offer major savings in
component and product development costs.36

Service offerings, too, can be designed for ease and efficiency of production. Motel
6, cost leader in US budget motels, carefully designs its product to keep operating costs
low. Its motels occupy low-cost, out-of-town locations; it uses standard motel designs;
it avoids facilities such as pools and restaurants; and it designs rooms to facilitate easy
cleaning and low maintenance. However, efficiency in service design is compromised
by the tendency of customers to request deviations from standard offerings (“I’d like
my hamburger with the bun toasted on one side only, please”). This requires a clear
strategy to manage variability either through accommodation or restriction.37

Capacity Utilization Over the short and medium terms, plant capacity is more or
less fixed and variations in output cause capacity utilization to rise or fall. Underutiliza-
tion raises unit costs because fixed costs must be spread over fewer units of production.
Pushing output beyond normal full capacity also creates inefficiencies. Boeing’s efforts
to boost output during 2006–2011 resulted in increased unit costs due to overtime pay,
premiums for night and weekend shifts, increased defects, and higher maintenance costs.

STRATEGY CAPSULE 7.6

Process Re-engineering at IBM Credit

Michel Hammer and James Champy describe how

business process re-engineering resulted in IBM

reducing the time taken to approve requests by sales

personnel for new customer credit approval from six

days to four  hours. Under the old system, five stages

were involved:

1 an IBM salesperson telephoned a request for financ-

ing, which was logged on a piece of paper;

2 the request was sent to the credit department,

which checked the customer’s creditworthiness;

3 the request and credit check were sent to the

business practices department where a loan cove-

nant was drawn up;

4 the paperwork was passed to a pricer, who deter-

mined the interest rate;

5 the clerical group prepared a quote letter that was

sent to the salesperson.

Frustrated by the delays and resulting lost sales,

two managers undertook an experiment. They took a

financing request and walked it through all five steps—it

took just 90 minutes!

The problem was that the process had been designed

for the most complex credit requests that IBM received,

yet, in most cases no specialist judgment was called for: all

that was needed was to check credit ratings and to plug

numbers into standard algorithms. The credit approval

process was redesigned by replacing the specialists

(credit checkers, pricers, and so on) with generalists who

undertook all five processes. Specialists were reserved for

nonstandard or unusually complex requests. Processing

time was cut by 94%, fewer employees were required,

and the volume of customer approvals increased.

Source: Adapted from M. Hammer and J. Champy, Re-engineering
the Corporation: A Manifesto for Business Revolution (New York:
Harper Business, 1993): 36–39.

172 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Input Costs There are several reasons why a firm may pay less for an input than its
competitors:

● Locational differences in input prices: The prices of inputs—wage rates espe-
cially—vary between locations. In the United States, software engineers earned
an average of $85,000 in 2017. In India, the average was $13,000. In auto assem-
bly, the hourly rate in Chinese plants was about $3.90 an hour in 2016, com-
pared with $30 in the United States (not including benefits).38

● Ownership of low-cost sources of supply: In raw-material-intensive industries,
ownership of low-cost sources of material can offer a massive cost advantage.
In petroleum, lifting costs for the three “supermajors” (ExxonMobil, Royal
Dutch Shell, and BP) were about $21 per barrel in 2016; for Saudi Aramco they
were about $5.

● Nonunion labor: Labor unions result in higher levels of pay and benefits and
work rules that can lower productivity. In the US airline industry, nonunion
Virgin America had average salary and benefit cost per employee of $79,161 in
2013 compared with $98,300 for United States (80% unionized).

● Bargaining power: The ability to negotiate preferential prices and discounts can
be a major source of cost advantage for industry leaders, especially in retailing.39
Amazon’s growing dominance of book retailing allows it to demand discounts
from publishers of up to 60%.40

Residual Efficiency Even after taking account of the basic cost drivers—scale, tech-
nology, product and process design, input costs, and capacity utilization—unexplained
cost differences between firms typically remain. These residual efficiencies relate to the
extent to which the firm approaches its efficiency frontier of optimal operation which
depends on the firm’s ability to eliminate “organizational slack”41 or “X-inefficiency.”42
These excess costs have a propensity to accumulate within corporate headquarters—
where they become targets for activist investors.43 Eliminating these excess costs often
requires a threat to a company’s survival—in his first year as CEO, Carlos Ghosn cut
Nissan Motor’s operating costs by 20%.44 At Walmart, Ryanair, and Amazon, high levels
of residual efficiency are the result of management systems and company values that
are intolerant of unnecessary costs and glorify frugality.

Using the Value Chain to Analyze Costs

To analyze an organization’s cost position and seek opportunities for cost reduction,
we need to look at individual activities. Chapter  5 introduced the value chain as a
framework for viewing the sequence of activities that a company or business unit per-
forms. Each activity tends to be subject to a different set of cost drivers, which give it a
distinct cost structure. A value chain analysis of a firm’s costs seeks to identify:

● the relative importance of each activity with respect to total cost;

● the cost drivers for each activity and the comparative efficiency with which the
firm performs each activity;

● how costs in one activity influence costs in another;

● which activities should be undertaken within the firm and which activities
should be outsourced.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 173

A value chain analysis of a firm’s cost position comprises the following stages:

1 Disaggregate the firm into separate activities: Identifying value chain activities is
a matter of judgment. It requires identifying which activities are separate from
one another, which are most important in terms of cost, and their dissimilarity in
terms of cost drivers.

2 Estimate the cost that each activity contributes to total costs. The goal is to
identify which activities are the most important sources of cost, since, even with
activity-based costing, detailed cost allocation can be a major exercise.45

3 Identify cost drivers: For each activity, what factors determine the level of unit
cost relative to other firms? For activities with large fixed costs such as new prod-
uct development or marketing, the principal cost driver is likely to be the ability
to amortize costs over a large volume of sales. For labor-intensive activities, key
cost drivers tend to be wage rates, process design, and defect rates.

4 Identify linkages: The costs of one activity may be determined, in part,
by the way in which other activities are performed. Xerox discovered that
its high service costs relative to competitors’ reflected the complexity of
design of its.

5 Identify opportunities for reducing costs: By identifying areas of compara-
tive inefficiency and the cost drivers for each, opportunities for cost reduction
become evident. If the sources of inefficiency cannot be resolved, can the activity
be outsourced?

Figure 7.10 shows how the application of the value chain to automobile manufac-
ture can identify possibilities for cost reductions.

Differentiation Advantage

A firm differentiates itself from its competitors “when it provides something unique that
is valuable to buyers beyond simply offering a lower price.”46 Differentiation advantage
occurs when the price premium that the firm earns from differentiation exceeds the
cost of providing the differentiation.

Every firm has opportunities to differentiate its offering, although the range of
differentiation opportunities depends on the characteristics of the product. An auto-
mobile or a restaurant offers greater potential for differentiation than cement, wheat,
or memory chips. These latter products are called commodities precisely because they
lack physical differentiation. Yet, according to Tom Peters, “Anything can be turned into
a value-added product or service.”47 Consider the following:

● Cement is the ultimate commodity product, yet Cemex, based in Mexico, has
become a leading worldwide supplier of cement and ready-mix concrete through
emphasizing “building solutions”—one aspect of which is ensuring that 98% of
its deliveries are on time (compared to 34% for the industry as a whole).48

● Online bookselling is inherently a commodity business—any online
bookseller has access to the same titles and same modes of distribution.
Yet, Amazon has exploited the information generated by its business to offer
a range of value-adding services: best-seller lists, reviews, and customized
recommendations.

174 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

The lesson is this: differentiation is not simply about offering different product fea-
tures; it is about identifying and understanding every possible interaction between the
firm and its customers and asking how these interactions can be enhanced or changed
in order to deliver additional value to the customer. This requires looking at both the
firm (the supply side) and its customers (the demand side). While supply-side analysis

1. IDENTIFY ACTIVITIES
Establish the basic framework of the value
chain by identifying the principal activities
of the firm.

2. ALLOCATE TOTAL COSTS
For a first-stage analysis, a rough estimate
of the breakdown of total cost by activity is
sufficient to indicate which activities offer
the greatest scope for cost reductions.

3. IDENTIFY COST DRIVERS
(See diagram.)

4. IDENTIFY LINKAGES
Examples include:
1. Consolidating purchase orders to
increase discounts increases inventories.
2. High-quality parts and materials reduce
costs of defects at later stages.
3. Reducing manufacturing defects cuts
warranty costs.
4. Designing different models around
common components and platforms
reduces manufacturing costs.

5. IDENTIFY OPPORTUNITIES
COST REDUCTION
For example:
Purchasing: Concentrate purchases on
fewer suppliers to maximize purchasing
economies. Institute just-in-time
component supply to reduce inventories.

R&D/Design/Engineering: Reduce
frequency of model changes. Reduce
number of different models (e.g., single
range of global models). Design for
commonality of components and platforms.

Component manufacture: Exploit
economies of scale through concentrating
production of each component on fewer
plants. Outsource wherever scale of
production or run lengths is suboptimal
or where outside suppliers have technology
advantages. For labor-intensive
components (e.g., seats, dashboards,
trim), relocate production in low-wage
countries. Improve capacity utilization
through plant rationalization or supplying
components to other manufacturers.

SEQUENCE OF ANALYSIS VALUE CHAIN COST DRIVER

PURCHASING
COMPONENTS

AND
MATERIALS

R&D, DESIGN,
AND

ENGINEERING

COMPONENT
MANUFACTURE

ASSEMBLY

TESTING AND
QUALITY

CONTROL

INVENTORIES
OF FINISHED
PRODUCTS

SALES AND
MARKETING

DISTRIBUTION
AND DEALER

SUPPORT

Prices of bought-in
components depend upon:

• Order sizes
• Average value of purchases
per supplier
• Location of suppliers

Size of R&D commitment
Productivity of R&D
Number and frequency of new
models
Sales per model

Scale of plants
Run length per component
Capacity utilization
Location of plants

Scale of plants
Number of models per plant
Degree of automation
Level of wages
Location of plants

Level of quality targets
Frequency of defects

Predictability of sales
Flexibility of production
Customers’ willingness to wait

Size of advertising budget
Strength of existing reputation
Sales volume

Number of dealers
Sales per dealer
Desired level of dealer support
Frequency of defects
repaired under warranty

FIGURE 7.10 Using the value chain in cost analysis: An automobile manufacturer

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 175

identifies the firm’s potential to create uniqueness, the critical issue is whether such
differentiation creates value for customers and whether the value created exceeds the cost
of the differentiation. Only by understanding what customers want, how they choose,
and what motivates them can we identify opportunities for profitable differentiation.

Thus, differentiation strategies are not about pursuing uniqueness for its own sake.
Differentiation is about understanding customers and how to best meet their needs.
To this extent, the quest for differentiation advantage takes us to the heart of business
strategy. The fundamental issues of differentiation are also the fundamental issues of
business strategy: Who are our customers? How do we create value for them? And how
do we do it more effectively and efficiently than anyone else?

Because differentiation is about uniqueness, establishing differentiation advantage
requires creativity: it cannot be achieved simply through applying standardized frame-
works and techniques, but it can be guided by systematic analysis. As we have observed,
there are two requirements for creating profitable differentiation. On the supply side,
the firm must be aware of the resources and capabilities through which it can create
uniqueness (and do it better than competitors). On the demand side, the key is insight
into customers and their needs and preferences. These two sides form the major com-
ponents of our analysis of differentiation.

The Nature and Significance of Differentiation

The potential for differentiating a product or service is partly determined by its
physical characteristics. For products that are technically simple (a pair of socks, a
brick), that satisfy uncomplicated needs (a corkscrew, a nail), or must meet rigorous
technical standards (a DRAM chip, a thermometer), differentiation opportunities are
constrained by technical and market factors. Products that are technically complex (an
airplane), that satisfy complex needs (an automobile, a vacation), or that do not need
to conform to particular technical standards (wine, toys) offer much greater scope for
differentiation.

Beyond these constraints, the potential in any product or service for differentiation
is limited only by the boundaries of the human imagination. For seemingly simple
products such as shampoo, toilet paper, and bottled water, the proliferation of brands
on any supermarket’s shelves is testimony both to the ingenuity of firms and the com-
plexity of customers’ preferences. Differentiation extends beyond the physical charac-
teristics of the product or service to encompass everything about the product or service
that influences the value that customers derive from it. Hence, differentiation requires
an understanding of every aspect of a company’s relationship with its customers. Star-
bucks’ ability to charge up to $5 for a cup of coffee (compared to $1 at Burger King)
reflects, not just the characteristics of the coffee, but also the overall “Starbucks Experi-
ence” which encompasses the retail environment, the community in which customers
participate, and the values that Starbucks projects.

Differentiation includes both tangible and intangible dimensions. Tangible differentiation
is concerned with the observable characteristics of a product or service that are relevant
to customers’ preferences and choice processes: for example, size, shape, color, weight,
design, material, and performance attributes such as reliability, consistency, taste, speed,
durability, and safety. Tangible differentiation also extends to products and services that
complement the product in question: delivery, after-sales services, and accessories.

Opportunities for intangible differentiation arise because the value that customers
perceive in a product is seldom determined solely by observable product features or
objective performance criteria. Social, emotional, psychological, and esthetic criteria
also guide customer choices. For consumer goods and services, the desire for status,

176 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

exclusivity, individuality, security, and community are powerful motivational forces.
These attributes are closely linked to the overall image of the firm and its offering.
Image is especially important for those products and services whose qualities and
performance are difficult to ascertain at the time of purchase (so-called experience
goods). These include cosmetics, medical services, and education.

Differentiation and Segmentation Differentiation is different from segmentation.
Differentiation is concerned with how a firm competes—the ways in which it can offer
uniqueness to customers. Such uniqueness might relate to consistency (McDonald’s),
reliability (Federal Express), status (American Express), quality (BMW), and innovation
(Apple). Segmentation is concerned with where a firm competes in terms of customer
groups, localities, and product types.

Whereas segmentation is a feature of market structure, differentiation is a strategic
choice made by a firm. Differentiation may lead to focusing upon particular market
segments, but not necessarily. IKEA, McDonald’s, Honda, and Starbucks all pursue
differentiation, but position themselves within the mass market spanning multiple
demographic and socioeconomic segments.49

The Sustainability of Differentiation Advantage Differentiation offers a more
secure basis for competitive advantage than low cost does. A position of cost advantage
is vulnerable to adverse movements in exchange rates and to new competitors taking
advantage of low input costs and new technologies. Differentiation advantage would
appear to be more sustainable. Large companies that consistently earn above-average
returns on capital—such as Colgate-Palmolive, Diageo, Johnson & Johnson, Kellogg’s,
Procter & Gamble, 3M, and Wyeth—tend to be those that have pursued differentiation
through quality, branding, and innovation.

Analyzing Differentiation: The Demand Side

Analyzing customer demand enables us to determine which product characteris-
tics have the potential to create value for customers, customers’ willingness to pay
for differentiation, and a company’s optimal competitive positioning in terms of
differentiation variables. Analyzing demand begins with understanding why customers
buy a product or service. Market research systematically explores customer prefer-
ences and customer perceptions of existing products. However, the key to successful
differentiation is to understand customers: a simple, direct inquiry into the purpose of
a product and the needs of its customers can often be far more illuminating than sta-
tistically validated market research (Strategy Capsule 7.7).

Understanding customer needs requires the analysis of customer preferences in rela-
tion to product attributes. Techniques include the following:

● Multidimensional scaling (MDS) compares competing products in terms of key
product attributes.50 Figure 7.11 shows consumer ratings of competing pain
relievers. Multidimensional scaling has also been used to classify 109 single-malt
Scotch whiskies according to their color, nose, palate, body, and finish.51

● Conjoint analysis measures the strength of customer preferences for
different products which then allows consumer preference for a hypothetical
new product to be predicted.52 Conjoint analysis was used by Marriott to design
its Courtyard hotel chain.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 177

● Hedonic price analysis views products as bundles of underlying attributes.53
It uses regression analysis to estimate the implicit market price for each
attribute. For example, price differences among European washing machines
can be related to differences in capacity, spin speed, energy consump-
tion, number of programs, and reliability.54 Similarly, price differences bet-
ween models of personal computer reflect differences in processor speed,
memory, and hard drive capacity. This analysis can be used to decide what
levels of each attribute to include within a new product and the price for
that product.

The Role of Social and Psychological Factors Analyzing product differentiation
in terms of measurable performance attributes fails to take account of customers’
underlying motivations. Few goods or services only satisfy physical needs: most buy-
ing is influenced by social and psychological motivations, such as the desire to find

STRATEGY CAPSULE 7.7

Understanding What a Product Is About

Kenichi Ohmae was the head of McKinsey &

Company’s Tokyo office (1972–1995). He is Japan’s

most renowned strategy guru. Product differentiation,

in his view, is about understanding customers and

their relationship to the product. He recounts the

efforts of a Japanese appliance maker to develop a

coffee percolator. The development team sought to

differentiate its coffee maker from those produced

by General Electric, Philips, and Faberware in terms of

size, speed, brewing system, and shape. Ohmae urged

the development team to ask a different question:

“Why do people drink coffee?” The answer: “For the

taste.” Yet, the company’s engineers knew nothing

about what determined the taste of good coffee.

After a few weeks they discovered that a superior

tasting cup of coffee required freshly-ground quality

beans, pure water, optimal water temperature, and

an even distribution of grains.

As a result, the essential design features for the

coffee  maker emerged: it had to have a built-in

grinder,  it  needed a water purifier to remove chlo-

rine, it  required precise control of water temperature,

and so on.

Ohmae emphasizes the need to ask the right ques-

tions when formulating strategy. It is vital to establish a

competitive advantage, but concentrating upon what

competitors are doing can lock a company into con-

ventional ways of thinking. The Japanese appliance

company risked becoming fixated on General Electric’s

new percolator that brewed coffee in 10 minutes—it

targeted a brewing time of eight minutes. Where does

this logic lead us? To the conclusion that instant coffee

is best! Ohmae encourages us to take a step back and

consider a product in relation to customers’ innate needs

and motives.

Nintendo’s success with its Wii and Switch video

games consoles confirms the potential of this approach.

Rather than a futile attempt to match Sony and Micro-

soft on computing power, graphics, or virtual reality,

Nintendo has concentrated on enhancing users’ gaming

experiences. This has allowed it to discover differentiation

opportunities that don’t depend upon advanced micro-

electronics.

Sources: K. Ohmae “Getting Back to Strategy,” Harvard Business
Review (November/December 1988); K. Ohmae, The Borderless
World, (New York: HarperCollins,1999).

178 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

community with others and to reinforce one’s own identity. Psychologist Abraham
Maslow proposed a hierarchy of human needs that progress from basic survival needs to
security needs, to belonging needs, to esteem needs, up to the desire for self-actual-
ization.55 For most goods, brand equity has more to do with higher-level needs such
as status and identity than with tangible product performance. The disastrous intro-
duction of “New Coke” in 1985 was the result of Coca-Cola giving precedence to tan-
gible differentiation (taste preferences) over intangible differentiation (authenticity).56
Harley-Davidson harbors no such illusions: it recognizes quite clearly that it is in the
business of selling lifestyle, not transportation.

If the main drivers of consumer behavior are identity and social affiliation, the
implications for differentiation are that we must analyze not only the product and its
characteristics but also customers, their lifestyles and aspirations, and the relation-
ship of the product to those lifestyles and aspirations. Market research that focuses
upon traditional demographic and socioeconomic factors may be less useful than a
deep understanding of consumers’ relationships with a product. As consumers become
increasingly sensitive to the activities of companies that supply their goods and ser-
vices, so companies are drawn toward corporate social responsibility as a means of
protecting and augmenting the value of their brands.57

Figure 7.12 summarizes the key points of this discussion by posing some basic ques-
tions that explore the potential for demand-side differentiation.

Analyzing Differentiation: The Supply Side

Creating differentiation advantage also depends on a firm’s ability to offer differentiation.
This requires us to pay attention to the activities that the firm undertakes and its capa-
bilities in performing them.

High

Tylenol

Buf ferin

Excedrin

Bayer

Anacin
Private-

label
aspirin

GENTLENESS

EFFECTIVENESS

Low

Low

High

FIGURE 7.11 Consumer perceptions of competing pain relievers: A
multidimensional scaling mapping

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 179

The Drivers of Uniqueness Differentiation is concerned with providing customers
with uniqueness. Michael Porter argues that the opportunities for providing uniqueness
are not limited to a particular function or activity but can arise in virtually everything
that the firm does, including:

● product features and product performance;

● complementary services (such as credit, delivery, repair);

● intensity of marketing activities (such as rate of advertising spending);

● technology embodied in design and manufacture;

● quality of purchased inputs;

● procedures that influence the customer experience (such as the rigor of quality
control, service procedures, frequency of sales visits);

● skill and experience of employees;

● location (e.g., proximity to the customer);

● degree of vertical integration (which influences a firm’s ability to control inputs
and intermediate processes).58

Differentiation can also occur through bundling—combining complementary
products and services in a single offering.59 Such bundling runs contrary to the
normal tendency for  products to unbundle as markets mature and complementary
services become provided by specialist suppliers. Electronic commerce has reinforced
unbundling: consumers increasingly create their own customized vacations in preference
to purchasing an all-inclusive vacation package. However, rebundling of products and
services has become especially important in business-to-business transactions through
“providing customer solutions”—combinations of goods and services that are tailored to
the needs of each client. This involves a radical rethink of the business models in many
companies.60

What needs
does it satisfy?

THE
PRODUCT

Relate patterns of
customer

preferences to
product attributes

What price
premiums do

product attributes
command?

What are the
demographic,

sociological, and
psychological
inf luences on

customer behavior?

• Select product
positioning in relation
to product attributes

• Ensure customer/
product compatibility

FORMULATE
DIFFERENTIATION

STRATEGY

By what criteria
do they
choose?

What are its key
attributes?

THE
CUSTOMER

What
motivates

them?

• Select target
customer group

• Evaluate costs and
benef its of
dif ferentiation

FIGURE 7.12 Identifying differentiation potential: The demand side

180 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Product Integrity Differentiation decisions cannot be made on a piecemeal
basis. Establishing a coherent and effective differentiation position requires the firm
to assemble a complementary package of differentiation attributes. If Burberry, the
British fashion house, wants to expand its range of clothing and accessories, it needs
to ensure that every new product offering is consistent with its overall image as a
quality-focused brand that combines traditional British style with contemporary edg-
iness. Product integrity refers to the consistency of a firm’s differentiation; it is the
extent to which a product achieves:

total balance of numerous product characteristics, including basic functions, esthetics,
semantics, reliability, and economy… Internal integrity refers to consistency between
the function and structure of the product… External integrity is a measure of how
well a product’s function, structure, and semantics fit the customer’s objectives, values,
production system, lifestyle, use pattern, and self-identity.61

Simultaneously achieving internal and external integrity is a complex organiza-
tional challenge: it requires close cross-functional collaboration and intimate customer
contact.62 This integration of internal and external product integrity is especially impor-
tant to those supplying “lifestyle” products, where differentiation is based on customers’
social and psychological needs. Here, the credibility of the image depends critically on
the consistency of the image presented. One element of this integration is a common
identity between customers and company employees. For instance:

● Harley-Davidson’s image of ruggedness, independence, individuality, and
community is supported by a top management team that dons biking leathers
and participates in owners’ group rides, and a management system that
empowers shop-floor workers and fosters quality, initiative, and responsibility.

● Central to the “Starbucks Experience” is the connection between customers and
employees, which is reinforced by Starbuck’s generous employee benefits and
employee involvement in Starbuck’s social and environmental initiatives.

Signaling and Reputation Differentiation is only effective if it is communicated
to customers. But information about the qualities and characteristics of products is
not always readily available to potential customers. The economics literature distin-
guishes between search goods, whose qualities and characteristics can be ascertained
by inspection, and experience goods, whose qualities and characteristics are only recog-
nized after consumption. This latter class of goods includes medical services, baldness
treatments, frozen TV dinners, and wine. Even after purchase, performance attributes
may be slow in revealing themselves. Bernie Madoff established Bernard L. Madoff
Investment Securities LLC in 1960—it took 48 years before the renowned investment
house was revealed as a “giant Ponzi scheme.”63

In the terminology of game theory (see Chapter  4), the market for experience
goods corresponds to a classic prisoners’ dilemma. A firm can offer a high-quality or
a low-quality product. The customer can pay either a high or a low price. If quality
cannot be detected, then equilibrium is established, with the customer offering a low
price and the supplier offering a low-quality product, even though both would be better
off with a high-quality product sold at a high price. The resolution of this dilemma is
for producers to find some credible means of signaling quality to the customer. The
most effective signals are those that change the payoffs in the prisoners’ dilemma.
Thus, an extended warranty is effective because providing such a warranty would be

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 181

more expensive for a low-quality producer than a high-quality producer. Brand names,
warranties, expensive packaging, money-back guarantees, sponsorship of sports and
cultural events, and a carefully designed retail environment for the product are all sig-
nals of quality. Their effectiveness stems from the fact that they represent significant
investments by the manufacturer that will be devalued if the product proves unsatis-
factory to customers.

The more difficult it is to ascertain performance prior to purchase, the more impor-
tant are these signals of quality.

● A perfume can be sampled prior to purchase and its fragrance assessed, but
its ability to augment the identity of the wearer and attract attention remains
uncertain. Hence, the key role of branding, packaging, advertising, and lav-
ish promotional events in establishing the perfume’s identity and performance
credentials.

● In financial services, the customer cannot easily assess the honesty, financial
soundness, or competence of the supplier. Hence, financial service companies
rely upon symbols of security and stability: imposing head offices, conserva-
tive office decor, smartly dressed employees, and trademarks such as Pruden-
tial’s rock and Travelers’ red umbrella. Bernie Madoff’s multibillion investment
swindle was sustained by his association with leading figures among New
York’s Jewish community, his prominent role in cultural and charitable organiza-
tions, and the aura of exclusivity around his investment firm.

Brands Brands fulfill multiple roles. At the most basic level, a brand provides an
implicit guarantee of quality simply by identifying the producer of a product, thereby
ensuring the producer is legally accountable for its products. Further, the brand rep-
resents an investment that provides an incentive to maintain quality and customer
satisfaction. It is a credible signal of quality because of the disincentive of its owner
to devalue it. As a result, a brand acts as a guarantee to the customer that reduces
uncertainty and search costs. The more difficult it is to discern quality on inspection,
and the greater the cost to the customer of purchasing a defective product, the greater
the value of a brand: a trusted brand name is more important to us when I purchase
mountaineering equipment than when I buy a pair of socks.

However, the value conferred by consumer brands such as Red Bull, Tesla,
Mercedes-Benz, Gucci, Virgin, and American Express is more about conferring
identity than guaranteeing reliability and quality. As brand building focuses increas-
ingly on “brand experience,” “tribal identity,” “shared values,” and “emotional dialogue,”
traditional mass-market advertising is taking a back seat to word-of-mouth promotional
initiatives using social and the other digital marketing tools of viral marketing.64

The Costs of Differentiation Differentiation adds cost: higher-quality inputs,
better-trained employees, higher advertising costs, and better after-sales service. If
differentiation narrows a breadth of appeal, it also limits the potential for exploiting
scale economies.

One means of reconciling differentiation with cost efficiency is to postpone
differentiation to later stages of the firm’s value chain. Modular design with common
components permits scale economies while permitting product variety. All the major
automakers have standardized platforms, engine types, and components, while
offering customers multiple models and innumerable combinations of colors, trim,
and accessories.

182 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

FIRM INFRASTRUCTURE

HUMAN RESOURCE MANAGEMENT

TECHNOLOGY DEVELOPMENT

OPERATIONS OUTBOUND
LOGISTICS

MARKETING
AND SALES

SERVICEINBOUND
LOGISTICS

Quality of
components
and materials

Defect-free
products.

Wide variety

Fast delivery.
E�cient order

processing

Building
brand

reputation

Customer technical
support. Consumer
credit. Availability

of spares

IT that supports
fast response
capabilities

Unique product features.
Fast new product

development

Training to support
customer service

excellence

FIGURE 7.13 Using the value chain to identify differentiation potential on the
supply side

Bringing It All Together: The Value Chain in
Differentiation Analysis

Demand side and supply side analyses of differentiation potential is only useful once
they are brought together. The key to successful differentiation is matching the firm’s
capacity for creating differentiation to the attributes that customers value most. For this,
the value chain provides a particularly useful framework. Let’s begin with the case of a
producer good, that is, one that is supplied by one firm to another.

Value Chain Analysis of Producer Goods Using the value chain to identify oppor-
tunities for differentiation advantage involves three principal stages:

1 Construct a value chain for the firm and its customer. It may be useful to consider
not just the immediate customer but also firms further downstream in the value
chain. If the firm supplies different types of customers, it’s useful to draw sepa-
rate value chains for each major category of customer.

2 Identify the drivers of uniqueness in each activity of the firm’s value chain.
Figure 7.13 identifies some possible sources of differentiation within Porter’s
generic value chain.

3 Locate linkages between the value chain of the firm and that of the buyer. What
can the firm do with its own value chain activities that can reduce the cost or
enhance the differentiation potential of the customer’s value chain activities?
The amount of additional value that the firm creates for its customers through
exploiting these linkages represents the potential price premium the firm can
charge for its differentiation. Strategy Capsule 7.8 demonstrates the identification
of differentiation opportunities by lining the value chains of a firm and its
customers.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 183

Value Chain Analysis of Consumer Goods Value chain analysis of differentiation
opportunities can also be applied to consumer goods. Few consumer goods are con-
sumed directly: typically, consumers engage in a chain of activities that involve search,
acquisition, and use of the product. In the case of consumer durables, the value chain
may include search, purchase, financing, acquisition of complementary products and
services, operation, service and repair, and eventual disposal. Such complex consumer
value chains offer many potential linkages with the manufacturer’s value chain, with
rich opportunities for innovative differentiation. Harley-Davidson has built its strategy
around the notion that it is not supplying motorcycles; it is supplying a customer
experience. This has encouraged it to expand the scope of its contact with its cus-
tomers to provide a wider range of services than any other motorcycle company.
Even nondurables involve the consumer in a chain of activities. Consider a frozen TV

STRATEGY CAPSULE 7.8

Using the Value Chain to Identify Differentiation
Opportunities for a Manufacturer of Metal Containers

The metal container industry is a highly competitive,

low-growth, low-profit industry. Cans lack potential for

differentiation, and buyers (especially beverage and food

canning companies) are very powerful. Cost efficiency is

essential, but can we also identify opportunities for prof-

itable differentiation? Following the procedure outlined

above, we can construct a value chain for a firm and its

customers, and then identify linkages between the two.

Figure 7.14 identifies five such linkages:

1 Distinctive can designs (e.g., Sapporo’s beer can)

can support the customer’s efforts to differentiate

its product.

2 Manufacturing cans to high tolerances can mini-

mize breakdowns on customers’ canning lines.

3 Reliable, punctual can deliveries allow canners to

economize on their can inventories.

4 An efficient order-processing system reduces can-

ners’ ordering costs.

5 Speedy, proficient technical support allows customers

to operate their canning lines with high-capacity

utilization and low downtime.

FIGURE 7.14 Identifying differentiation opportunities by linking the firm’s value chain to
that of the customer

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CANMAKER CANNER

184 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

TABLE 7.1 Features of cost leadership and differentiation strategies

Generic strategy Key strategy elements Organizational requirements

Cost leadership Scale-efficient plants

Maximizing labor productivity

Design for manufacture

Control of overheads

Process innovation

Outsourcing

Avoid marginal
customering accounts

Access to capital

Division of labor with incentives linked
to quantitative performance targets

Product design coordinated with
manufacture

Tight cost controls

Process engineering skills

Benchmarking

Measuring profit per customer

Differentiation Emphasis on branding, advertising,
design, customer service, quality,
and new product development

Marketing abilities

Product engineering skills

Cross-functional coordination

Creativity

Research capability

Incentives linked to qualitative
performance targets

dinner: it must be purchased, taken home, removed from the package, heated, and
served before it is consumed. After eating, the consumer must clean any used dishes,
cutlery, or other utensils. A value chain analysis by a frozen foods producer would
identify ways in which the product could be formulated, packaged, and distributed to
assist the consumer in performing this chain of activities.

Can Firms Pursue Both Cost and Differentiation Advantage?

The two primary sources of competitive advantage require fundamentally different
approaches to business strategy. A firm that is competing on low cost is distinguish-
able from a firm that competes through differentiation in terms of market positioning,
resources and capabilities, and organizational characteristics. Table 7.1 outlines some
of the principal features of cost and differentiation strategies.

Porter views cost leadership and differentiation as mutually exclusive strategies. A
firm that attempts to pursue both is “stuck in the middle”:

The firm stuck in the middle is almost guaranteed low profitability. It either loses
the high-volume customers who demand low prices or must bid away its profits to
get this business from the low-cost firms. Yet, it also loses high-margin business—
the cream—to the firms who are focused on high-margin targets or have achieved
differentiation overall. The firm that is stuck in the middle also probably suffers from
a blurred corporate culture and a conflicting set of organizational arrangements and
motivation system.65

In practice, few firms are faced with such stark alternatives. Differentiation is not
simply an issue of “to differentiate or not to differentiate.” All firms must make decisions
as to which customer requirements to focus on and where to position their product or
service in the market. A cost leadership strategy typically implies limited-feature, stan-
dardized offerings, but this does not necessarily imply that the product or service is an

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 185

undifferentiated commodity. Southwest Airlines and AirAsia are budget airlines with a
no-frills offering yet have clear market positions with unique brand images. The VW
Beetle shows that a utilitarian, mass-market product can achieve cult status.

In most industries, market leadership is held by a firm that maximizes customer
appeal by reconciling effective differentiation with low cost—Toyota in cars, McDon-
ald’s in fast food, Nike in athletic shoes. The huge global success of Japanese suppliers
of cars, motorcycles, consumer electronics, and musical instruments during the 1980s
and 1990s was the result of simultaneously pursuing cost efficiency, quality, innovation,
and brand building. The management techniques pioneered by Japanese companies—
notably total quality management—reconciling cost efficiency with differentiation has
been facilitated by new management techniques: total quality management repudiated
the conventional trade-off between quality and cost; flexible manufacturing systems
have reconciled scale economies with variety. In many industries, the cost leader is not
the market leader but a smaller competitor with minimal overheads, nonunion labor
and cheaply acquired assets.

Summary

Making money in business requires establishing and sustaining competitive advantage. Identifying
opportunities for competitive advantage requires insight into the nature and process of competition
within a market. Our analysis of the imperfections of the competitive process takes us back to the
resources and capabilities needed to compete in a particular market and conditions under which these
are available. Similarly, the isolating mechanisms that sustain competitive advantage are dependent pri-
marily upon the ability of rivals to access the resources and capabilities needed for imitation.

Competitive advantage has two primary dimensions: cost advantage and differentiation advantage.
The first of these, cost advantage, is the outcome of seven primary cost drivers. We showed that by
applying these cost drivers and by disaggregating the firm into a value chain of linked activities, we can
appraise a firm’s cost position relative to competitors and identify opportunities for cost reduction. The
principal message of this section is the need to look behind cost accounting data and beyond simplistic
approaches to cost efficiency, and to analyze the factors that drive relative unit costs in each of the firm’s
activities in a systematic and comprehensive manner.

The appeal of differentiation is that it offers multiple opportunities for competitive advantage with a
greater potential for sustainability than does cost advantage. The vast realm of differentiation opportu-
nity extends beyond marketing and design to encompass all aspects of a firm’s interactions with its cus-
tomers. Achieving a differentiation advantage requires the firm to match its own capacity for creating
uniqueness to the requirements and preferences of customers. The value chain offers firms a useful
framework for identifying how they can create value for their customers by combining demand-side
and supply-side sources of differentiation.

Finally, the basis of a firm’s competitive advantage has important implications not just for the design
of its strategy but for the design of its organizational structure and systems. Typically, companies that are
focused on cost leadership design their organizations differently from those that pursue differentiation.
However, the implications of competitive strategy for organizational design are complicated by the fact
that, for most firms, cost efficiency and differentiation are not mutually exclusive—in today’s intensely
competitive markets, firms have little choice but to pursue both.

186 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Notes

1. The dynamic relationship between competitive advantage
and profitability is emphasized by Richard Rumelt: when
competitive advantage increases profit increases (and
vice versa). See Good Strategy Bad Strategy (New York:
Crown Business, 2011): 163–177.

2. K. Ferdows, M. A. Lewis, and J. Machuca, “Rapid-Fire
Fulfillment,” Harvard Business Review (November
2004): 104–110.

3. G. Stalk, Jr., “Time: The Next Source of Competitive
Advantage,” Harvard Business Review ( July/August,
1988): 41–51.

4. See, for example, Y. Doz and M. Kosonen, “Embedding
Strategic Agility: A Leadership Agenda for Accelerating
Business Model Renewal,” Long Range Planning 43 (April
2010): 370–382; and S. Fourné, J. Jansen, and T. Mom,
“Strategic Agility in MNEs: Managing Tensions to Capture

Self-Study Questions

1. Figure 7.1 implies that stable industries, where firms have similar resources and capabilities,
offer less opportunity for competitive advantage than industries where change is rapid and
firms are heterogeneous. On the basis of these considerations, among the following industries,
in which do you predict that interfirm differences in profitability will be small and in which
will they be wide: retail banking, video games, wireless handsets, insurance, supermarkets,
and semiconductors?

2. Since 2009, Apple has been the world’s most profitable supplier of wireless handsets by a large
margin. Can Apple sustain its competitive advantage in this market?

3. Illy, the Italian-based supplier of quality coffee and coffee-making equipment, is launching an
international chain of gourmet coffee shops. What advice would you offer Illy for how it can
best build competitive advantage in the face of Starbucks’ market leadership?

4. Which drivers of cost advantage (Figure  7.7) do low-cost carriers such as Southwest Air-
lines and Ryanair exploit in order to undercut legacy carriers such as United Airlines and
British Airways?

5. Target (the US discount retailer), H&M (the Swedish fashion clothing chain), and Primark (the
UK discount clothing chain) have pioneered cheap chic—combining discount store prices
with fashion appeal. What are the principal challenges of designing and implementing a
cheap chic strategy? Design a “cheap chic” strategy for a company entering another market,
for example, restaurants, sports shoes, cosmetics, or office furniture.

6. To what extent are the seven cost drivers shown in Figure 7.7 relevant in analyzing the costs
per student at your business school or educational institution? What recommendations would
you make to your dean for improving the cost efficiency of your school?

7. Bottled water sells at least 200 times the price of tap water, with substantial price differentials
between different brands. What are the key differentiation variables that determine the price
premium that can be obtained for bottled water?

8. Advise a chain of movie theaters on a differentiation strategy to restore its flagging profit-
ability. Use the value chain framework outlined in Strategy Capsule 7.8 to identify potential
linkages between the company’s value chain and that of its customers in order to identify
differentiation opportunities.

CHAPTER 7 THE SOURCES AND DIMENSIONS OF COMPETITIVE ADVANTAGE 187

Opportunities across Emerging and Established Markets,”
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6. R. Buaron, “New Game Strategies,” McKinsey Quarterly
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7. However, a review of the literature on business model
innovation (BMI) revealed: “deep ambiguity with respect
to what a BMI is” (N. J. Foss and T. Saebi, “Fifteen Years
of Research on Business Model Innovation: How Far
Have We Come, and Where Should We Go?” Journal of
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8. IBM Global Technology Services “Business Model
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9. L. L. Martins, V. P. Rindova, and B. E. Greenbaum,
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10. G. Gavetti, D. A. Levinthal, and J. W. Rivkin, “Strategy
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11. H. Chesbrough, “Business Model Innovation: Oppor-
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13. P. Aversa, S. Haefliger, and D. G. Reza, “Building a Win-
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14. C. Kim and R. Mauborgne, “Blue Ocean Strategy,”
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15. C. Kim and R. Mauborgne, “Blue Ocean Strategy: From
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16. R. P. Rumelt, “Toward a Strategic Theory of the Firm,” in
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17. R. Jacobsen, “The Persistence of Abnormal Returns,”
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18. G. Stalk, “Curveball: Strategies to Fool the Competition,”
Harvard Business Review (September 2006): 114–122.

19. Monopolies and Mergers Commission, Cat and Dog Foods
(London: Her Majesty’s Stationery Office, 1977).

20. D. Besanko, D. Dranove, S. Schaefer, and M. Shanley,
Economics of Strategy, 6th edn (Hoboken, NJ: John
Wiley & Sons, Inc., 2013): section on “Limit Pricing,”
pp. 207–211.

21. T. C. Schelling, The Strategy of Conflict, 2nd edn (Cam-
bridge, MA: Harvard University Press, 1980): 35–41.

22. A. Brandenburger and B. Nalebuff, Co-opetition (New
York: Doubleday, 1996): 72–80.

23. R. Schmalensee, “Entry Deterrence in the Ready-to-Eat
Breakfast Cereal Industry,” Bell Journal of Economics 9
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24. Monopolies and Mergers Commission, Indirect
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25. S. A. Lippman and R. P. Rumelt, “Uncertain Imitability:
An Analysis of Interfirm Differences in Efficiency under
Competition,” Bell Journal of Economics 13 (1982):
418–438. See also R. Reed and R. DeFillippi, “Causal
Ambiguity, Barriers to Imitation, and Sustainable Com-
petitive Advantage,” Academy of Management Review 15
(1990): 88–102.

26. P. R. Milgrom and J. Roberts, “Complementarities and Fit:
Strategy, Structure, and Organizational Change in Man-
ufacturing,” Journal of Accounting and Economics 19
(1995): 179–208.

27. J. W. Rivkin, “Imitation of Complex Strategies,”
Management Science 46 (2000): 824–844.

28. M. E. Porter and N. Siggelkow, “Contextuality within
Activity Systems and Sustainable Competitive Advantage,”
Academy of Management Perspectives 22 (May
2008): 34–56.

29. M. E. Porter, Competitive Advantage (New York: Free
Press, 1985): 13.

30. Ibid.: 120.
31. L. Rapping, “Learning and World War II Production

Functions,” Review of Economics and Statistics (February
1965): 81–86.

32. L. Argote, S. L. Beckman, and D. Epple, “The Persis-
tence and Transfer of Learning in Industrial Settings,”
Management Science 36 (1990): 140–154; M. Zollo and S. G.
Winter, “Deliberate Learning and the Evolution of Dynamic
Capabilities,” Organization Science 13 (2002): 339–351.

33. J. Womack and D. T. Jones, “From Lean Production to
Lean Enterprise,” Harvard Business Review (March/April
1994); J. Womack and D. T. Jones, “Beyond Toyota: How
to Root Out Waste and Pursue Perfection,” Harvard
Business Review (September/October, 1996).

34. M. Hammer and J. Champy, Re-engineering the Corpo-
ration: A Manifesto for Business Revolution (New York:
HarperBusiness, 1993): 32.

35. V. Glover and M. L. Marcus, “Business Process Transfor-
mation,” Advances in Management Information Systems
9 (M. E. Sharpe, March 2008); R. Merrifield, J. Calhoun,
and D. Stevens, “The Next Revolution in Productivity,”
Harvard Business Review (November 2006): 72–79.

36. www.autoevolution.com/news/gm-to-cut-costs-by-
using-only-4-platforms-by-2025-87460.html. Accessed
December 19, 2017.

37. F. X. Frei, “Breaking the Tradeoff between Efficiency
and Service,” Harvard Business Review (November
2006): 92–103.

38. Bureau of Labor Statistics, http://www.bls.gov/iag/tgs/iag-
auto.htm, accessed July 20, 2015.

39. “Buying Power of Multiproduct Retailers,” OECD Journal
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40. P. Krugman, “Amazon’s Monopsony Is Not O.K.,” New
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41. R. Cyert and J. March, A Behavioral Theory of the Firm
(Englewood Cliffs, NJ: Prentice Hall, 1963).

42. H. Leibenstein, “Allocative Efficiency versus X-Efficiency,”
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188 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

43. “Fighting the Flab,” Economist (March 22, 2014).
44. K. Kase, F. J. Saez, and H. Riquelme, The New Sam-

urais of Japanese Industry (Cheltenham: Edward
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45. M. E. Porter, Competitive Advantage (New York: Free
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son, “Time-Driven Activity-based Costing,” Harvard
Business Review (November 2004): 131–138.

46. M. E. Porter, Competitive Advantage (New York: Free
Press, 1985): 120.

47. T. Peters, Thriving on Chaos (New York: Knopf,
1987): 56.

48. “Cemex: Cementing a Global Strategy,” Insead Case
No. 307-233-1 (2007).

49. The distinction between segmentation and
differentiation is discussed in P. R. Dickson
and J. L. Ginter, “Market Segmentation, Product
Differentiation, and Marketing Strategy,” Journal of
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50. S. Schiffman, M. Reynolds, and F. Young, Introduction
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51. F.-J. Lapointe and P. Legendre, “A Classification
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52. P. Cattin and D. R. Wittink, “Commercial Use of
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53. K. Lancaster, Consumer Demand: A New Approach
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54. P. Nicolaides and C. Baden-Fuller, Price
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European Domestic Appliance Market (London:
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55. A. Maslow, “A Theory of Human Motivation,”
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58. Porter, Competitive Advantage, op. cit., 124–125.
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“Rethinking Customer Solutions: From Product Bun-
dles to Relational Processes,” Journal of Marketing
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61. K. Clark and T. Fujimoto, Product Development
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December, 1990): 107–118.

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64. D. J. Watts and J. Peretti, “Viral Marketing for
the Real World,” Harvard Business Review (May
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65. M. E. Porter, Competitive Strategy (New York: Free
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8

No company ever stops changing . . . Each new generation must meet changes—in
the automotive market, in the general administration of the enterprise, and in the
involvement of the corporation in a changing world. The work of creating goes on.

—ALFRED P. SLOAN JR., PRESIDENT OF GENERAL MOTORS 1923–37, CHAIRMAN 1937–56

It is not the strongest of the species that survive, nor the most intelligent, but the one
that is most responsive to change.

—CHARLES DARWIN

You keep same-ing when you ought to be changing.

—LEE HAZLEWOOD, THESE BOOTS ARE MADE FOR WALKING, RECORDED BY NANCY SINATRA, 1966

Industry Evolution and
Strategic Change

◆ Introduction and Objectives

◆ The Industry Life Cycle

● Demand Growth

● Creation and Diffusion of Knowledge

● How General is the Life-Cycle Pattern?

● Implications of the Life Cycle for Competition and
Strategy

◆ The Challenge of Organizational Adaptation and
Strategic Change

● Why is Change So Difficult? The Sources of Organiza-
tional Inertia

● Organizational Adaptation and Industry Evolution

● Coping with Technological Change

◆ Managing Strategic Change

● Dual Strategies and Organizational Ambidexterity

● Combatting Organizational Inertia

● Developing New Capabilities

● Dynamic Capabilities

● Using Knowledge Management to Develop
Organizational Capability

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

190 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Introduction and Objectives

Everything is in a state of constant change—the business environment especially. One of the greatest
challenges of strategic management is to ensure that the firm keeps pace with changes occurring
within its environment.

Change in the industry environment is driven by technology, consumer needs, politics, economic
conditions, and a host of other influences. Some industries have been transformed by these forces. In
the 1980s, telecommunications were dominated by monopolies such as British Telecom, Deutsche Tele-
kom, and AT&T. Now, diverse providers—Vodafone, SoftBank, Comcast, Twitter and WhatsApp (owned
by Facebook)—compete with multiple communications technologies. In other industries—food
processing, railroads, and car rental—change is more gradual and more predictable.

The purpose of this chapter is to help us to understand and manage change. To do this we shall
explore the forces that drive change and look for patterns that can help us to predict how industries are
likely to evolve over time. While each industry follows a unique development path, there are common
drivers of change that give rise to similar patterns of change, thereby allowing us to identify opportu-
nities for competitive advantage.

Understanding, even predicting, change in an industry’s environment is difficult. Adapting to
change is even more so. For individuals, change is disruptive, costly, and uncomfortable. For orga-
nizations, the forces of inertia are even stronger. As a result, the life cycles of firms tend to be much
shorter than the life cycles of industries: changes at the industry level tend to occur through the
death of existing firms and the birth of new firms rather than through continuous adaptation by
a constant population of firms. We need to understand these sources of inertia in organizations
in order to overcome them. We shall look, not only at firms’ adaptation to change, but also at the
potential for firms to initiate change. What determines the ability of some firms to become game-
changers in their industries?

Whether adapting to or initiating change, competing in a changing world requires the development
of new capabilities. Building upon our analysis of organizational capability in Chapters  5 and  6, we
address the challenges firms face in building new capabilities.

By the time you have completed this chapter, you will be able to:

◆ Recognize the different stages of industry development; understand the factors that drive
industry evolution; and recommend strategies appropriate to the different stages of the
industry life cycle.

◆ Understand the sources of organizational inertia, the process of organizational evolution,
and the challenges of technological change.

◆ Become familiar with the different tools to manage strategic change including: organi-
zational ambidexterity, scenarios, crisis management, capability development, dynamic
capabilities, and knowledge management.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 191

The Industry Life Cycle

One of the best-known and most enduring marketing concepts is the product life
cycle.1 Products are born, their sales grow, they reach maturity, they go into decline,
and they ultimately die. If products have life cycles, so the industries that produce them
experience an industry life cycle. To the extent that an industry produces multiple
generations of a product, the industry life cycle is likely to be of longer duration than
that of a single product.

The life cycle comprises four phases: introduction (or emergence), growth, matu-
rity, and decline (Figure 8.1). Let us first examine the forces that drive industry evolu-
tion, and then look at the features of each of these stages. Two forces are fundamental:
demand growth and the production and diffusion of knowledge.

Demand Growth

The life cycle and the stages within it are defined primarily by changes in an industry’s
growth rate over time. The characteristic profile is an S-shaped growth curve.

● In the introduction stage, sales are small and the rate of market penetration is
low because the industry’s products are little known and customers are few.
The novelty of the technology, small scale of production, and lack of experi-
ence mean high costs and low quality. Customers for new products tend to be
affluent, tech-savvy, and risk-tolerant.

● The growth stage is characterized by accelerating market penetration as
technical improvements and increased efficiency open up the mass market.

● Increasing market saturation causes the onset of the maturity stage. Once satu-
ration is reached, demand is wholly for replacement.

● Finally, as new substitute products appear, the industry enters its
decline stage.

INTRODUCTION

GROWTH

MATURITY

DECLINE

In
du

st
ry

S
al

es

Time

FIGURE 8.1 The industry life cycle

192 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Creation and Diffusion of Knowledge

The second driver of the industry life cycle is knowledge. New knowledge is responsible
for an industry’s birth, and the dual processes of knowledge creation and knowledge
diffusion exert a major influence on industry evolution.

In the introduction stage, product technology advances rapidly. There is no domi-
nant product technology, and rival technologies compete for attention. Competition is
primarily between alternative technologies and design configurations:

● The first 30 years of steam ships featured competition between paddles and
propellers, wooden hulls and iron hulls, and, eventually, between coal and oil.

● The beginnings of the personal computer industry during 1978–82 saw compe-
tition between different data storage systems (audiotapes vs. floppy disks), dif-
ferent visual displays (TV receivers vs. dedicated monitors), different operating
systems (CPM vs. DOS vs. Apple II), and different microprocessor architectures.

Dominant Designs and Technical Standards The outcome of competition bet-
ween rival designs and technologies is usually convergence by the industry around
a dominant design—a product architecture that defines the look, functionality, and
production method for the product and becomes accepted by the industry as a whole.
Dominant designs have included:

● The Underwood Model 5 introduced in 1899 established the basic architecture
and main features of typewriters for the 20th century: a moving carriage, the
ability to see the characters being typed, a shift function for upper-case charac-
ters, and a replaceable inked ribbon.2

● Leica’s Ur-Leica camera launched in Germany in 1924 established key features
of the 35 mm camera, though it was not until Canon began mass-producing
cameras based on the Leica original that this design of 35 mm camera came to
dominate still photography.

● When Ray Kroc opened his first McDonald’s hamburger restaurant in Illinois
in 1955, he established what would soon become a dominant design for the
fast-food restaurant industry: a limited menu, no waiter service, eat-in and
take-out options, roadside locations for motorized customers, and a franchising
model for licensing the entire business system.

The concepts of dominant design and technical standard are related but distinct.
Dominant design refers to the overall configuration of a product or system. A technical
standard is a technology or specification that allows compatibility. While technical stan-
dards typically embody intellectual property in the form of patents or copyright, dom-
inant designs usually do not. A dominant design may or may not embody a technical
standard. IBM’s PC established both a dominant design for personal computers and
the “Wintel” standard. Conversely, the Boeing 707 was a dominant design for large
passenger jets, but did not set industry standards in aerospace technology. Technical
standards arise where there are network effects—the need for users to connect with
one another. Network effects cause each customer to choose the same technology as
everyone else to avoid being stranded. Unlike a proprietary technical standard, which is
typically embodied in patents or copyrights, a firm that sets a dominant design does not
normally own intellectual property in that design. Hence, except for some early-mover
advantage, there is not necessarily any profit advantage from setting a dominant design.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 193

Dominant designs also exist in processes. In the flat glass industry, there has been
a succession of dominant process designs from glass cylinder blowing to continuous
ribbon drawing to float glass.3 Dominant designs are present, too, in business models.
In many new markets, competition is between rival business models. In home gro-
cery delivery, e-commerce start-ups such as Webvan and Peapod soon succumbed to
competition from “bricks and clicks” retailers such as Giant, and Walmart (and Tesco
in the UK).

From Product to Process Innovation The emergence of a dominant design marks
a critical juncture in an industry’s evolution. Once the industry coalesces around a
leading product design, there’s a shift from radical to incremental product innovation.
Greater certainty over product design and its trajectory reduces risks to customers and
firms, triggering the industry’s growth phase. The emphasis on efficiency and prod-
uct reliability causes process innovation to take precedence over product innovation
(Figure  8.2). The combination of process improvements, design modifications, and
scale economies results in falling costs, which drive rapidly increasing market pene-
tration. Strategy Capsule 8.1 uses the automobile industry to illustrate this pattern of
development.

Consumer also benefit from knowledge diffusion. As they become increasingly
knowledgeable about the performance attributes of rival manufacturers’ products,
so they are better able to judge value for money and become more price sensitive.

How General is the Life-Cycle Pattern?

To what extent do industries conform to this life-cycle pattern and how variable is the
duration of the life cycle?

● The hotel industry had its origins over two millennia ago. In year 1 AD, the
baby Jesus was born in a stable in Bethlehem because, according to Luke’s
Gospel, “there was no room at the inn.” In the US, hotels (as distinct from inns)
were established in the late 18th century. During the 21st century, the industry
has continued to expand. However, home sharing services such as Airbnb pre-
sent a threat to continued growth.

Time

Product Innovation

Process Innovation

Ra
te

o
f I

nn
ov

at
io

n

FIGURE 8.2 Product and process innovation over time

194 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

● The introduction phase of the US railroad industry extended from the building
of the first railroad, the Baltimore and Ohio in 1827, to the growth phase of the
1870s. With the growth of road transport, the industry entered its decline phase
during the late 1950s.

● Digital audio players (MP3 players) were first introduced by Seehan Information
Systems and Diamond Multimedia in 1997. With the launch of Apple’s iPod
in 2001, the industry entered its growth phase. After reaching a peak in 2009,
global sales of MP3 players, including the iPod, went into steep decline. By
2017, dedicated MP3 players were widely viewed as obsolete.

Over time, industry life cycles have become increasingly compressed—especially
in e-commerce. The implication is that “competing on internet time” requires a radical
rethink of strategies and management processes.4

Patterns of evolution also differ. Industries supplying basic necessities such as res-
idential construction, food processing, and clothing may never enter a decline phase

STRATEGY CAPSULE 8.1

Evolution of the Automobile Industry

The period 1890–1912 was one of rapid product inno-

vation in the auto industry. Karl Benz’s introduction of

a  three-wheel motor carriage in 1886 was followed

by  a  flurry of technical advances which occurred in

Germany, France, the US, and the UK. Developments

included

◆ the first four-cylinder four-stroke engine (by Karl

Benz in 1890);

◆ the honeycomb radiator (by Daimler in 1890);

◆ the manual gearbox (Panhard and Levassor in 1895);

◆ automatic transmission (by Packard in 1904);

◆ electric headlamps (by General Motors in 1908);

◆ the all-steel body (adopted by General Motors

in 1912).

Ford’s Model T, introduced in 1908, with its

front-mounted, water-cooled engine and transmis-

sion with a gearbox, wet clutch, and rear-wheel drive,

became a dominant design for the industry. During the

remainder of the 20th century, alternative technologies

and designs were eliminated. Volkswagen’s Beetle

was the last mass-produced car with a rear-mounted,

air-cooled engine. Citroen abandoned its distinctive

suspension and braking systems. Four-stroke engines

with four or six inline cylinders became dominant. Dis-

tinctive national differences eroded as American cars

became smaller and Japanese and Italian cars became

bigger. The fall of the Iron Curtain extinguished the

last outposts of nonconformity: by the mid-1990s, East

German two-stroke Wartburgs and Trabants were col-

lectors’ items.

As product innovation slowed, so process innova-

tion took off. In 1913, Ford’s Highland Park Assembly

Plant with its revolutionary moving assembly line began

production. The price of the Model T fell from $628 in

1908 to $260 in 1924. By 1927, 15 million Model Ts had

been produced.

Then came Toyota’s system of lean production,

involving a tightly integrated “pull” system of produc-

tion embodying just-in-time scheduling, team-based

production, flexible manufacturing, and total quality

management. By the end of the 20th century, lean produc-

tion had diffused throughout the world’s vehicle industry.

However, by 2018, a new era was dawning: electric

propulsion and autonomous driving threatened to trans-

form the world automobile industry.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 195

because obsolescence is unlikely for essential needs. Some industries may experience
a rejuvenation of their life cycle. The market for TV receivers has experienced multiple
revivals: color TVs, portable TVs, flat-screen TVs, and HDTVs. Similar waves of innova-
tion have revitalized retailing (Figure 8.3).

An industry is likely to be at different stages of its life cycle in different countries.
Although the automobile markets of the EU, Japan, and the US are in their decline
phase, those of Asia and Latin America are in their growth phase. Multinational com-
panies can exploit such differences: developing new products and introducing them
into the advanced industrial countries, then shifting attention to emerging markets once
maturity sets in.

A further feature of industry evolution is shifting industry boundaries—some indus-
tries converge (cell phones, portable game players, cameras, and calculators); other
industries (banking and medical services) fragment.5

Implications of the Life Cycle for Competition and Strategy

Changes in demand growth and technology over the cycle have implications for industry
structure, the population of firms, and competition. Table 8.1 summarizes them.

Product Differentiation The introduction stage typically features a variety of prod-
uct types that incorporate diverse technologies and designs. Convergence around a
dominant design is often followed by commoditization during the mature phase unless
producers develop new dimensions for differentiation. Personal computers, credit
cards, online financial services, wireless communication services, and Internet access
have all become commodity items, which buyers select primarily on price. However,
the trend toward commoditization also creates incentives for firms to create novel
approaches to differentiation.

Organizational Demographics and Industry Structure The number of firms
in an industry changes substantially over the life cycle. The field of organizational
ecology, founded by Michael Hannan, John Freeman, and Glen Carroll, analyzes the

Mail Order,
Catalogue
Retailers
e.g., Sears
Roebuck,

Montgomery
Ward

Chain
Stores

e.g., A&P,
Woolworth’s,

WHSmith

Warehouse
Clubs

e.g., Price Club
Sam’s Club

Department
Stores

e.g., Le Bon
Marché,
Macy’s,
Harrods

Discount
Stores

e.g., Kmart
Walmart

Category
Killers

e.g., Toys “R”
Us, Home

Depot

Internet
Retailers

e.g., Amazon,
Alibaba

Pop-Up
Stores

2000 1980196019401920190018801840

FIGURE 8.3 Innovation and renewal in the industry life cycle: Retailing

196 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

population of firms within an industry and the processes of founding and selection that
determine entry and exit.6 Some of the main findings of the organizational ecologists in
relation to industry evolution are:

● The number of firms in an industry increases rapidly during the early stages of
an industry’s life. As an industry gains legitimacy, failure rates decline and the
rate of new firm foundings increases. The US automobile industry comprised
272 manufacturers in 1909,7 while in TV receivers there were 92 companies in
1951.8 New entrants include both start-up companies (de novo entrants) and
established firms diversifying from other industries (de alio entrants).

● With the onset of maturity, the number of firms begins to fall—often involving
a shakeout phase during which the rate of firm failure increases sharply. After
this point, rates of entry and exit decline and the survival rate for incumbents
increases substantially.9 In the US tire industry, the number of firms grew from
one (Goodrich) in 1896 to 274 in 1922 before shakeout reduced the industry to
49 firms in 1936.10 By 2018, subsequent waves of consolidation resulted in the

TABLE 8.1 The evolution of industry structure and competition over the life cycle

Introduction Growth Maturity Decline

Demand Limited to early adopters:
high income,
avant garde

Rapidly increasing
market penetration

Mass market, replacement/
repeat buying. Cus-
tomers knowledgeable
and price sensitive

Obsolescence

Technology Competing technol-
ogies, rapid product
innovation

Standardization around
dominant tech-
nology, rapid process
innovation

Well-diffused technical
know-how: quest
for technological
improvements

Little product
or process
innovation

Products Poor quality, wide variety
of features and tech-
nologies, frequent
design changes

Design and quality
improve, emergence
of dominant design

Trend to commoditization.
Attempts to differentiate
by branding, quality,
and bundling

Limited scope for
differentiation

Manufacturing
and distribution

Short production runs,
high-skilled labor
content, specialized
distribution channels

Capacity shortages, mass
production, competi-
tion for distribution

Emergence of overcapacity,
deskilling of produc-
tion, long production
runs, distributors carry
fewer lines

Chronic over-
capacity,
reemergence of
specialty channels

Trade Producers and
consumers in
advanced countries

Exports from advanced
countries to
rest of world

Production shifts to newly
industrializing then
developing countries

Exports from coun-
tries with lowest
labor costs

Competition Few companies Entry, mergers, and exits Shakeout, price
competition increases

Price wars, exits

Key success factors Product innovation,
establishing cred-
ible image of firm
and product

Design for manufacture,
access to distribution,
brand building, fast
product development,
process innovation

Cost efficiency through
capital intensity, scale
efficiency, and low
input costs

Low overheads,
buyer selection,
signaling com-
mitment, ratio-
nalizing capacity

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 197

world tire industry being dominated by seven companies: Bridgestone, Michelin,
Continental, Goodyear, Pirelli, Hankook, and Sumitomo.

● Consolidation may be accompanied by a new phase of entry as new firms seek
niche positions in the industry—a process referred to as resource partitioning.
For example, as the world beer industry has become dominated by a few global
giants—AB Inbev, Carlsberg, and Heineken—so a wave of craft brewers have
entered the industry.11

Location and International Trade Industries migrate internationally during their
life cycles. New industries begin in the advanced industrial countries because of the
presence of affluent consumers and the availability of technical and scientific resources.
As demand grows in other countries, they are serviced initially by exports, but with
deskilling of production processes, production shifts first to newly industrializing coun-
tries and eventually to developing countries.

In 1975, the world’s leading producers of television receivers were Japan, US,
Germany, Taiwan, and UK. By 2014, the leading producers were China, Mexico, South
Korea, and India.

The Nature and Intensity of Competition These changes in industry structure
over the life cycle—commoditization, new entry, and international diffusion of pro-
duction—have implications for competition: first, a shift from nonprice competition to
price competition; second, margins shrink as the intensity of competition grows.

During the introduction stage, the battle for technological leadership means that
price competition may be weak, but heavy investments in innovation and market
development depress profitability. The growth phase is more conducive to profitability
as market demand outstrips industry capacity, especially if incumbents are protected
by barriers to entry. With the onset of maturity, increased product standardization and
excess capacity stimulate price competition, especially during shakeout. How intense
this is depends a great deal on the balance between capacity and demand and the
extent of international competition. In food retailing, airlines, motor vehicles, metals,
and insurance, maturity was accompanied by strong price competition and slender
profitability. In household detergents, breakfast cereals, cosmetics, and cigarettes, con-
solidation and strong brands have limited price rivalry and supported high margins.
The decline phase usually involves strong price competition (often degenerating into
destructive price wars) and dismal profit performance.

Key Success Factors and Industry Evolution These same changes in structure
together with changes in demand and technology over the industry life cycle also
have important implications for the sources of competitive advantage at each stage of
industry evolution:

1 During the introductory stage, product innovation is the basis for initial entry and
for subsequent success. Soon, other requirements for success emerge: growing
investment requirements necessitate increased financial resources; product
development needs to be supported by capabilities in manufacturing, marketing,
and distribution.

2 Once the growth stage is reached, the key challenge is scaling up. As the
market expands, product design and manufacturing must adapt to the needs

198 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

of large-scale production. As Figure 8.4 shows, investment in R&D, plant and
equipment, and sales tends to be high during the growth phase. Increased
manufacturing must be matched by widening distribution.

3 With maturity, competitive advantage is increasingly a quest for efficiency, par-
ticularly in industries that tend toward commoditization. Cost efficiency through
scale economies, low wages, and low overheads becomes the key success factor.
Figure 8.4 shows that R&D, capital investment, and marketing are lower in
maturity than during the growth phase.

4 The transition to decline intensifies pressures for cost cutting. It also requires
maintaining stability by encouraging the orderly exit of industry capacity and
capturing residual market demand.

The Challenge of Organizational Adaptation and Strategic Change

We have established that industries change. But what about the companies within
them? Let us turn our attention to business enterprises and consider both the impedi-
ments to change and the means by which change takes place.

12

10

8

6

4

2

0

RO
I

V
al

u
e

A
d

d
ed

/R
ev

en
u

e

Te
ch

n
ic

al
C

h
an

g
e

N
ew

P
ro

d
u

ct
s

%
S

al
es

fr
o

m
N

ew
Pr

o
d

u
ct

s

Pr
o

d
u

ct
R

&
D

/S
al

es

A
g

e
o

f P
la

n
t

an
d

Eq
u

ip
m

en
t

In
ve

st
m

en
t/

Sa
le

s

A
d

ve
rt

is
in

g
/S

al
es

Growth
Maturity
Decline

FIGURE 8.4 Differences in strategy and performance between businesses at
different stages of the industry life cycle

Note: The figure shows standardized means for each variable for businesses at each stage of the life cycle.

Source: C. Anderson and C. Zeithaml, “Stage of the Product Life Cycle, Business Strategy and Business
Performance,” Academy of Management Journal 27 (1984): 5–24.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 199

Why is Change so Difficult? The Sources of
Organizational Inertia

At the heart of all approaches to change management is the recognition that organi-
zations find change difficult. Why is this so? Different theories of organizational and
industrial change emphasize different barriers to change:

● Organizational routines: Evolutionary economists emphasize the fact that
capabilities are based on organizational routines—patterns of coordinated
interaction among organizational members that develop through continual
repetition. The more highly developed are an organization’s routines, the
more difficult it is to develop new routines. Hence, organizations get caught in
competency traps12 where “core capabilities become core rigidities.”13

● Social and political structures: Organizations are both social systems and
political systems. As social systems, organizations develop patterns of interaction
that make organizational change stressful and disruptive.14 As political systems,
organizations develop stable distributions of power; change represents a threat
to the power of those in positions of authority. Hence, both as social systems
and political systems, organizations tend to resist change.

● Conformity: Institutional sociologists emphasize the propensity of firms to
imitate one another in order to gain legitimacy. The process of institutional
isomorphism locks organizations into common structures and strategies that
make it difficult for them to adapt to change.15 The pressures for conformity can
be external—governments, investment analysts, banks, and other resource pro-
viders encourage the adoption of similar strategies and structures. Isomorphism
also results from voluntary imitation—risk aversion encourages companies to
adopt similar strategies and structures to their peers.16

● Limited search: The Carnegie School of organizational theory (associated with
Herbert Simon, Jim March, and Richard Cyert) views search as the primary
source of organizational change. Organizations tend to limit search to areas
close to their existing activities—they prefer exploitation of existing knowledge
over exploration for new opportunities.17 Limited search is reinforced, first, by
bounded rationality—human beings have limited information processing
capacity, which constrains the set of choices they can consider and, second, by
satisficing—the propensity for individuals (and organizations) to terminate the
search for better solutions when they reach a satisfactory level of performance
rather than to pursue optimal performance. The implication is that organizations
are only willing to accept major changes when they are faced with a dramatic
decline in performance.

● Complementarities between strategy, structure, and systems: We encountered
the notion of strategic fit in Chapter 1. A firm’s strategy must fit its external envi-
ronment and its internal resources and capabilities. Moreover, all the compo-
nents of a firm’s strategy must fit together: we observed that strategy is manifest
as an activity system. Ultimately, all the features of an organization—strategy,
structure, systems, culture, goals, and employee skills—are complemen-
tary.18 Organizations establish combinations of strategy, processes, structures,
and management styles during their early phases of development that are
shaped by the circumstances that they encounter. However, once established,

200 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

this configuration becomes a barrier to change. For the firm to adapt to new
circumstances, it is not enough to make incremental changes in a few dimen-
sions of strategy—it is likely that the firm will need to find a new configura-
tion that involves a comprehensive set of changes (Strategy Capsule 8.2).19
As a result, organizations tend to evolve through a process of punctuated
equilibrium, involving long periods of stability during which the widening mis-
alignment between the organization and its environment ultimately forces rad-
ical and comprehensive change on the company.20

Organizational Adaptation and Industry Evolution

Thinking about industrial and organizational change has been strongly influenced by
ideas from evolutionary biology. Evolutionary change is viewed as an adaptive process

STRATEGY CAPSULE 8.2

A Tight-Fitting Business System Makes Change Perilous:
The liz Claiborne Story

During the 1980s, Liz Claiborne became a highly suc-

cessful designer, manufacturer, and retailer of clothes for

professional women. Liz Claiborne’s success was based

upon a strategy that combined a number of closely

linked choices concerning functions and activities.

◆ Design was based around a “color by numbers”

approach involving “concept groups” of different gar-

ments that could be mixed and matched.

◆ Department stores were encouraged to provide

dedicated space to present Liz Claiborne’s con-

cept collections. Liz Claiborne consultants visited

department stores to train their sales staff and to

ensure that the collections were being displayed

correctly.

◆ Retailers could not purchase individual garment

lines; they were required to purchase the entire con-

cept group and had to submit a single order for each

season—they could not reorder.

◆ Most manufacturing was contracted out to garment

makers in SE Asia.

◆ To create close contact with customers, Liz Clai-

borne offered fashion shows at department stores,

“breakfast clinics” where potential customers could

see the latest collection, and tracked customer pref-

erences through point-of-sale data collection.

◆ Rather than the conventional four-season product

cycle, Liz Claiborne operated a six-season cycle.

During the 1990s, Liz Claiborne’s performance went

into a sharp decline. The key problem was the trend

toward more casual clothes in the workplace. Moreover,

financial pressures on department stores made them

less willing to buy complete collections. As a result, Liz

Claiborne allowed reordering by retailers. However,

once retailers could split orders into smaller, more fre-

quent orders, the entire Liz Claiborne system began to

break down: it could not adapt to the quick-response,

fast-cycle model that was increasingly dominant within

the garment trade. In 1994, Liz Claiborne appointed a

new CEO who systematically rebuilt the business around

a more casual look, more flexibility within its collec-

tions (although still with a common “color card”), and a

shorter supply chain, with most production in North and

Central America.

Source: N. Siggelkow, “Change in the Presence of Fit: The Rise,
the Fall, and the Renaissance of Liz Claiborne,” Academy of
Management Journal 44 (2001): 838–857.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 201

that involves variation, selection, and retention.21 Different research traditions focus on
different levels at which these evolutionary processes occur:

● Organizational ecology has been discussed in relation to changes in the number
of firms in an industry over time. However, organizational ecology is a broader
theory of economic change that assumes organizational inertia. As a result,
industry evolution occurs through changes in the population of firms rather
than by adaptation of firms themselves. Industries develop and grow through
new entry spurred by the imitation of initial successful entrants. The competitive
process is a selection mechanism, in which organizations whose characteristics
match the requirements of their environment can attract resources; those that do
not are eliminated.22

● Evolutionary economics emphasizes change within individual firms. The
processes of variation, selection, and retention take place at the level of the
organizational routine—unsuccessful routines are abandoned; successful rou-
tines are retained and replicated within the organization.23 As we discussed in
Chapter 5, these patterns of coordinated activity are the basis for organizational
capability. Firms evolve through searching for new routines, replicating success-
ful routines, and abandoning unsuccessful routines.

While the membership of most industries changes dramatically over time, some
firms show a remarkable capacity for adaptation. BASF has been one of the world’s
leading chemical companies since it was founded in 1865 to produce synthetic dyes.
Exxon and Shell have led the world’s petroleum industry since the late 19th century.24
Mitsui Group, a Japanese conglomerate, is even older—its first business, a retail store,
was established in 1673.

Yet these companies are exceptions. Among the companies forming the original
Dow Jones Industrial Average in 1896, only General Electric remained in the index
until it was dropped in July 2018. Of the world’s 12 biggest companies in 1912, none
remained in the top 12 by 2018 (Table 8.2). And life spans are shortening: the average
period in which companies remained in the S&P 500 was 90 years in 1935; in 1958 it
was 61 years; by 2011 it was down to 18 years.

The demise of great companies partly reflects the rise of new industries—notably
the information and communications technology (ICT) sector, but also the failure of
established firms to adapt successfully to the life cycles of their own industries.

Even if the pattern of industry evolution can be predicted, different stages of the life
cycle require different resources and capabilities. The innovators that pioneer the
creation of a new industry are typically different companies from the “consolidators”
that develop it:

The skills, mind-sets, and competences needed for discovery and invention are not
only different from those needed for commercialization; they conflict with the needed
characteristics. This means that the firms good at invention are unlikely to be good at
commercialization and vice versa.25

The typical pattern is that technology-based start-ups that pioneer new areas of
business are acquired by companies that are well established in closely related indus-
tries, and these established incumbents offer the financial resources and functional
capabilities needed to grow start-ups. In plant biotechnology, the pioneers were start-
ups such as Calgene, Cetus Corporation, DNA Plant Technologies, and Mycogen;

202 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

by 2018, the leading suppliers of genetically modified seeds were Bayer (which
acquired Monsanto), ChemChina (which acquired Syngenta), and DowDuPont—all
long-established chemical firms. Of course, some start-ups do survive industry shake-
outs and acquisition to become industry leaders: Google, Cisco Systems, and Face-
book are examples. Geoffrey Moore describes the transition from a start-up serving
early adopters to an established business serving mainstream customers as “crossing
the chasm.”26

In most new industries, we find a mixture of start-up companies (de novo entrants)
and established companies that have diversified from other sectors (de alio entrants).
Which is more successful depends upon whether the flexibility and entrepreneurial
advantages of start-ups outweigh the superior resources and capabilities of established
firms. This further depends upon whether the resources and capabilities required in the
new industry are similar to those present in an existing industry. Where these linkages
are close, de alio entrants are at an advantage: in automobiles, former bicycle, carriage,
and engine manufacturers tended to be the best performers;27 television production
was dominated by former producers of radios.28

Many start-up ventures also draw resources and capabilities from established firms.
A high proportion of new ventures are established by former employees of existing
firms within that sector. In Silicon Valley, most of the leading semiconductor firms,
including Intel, trace their origins to Shockley Semiconductor Laboratories, the pioneer
of integrated circuits.29 Established companies are often important investors in new
ventures. Investors in Uber include the Chinese Internet giant Baidu and the founders
of Amazon, Napster, and Yelp.

TABLE 8.2 World’s biggest companies in terms of market capitalization,
1912 and 2018

1912 $billion 2018 $billion

US Steel 0.74 Apple 876

Standard Oil NJ (Exxon) 0.39 Alphabet 737

J&P Coates 0.29 Microsoft 658

Pullman 0.20 Amazon 567

Royal Dutch Shell 0.19 Facebook 511

Anaconda 0.18 Tencent 496

General Electric 0.17 Berkshire Hathaway 488

Singer 0.17 Alibaba 441

American Brands 0.17 Johnson & Johnson 376

Navistar 0.16 JP Morgan Chase 371

British American Tobacco 0.16

De Beers 0.16

Sources: L. Hannah “Marshall’s ‘Trees’ and the Global ‘Forest’: Were ‘Giant Redwoods’ Different?” in N. Lamoreaux, D.
Raff, and P. Temin (eds), Learning by Doing in Markets, Firms and Nations, Chicago: University of Chicago Press, 1999:
253–94; Financial Times (January 3, 2018).

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 203

Coping with Technological Change

Competition between new start-ups and established firms is not restricted to the early
phases of an industry’s life cycle: it is ongoing. The threat that newcomers pose to
established firms is greatest during periods of technological change—especially when
the new technology is “competence destroying,” “architectural,” or “disruptive.”

Competence Enhancing and Competence Destroying Technological Change
Some technological changes undermine the resources and capabilities of established
firms—according to Tushman and Anderson, they are “competence destroying.” Other
changes are “competence enhancing”—they preserve, even strengthen, the resources
and capabilities of incumbent firms.30 The quartz watch radically undermined the compe-
tence base of mechanical watchmakers. Conversely, the turbofan, a major advance in jet
engine technology, reinforced the capability base of existing aero engine manufacturers.

Architectural and Component Innovation The ease with which established firms
adapt to technological change depends upon whether the innovation occurs at the
component or the architectural level. Innovations that change the overall architecture
of a product create great difficulties for established firms because an architectural inno-
vation requires a major reconfiguration of a company’s strategy and activity system.31
In automobiles, the hybrid engine was an important innovation but did not require
a major reconfiguration of car design and engineering. The battery-powered electric
motor is an architectural innovation—it requires redesign of the entire car and involves
carmakers in creating systems for recharging. In many sectors of e-commerce—online
grocery purchases and online banking—the internet involved innovation at the com-
ponent level (it provided a new channel of distribution for existing products). Hence,
existing supermarket chains and established retail banks with their clicks and bricks
business models have dominated online groceries and online financial services. The
rise of Boeing during the 1960s to become the world’s leading producer of passenger
aircraft was primarily because of its recognition that the jet engine was an architectural
innovation that necessitated a major redesign of airplanes.32

Disruptive Technologies Clay Christiansen distinguishes between new technology
that is sustaining—it augments existing performance attributes—and new technology
that is disruptive—it incorporates different performance attributes than the existing
technology.33

Steam-powered ships were initially slower, more expensive, and less reliable than
sailing ships. The leading shipbuilders failed to make the transition to steam power
because their leading customers, the transoceanic shipping companies, remained loyal
to sail until the closing decades of the 19th century. Steam power was used mainly
for inland waters, which lacked constant winds. After several decades of gradual
development for these niche markets, stream-powered ships were able to outperform
sailing ships on ocean routes.

In the disk-drive industry, some technological innovations—such as thin-film heads
and more finely dispersed ferrous oxide coatings—enhanced the dominant performance
criterion—recording density—reinforcing the market positions of established industry
leaders. Other disk-drive technologies, notably new product generations with smaller
diameters, were disruptive: established companies lagged behind newcomers in
launching the new disk sizes and typically lost their industry leadership.34 They stored
less data and were resisted by major customers. Thus, the 3.5-inch disk was introduced

204 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

by Connor Peripherals (mainly for use in laptop computers), but was initially rejected
by industry leader, Seagate. Within three years, the rapid development of the 3.5-inch
disk had rendered the 5.25-inch disk obsolete.35

Managing Strategic Change

Given the many barriers to organizational change and the difficulties that companies
experience in coping with disruptive technologies and architectural innovation, how
can companies adapt to changes in their environment?

Just as the sources of organizational inertia are many, so too are the theories and
methods of organizational change. Until the 1980s, most approaches to organizational
change were based upon the behavioral sciences and emphasized bottom-up, decen-
tralized initiatives. Socio-technical systems emphasized the need for social systems to
adapt to the requirements of new technologies,36 while organizational development
(OD) emphasized group dynamics and the role of “change agents.”37

More recently, managing change has become a central topic within strategic
management practice and research. In this section, we review four approaches to
managing strategic change. We begin with the challenge of managing for today while
preparing for tomorrow and discuss the potential for organizational ambidexterity.
Second, we examine management tools for counteracting organizational inertia. Third,
we explore the means by which companies develop new capabilities. Fourth, we
address the role and nature of dynamic capabilities. Finally, we examine the contri-
bution of knowledge management.

Dual Strategies and Organizational Ambidexterity

In Chapter 1, we learned that strategy has two major dimensions: positioning for the
present and adapting to the future. Reconciling the two is difficult. Derek Abell argued
that “managing with dual strategies”—in terms of “lavishing attention on those factors
that are critical to short-term success” while “changing a business in anticipation of the
future”—is the most challenging dilemma that senior managers face.38

Abell argues that dual strategies require dual planning systems: short-term planning
that focuses on strategic fit and performance over a one- or two-year period; and
longer-term planning to develop vision, reshape the corporate portfolio, redefine and
reposition individual businesses, develop new capabilities, and redesign organizational
structures over periods of five years or more. This challenge of reconciling “competing
for today” with “preparing for tomorrow” is closely related to the tradeoff between
exploitation and exploration that we discussed in relation to organizational inertia.

Charles O’Reilly and Michael Tushman use the term “organizational ambidexterity”
to refer to the capacity to reconcile exploration with exploitation. The ambidextrous
firm is “capable of simultaneously exploiting existing competences and exploring new
opportunities.”39 There are two approaches to creating organizational ambidexterity:
structural and contextual.

Structural Ambidexterity involves creating organizational units for exploration
activities that are separate from the core operational activities of the company.40 For
example:

● IBM developed its PC in a separate unit in Florida—far from IBM’s corporate
headquarters in New York. Its leader, Bill Lowe, claimed that this separation was

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 205

critical to creating a business system that was radically different from IBM’s ver-
tically integrated mainframe business.41

● Shell’s GameChanger program was established to develop new avenues for
future growth by exploiting innovations and entrepreneurial initiatives that
would otherwise be stifled by Shell’s financial system and organizational
structure.42

The key challenge is whether the initiatives fostered within the “exploration” unit will
lead change within the organization as a whole. Xerox’s Palo Alto Research Center
developed many of the innovations that drove the microcomputer revolution of the
1980s and 1990s, but few of these innovations were exploited by Xerox itself. Similarly,
the innovative business system established by General Motors’ Saturn division did little
to turn GM into “a new kind of car company.”43

Contextual ambidexterity involves the same organizational units and the same
organizational members pursuing both exploratory and exploitative activities. At Oticon,
the Danish hearing aid company, employees were encouraged to sustain existing prod-
ucts while pursuing innovation and creativity.44 Under the slogan “Innovation from
Everyone, Everywhere,” Whirlpool sought to embed innovation throughout its existing
organization.45 The problem of contextual ambidexterity is that the management sys-
tems and the individual behaviors required for exploitation are incompatible with those
needed for exploration.

Combatting Organizational Inertia

If organizational change follows a process of punctuated equilibrium in which periods
of stability are interspersed by periods of intense upheaval, what precipitates these
episodes of transformational change? Corporate restructuring, involving simultaneous
changes in strategy, structure, management systems, and top management personnel,
typically follows declining performance. For example, the oil and gas majors under-
went far-reaching restructuring during 1986–92 following the oil price decline of 1986.46
During 2017, consumer goods giants Unilever, Procter & Gamble, and Nestle all initi-
ated major restructuring programs in response to sluggish sales, declining profitability,
and takeover threats. A challenge for top management is to undertake large-scale
change before being pressured by declining performance. This may require managers
to let go of the beliefs that wed them to the prevailing strategy. Polaroid’s failure to
adapt to digital imaging despite developing leading-edge digital-imaging capabilities
can be attributed to top management’s entrenched beliefs about the company and its
strategy.47

Creating Perceptions of Crisis Crises create the conditions for strategic change
by loosening the organization’s attachment to the status quo. The problem is that
by the time the organization is engulfed in crisis it may already be too late. Hence,
leaders may foster the perception of impending crisis so that necessary changes can
be implemented well before a real crisis emerges. At General Electric, even when the
company was reporting record profits, Jack Welch was able to convince employees
of the need for change in order to defend against emerging threats. Andy Grove’s
dictum “Only the paranoid survive” helped Intel to maintain a continual striving for
improvement and development despite its dominance of the market for PC micro-
processors.

206 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Establishing Stretch Targets Another approach to counteracting organizational
inertia is to continually pressure the organizations by setting ambitious performance
targets. Stretch goals can motivate creativity and initiative while attacking compla-
cency. Stretch goals are usually quantitative and short term; however, they also relate to
long-term strategic goals. A key role of vision statements and ambitious strategic intent
is to create a sustained sense of ambition and organizational purpose. These ideas are
exemplified by Collins and Porras’ notion of “Big Hairy Ambitious Goals” that I dis-
cussed in Chapter 1. Apple’s success in introducing “insanely great” new products owes
much to Steve Jobs imposing seemingly impossible goals on his product development
teams. For the iPod he insisted that it should store thousands of songs, have a battery
life exceeding four hours, and be smaller and thinner than any existing MP3 player.48

Corporate-Wide Initiatives as Catalysts of Change Chief executives are limited
in their ability to initiate and implement organization-wide change. However, by a
combination of authoritative and charismatic leadership, they may be able to pioneer
specific initiatives with a surprisingly extensive impact. Corporate initiatives sponsored by
the CEO are effective for disseminating strategic changes, best practices, and management
innovations. At General Electric, Jack Welch was an especially effective exponent of using
corporate initiatives to drive organizational change. These were built around communi-
cable and compelling slogans such as “Be number 1 or number 2 in your industry,” “GE’s
growth engine,” “boundarylessness,” “six-sigma quality,” and “destroy-your-business-dot-
com.” Leaders can also have a profound impact through symbolic actions. A key incident
in the transformation of the Qingdao Refrigerator Plant into Haier, one of the world’s
biggest appliance companies, was when the CEO, Zhang Ruimin, took a sledgehammer
to defective refrigerators in front of the assembled workforce.49

Reorganizing Company Structure By reorganizing the structure, top management
can redistribute power, reshuffle top management, and introduce new blood. One
of the last major actions of CEO Steve Ballmer before retiring in August 2013 was to
reorganize Microsoft’s divisional structure in order to break down established power
centers and facilitate the transition to a more integrated company. Activist investor,
Nelson Peltz, has urged Procter & Gamble to reorganize around three operating units
as a means of reducing corporate power and stimulating innovation and efficiency.50
Periodic changes in organizational structure can stimulate decentralized search and
local initiatives while encouraging more effective exploitation of the outcomes of such
search.51 Reconciling the benefits of integration and flexibility may require organiza-
tions to oscillate between periods of decentralization and periods of centralization.52

New Leadership If strategic change is hampered by management’s adherence to
outmoded beliefs or if the existing team lacks the diversity of opinion and outlook for
new strategic thinking, then an outsider may be needed to lead change. Evidence of
the relative performance of internal and external CEOs is mixed. However, if an orga-
nization is performing poorly, an external CEO tends to be more effective at leading
change than an internal appointment.53 Certainly, the crisis that engulfed Uber Tech-
nologies in 2017 made it essential to appoint a new CEO from outside the company.

Scenario Analysis Adapting to change requires anticipating change. Yet predicting
the future is hazardous, if not impossible. “Only a fool would make predictions espe-
cially about the future,” remarked movie mogul Samuel Goldwyn. But the inability to
predict does not preclude preparing for change. Scenario analysis is a systematic way
of thinking about how the future might unfold. Scenario analysis is not a forecasting

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 207

technique, but a process for thinking about and analyzing the future by drawing upon
a broad range of information and expertise.

Herman Kahn, who pioneered their use first at the Rand Corporation, defined sce-
narios as “hypothetical sequences of events constructed for the purpose of focusing
attention on causal process and decision points.”54 The multiple-scenario approach
constructs several distinct, internally consistent views of how the future may look
5–50 years ahead. Its key value is in combining the interrelated impacts of a wide
range of economic, technological, demographic, and political factors into a few dis-
tinct alternative stories of how the future might unfold. Scenario analysis can be either
qualitative or quantitative or a combination of the two. Quantitative scenario analysis
builds simulation models to identify likely outcomes. Qualitative scenarios typically
take the form of narratives and can be particularly useful in engaging the insight and
imagination of decision makers.

Scenario analysis is used to explore paths of industry evolution, the development
of particular countries, and the impact of new technology. However, as with most
strategy techniques, the value of scenario analysis is not in the results but in the
process. Scenario analysis is a powerful tool for communicating different ideas and
insights, surfacing deeply held beliefs and assumptions, identifying possible threats
and opportunities, generating and evaluating alternative strategies, encouraging more
flexible thinking, and building consensus. Evaluating different strategies under differ-
ent scenarios can help identify which strategies are most robust and force managers to
address “what if?” questions. Strategy Capsule 8.3 outlines the use of scenarios at Shell.

Developing New Capabilities

Ultimately, adapting to a changing world requires developing the capabilities needed
to renew competitive advantage. In Chapter 6, we saw that developing organizational
capability is an essential task for strategy implementation. Yet, for established organiza-
tions—both for-profit and not-for-profit—creating new capabilities represents a formi-
dable challenge. To understand why, let us consider where do capabilities come from?

The Origins of Organizational Capability: Early Experiences and Path Depen-
dency As Table 8.3 illustrates, a company’s distinctive capabilities can often be traced
back to the circumstances which prevailed during its founding and early development.
They are subject to path dependency—a company’s capabilities today are the result
of its history.55

The examples in Table 8.3 are troubling for managers in established companies: if a
firm’s capabilities are determined during the early stages of its life, is it really possible
to develop the new capabilities needed to adapt to changes? Established capabilities
embedded within organizational structure and culture present formidable barriers to
building new capabilities. Indeed, the more highly developed a firm’s organizational
capabilities, the greater the barrier they create. Because Dell Computer’s direct sales
model was so highly developed, Dell found it difficult to adapt to selling through retail
outlets as well. Hence the argument that core capabilities are simultaneously core
rigidities.56

Developing Capabilities Sequentially In Chapter 6, we saw that developing capa-
bilities requires putting in place processes, organizational structure, and motivation.
However, identifying the essential components of organizational capability provides
limited guidance to managers seeking to create a new capability. The key challenge is

208 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

not obtaining the necessary resources: it is integrating them through establishing and
developing processes through routinization and learning, building structure, motivating
the people involved, and aligning the new capability with other aspects of the organi-
zation, the demands upon management are considerable. Hence, an organization must
limit the number and scope of the capabilities that it is attempting to create at any point
in time. This implies that capabilities need to be developed sequentially rather than all
at once.

The task is further complicated by the fact that we have limited knowledge about
how to manage capability development. Hence, it may be helpful to focus not on
the organizational capabilities themselves but on developing and supplying the prod-
ucts that use those capabilities. A trajectory through time of related, increasingly

STRATEGY CAPSULE 8.3

Multiple-Scenario Development at Shell

Royal Dutch Shell has used scenarios as a basis for

long-term strategic planning since 1967. Mike Pocock,

Shell’s former chairman, observed: “We believe in basing

planning not on single forecasts, but on deep thought

that identifies a coherent pattern of economic, political,

and social development.”

Shell’s scenarios are critical to the transition of its

planning function from producing plans to leading a

process of dialogue and learning, the outcome of which

is improved decision making by managers. This involves

continually challenging current thinking within the

group, encouraging a wider look at external influences

on the business, and forging coordination among Shell’s

200+ subsidiaries.

Shell’s global scenarios are prepared every four or

five years by a team comprising corporate planning

staff, executives, and outside experts. Economic, political,

technological, and demographic trends are analyzed up

to 50 years into the future. In 2014, Shell identified two

global scenarios for the period to 2060:

◆ Mountains: A world where current elites retain

their power, manage for stability, and “unlock

resources steadily and cautiously, not solely dictated

by immediate market forces. The resulting rigidity

within the system dampens economic dynamism

and stifles social mobility.”

◆ Oceans: A world of devolved power where “com-

peting interests are accommodated and compro-

mise is king. Economic productivity surges on a huge

wave of reforms, yet social cohesion is sometimes

eroded and politics destabilized . . . giving immediate

market forces greater prominence.”

Once approved by top management, the scenarios

are disseminated by reports, presentations, and work-

shops, where they form the basis for long-term strategy

discussion by business sectors and operating companies.

Shell is adamant that its scenarios are not forecasts. They

represent carefully thought-out stories of how the various

forces shaping the global energy environment of the future

might play out. Their value is in stimulating the social and

cognitive processes through which managers envisage

the future: “They are designed to stretch management to

consider even events that may be only remotely possible.”

According to former CEO Jeroen van der Veer: “the impera-

tive is to use this tool to gain deeper insights into our global

business environment and to achieve the cultural change

that is at the heart of our group strategy.”

Sources: A. de Geus, “Planning as Learning,” Harvard Business
Review (March/April 1988): 70–4; P. Schoemacher, “Multiple Sce-
nario Development: Its Conceptual and Behavioral Foundation,”
Strategic Management Journal 14 (1993): 193–214; Royal Dutch
Shell, New Lens Scenarios: A Shift in Perspective for a World in
Transition (2014).

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 209

sophisticated products allows a firm to develop the “integrative knowledge” that is at
the heart of organizational capability.57 Consider Panasonic’s approach to developing
manufacturing capabilities in emerging markets:

In every country batteries are a necessity, so they sell well. As long as we bring a
few advanced automated pieces of equipment for the processes vital to final product
quality, even unskilled labor can produce good products. As they work on this rather
simple product, the workers get trained, and this increased skill level then permits us
to gradually expand production to items with increasingly higher technology levels,
first radios, then televisions.58

TABLE 8.3 Childhood experiences shape distinctive capabilities

Company Distinctive capability Early history

Walmart Stores Inc. Supply chain management Walmart stores were initially located in
small towns in Arkansas and Oklahoma.
With vendors unable to provide reli-
able distribution, Walmart built its own
warehouses and designed its own
hub-and-spoke distribution system

Exxon Mobil Inc. Financial management (espe-
cially capital budgeting)

Exxon and Mobil were both members of
Rockefeller’s Standard Oil Trust. Exxon’s
predecessor was Standard Oil New Jer-
sey, the holding company for the group
with primary responsibility for financial
management

Royal Dutch Shell Adaptability to local conditions
in over 120 countries

The original parents were established
with headquarters in Europe to man-
age operations thousands of miles
away: Royal Dutch Petroleum had oil-
fields in Indonesia; Shell Transport and
Trading bought oil products in Russia
for sale in the Far East. Both developed
highly decentralized, locally adaptable
organizations

Eni SpA Host country relations As a newcomer in the industry where the
established majors controlled most of
the world’s known reserves, Eni’s initial
internationalization involved innovative
partnership agreements with producer
governments

Toyota Motor Corp. Lean production “Lean production”—a combination of
kaizen (continuous improvement),
just-in-time supply chain management,
and total quality management
developed in the aftermath of World War
II when acute shortages of materials and
finance forced Toyota to be fastidious
in avoiding waste and minimizing
work-in-progress

210 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

The key to such a sequential approach is for each stage of development to be linked
not just to a specific product (or part of a product) but also to a clearly defined set of
capabilities. Strategy Capsule 8.4 outlines Hyundai’s sequential approach to capability
development.

STRATEGY CAPSULE 8.4

Hyundai Motor: Developing Capabilities through Product
Sequencing

Hyundai’s emergence as a world-class automo-

bile producer is a remarkable example of capability

development over a sequence of compressed phases

(Figure  8.5). Each phase of the development process

was characterized by a clear objective in terms of prod-

uct outcome, a tight time deadline, an empowered

development team, a clear recognition of the capabil-

ities that needed to be developed in each phase, and

an atmosphere of impending crisis should the project

not succeed. The first phase was the construction of

an assembly plant in the unprecedented time of 18

months in order to build Hyundai’s first car—a Ford

Cortina imported in semi-knocked down (SKD) form.

Subsequent phases involved products of increasing

sophistication and the development of more advanced

capabilities.

FIGURE 8.5 Phased development at Hyundai Motor, 1968–95

Source: Draws upon L. Kim, “Crisis construction and organizational learning: Capability building and catching
up at Hyundai Motor,” Organizational Science 9 (1998): 506–521.

1970 1974 1985 1994–95

• Large-scale design
integration
• Global logistics
• Life-cycle engineering

• Assembly
• Production
engineering
• Local
marketing

• Hydrodynamics
• Thermodynamics
• Fuel engineering
• Emission control
• Lubrication
• Kinetics and vibration
• Ceramics
• Electronic control
systems

CAPABILITIES

PRODUCTS

Accent
Avante
Sonata

• Auto styling
and design
• Casting and
forging
• Chassis
design
• Tooling
• Body
production
• Export
marketing

• FWD
engineering
• CAD/CAM
• Assembly
control
systems
• Advanced
component
handling

1968

SKD/CKD
Ford Cortina

Pony
”Alpha”
engine

Excel

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 211

Dynamic Capabilities

The ability of some firms (e.g., IBM, General Electric, 3M, Toyota, and Tata Group) to
repeatedly adapt to new circumstances while others stagnate and die, suggests that the
capacity for change is itself an organizational capability. David Teece and his colleagues
introduced the term dynamic capabilities to refer to a “firm’s ability to integrate, build,
and reconfigure internal and external competences to address rapidly changing envi-
ronments.”59

Despite a lack of consensus over definition, common to most conceptions of dynamic
capabilities is that they are “higher-order” capabilities that orchestrate change among
lower-level “ordinary” or “operational” capabilities. Teece proposes that “dynamic capa-
bilities can be disaggregated into the capacity (1) to sense and shape opportunities
and threats, (2) to seize opportunities, and (3) to maintain competitiveness through
enhancing, combining, protecting, and, when necessary, reconfiguring the business
enterprise’s intangible and tangible assets.”60 However, this does not help us much when
trying to identify the dynamic capabilities a company possesses, or in distinguishing
dynamic from ordinary capabilities. To facilitate the identification of dynamic capa-
bilities, it is therefore useful to equate dynamic capabilities with “specific and iden-
tifiable processes”61 and “patterned and routine”62 behavior (as opposed to ad hoc
problem solving).

IBM offers an example of how management processes can build higher-level dynamic
capabilities. Under the leadership of three CEOs—Lou Gerstner, Sam Palmisano, and
Ginni Rometty—IBM’s Strategic Leadership Model comprised a number of processes
designed to sense new business opportunities and then fund their development into
new business initiatives. Strategy Capsule 14.3 in Chapter 14 outlines IBM’s strategic
management system.63

Using Knowledge Management to Develop
Organizational Capability

Since the early 1990s, the development of capabilities by organizations has been
profoundly influenced by a set of concepts and practices referred to as knowledge
management. Knowledge management comprises a range of management organi-
zational processes and practices whose common feature is their goal of generating
value from knowledge.64 Knowledge management includes many long-established orga-
nizational functions such as R&D, management information systems, employee training,
and managing intellectual property, even strategic planning; however, at its core it
comprises:

● The application of information technology to management processes—espe-
cially the use of databases, intranets, expert systems, and groupware for storing,
analyzing, and disseminating information.

● The promotion of organizational learning—including best practices
transfer, “lessons learned” from ongoing activities, and processes for
sharing know-how.

212 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

These two areas of knowledge management correspond to the two principal types
of knowledge—knowing about and knowing how65:

● Knowing about is explicit: it comprises facts, theories, and sets of instructions.
Explicit knowledge can be communicated at negligible marginal cost between
individuals and across space and time. This ability to disseminate knowledge
such that any one person’s use does not limit anyone else’s access to the same
knowledge means that explicit knowledge has the characteristic of a public
good: once created, it can be replicated among innumerable users at low cost.
Information and communication technologies play a major role in storing, ana-
lyzing, and disseminating explicit knowledge.

● Know-how is tacit in nature: it involves skills that are expressed through their
performance (riding a bicycle, playing the piano). Such tacit knowledge cannot
be directly articulated or codified. It can only be observed through its applica-
tion and acquired through practice. Its management requires socially embedded
person-to-person processes.

If explicit knowledge can be transferred so easily, it is seldom the foundation
of sustainable competitive advantage. It is only secure from rivals when it is pro-
tected, either by intellectual property rights (patents, copyrights, trade secrets) or by
secrecy (“The formula for Coca-Cola will be kept in a safe in the vault of our Atlanta
headquarters guarded by heavily-armed Coca-Cola personnel.”). The challenge of
tacit knowledge is the opposite. The Roca brothers’ Catalan restaurant, El Celler
de Can Roca, has been declared the world’s best restaurant. If their culinary skills
have been acquired through intuition and learning-by-doing, how do they transfer
this know-how to the chefs and managers of their new restaurant in Barcelona’s
Hotel Omm?

To build organizational capability, individual know-how must be shared within the
organization. Replicating knowledge in a new location requires making know-how
explicit. This systematization is the basis of McDonald’s incredible growth, but is
more difficult for a Michelin three-starred restaurant. For consulting companies,
the distinction between tacit (personalized) and explicit (systematized) knowledge
defines their business model and is a central determinant of their strategy.66 More-
over, while systematization permits internal replication, it also facilitates imitation by
rivals. The result is a “paradox of replication.” In order to utilize knowledge to build
organizational capability, we need to replicate it; and replication is much easier if the
knowledge is in explicit form.67

Knowledge Management Activities That Contribute to Capability Development
Knowledge management can be represented as a series of activities that contribute to
capability development by building, retaining, accessing, transferring, and integrating
knowledge. Table 8.4 lists several knowledge management practices.

However, the contribution of knowledge management to capability development
in organizations may be less about specific techniques and more about the

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 213

TABLE 8.4 Knowledge management practices

Knowledge process Contributing activities Explanation and examples

Knowledge identification Intellectual property
management

Corporate yellow pages

Firms are devoting increased effort to identifying and
protecting their intellectual property, and patents
especially

BP’s Connect comprises personnel data that allows each
employee to identify the skills and experience of other
employees in the organization

Knowledge measurement Intellectual capital accounting Skandia’s intellectual capital accounting system pio-
neered the measurement and valuation of a firm’s
stock of knowledge. Dow Chemical uses intellectual
capital metrics to link its patent portfolio to share-
holder value

Knowledge retention Lessons learned The US Army’s Center for Lessons Learned distils the
results of maneuvers, simulated battles, and actual
operations into tactical guidelines and recommended
procedures. Most consulting firms have post project
reviews to capture the knowledge gained from
each project

Knowledge transfer
and sharing

Databases Project-based organizations typically store knowledge
generated by client assignments in search-
able databases

Communities-of-practice Communities of practice are informal, self-
organizing networks for transferring experiential
knowledge among employees who share the same
professional interests

Best practice transfer Where operations are geographically dispersed, differ-
ent units are likely to develop local innovations and
improvements. Best practice methodology aims to iden-
tify then transfer superior practices

Data analysis Big data “Big data” refers to the collation and analysis of huge data
sets such as Walmart’s more than one million customer
transactions each hour and UPS’s tracking of its 16.3
million packages per day and telematic data for its
46,000 vehicles

insight that the knowledge-based view of the firm has given to organizational
performance and the role of management. For example, Ikujiro Nonaka’s model of
knowledge creation offers penetrating insights into the organizational processes
through which knowledge is created and value is created from knowledge (Strategy
Capsule 8.5).

214 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Source: Based upon I. Nonaka, “A Dynamic Theory of Organizational Knowledge Creation,”
Organization Science 5 (1994): 14–37.

FIGURE 8.6 Knowledge conversion

Individual Organization

Explicit

Tacit

Skills,
Know-how

Organizational
routines

Ty
p

es
o

f K
n

o
w

le
d

g
e

Levels of knowledge

Facts, Information,
Scientif ic kn.

Databases, Rules,
Systems, IP

Internalization

Externalization

CRAFT
ENTERPRISES

INDUSTRIAL
ENTERPRISES

Combination

Socialization

Routinization

Sys
tem

ati
zat

ion

STRATEGY CAPSULE 8.5

Knowledge Conversion and Knowledge Replication

Ikujiro Nonaka’s theory of knowledge creation argues

that knowledge conversion between tacit and explicit

forms and between individual and organizational levels

produces a “knowledge spiral” in which the organization’s

stock of knowledge broadens and deepens. For example,

explicit knowledge is internalized into tacit knowledge

in the form of intuition, know-how, and routines, while

tacit knowledge is externalized into explicit knowledge

through articulation and codification. Knowledge

also moves between levels: individual knowledge is

combined into organizational knowledge; individual

knowledge is socialized into organizational knowledge.

Knowledge conversion lies at the heart of a key stage

of business development: the transition from the craft

enterprise based upon individual, tacit knowledge, to the

industrial enterprise based upon explicit, organizational

knowledge. This transition is depicted in Figure  8.6 and

is illustrated by the following examples:

◆ Henry Ford’s Model T was initially produced on a

small scale by skilled workers. Ford’s assembly line

mass-production technology systematized that

individual, tacit knowledge and built it into machines

and processes. Ford’s industrial system was no longer

dependent upon skilled craftsmen: the assembly

lines could be operated by former farm workers and

new immigrants.

◆ When Ray Kroc discovered the McDonald brothers’

hamburger stand in Riversdale, California, he recog-

nized the potential for systematizing and replicating

their process. McDonald’s business model was rep-

licated through operating manuals and training

programs. Now 400,000 employees, most of whom

lack the most rudimentary culinary skills, serve 68

million customers daily. The relevant knowledge is

embedded within McDonald’s business system.

This systematization of knowledge offers massive

potential for value creation through replication and

deskilling. This systematization has transformed the

service sector: with the replacement of individual pro-

prietorships by international chains in hotels (Marriott),

car rental (Hertz), coffee shops (Starbucks), and tax

preparation (H&R Block).

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 215

Summary

A vital task of strategic management is to navigate the crosscurrents of change. But predicting and
adapting to change are huge challenges for businesses and their leaders.

The life-cycle model allows us to understand the forces driving industry evolution and to anticipate
their impact on industry structure and the basis of competitive advantage.

But, identifying regularities in the patterns of industry evolution is of little use if firms are unable to
adapt to these changes. The challenge of adaptation is huge: the presence of organizational inertia
means that industry evolution occurs more through the birth of new firms and the death of old ones
rather than through adaptation by established firms. Even flexible, innovative companies experi-
ence problems in coping with new technologies—especially those that are “competence destroying,”
“ disruptive,” or embody “architectural innovation.”

Managing change requires managers to operate in two time zones: they must optimize for today
while preparing the organization for the future. The concept of the ambidextrous organization is an
approach to resolving this dilemma. Other tools for managing strategic change include: creating per-
ceptions of crisis, establishing stretch targets, corporate-wide initiatives, recruiting external managerial
talent, dynamic capabilities, and scenario planning.

Whatever approach or tools are adopted to manage change, strategic change requires building new
capabilities. To the extent that an organization’s capabilities are a product of its entire history, building
new capabilities is a formidable challenge. To understand how organizations build capability, we need
to understand how resources are integrated into capability—in particular, the role of processes, struc-
ture, motivation, and alignment. The complexities of capability development and our limited under-
standing of how capabilities are built point to the advantages of sequential approaches to developing
capabilities.

Ultimately, capability building is about harnessing the knowledge which exists within the organiza-
tion. For this purpose, knowledge management offers considerable potential for increasing the effec-
tiveness of capability development. In addition to specific techniques for identifying, retaining, sharing,
and replicating knowledge, the knowledge-based view of the firm offers penetrating insights into the
challenges of—and potential for—the creation and exploitation of knowledge by firms.

In the next two chapters, we discuss strategy formulation and strategy implementation in industries
at different stages of their development: emerging industries, which are characterized by rapid change
and technology-based competition, and mature industries.

Self-Study Questions

1. Consider the changes that have occurred in a comparatively new industry (e.g., wireless tele-
communications, smartphones, video game consoles, online brokerage services, and fitness
clubs). To what extent has the evolution of the industry followed the pattern predicted by the
industry life-cycle model? What are the features of the industry that have influenced its pattern
of evolution? At what stage of development is the industry today? How is the industry likely to
evolve in the future?

216 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Notes

1. T. Levitt, “Exploit the Product Life Cycle,” Harvard
Business Review (November/December 1965): 81–94; G.
Day, “The Product Life Cycle: Analysis and Applications,”
Journal of Marketing 45 (Autumn 1981): 60–67.

2. F. F. Suárez and J. M. Utterback, “Dominant Designs and
the Survival of Firms,” Strategic Management Journal 16
(1995): 415–430.

3. P. Anderson and M. L. Tushman, “Technological Discon-
tinuities and Dominant Designs,” Administrative Science
Quarterly 35 (1990): 604–633.

4. M. A. Cusumano and D. B. Yoffie, Competing on Internet
Time: Lessons from Netscape and Its Battle with Microsoft
(New York: Free Press, 1998).

5. M. G. Jacobides, “Industry Change through Vertical Dis-
integration: How and Why Markets Emerged in Mort-
gage Banking,” Academy of Management Journal 48
(2005): 465–498.

6. G. Carroll and M. Hannan, The Demography of Corpora-
tions and Industries (Princeton, MA: Princeton University
Press, 2000). For a survey, see J. Baum, “Organizational
Ecology,” in S. R. Clegg, C. Hardy, and W. R. Nord (eds),
The SAGE Handbook of Organizational Studies (Thousand
Oaks, CA: SAGE Publications, 1996); and D. Barron, “Evo-
lutionary Theory,” in D. O. Faulkner and A. Campbell
(eds), The Oxford Handbook of Strategy (Oxford: Oxford
University Press, 2003), vol. 1: 74–97.

7. G. R. Carroll, L. S. Bigelow, M.-D. Seidel, and B. Tsai, “The
Fates of de novo and de alio Producers in the American
Automobile Industry, 1885–1981,” Strategic Management
Journal 17 (Summer 1996): 117–137.

8. S. Klepper and K. L. Simons, “Dominance by Birthright:
Entry of Prior Radio Producers and Competitive Ramifi-
cations in the US Television Receiver Industry,” Strategic
Management Journal 21 (2000): 997–1016.

2. Select a product that has become a dominant design for its industry (e.g., the IBM PC in
personal computers, McDonald’s in fast food, Harvard Business School in MBA education, and
Southwest in budget airlines). What factors caused one firm’s product architecture to become
dominant? Why did other firms imitate this dominant design? How did the emergence of the
dominant design influence the evolution of the industry?

3. The resource partitioning model argues that, as industries become dominated by a few major
companies with similar strategies and products, so opportunities open for new entrants to
build specialist niches. Identify an opportunity for establishing a specialist new business in an
industry currently dominated by mass-market giants.

4. Choose an industry that faces significant change over the next 10 years. Identify the main
drivers of change and construct two scenarios of how these changes might play out. In relation
to one of the leading firms in the industry, what are the implications of the two scenarios, and
what strategy options should the firm consider?

5. Identify two sports teams: one that is rich in resources (such as talented players) but whose
capabilities (as indicated by performance) have been poor; one that is resource-poor but has
displayed strong team capabilities. What clues can you offer as to the determinants of capabil-
ities among sports teams?

6. The market leaders in video games for mobile devices during 2012–17 were start-up com-
panies such as DeNA, GungHo Online, Supercell, King, and Rovio. Why have start-ups outper-
formed established video game giants such as Electronic Arts, Rock Star Games, and Activision
Blizzard in this market?

7. The dean of your business school wishes to upgrade the school’s educational capabilities in
order to better equip its graduates for success in their careers and in their lives. Advise your
dean on what tools and systems of knowledge management might be deployed in order to
support these goals.

CHAPTER 8 INDUSTRY EVOlUTION AND STRATEGIC CHANGE 217

9. High rates of entry and exit may continue well into
maturity. See T. Dunne, M. J. Roberts, and L. Samu-
elson, “Patterns of Firm Entry and Exit in US Manu-
facturing Industries,” Rand Journal of Economics 19
(1988): 495–515.

10. S. Klepper and K. Simons, “The Making of an Oligopoly:
Firm Survival and Technological Change in the Evolution
of the US Tire Industry,” Journal of Political Economy 108
(2000): 728–760.

11. G. Carroll and A. Swaminathan, “Why the Microbrewery
Movement? Organizational Dynamics of Resource Par-
titioning in the American Brewing Industry,” American
Journal of Sociology 106 (2000): 715–762.

12. B. Levitt and J. G. March, “Organizational Learning,”
Annual Review of Sociology 14 (1988): 319–340.

13. D. Leonard-Barton, “Core Capabilities and Core Rigidities:
A Paradox in Managing New Product Development,” Stra-
tegic Management Journal 13 (Summer 1992): 111–125.

14. M. T. Hannan, L. Polos, and G. R. Carroll, “Structural
Inertia and Organizational Change Revisited III: The Evo-
lution of Organizational Inertia,” Stanford GSB Research
Paper 1734 (April 2002).

15. P. J. DiMaggio and W. Powell, “The Iron Cage Revisited:
Institutional Isomorphism and Collective Rationality in
Organizational Fields,” American Sociological Review 48
(1983): 147–160.

16. J.-C. Spender, Industry Recipes (Oxford: Blackwell Pub-
lishing, 1989).

17. J. G. March, “Exploration and Exploitation in Organiza-
tional Learning,” Organizational Science 2 (1991): 71–87.

18. The concept of fit is common to several disciplines within
management including: organizational economics (e.g.,
P. R. Milgrom and J. Roberts, “Complementarities and Fit:
Strategy, Structure, and Organizational Change in Man-
ufacturing,” Journal of Accounting and Economics 19
(1995): 179–208); sociotechnical systems (e.g., E. Trist,
“The Sociotechnical Perspective,” in A. H. Van de Ven
and W. H. Joyce (eds), Perspectives on Organization
Design and Behavior (New York: John Wiley & Sons, Inc.,
1984); and complexity theory (e.g., J. W. Rivkin, “Imi-
tation of Complex Strategies,” Management Science 46
(2000): 824–844).

19. M. E. Porter and N. Siggelkow, “Contextual Interactions
within Activity Systems,” Academy of Management Per-
spectives 22 (May 2008): 34–56.

20. E. Romanelli and M. L. Tushman, “Organizational Trans-
formation as Punctuated Equilibrium: An Empirical Test,”
Academy of Management Journal 37 (1994): 1141–1166.

21. H. E. Aldrich, Organizations and Environments (Stanford,
CA: Stanford University Press, 2007).

22. For an introduction to organizational ecology, see M. T.
Hannan and G. R. Carroll, “An Introduction to Organiza-
tional Ecology,” in G. R. Carroll and M. T. Hannan (eds),
Organizations in Industry (Oxford: Oxford University
Press, 1995): 17–31.

23. For a survey of evolutionary approaches, see R. R.
Nelson, “Recent Evolutionary Theorizing about Economic
Change,” Journal of Economic Literature 33 (March
1995): 48–90.

24. R. Foster, “Creative Destruction Whips through Corporate
America,” Innosight Executive Briefing (Winter 2012).

25. C. Markides and P. Geroski, “Colonizers and Consolida-
tors: The Two Cultures of Corporate Strategy,” Strategy
and Business 32 (Fall 2003).

26. G. A. Moore, Crossing the Chasm (New York: HarperCol-
lins, 1991).

27. S. Klepper, “The Capabilities of New Firms and the Evolu-
tion of the US Automobile Industry,” Industrial and Cor-
porate Change 11 (2002): 645–666.

28. S. Klepper and K. L. Simons, “Dominance by Birthright:
Entry of Prior Radio Producers and Competitive Ramifi-
cations in the US Television Receiver Industry,” Strategic
Management Journal 21 (2000): 997–1016.

29. D. A. Kaplan, The Silicon Boys and Their Valley of Dreams
(New York: Morrow, 1999).

30. M. L. Tushman and P. Anderson, “Technological Disconti-
nuities and Organizational Environments,” Administrative
Science Quarterly 31 (1986): 439–465.

31. R. M. Henderson and K. B. Clark, “Architectural Innova-
tion: The Reconfiguration of Existing Systems and the
Failure of Established Firms,” Administrative Science
Quarterly (1990): 9–30.

32. Ibid: 17.
33. J. Bower and C. M. Christensen, “Disruptive Technologies:

Catching the Wave,” Harvard Business Review ( January/
February 1995): 43–53.

34. C. M. Christensen, The Innovator’s Dilemma (Boston: Har-
vard Business School Press, 1997).

35. Ibid.
36. W. A. Pasmore, Designing Effective Organizations: The

Sociotechnical Systems Perspective (New York: John Wiley
& Sons, Inc., 1988).

37. W. G. Bennis, Organization Development: Its Nature, Ori-
gins, and Prospects (New York: Addison-Wesley, 1969).

38. D. F. Abell, Managing with Dual Strategies (New York:
Free Press, 1993): 3.

39. C. A. O’Reilly and M. L. Tushman, “The Ambidex-
trous Organization,” Harvard Business Review (April
2004): 74–81.

40. C. M. Christensen and M. Overdorf, “Meeting the
Challenge of Disruptive Change,” Harvard Business
Review (March/April 2000): 66–76.

41. T. Elder, “Lessons from Xerox and IBM,” Harvard Business
Review ( July/August 1989): 66–71.

42. “Shell GameChanger: A Safe Place to Get Crazy Ideas
Started,” http://www.managementexchange.com,
Management Innovation eXchange ( January 7, 2013),
www.managementexchange.com/story/shell-game-
changer, accessed July 20, 2015.

43. See “Lab Inventors: Xerox PARC and Its Innovation
Machine,” in A. Rao and P. Scaruffi, A History of Silicon
Valley, 2nd edn (Omniware, 2013); and “Saturn: Why One
of Detroit’s Brightest Hopes Failed,” Christian Science
Monitor (October 1, 2009).

44. G. Verona and D. Ravasi, “Unbundling Dynamic Capa-
bilities: An Exploratory Study of Continuous Product
Innovation,” Industrial and Corporate Change 12
(2002): 577–606.

45. Interview with Nancy Snyder, Whirlpool’s vice-president
of leadership and strategic competency development,
Business Week (March 6, 2006), http://www.businessweek.
com/innovate/content/mar2006/id20060306_287425.htm?.

218 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

46. R. Cibin and R. M. Grant, “Restructuring among the
World’s Leading Oil Companies,” British Journal of
Management 7 (1996): 283–308.

47. M. Tripsas and G. Gavetti, “Capabilities, Cognition
and Inertia: Evidence from Digital Imaging,” Strategic
Management Journal 21 (2000): 1147–1161.

48. H. Y. Howard, “Decoding Leadership: How Steve Jobs
Transformed Apple to Spearhead a Technological
Informal Economy,” Journal of Business and Management
19 (2013): 33–44.

49. “Haier: Taking a Chinese Company Global in 2011,” Harvard
Business School Case No. 712408-PDF-ENG (August 2011).

50. “P&G vs. Nelson Peltz,” Wall Street Journal (Octo-
ber 8, 2017).

51. N. Siggelkow and D. A. Levinthal, “Escaping Real (Non-
benign) Competency Traps: Linking the Dynamics of
Organizational Structure to the Dynamics of Search,” Stra-
tegic Organization 3 (2005): 85–115.

52. J. Nickerson and T. Zenger, “Being Efficiently Fickle: A
Dynamic Theory of Organizational Choice,” Organization
Science 13 (September/October 2002): 547–567.

53. A. Karaevli and E. Zajac, “When Is an Outsider CEO a
Good Choice?” MIT Sloan Management Review (Summer
2013); A. Falato and D. Kadyrzhanova, “CEO Succes-
sions and Firm Performance in the US Financial Industry,”
Finance and Economics Discussion Series (Federal
Reserve Board, 2012).

54. H. Kahn, The Next 200 Years: A Scenario for America and
the World (New York: William Morrow, 1976). For a guide
to the use of scenarios in strategy making, see K. van
der Heijden, Scenarios: The Art of Strategic Conversation
(Chichester: John Wiley & Sons, Ltd, 2005).

55. B. Wernerfelt, “Why Do Firms Tend to Become Different?”
in C. E. Helfat (ed), Handbook of Organizational Capabil-
ities (Oxford: Blackwell, 2006): 121–133.

56. D. Leonard-Barton, “Core Capabilities and Core
Rigidities,” Strategic Management Journal 13
(Summer 1992): 111–126.

57. C. E. Helfat and R. S. Raubitschek, “Product Sequencing:
Co-evolution of Knowledge, Capabilities and Products,”
Strategic Management Journal 21 (2000): 961–979. The
parallel development of capabilities and products has also
been referred to as “dynamic resource fit.” See: H. Itami,
Mobilizing Invisible Assets (Boston: Harvard University
Press, 1987): 125.

58. A. Takahashi, What I Learned from Konosuke Matsushita
(Tokyo: Jitsugyo no Nihonsha, 1980); in Japanese, quoted
by H. Itami, Mobilizing Invisible Assets (Boston: Harvard
University Press, 1987): 25.

59. D. J. Teece, G. Pisano, and A. Shuen, “Dynamic Capabil-
ities and Strategic Management,” Strategic Management
Journal 18 (1997): 509–533.

60. D. J. Teece, “Explicating Dynamic Capabilities: The
Nature and Microfoundations of (Sustainable) Enterprise
Performance,” Strategic Management Journal 28
(2007): 1319.

61. K. M. Eisenhardt and J. Martin, “Dynamic Capabilities:
What Are They?” Strategic Management Journal 21 (2000):
1105–1121.

62. S. G. Winter, “Understanding Dynamic Capabilities,” Stra-
tegic Management Journal 24 (2003): 991–995.

63. J. B. Harreld, C. A. O’Reilly, and M. L. Tushman,
“Dynamic Capabilities at IBM: Driving Strategy
into Action,” California Management Review 49
(2007): 21–43.

64. K. Dalkir, Knowledge Management in Theory and Prac-
tice, 2nd edn (Cambridge, MA: MIT Press, 2011).

65. R. M. Grant, “Toward a Knowledge-Based Theory of the
Firm,” Strategic Management Journal 17 (Winter Special
Issue, 1996): 109–122.

66. M. Hansen, N. Nohria, and T. Tierney, “What’s Your
Strategy for Managing Knowledge?” Harvard Business
Review (March 1999): 106–116.

67. J. Rivkin, “Reproducing Knowledge: Replication without
Imitation at Moderate Complexity,” Organization Science
12 (2001): 274–293.

9 Technology-Based
Industries and the
Management of Innovation

Whereas a calculator on the ENIAC is equipped with 18,000 vacuum tubes and weighs
30 tons, computers in the future may have only 1000 vacuum tubes and perhaps
weigh only 1.5 tons.

—POPULAR MECHANICS, MARCH 1949

There’s no chance that the iPhone is going to get any significant market share.

—STEVE BALLMER, CEO, MICROSOFT, APRIL 30, 2007

◆ Introduction and Objectives

◆ Competitive Advantage in Technology-Intensive
Industries

● The Innovation Process

● Capturing Value from Innovation

● Which Mechanisms Are Effective at Protecting
Innovation?

◆ Strategies to Exploit Innovation: How and
When to Enter

● Alternative Strategies to Exploit Innovation

● Timing Innovation: To Lead or to Follow?

● Managing Risks

◆ Standards, Platforms, and Network Externalities

● Types of Standard

● The Role of Network Externalities

● Competing for Standards

◆ Implementing Technology Strategies: Internal and
External Sources of Innovation

● Internal Sources of Innovation: Fostering Creativity

● Sourcing Innovation from Customers and Partners

◆ Implementing Technology Strategies: Organizing
for Innovation

● Aligning Innovation with Business Strategy

● Reconciling Creativity with Commercial Discipline

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

220 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Introduction and Objectives

In the previous chapter, we saw that technology is the primary force that creates new industries and
transforms existing ones. New technology-based industries include: biotechnology, photovoltaic power,
cloud computing, robotics, and social networking. Industries transformed by new technologies include
photography, recorded music, telecommunications, and securities trading. New technology is a source
of opportunity, especially for new businesses but, as we saw in the previous chapter, it presents major
problems for many established companies.

This chapter focuses on businesses where technology is a key driver of change and an important
source of competitive advantage. Technology-intensive industries include both emerging industries
(those in the introductory and growth phases of their life cycle) and established industries where tech-
nology continues to drive competition. The issues we examine, however, are also relevant to all indus-
tries where technology has the potential to create competitive advantage including those which may
be revolutionized by new technology, such as healthcare, banking services, automotive transportation,
and education.

In the last chapter, we viewed technology as an external driver of industrial change. In this chapter,
our primary concern will be the use of technology as a tool of competitive strategy. How can an
enterprise best exploit technology to establish a competitive advantage?

The chapter is organized around four topics in technology management. First, we examine the
potential for innovation to establish sustainable competitive advantage. Second, we discuss the design
of innovation strategies, including alternative business models for exploiting an innovation, timing,
and managing risk. Third, we discuss network externalities and setting industry standards. Fourth, we
look at how firms are extending their innovation processes beyond their organizational boundaries.
Finally, we examine how technology-based strategies can best be implemented.

By the time you have completed this chapter, you will be able to:

◆ Identify the factors that determine the returns to innovation, and evaluate the potential
for an innovation to establish competitive advantage.

◆ Formulate strategies for exploiting innovation including: assessing alternative approaches
to commercializing innovation, comparing the relative merits of being a leader or a fol-
lower, and managing risk.

◆ Formulate strategies that exploit network effects, create successful platforms, and win
standards wars.

◆ Understand that innovation may be generated internally and also sourced externally
(“open innovation”).

◆ Design organizational structures and systems that foster innovation and new product
development.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 221

Competitive Advantage in Technology-Intensive Industries

Innovation forms the key link between technology and competitive advantage. The
quest for competitive advantage stimulates the search for innovation and successful
innovations allow some firms to dominate their industries. To explore the conditions
under which innovation creates competitive advantage, let us begin by examining the
innovation process.

The Innovation Process

Invention is the creation of new products and processes through the development
of new knowledge or from new combinations of existing knowledge. Most inventions
are the result of novel applications of existing knowledge. Samuel Morse’s telegraph,
patented in 1840, was based on several decades of research into electromagnetism
from Ben Franklin to Ørsted, Ampère, and Sturgeon. The compact disk embodies
knowledge about lasers developed several decades previously.

Innovation is the initial commercialization of an invention or an idea in the form
of a new product or process. Once introduced, innovation diffuses: on the demand
side, through customers purchasing the product; on the supply side, through imitation
by competitors. An innovation may be the result of a single invention (most product
innovations in chemicals and pharmaceuticals involve discoveries of new chemical com-
pounds) or it may combine many inventions. The first automobile, introduced by Karl
Benz in 1885, embodied a multitude of inventions, from the wheel, invented some 5000
years previously, to the internal combustion engine, invented nine years earlier. Not all
invention progresses into innovation: among the patent portfolios of most technology-
intensive firms are inventions that have yet to find a viable commercial application. Con-
versely, innovations may involve little or no new technology: the personal computer was
a new configuration of existing technologies; most new types of packaging, including
the vast array of tamper-proof packages, involve novel designs but no new technology.

Figure 9.1 shows the pattern of development from knowledge creation to invention
and innovation. Historically, the lags between knowledge creation and innovation have
been long. For example, the jet engine, patented by Frank Whittle in 1930, uses Isaac

Invention Innovation Dif fusion

ADOPTION

IMITATION

Supply side

Demand side

Basic
Knowledge

FIGURE 9.1 The development of technology: From knowledge creation to diffusion

222 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Newton’s laws of motion discovered in the 17th century. Its first commercial use was in
the De Havilland Comet in 1957 and, two years later, the Boeing 707.

Recently, the innovation cycle has speeded up:

● The use of satellite radio signals for global positioning was developed by phys-
icists at Johns Hopkins University in late 1950s. An experimental GPS satellite
was launched by the US Air Force in 1978 and the GPS system was fully oper-
ational by 1995. Commercial applications began in the 1990s: Garmin launched
its car sat-nav system in 1998 followed by TomTom in 2002.

● First developed at MIT in the 1980s, the first patent for instant messaging was
issued to AOL in 2002. The world’s most popular instant messaging applica-
tions, Whatsapp, Facebook Messenger, and WeChat, were introduced between
2008 and 2011.

The speed with which new research findings are applied commercially depends upon
the motivation of the research. Research motivated by practical need, such as Louis
Pasteur’s study of micro-organisms, has more immediate application than research
motivated by pure science, such as Neils Bohr’s study of atomic physics.1 The huge,
and rapid, commercial impact of the research undertaken by the US Department of
Defense’s Advanced Research Projects Agency—GPS satellites, the internet, RISC com-
puting, motion-sensing devices—underlines the potential of basic research inspired by
practical needs.2

Capturing Value from Innovation

“If a man can … make a better mousetrap than his neighbor, though he build his house
in the woods, the world will make a beaten path to his door,” claimed Emerson. Yet
the inventors of new mousetraps, and other gadgets too, are more likely to be found at
the bankruptcy courts than in the millionaires’ playgrounds of the Caribbean. The weak
linkage between innovation and prosperity is also true for companies. There is no con-
sistent evidence that either R&D intensity or frequency of new-product introductions is
positively associated with profitability.3

The profitability of an innovation to the innovator depends on the value cre-
ated by the innovation and the share of that value that the innovator is able to
capture. As Strategy Capsule 9.1 shows, different innovations result in very different
distributions of value.

The term regime of appropriability describes the conditions that influence the
distribution of the value created by innovation. In a strong regime of appropriability,
the innovator is able to capture a substantial share of that value: Pilkington’s float glass
process, Pfizer’s Viagra, and Dyson’s dual-cyclone vacuum cleaner—like Searle’s NutraS-
weet—all generated huge profits for their owners. In a weak regime of appropriability,
other parties derive most of the value. E-book readers, music streaming and online
brokerage services are similar to personal computers: a lack of proprietary technology
results in fierce price competition and most of the value created goes to consumers.

Four factors determine the innovator’s ability to profit from innovation: property rights,
the tacitness and complexity of the technology, lead time, and complementary resources.

Property Rights in Innovation Capturing the returns to innovation depends, to
a great extent, on the ability to establish property rights in the innovation. It was the
desire to protect the returns to inventors that prompted the English Parliament to pass

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 223

the 1623 Statute of Monopolies, which established the basis of patent law. Since then,
the law has been extended to several areas of intellectual property, including:

● Patents: Exclusive rights to a new and useful product, process, substance, or
design. Obtaining a patent requires that the invention is novel, useful, and
not excessively obvious. Patent law varies from country to country. In the
United States, a patent is valid for 17 years (14 for a design).

STRATEGY CAPSULE 9.1

How the Returns on Innovation are Shared

The value created by an innovation is distributed among

a number of different parties (Figure 9.2).

◆ Aspartame: Aspartame, the artificial sweetener, was

discovered in 1965 by the drug company G. D. Searle

& Co. (later acquired by Monsanto) and launched

in 1981 as NutraSweet. The patent on aspartame

expired in 1992, after which competition grew. How-

ever, Searle/Monsanto, successfully appropriated a

major part of the value created.

◆ Personal computers: The innovators—MITS, Tandy,

Apple, and Xerox—earned modest profits from

their innovation. The followers—IBM, Dell, Compaq,

Acer, Toshiba, and a host of later entrants—

did somewhat better, but their returns were

overshadowed by the huge profits earned by the

suppliers to the industry, especially: Intel in micro-

processors and Microsoft in operating systems.

Complementors, notably the suppliers of applica-

tions software, also did well. However, intense price

competition meant that the primary beneficiaries

from the PC were consumers, who typically paid

prices for their PCs that were a fraction of the value

they derived.

◆ Smartphones: The first were the IBM Simon (1993)

and the Nokia 9000 series (1996). Followers—notably

RIM, Apple, and Samsung—have earned huge profits

from smartphones. Several suppliers have also been

big winners (e.g., microprocessor supplier, ARM); also

complementors, notably app suppliers.

FIGURE 9.2 Appropriating of value: Who gets the benefits from innovation?

Customers Customers

Followers

Followers

Complementors Complementors

Suppliers

Suppliers

Innovator Innovator
ASPARTAME

Customers

Followers

Suppliers
Innovator

SMARTPHONESPERSONAL COMPUTERS

224 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

● Copyrights: Exclusive production, publication, or sales rights to the creators of
artistic, literary, dramatic, or musical works. Examples include articles, books,
drawings, maps, photographs, and musical compositions.

● Trademarks: Words, symbols, or other marks used to distinguish the goods or
services supplied by a firm. In the United States and the United Kingdom, they
are registered with the Patent Office. Trademarks provide the basis for brand
identification.

● Trade secrets: Offer a modest degree of legal protection for recipes, formulae,
industrial processes, customer lists, and other knowledge acquired in the course
of business.

The effectiveness of intellectual property law depends on the type of innovation
being protected. Where the invention is the new product—as in the case of a new drug
or a new synthetic fiber—patents can provide effective protection. For products that
reconfigure existing components, patents may fail to prevent rivals from innovating
around them. The scope of the patent law has been extended to include computer
software, business methods, and genetically engineered life forms. While patents and
copyright establish property rights, their disadvantage (from the inventor’s viewpoint)
is that they make information public. Hence, companies often prefer secrecy to patent-
ing as a means of protecting innovations.

In recent decades, companies have increasingly recognized the economic value of
their intellectual property. This has involved monetizing patents through licensing and
an upsurge in patenting to convert ideas and know-how into intellectual property.
Between 2010 and 2017, the US Patent and Trademark Office issued an average of
about 300,000 patents annually—three times as many as during the final two decades
of the 20th century.

However, the management of intellectual property is not all about protecting one’s
proprietary technology. In certain circumstances, it may be advantageous for a firm to
make its technology freely accessible to other firms. These circumstances include:

● Winning standards wars. In battling to set the standard for next-generation,
high-definition DVDs, Sony and Toshiba both made their technology freely
available to manufacturers and film studios.

● Growing the market. Telsa opened its patent portfolio to competitors in 2014 in
the belief that any loss in competitive advantage was outweighed by the bene-
fits of growing the market for electric vehicles.

● Counteracting the power of suppliers. In 2011, Facebook initiated the Open
Compute Project, an open-source, collaborative effort to improve hardware
design. The goal of the project was to lower the costs of servers purchased by
Facebook and other project partners.4

Tacitness and Complexity of the Technology In the absence of effective legal
protection, a competitor’s ability to imitate an innovation depends on the ease with
which the technology can be comprehended and replicated. The more an innovation
is based upon tacit rather than codified knowledge, the more difficult it is to copy.
Financial innovations such as mortgage-backed securities and credit default swaps
embody readily codifiable knowledge that can be copied very quickly. Intel’s designs
for advanced microprocessors are codified and can be copied; however, manufacturing
them requires deeply tacit knowledge.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 225

The second key factor is complexity. Every new fashion, from the Mary Quant
miniskirt of 1962 to Gucci’s 2017 Marmot bag, involves simple, easy-to-copy ideas.
Conversely, Airbus’s A380 and Intel’s Core i9 microprocessor present entirely different
challenges for the would-be imitator.

Lead Time Tacitness and complexity do not provide lasting barriers to imitation, but
they do offer the innovator time. Innovation creates a temporary competitive advantage
that offers a window of opportunity for the innovator to build on the initial advantage.
The challenge for the innovator is to use initial lead-time advantages to build the capa-
bilities and market position to entrench industry leadership. Intel in microprocessors,
Cisco Systems in routers, and Nvidia in graphics chips were brilliant at exploiting lead
time to build advantages in efficient manufacture, quality, and market presence.

Complementary Resources Bringing new products and processes to market requires
not just invention; it also requires the diverse resources and capabilities needed to finance,
produce, and market the innovation. These are referred to as complementary resources
(Figure  9.3). Chester Carlson invented xerography but was unable for many years to
bring his product to market because he lacked the complementary resources needed to
develop, manufacture, market, distribute, and service his invention. Conversely, Searle
(and its later parent, Monsanto) was able to provide almost all the development, manufac-
turing, marketing, and distribution resources needed to exploit its NutraSweet innovation.
Carlson was able to appropriate only a tiny part of the value created by his Xerox copier;
Searle/Monsanto was much more successful in profiting from its new artificial sweetener.

Complementary resources may be accessed through alliances with other firms, for
example biotech firms ally with large pharmaceutical companies for clinical trials,
manufacture, and marketing.5 When an innovation and the complementary resources
that support it are supplied by different firms, the division of value between them
depends on their relative power. A key determinant of this is whether the complemen-
tary resources are specialized or unspecialized. Suppose that Alphabet’s autonomous
vehicle subsidiary, Waymo is first to market with a government-approved self-driving
software platform. How much profit might Waymo earn? A key factor will be whether

Distribution

Customer service
capability

Marketing
capability

Financial
resources

Complementary
technologies

Supplier
relationships

Brand

Manufacturing
capability

Innovation
and core

technological
know-how

FIGURE 9.3 Complementary resources

226 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

TABLE 9.1 The effectiveness of different mechanisms for protecting innovation

Secrecy
(%)

Patents
(%)

Lead-time
(%)

Sales/service
(%)

Manufacturing
(%)

Product innovations

Food 59 18 53 40 51
Drugs 54 50 50 33 49
Electronic components 34 21 46 50 51
Telecom equipment 47 26 66 42 41
Medical equipment 51 55 58 52 49
All industries 51 35 53 43 46
Process innovations

Food 56 16 42 30 47
Drugs 68 36 36 25 44
Electronic components 47 15 43 42 56
Telecom equipment 35 15 43 34 41
Medical equipment 49 34 45 32 50
All industries 51 23 38 31 43

Note:
These data show the percentage of companies reporting that the particular mechanism, their sales and service, and their manufacturing
capabilities were effective in protecting their innovations.
Source: W. M. Cohen, R. R. Nelson, and J. P. Walsh, “Protecting Their Intellectual Assets: Appropriability Conditions and Why US Manufacturing
Firms Patent (Or Not),” NBER Working Paper No. W7552 (February 2000). © 2000. Reprinted by permission of the authors.

the complementary resources that the software requires are specialized or not. If devel-
opments in vehicle design allow Waymo’s software to be installed in all new cars, the
profit potential is likely to be considerable. If, on the other hand, using Waymo’s soft-
ware requires extensive adaptations by other firms—design changes by auto makers,
specialized graphics processing units from Nvidia, radar sensors from Bosch—then
Waymo’s profit potential will be more limited.

Which Mechanisms are Effective at Protecting Innovation?

How effective are these different mechanisms in protecting innovations? Table  9.1
shows that, despite considerable variation across industries, patent protection is of
limited effectiveness as compared with lead time, secrecy, and complementary manu-
facturing and sales/service resources. Indeed, since the late 1980s, the effectiveness of
patents appeared to have declined despite the strengthening of patent law. Although
patents are effective in increasing the lead time before competitors are able to bring
imitative products to market, these gains tend to be small. The great majority of pat-
ented products and processes are duplicated within three years.6

Given the limited effectiveness of patents, why do firms continue to engage in pat-
enting? Figure 9.4 shows that, while protection from imitation is the principal motive,
several others are also very important. In particular, much patenting activity appears to
be strategic: it is directed toward blocking the innovation efforts of other companies and
building patent portfolios that can be used to bargain with other companies for access
to their patents. In microelectronics and software, such cross-licensing arrangements

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 227

are critical in permitting “freedom to design”: the ability to design products that draw
on technologies owned by different companies.7

Strategies to Exploit Innovation: How and When to Enter

Having established some of the key factors that determine the returns to innovation,
let us consider some of the main questions concerning the formulation of strategies to
manage technology and exploit innovation.

Alternative Strategies to Exploit Innovation

How should a firm maximize the returns to its innovation? A number of alternative
strategies are available. Figure  9.5 orders them according to the size of the com-
mitment of resources that each requires. Thus, licensing requires little involvement
by the innovator in subsequent commercialization, hence is a limited investment.
Internal commercialization, possibly through creating a new enterprise or business
unit, involves a much greater investment of resources and capabilities. In between
there are various opportunities for collaboration with other companies—joint ven-
tures, strategic alliances, and outsourcing that allow resource sharing between
companies.

A firm’s choice of exploitation mode depends on two sets of factors: the character-
istics of the innovation and the resources and capabilities of the firm.

Characteristics of the Innovation The extent to which a firm can establish clear
property rights in an innovation is a critical determinant of its innovation strategy.
Licensing is only viable where ownership in the innovation is protected by patent
or copyrights. Thus, in pharmaceuticals, licensing is widespread because patents
are clear and defensible. Many biotech companies engage only in R&D and license

0 10 20 30 40 50 60 70 80 90 100

To prevent copying

For licensing revenue

To prevent lawsuits

To block others

For use in negotiations

To enhance reputation

To measure performance Process innovations
Product innovations

FIGURE 9.4 Why do companies patent? (Responses by 674 US companies)

Source: W. M. Cohen, R. R. Nelson, and J. P. Walsh, “Protecting Their Intellectual Assets: Appropriability Conditions
and Why US Manufacturing Firms Patent (Or Not),” NBER Working Paper No. W7552 (February 2000). © 2000.
Reprinted by permission of the authors.

228 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

their drug discoveries to large pharmaceutical companies that possess the necessary
complementary resources. Royalties from licensing its sound-reduction technologies
accounted for 90% of Dolby Laboratories’ 2017 revenues. Conversely, when Mark
Zuckerberg launched Facebook in his Harvard dorm, he had little option other than
to develop the business himself: the absence of proprietary technology ruled out
licensing as an option.

The advantages of licensing are relieving a company of the need to acquire comple-
mentary resources and capabilities and speed of commercialization: multiple licensing
can allow for a fast global rollout. The problem, however, is that the success of the
innovation is dependent on the commitment and effectiveness of the licensees. James
Dyson, the British inventor of the dual cyclone vacuum cleaner, created his own
company to manufacture and market his vacuum cleaners after failing to interest any
major appliance company in licensing his technology.

Resources and Capabilities of the Firm As Figure 9.5 shows, different strategies
require very different resources and capabilities. Hence, the choice of how to exploit
an innovation depends critically upon the resources and capabilities that the inno-
vator brings to the party. Start-up firms possess few of the complementary resources
and capabilities needed to commercialize their innovations. Inevitably, they will be
attracted to licensing or to accessing the resources of larger firms through outsourcing,
alliances, or joint ventures. As we noted in the previous chapter, new industries often
follow a two-stage evolution where “innovators” do the pioneering and “consolidators”
with their complementary resources do the developing.

Certain large, established corporations such as DuPont, Corning, Siemens, Hitachi,
and IBM have strong traditions of pursuing basic research, then internally devel-
oping the innovations that arise. However, even these companies have expanded their
technological collaborations with other companies. Innovation increasingly requires

Licensing
Outsourcing

certain
functions

Strategic
alliance

Joint
venture

Internal
commercialization

Little investment risk
but returns also
limited. Risk that the
licensee either lacks
motivation or steals
the innovation

Risk and
return

Limits capital
investment, but may
create dependence
on suppliers/partners

Benef its of
f lexibility. Risks of
informal structure

Shares investment
and risk. Risk of
partner
disagreement
and culture clash

Biggest investment
requirement and
corresponding risks.
Benef its of control

Legal protection Capability in managing
outsourced activities

Pooling of the resources and capabilities
of multiple f irms requires collaborative
capability

Full set of
complementary
resources and
capabilities

ARM licenses its
microprocessor
technology to over
200 semiconductor
companies; Stanford
University earns over
$100m annually from
licensing its inventions

Apple designs its iPhones
and Nvidia designs its
graphics processing units,
but both outsource
manufacturing

Spotify’s data-
sharing alliance
with WPP, the
world’s largest
advertising and
marketing
company, allows
Spotify to better
monetize its
160-million user
base

Panasonic and Tesla
Motors formed a
joint venture in 2014
to develop a
gigafactory to
produce lithium ion
batteries

Larry Page and
Sergey Brin
established Google
Inc. to develop and
market their internet
search technology

Resource
requirements

Examples

FIGURE 9.5 Alternative strategies for exploiting innovation

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 229

coordinated responses by multiple companies. Hence, innovating firms need to iden-
tify and map their innovation ecosystem, then manage the interdependencies within
it. The delayed introduction of HDTV can be attributed to inadequate coordination
among TV manufacturers, production studios, and broadcasters.8 We shall return to
the challenges of managing innovation ecosystems when we look more closely at
platform-based competition.

Timing Innovation: To Lead or to Follow?

To gain competitive advantage in emerging and technologically intensive industries, is
it better to be a leader or a follower in innovation? As Table 9.2 shows, the evidence is
mixed: in some products the leader has been the first to grab the prize; in others, the
leader has succumbed to the risks and costs of pioneering. Optimal timing of entry into
an emerging industry and the introduction of new technology are complex issues. The
advantage of being an early mover depends on the following factors:

● The extent to which innovation can be protected by property rights or lead-time
advantages: If an innovation is appropriable through a patent, copyright, or
lead-time advantage, there is advantage in being an early mover. This is espe-
cially the case where patent protection is important, as in pharmaceuticals.
Notable patent races include that between Alexander Bell and Elisha Gray to
patent the telephone (Bell got to the Patent Office a few hours before Gray),9
and between Celera Inc. and the National Institutes of Health to sequence the
human genome (although Celera won the race, President Clinton ruled that the
human genome could not be patented).10

TABLE 9.2 Leaders, followers, and success in emerging industries

Product Innovator Follower The winner

Jet airliner De Havilland (Comet) Boeing (707) Follower
Float glass Pilkington Corning Leader
X-ray scanner EMI General Electric Follower
Airline reservation system Sabre Amadeus, Apollo Leader
VCRs Ampex/Sony Matsushita Follower
Instant camera Polaroid Kodak Leader
Microwave oven Raytheon Samsung Follower
Video games player Atari Nintendo/Sony Followers
Disposable diaper Procter & Gamble Kimberley-Clark Leader
Compact disk Sony/Philips Matsushita, Pioneer Leader
Web browser Netscape Microsoft Follower
Web search engine Lycos Google Follower
MP3 music players Diamond Multimedia Apple (iPod) Follower
Operating systems for

mobile devices
Symbian, Palm OS Apple, Google Followers

Cryptocurrencies Bitcoin Etherium, Ripple Leader
Flash memory Toshiba Samsung, Intel Followers
E-book reader Sony (Digital Reader) Amazon (Kindle) Follower

Social networking SixDegrees.com Facebook Follower

230 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

● The importance of complementary resources: The more important complemen-
tary resources are in exploiting an innovation, the greater the costs and risks
of pioneering. Tesla Motors’ pioneering of the all-electric car reveals the huge
development costs that arise from the need to orchestrate multiple technol-
ogies and create an entire infrastructure for distribution, service, and recharg-
ing. Where the need for complementary resources is great, followers are also
favored by the fact that, as an industry develops, specialist firms emerge to
supply complements.

● The potential to establish a standard: As we shall see later in this chapter, some
markets converge toward a technical standard. The greater the importance of
technical standards, the greater the advantages of being an early mover in order
to influence those standards and gain the market momentum needed to estab-
lish leadership. Once a standard has been set, displacing it becomes excep-
tionally difficult. IBM was responsible for establishing Microsoft’s MS-DOS as
the dominant operating system for personal computers. However, when in
1987 IBM launched its OS/2 operating system, it had little success against the
entrenched position of Microsoft. Only by offering their operating systems for
free have Linux and Google’s Chrome been able to take market share from
Microsoft’s Windows.

The implication is that optimal timing depends on the resources and capabil-
ities that a firm has at its disposal. Hence, different firms have different strategic
windows—periods in time when their resources and capabilities are aligned with the
opportunities available in the market. A small, technology-based firm may have no
choice but to pioneer innovation: its opportunity is to grab first-mover advantage
and then develop the necessary complementary resources before more powerful
rivals appear. For the large, established firm with financial resources and strong
production, marketing, and distribution capabilities, the strategic window is likely
to be both longer and later. The risks of pioneering are greater for an established
firm with a reputation and brands to protect, while to exploit its complementary
resources effectively typically requires a more developed market. Consider the fol-
lowing examples:

● In the early days of personal computers, Apple was a pioneer, IBM a follower.
The timing of entry was probably optimal for each. Apple’s resources com-
prised the vision of Steve Jobs and the technical genius of Steve Wozniak; only
by pioneering could it hope to be successful. IBM had enormous strengths in
manufacturing, distribution, and reputation. The key for IBM was to delay its
entry until the time when the market had developed to the point where IBM’s
strengths could have their maximum impact.

● In the browser war between Netscape and Microsoft, Microsoft had the luxury
of being able to follow the pioneer, Netscape. Microsoft’s huge product
development, marketing, and distribution capabilities, and, most important,
its vast installed base of the Windows operating system allowed it to overhaul
Netscape’s initial lead.

● EMI, the British music and electronics company, introduced the world’s first CT
scanner in 1972. Despite a four-year lead, General Electric’s vast technological
and commercial capabilities within medical electronics allowed it to drive EMI
out of the market.11

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 231

While first movers launch innovative new products that embody new technology
and new functionality, fast followers are especially effective in initiating a new prod-
uct’s transition from niche market to mass market by lowering cost and increasing
quality.12 Timing is critical. Don Sull argues that a successful follower strategy requires
“active waiting”: a company needs to monitor market developments and assemble
resources and capabilities while it prepares for large-scale market entry.13

Managing Risks

Emerging industries are risky. There are two main sources of uncertainty:

● Technological uncertainty arises from the unpredictability of technological evo-
lution and the complex dynamics through which technical standards and domi-
nant designs are selected. Hindsight is always 20/20, but ex ante it is difficult to
predict how technologies and the industries that deploy them will evolve.

● Market uncertainty relates to the size and growth rates of the markets for new
products. When Xerox introduced its first plain-paper copier in 1959, Apple its
first personal computer in 1977, or Sony its Walkman in 1979, none had any idea
of the size of the potential market. When Brian Chesky and Joe Gebbia began
renting the use of an air mattress in their San Francisco apartment to help pay the
rent, they had little idea that the outcome would be Airbnb (valued at $31 billion
in 2017). Forecasting demand for new products is hazardous—most forecasting
techniques are based on past data. Demand forecasts for new products tend to
rely either on analogies14 or expert opinion, for example, the Delphi technique.15

If managers are unable to forecast technology and demand, then to manage risk they
must be alert to emerging trends while limiting their exposure to risk through avoiding
large-scale commitments. Useful strategies for limiting risk include:

● Cooperating with lead users: During the early phases of industry development,
careful monitoring of and response to market trends and customer requirements
are essential in order to avoid major errors in technology and design. Von Hip-
pel argues that lead users provide a source of leading market indicators, can
assist in developing new products and processes, and offer an early cash flow
to fund development expenditures.16 In computer software, beta versions are
released to computer enthusiasts for testing. Nike has two sets of lead users:
professional athletes who are trendsetters for athletic footwear and hip-hop
artists who are at the leading edge of urban fashion trends. In communications
and aerospace, government defense contracts play a crucial role in developing
new technologies.17

● Limiting risk exposure: The financial risks of emerging industries can be miti-
gated by financial and operational practices that minimize a firm’s exposure to
adversity. By avoiding debt and keeping fixed costs low, a firm can lower its
financial and operational gearing. Outsourcing and strategic alliance can also
hold down capital investment and fixed costs.

● Flexibility: Uncertainty necessitates rapid responses to unpredicted events.
Achieving such flexibility means keeping options open and delaying com-
mitment to a specific technology until its potential becomes clear. Twitter—
originally Odeo—was founded to develop a podcasting platform. Once Apple

232 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

added a podcasting facility to iTunes, Odeo redirected itself toward a platform
for internet-hosted text messages.

● Multiple strategic options: Faced with technological uncertainty, well-resourced
companies—such as IBM, Microsoft, and Google—have the luxury of simul-
taneously investing in multiple technologies—what Eric Beinhocker refers to
as “robust, adaptive strategies.”18 For Microsoft, this portfolio of options has
included a number of prominent failures—MP3 players (Zune), smartphones
(Nokia), and social networking (Yammer)—but also leadership positions in
several new fields, including online gaming and cloud computing.

Standards, Platforms, and Network Externalities

In the previous chapter, we noted that the establishment of a standard can be a key
event in an industry’s development and growth. In the digital, networked economy,
more and more markets are subject to standards which play a vital role in ensuring
compatibility between users. For companies, owning a standard can be an important
source of competitive advantage with the potential to offer returns that are unmatched
by any other type of competitive advantage. Table 9.3 lists several companies which
own key technical standards within a particular product category. A characteristic of
most of these companies is the fact that these standards have generated considerable
profits and shareholder value.

Types of Standard

A standard is a format, an interface, or a system that allows interoperability. Adhering
to standards allows us to browse millions of different web pages, ensures the light

TABLE 9.3 Examples of companies that own de facto industry standards

Company Product category Standard

Microsoft PC operating systems Windows
Intel PC microprocessors x86 series
Sony/Philips Compact disks CD-ROM format
ARM (Holdings) Microprocessors for mobile devices ARM architecture
Oracle Corporation Programming language for web apps Java
Qualcomm Digital cellular wireless communication CDMA
Adobe Systems Common file format for creating and view-

ing documents
Acrobat Portable

Document Format
Adobe Systems Web page animation Adobe Flash
Adobe Systems Page description language for document printing Post Script
Bosch Antilock braking systems ABS and TCS (Traction

Control System)
IMAX Corporation Motion picture filming and projection system IMAX
Apple Music downloading system iTunes/iPod
Sony High definition DVD Blu-ray
Nissan, Toyota, PSA Electric vehicle charging CHAdeMO

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 233

bulbs made by any manufacturer will fit any manufacturer’s lamps, and keeps the traffic
moving in Los Angeles (most of the time). Standards can be public or private.

● Public (or open) standards are those that are available to all users. They include
mandatory standards set by government and backed by the force of law (these
relate mainly to safety, environmental, and consumer protection standards) and
consensus standards set by standards bodies such as the International Organiza-
tion for Standardization (ISO) or by industry or professional associations such as
Institute of Electrical and Electronics Engineers (IEEE).19 Although most public
standards are free, they may utilize privately owned intellectual property—3G
wireless communication standards rely heavily on Qualcomm’s CDMA patents
(from which Qualcomm earns most of its profits).

● Private (proprietary) standards are owned by companies or individuals. If I
own the technology that becomes a standard, I can embody the technology in
a product that others buy or license the technology to others who wish to use
it. Thus, in smartphones the major rival standards are Apple’s iOS and Google’s
Android. Apple’s iOS is used only in Apple’s mobile devices; Android is licensed
widely. Android also represents another variant on technical standards: it is
open source; it is freely available; and it can be used, adapted, and developed
by anyone. Most private standards are de facto standards: they emerge through
voluntary adoption by producers and consumers. Table 9.3 gives examples.

A problem with de facto standards is that they may take a long time to emerge, result-
ing in a duplication of investments and delaying the development of the market. It was
40 years before a standard railroad gauge was agreed in the United States.20 A mandated,
public standard can avoid much of this uncertainty. Europe’s mandating of standards for
wireless telephony as compared with the United States’ market-based approach resulted
in Europe making the transition to 2G much quicker than the United States. In establish-
ing 3G, 4G, and 5G wireless standards, the 3rd Generation Partnership Project (3GPP), a
worldwide grouping of telecommunications associations, has played a lead role.

The Role of Network Externalities

Standards that permit connectivity tend to emerge in markets that are subject to net-
work externalities. A network externality exists whenever the value of a product
to an individual customer depends on the number of other users of that product.
The classic example of network externality is the telephone. Since there is little sat-
isfaction to be gained from talking to oneself, the value of a telephone to each user
depends on the number of other users connected to the same network. This is dif-
ferent from most products. When I pour myself a glass of Glenlivet after a couple of
exhausting MBA classes, my enjoyment is independent of how many other people
in the world are drinking whiskey. Indeed, some products may have negative net-
work externalities—the value of the product is less if many other people purchase
the same product. If I spend $3000 on an Armani silver lamé tuxedo and find that
half my colleagues at the faculty Christmas party are wearing the same jacket, my
satisfaction is lessened.

Networks require technical standards to ensure connection to the network. This
does not require everyone to use the same product or even the same technology, but
rather that the different products are compatible with one another through a common
interface. In the case of wireless telephone service, it doesn’t matter (as far as network

234 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

access is concerned) whether I purchase service from AT&T, Verizon, or T-Mobile:
technical standards ensure compatibility between each network which allows connec-
tivity. Similarly with railroads: if I am transporting coal from Wyoming to Boston, my
choice of railroad company is not critical. Unlike in the 1870s, every railroad company
now uses a standard gauge and is required to give “common carrier” access to other
companies’ rolling stock.

Network externalities arise from several sources:

● Products where users are linked to a network: Telephones, railroad systems,
and email instant messaging groups are networks where users are linked
together. Applications software, whether spreadsheet programs or video games,
also links users—they can share files and play games interactively. User-level
externalities may also arise through social identification. I watch Game of
Thrones and the Hollywood Oscar presentations on TV not because I enjoy
them but so that I have something to talk to my colleagues about in the faculty
common room.21

● Availability of complementary products and services: Where products are con-
sumed as systems, the availability of complementary products and services
depends on the number of customers for that system. By 2015, Microsoft and
Blackberry were doomed as suppliers of smartphone operating systems. With
less than 2% of the market, they could no longer attract support from third-party
application developers. Similarly, I choose to own a Ford Focus rather than a
Ferrari Testarossa, not only because I’m a lousy driver but also because I know
that, should I break down in northern Saskatchewan, spare parts and a repair
service will be more readily available.

● Economizing on switching costs: By purchasing the product or system that is
most widely used, there is less chance that I shall have to bear the costs of
switching. By using Microsoft PowerPoint rather than an alternative presentation
software such as WPS Presentation or Prezi, it is more likely that I will avoid
the costs of retraining and file conversion when I become a visiting professor at
another university.

Network externalities create positive feedback. Once a technology or system gains
market leadership, it attracts more and more users. Conversely, once market lead-
ership is lost, a downward spiral is likely. This process is called tipping: once a
certain threshold is reached, cumulative forces become unstoppable—the result
is  a  winner-takes-all market, a phenomenon particularly associated with digital
technologies.22

Once established, technical and design standards tend to be highly resilient.
Standards are difficult to displace due to learning effects and collective lock-
in. Learning effects cause the dominant technology and design to be continually
improved and refined. Even where the existing standard is inherently inferior, switch-
ing to a superior technology may not occur because of collective lock-in. A classic
case is the QWERTY typewriter layout. Its 1873 design was based on the need to slow
the speed of typing to prevent typewriter keys from jamming. Although the jamming
problem was soon solved, the QWERTY layout has persisted.23 Technical standards
are especially important in relation to digital technologies where connectivity and
compatibility are vital. Strategy Capsule 9.2 discusses the strategic aspects of digital
innovation—particularly the role of platforms and new business models.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 235

Competing for Standards

In markets subject to network externalities, control over standards is the primary basis
for competitive advantage. Owning a proprietary standard—especially when it is incor-
porated into a platform—can be the basis for market domination and a source of mas-
sive profits. What do we know about designing winning strategies in markets subject
to network externalities?

STRATEGY CAPSULE 9.2

Digital Innovation: Platforms and Ecommerce Business Models

Innovation during the past four decades has been domi-

nated by applications of digital technology. Digital innova-

tion has distinctive characteristics to the extent that digital

technology is generic: it reduces a vast range of artifacts—

information, images, sounds—to binary code. It creates

new products—websites, mobile communication, video

games—and transforms existing ones—retailing, travel

reservations, payments, and recorded music.

The wealth-creating potential of digital innovation

is remarkable. McKinsey & Co. show that the “economic

profit generated by TMT [technology, media, and tel-

ecom] companies grew 100-fold, or by $200 billion from

2000 to 2014.” However, most of this value creation was

concentrated among a few giant companies. As a result,

by 2018, the world’s seven most valuable companies—

Apple, Alphabet, Microsoft, Amazon, Tencent, Facebook,

and Alibaba—were all based on digital technologies.

Common to all seven of these companies—as well

as other digital startups that have established multi

billion dollar valuations, such as Netflix, Uber, Airbnb, and

Pinterest—is their platform-based businesses.

Digital technologies, together with Internet or wireless

connectivity, have created markets where network exter-

nalities arise both from user connections and from the

availability of complements. These platform-based mar-

kets are also referred to as two-sided (or even multi-sided)

markets because they form an interface between two

groups of users: customers and the suppliers of comple-

mentary products.

Operating systems are the quintessential platforms:

Microsoft’s Windows, Apple’s iOS, and Google’s Android

create network externalities among users (direct

externalities) and among the suppliers of applica-

tions (indirect externalities). Each of these platforms

is central to an ecosystem comprising thousands of

interdependent companies that co-evolve. Thus, the

Android ecosystem comprises over 100 smartphone

manufacturers, thousands of app developers, suppliers

of hardware components, accessory providers, and

many other types of player. As Strategy Capsule  4.1 in

Chapter  4 describes in relation to smartphones, com-

petition between rival platforms for market dominance

is often intense.

However, platforms are not restricted to digital

markets, and nor do the networks necessarily require

technical standards. A shopping mall is a platform: the

mall developer creates a two-sided market comprising

the retailers who lease the individual stores and the cus-

tomers who do the shopping—network externalities

operate on both sides.

Deciding whether to pursue a product strategy or

a platform strategy is a key strategic issue. Google and

Facebook both began with product strategies but soon

recognized the potential for their products—Google’s

search engine and Facebook’s social network—to

become platforms. Many department stores have under-

taken a similar transition: abandoning retailing in favor

of managing an infrastructure that hosts multiple con-

cession stores. The success of the Apple Macintosh bet-

ween 1984 and 2004 was limited by Apple’s pursuit of a

product rather than a platform strategy. We look further

at platform strategies in Strategy Capsule 9.3.

236 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

STRATEGY CAPSULE 9.3

Winning Standards Wars

Past competitive battles between rival platforms

embodying different technical standards have exercised a

powerful influence over current thinking about designing

strategies for markets subject to network externalities.

None has been more influential than the competitive bat-

tles of the late 1970 and 1980s in videocassette recorders

(VCRs) and personal computers (PCs).

In neither case was technical superiority the key—

indeed, in both instances it could be argued that the

superior technology lost. The key factor was managing

the dynamics of market penetration in order to build

market leadership:

◆ In VCRs, Sony kept tight proprietary control of its

Betamax system; JVC licensed its VHS system to

Sharp, Philips, GE, RCA, and others, fueling market

penetration.

◆ In computers, IBM’s PC platform became dominant

because access to its product specifications and

the availability of the core technologies—notably

Microsoft’s operating system and Intel’s micropro-

cessors—allowed a multitude of “clone makers” to

enter the market. The problem for IBM was that it

established the dominant “Wintel” standard but Intel

and Microsoft appropriated most of the value. For

Apple, the situation was the reverse: by keeping tight

control over its Macintosh operating system and

product architecture, it earned high margins, but it

forfeited the opportunity for market dominance.

This trade-off between penetrating the market and

appropriating the returns to platform ownership is shown

in Figure  9.6. Learning from these two epic contests,

platform owners have relinquished more and more value

to complementors, competitors, and customers in order

to build a bigger bandwagon than their rivals. In some

cases this has meant foregoing all possible profits. In the

browser war of 1995–1998, both Netscape (Navigator) and

Microsoft (Explorer) ended up giving away their products.

Finding a better balance between market penetra-

tion and value appropriation has resulted in new pricing

The first key issue is to determine whether we are competing in a market that will
converge around a single technical standard. This requires a careful analysis of the
presence and sources of network externalities.

The second strategic issue in standards setting is recognizing the role of positive
feedback: the technology that can establish early leadership will rapidly gain
momentum. Building a “bigger bandwagon” according to Shapiro and Varian24 requires
the following:

● Before you go to war, assemble allies: You’ll need the support of consumers,
suppliers of complements, even your competitors. Not even the strongest com-
panies can afford to go it alone in a standards war.

● Preempt the market: Enter early, achieve fast-cycle product development, make
early deals with key customers, and adopt penetration pricing.

● Manage expectations: The key to managing positive feedback is to convince
customers, suppliers, and the producers of complementary goods that you will
emerge as the victor. These expectations become a self-fulfilling prophecy.
Sony’s massive pre-launch promotion and publicity campaign prior to the

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 237

launch of PlayStation 4 in November 2013 was an effort to convince consumers, retailers, and
game developers that the product would dominate the new generation of video game consoles,
thereby stymieing efforts by Nintendo and Microsoft to establish their rival systems.25

A great deal has been learned from the past, especially two high-profile standards wars of the 1980s—see
Strategy Capsule 9.3. If a company attempts to appropriate too great a share of the value created, it may
well fail to build a big enough bandwagon to gain market leadership. Thus, recent standards battles have
involved broad alliances, which comprise multiple ecosystem members. In the 2006–2008 struggle between
Sony (Blu-ray) and Toshiba (HD-DVD), each camp recruited movie studios, software firms, and producers
of computers and consumer electronics using various inducements, including direct cash payments. The
defection of Warner Brothers to the Sony camp was critical to the market tipping suddenly in Sony’s favor.
However, it appears that all the financial gains from owning the winning standard were dissipated by the
costs of the war.26

Achieving compatibility with existing products is a critical issue in standards battles. An evolutionary
strategy (that offers backward compatibility) is usually superior to a revolutionary strategy.27 Because the
Apple Mac, launched in 1984, was incompatible with the Apple II, it was unable to take advantage of the
Apple II’s vast installed base.

models. Adobe (and many other software suppliers)

follows a “freemium” model—Acrobat Reader is avail-

able free of charge, but to create or convert PDF files,

the necessary Acrobat software must be purchased.

Other standards show that winning is not solely

about building the biggest bandwagon of users and

complementors. Users buy a system, not a platform, and

their choices depend on the overall quality of the system.

Apple’s dominant share of the profits from the global

smartphone industry, despite having a smaller market

share than Google’s Android, derives from the overall

quality of the iPhone system, which depends to a great

extent on Apple’s exercise of tight control over applica-

tion developers, including quality standards and overall

system integration.

Sources: A. Gawer and M. A. Cusumano, “How Companies
Become Platform Leaders,” MIT Sloan Management Review 49
(2008): 28–35; C. Cennamo and J. Santal, “Platform Competition:
Strategic Trade-offs in Platform Markets,” Strategic Management
Journal 34 (2013): 133–150.

FIGURE 9.6 Standards wars in videocassette recorders and personal
computers

Maximizing
market

penetration

Maximizing
value

appropriation

VHS Betamax

IBM PC

Personal computers

Apple Mac

VCRs

238 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

What are the key resources needed to win a standards war? Shapiro and Varian
emphasize the following:

● control over an installed base of customers;

● owning intellectual property rights in the new technology;

● the ability to innovate in order to extend and adapt the initial technolog-
ical advance;

● early-mover advantage;

● strength in complements (e.g., Intel has preserved its standard in microproces-
sors by promoting standards in buses, chipsets, graphics controllers, and inter-
faces between motherboards and CPUs);

● reputation and brand name.28

However, the dynamics of standards wars are complex and we are far from being
able to propose general strategy principles. As Strategy Capsule  9.3 shows, it is not
always the case that “the biggest bandwagon wins”—issues of quality and brand
differentiation are also important. Nor does market leadership necessarily translate into
a platform owner’s ability to capture value. Finally, it is often unclear whether a market
will converge around a single platform (e.g., eBay in online auctions) or multiple plat-
forms (e.g., video game consoles and smartphones).29

Implementing Technology Strategies: Internal and External
Sources of Innovation

As we have noted previously, strategy formulation cannot be separated from its imple-
mentation. Nowhere is this more evident than in technology-intensive businesses.

Our analysis so far has taught us about the potential for generating competitive
advantage from innovation and about the design of technology-based strategies, but has
said little about the conditions under which innovation is achieved. Incisive strategic anal-
ysis of how to make money out of innovation is of little use if we cannot generate inno-
vation in the first place. We know that innovation requires certain resources— people,
facilities, information, and time—but, like other capabilities, the relationship between
R&D input and innovation output is weak—indeed lack of resources may act as a spur to
innovation.30 The productivity of R&D depends critically on the organizational conditions
that foster innovation. What are these conditions and how do we create them?

Let’s begin with the critical distinction between invention and innovation. While
these activities are complementary, they require different resources and different orga-
nizational conditions. While invention depends on creativity, innovation requires col-
laboration and cross-functional integration.

Internal Sources of Innovation: Fostering Creativity

The Conditions for Creativity Invention is an act of creativity requiring knowledge
and imagination. The creativity that drives invention is typically an individual act that
establishes a meaningful relationship between concepts or objects that had not previ-
ously been related. This reconceptualization can be triggered by accidents: an apple
falling on Isaac Newton’s head or James Watt observing a kettle boiling. Creativity is asso-
ciated with particular personality traits. Creative people tend to be curious, imaginative,
adventurous, assertive, playful, self-confident, risk-taking, reflective, and uninhibited.31

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 239

Individuals’ creativity also depends on the organizational environment in which
they work—this is as true for the researchers and engineers at Amgen and Google as
it was for the painters and sculptors of the Florentine and Venetian schools. Few great
works of art or outstanding inventions are the products of solitary geniuses. Creativity
is stimulated by human interaction: the productivity of R&D laboratories depends crit-
ically on the communication networks that the engineers and scientists establish.32 An
important catalyst of interaction is play, which creates an environment of inquiry, lib-
erates thought from conventional constraints, and provides the opportunity to establish
new relationships by rearranging ideas and structures at a safe distance from reality.
The essence of play is that it permits unconstrained forms of experimentation.33 The
potential for low-cost experimentation has expanded vastly, thanks to advances in
computer modeling and simulation that permit prototyping and market research to be
undertaken speedily and virtually.34

Organizing for Creativity Creativity requires management systems that are quite
different from those that are appropriate for efficiency. We observed in Chapter  8,
when discussing the challenge of ambidexterity, that exploration needs to be managed
very differently from exploitation. In particular, creatively oriented people tend to be
responsive to distinctive types of incentive. They want to work in an egalitarian culture
with enough space and resources to provide the opportunity to be spontaneous, expe-
rience freedom, and have fun in the performance of a task that, they feel, makes a
difference to the performance of their organization (and, possibly, to the world as a
whole). Praise, recognition, and opportunities for education and professional growth
are also more important than assuming managerial responsibilities.35 Evidence from
open-source projects shows that people will devote time and effort to creative activities
even in the absence of financial rewards.36 Nurturing the drive to create may require a
degree of freedom and flexibility that conflicts with conventional HR practices. At many
technology-based companies, including Google and W. L. Gore & Associates, engineers
choose which projects they wish to join.

Organizational environments conducive to creativity tend to be both nurturing and
competitive. Creativity requires a work context that is secure but not cozy. Dorothy
Leonard points to the merits of creative abrasion within innovative teams—fostering
innovation through the interaction of different personalities and perspectives. Man-
agers must resist the temptation to clone in favor of embracing diversity of cognitive
and behavioral characteristics within work groups—creating whole brain teams.37 Jeff
and Staney DeGraff make a similar point: they extol the merits of combining different
innovation archetypes: artists, engineers, athletes, and sages.38 The constructive conflict
they advocate is an established feature of new product development in Silicon Valley
where development team meetings are renowned for open criticism and intense dis-
agreement. Such conflict can spur progress toward better solutions.

Table  9.4 contrasts some characteristics of innovative organizations with those
designed for operational efficiency.

Sourcing Innovation from Customers and Partners

Internal creativity is not the sole source of innovation: innovation can be accessed
beyond an organization’s boundaries. A major trend in innovation management has
been a shift in focus away from firms’ internal R&D toward accessing ideas and
knowledge from the wider world. New tools of information and communications tech-
nology have reinforced this trend.

240 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Customers as Sources of Innovation We observed earlier in this chapter that
research directed toward practical needs is more likely to lead to innovation than that
motivated toward scientific discovery. Few important inventions have been spontaneous
creations by scientists—most have resulted from grappling with practical problems.
Chester Carlson was a patent attorney. His invention of the Xerox copying process was
inspired by his frustration with the tedious task of making multiple copies of patent
applications. Joseph Lister, a British surgeon, developed sterile surgery in response to
the appalling fatality rate from surgery in the Victorian era.

The old adage that “necessity is the mother of invention” explains why customers are
such fertile sources of innovation—they are most acutely involved with matching exist-
ing products and services to their needs. However, listening to customers is typically
a weak inspiration and guide for innovation. As Henry Ford remarked: “If I had asked
people what they wanted, they would have said faster horses!” Moreover, as studies of
disruptive innovation have shown, customers tend not to embrace radical innovation.

According to management thinker, Adrian Slywotzky, the key is “Creating What
People Love Before They Know They Want It.” This requires focusing not on what
customers want but on their sources of dissatisfaction. He advocates creating a “hassle
map”: a sequence of customers’ frustrations and negative emotions that can guide new
approaches to creating customer value.39

Eric von Hippel advocates making customers part of the innovation process.40 Com-
panies can induce and exploit customer-initiated innovation by identifying leading-
edge customers, supplying them with easy-to-use design tools, and ensuring flexibility
in production processes so that customers’ innovations can be effectively exploited.41
Lego has an online community, Lego Ideas, where members share creative ideas and
submit their own designs for new Lego products. In February 2018, Lego released its
20th new customer-designed product: Ship-In-A-Bottle.42

TABLE 9.4 The characteristics of “operating” and “innovating” organizations

Operating organization Innovating organization

Structure Bureaucratic
Specialization and division of labor
Hierarchical control
Defined organizational boundaries

Flat organization without
hierarchical control

Task-oriented project teams
Fuzzy organizational boundaries

Processes Emphasis on eliminating variation
(e.g., six-sigma)

Top-down control
Tight financial controls

Emphasis on enhancing variation
Loose controls to foster idea generation
Flexible strategic planning and finan-

cial control

Reward systems Financial compensation
Promotion up the hierarchy
Power and status symbols

Autonomy
Recognition
Equity participation in new ventures

People Recruitment and selection based
on the needs of the organization
structure for specific skills: functional
and staff specialists, general
managers, and operatives

Key need is for idea generators
who combine required technical
knowledge with creative person-
ality traits

Managers must act as sponsors and
orchestrators.

Source: Adapted from J. K. Galbraith and R. K. Kazanjian, Strategy Implementation: Structure, Systems and Processes,
2nd edn (St. Paul, MN: West, 1986).

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 241

Open Innovation Involving customers in innovation is one step in opening the
innovation processes. As innovation increasingly integrates multiple technologies and
becomes pressured by time, so companies are forced to look outside their own bound-
aries for ideas and expertise. The evidence that boundary spanning stimulates inno-
vation is overwhelming. This is true whether we are considering R&D teams within
organizations, inter-firm alliances, interpersonal networks, or clusters of firms concen-
trated within industrial districts.43 Building on the principle that the gains to collaborative
knowledge sharing outweigh the risks of one’s proprietary knowledge being expropri-
ated, an increasing number of firms are adopting open innovation—an approach to
innovation that seeks, exploits, and applies knowledge both from inside and outside
the organization. According to Henry Chesbrough: “Open innovation is fundamentally
about operating in a world of abundant knowledge, where not all the smart people
work for you, so you’d better go find them, connect to them, and build upon what they
can do.”44 Open innovation takes many forms. Most extensive are open-source software
communities, such as Linux where thousands of independent developers contribute to
the Linux operating system. Increasingly, open innovation has been embraced by large,
established companies—see Strategy Capsule 9.4.

Buying Innovation Despite the success of the internal innovation efforts of large,
established companies such as Samsung Electronics, Siemens, IBM, and Alphabet, the
fact remains that small, technology-intensive start-ups have advantages over large cor-
porations in the early stages of the innovation process. Hence, the major source of inno-
vation for many large companies is to buy it. This may involve licensing or purchasing

STRATEGY CAPSULE 9.4

Open Innovation at IBM

IBM’s Innovation Jam is one element of IBM’s extensive col-

laborative innovation network. It is a massive online brain-

storming process to generate, select, and develop new

business ideas. The 2006 Jam was based upon an initial

identification of 25 technology clusters grouped into six

broad categories. Websites were built for each technology

cluster and, for a 72-hour period, IBM employees, their

families and friends, suppliers, customers, and individual

scientists and engineers from all around the world were

invited to contribute ideas for innovations based on these

technologies. The 150,000 participants generated vast

and diverse suggestions that were subject to text mining

software and review by 50 senior executives and technical

specialists who worked in nine separate teams to identify

promising ideas. The next phase of the Jam subjected

the selected innovation ideas to comments and review

by the online community. This was followed by a further

review process in which the ten best proposals were

selected and a budget of $100 million was allocated to

their development. The selected business ideas included

a real-time foreign language translation service, smart

healthcare payment systems, IT applications to environ-

mental projects, and 3-D Internet. The new businesses

were begun as incubator projects and were then trans-

ferred to one or other of IBM’s business groups. As well

as divisional links, the new ventures were also subject to

monthly review by IBM’s corporate top management. IBM

has since extended its jam methodology to address a

widening array of issues.

Sources: O. M. Bjelland and R. C. Wood, “An Inside View of IBM’s
Innovation Jam,” MIT Sloan Management Review (Fall 2008):
32–43.

242 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

patents, or acquiring young, technology-based companies. Between 2014 and 2017,
the world’s four biggest pharmaceutical companies ( Johnson & Johnson, Pfizer, Roche,
and Novartis) acquired 45 companies; the world’s four biggest ecommerce companies
(Amazon. Google, Facebook, and Tencent) acquired 94 companies. We shall look more
closely at mergers, acquisitions, and alliances in Chapter 14.

Implementing Technology Strategies: Organizing for Innovation

Aligning Innovation with Business Strategy

For a firm’s innovation efforts to be effective, they must be aligned with its overall
strategy. Gary Pisano of Harvard Business School observes that, for many firms, inno-
vation strategy is no more than a grab-bag of best-practices: crowdsourcing, lead-
customer collaboration, corporate ventures, rapid-prototyping, and so on.

Companies need an innovation system: “a coherent set of interdependent processes
and structures that dictates how the company searches for novel problems and solu-
tions, synthesizes ideas into a business concept and product designs, and selects which
projects get funded.”45 Designing an innovation system that creates value for a firm
requires a clear understanding of how innovation fits with business strategy. A firm
needs to consider how its innovation can create value for its customers and how it will
capture value from these innovations.

In assessing the implementation challenges of innovation, it is important to recog-
nize the implications of innovation for a firm’s capabilities and its business model. On
these two dimensions, Pisano identifies four innovation archetypes (see Figure  9.7).
Established companies are likely to require a combination of different innovation
types—e.g. Alphabet uses all four innovation modes, including routine innovation in
relation to its Google search engine, and architectural innovation in relation to its
Waymo (autonomous driving) and Calico (extending human longevity) projects.

Requires
new
business
model

DISRUPTIVE

For example,
Google’s Android is an
open-source operating
system, but draws upon
Google’s expertise in
software development

ARCHITECTURAL

For example,
Kodak’s entry into
digital imaging required
new capabilities and a
di�erent business model

Leverages
current
business
model

ROUTINE

For example, Intel’s new
microprocessors deploy
its existing design and
fabrication capabilities
and require no change in
Intel’s business model

RADICAL

For example, The major
pharmaceutical firms’
entry into biotechnology
required new genetic
capabilities, but no change
in their existing business
models

Uses existing
technical capabilities

Requires new
technical capabilities

FIGURE 9.7 Innovation modes

Source: Adapted from Gary Pisano, “You Need an Innovation Strategy,” Harvard
Business Review (June 2015): 44–54.

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 243

Reconciling Creativity with Commercial Discipline

For innovation to create value, it must be directed to customer need and harnessed to
commercial discipline. Reconciling creativity with financial performance is a challenge
not just for technology-based companies but for all businesses whose products derive
from the human imagination, including fashion and media companies: “The two
cultures—of the ponytail and the suit—are a world apart, and combustible together.”46
Many innovative companies have been formed by frustrated inventors leaving established
companies. The success of Google in Internet-based software, Apple in digital mobile
devices, Disney in animated movies, and HBO with its succession of award-winning TV
series reveals a remarkable ability to mesh creativity with commercial acuity.

Reconciling creativity with commercial effectiveness is a major challenge for orga-
nizational design—as Table 9.4 shows, the organizational requirements of the two are
very different. This is a special case of the challenge of organizational ambidexterity
that we encountered in the previous chapter. Innovation is concerned with exploring
new opportunities, while the operational side of the business is all about exploit-
ing existing capabilities. Yet, ultimately, the key to successful innovation is integrating
creativity and technological expertise with operational capabilities in production,
marketing, finance, distribution, and customer support. Achieving such integration is
difficult. Tension between the operating and the innovating parts of organizations is
inevitable. Innovation upsets established routines and threatens the status quo. The
more stable the operating and administrative side of the organization, the greater its
propensity to resist innovation.

As innovation has become an increasing priority for established corporations, so
chief executives have sought to emulate the flexibility, creativity, and entrepreneurial
spirit of technology-based start-ups. Organizational initiatives aimed at stimulating
new product development and the exploitation of new technologies include the
following:

● Cross-functional product development teams: These have proven highly effective
mechanisms for integrating creativity with functional effectiveness. Conventional
approaches to new product development involved a sequential process that
began in the corporate research lab, then went “over the wall” to engineering,
manufacturing, finance, and so on. Japanese companies pioneered autono-
mous product development teams staffed by specialists seconded from different
departments with leadership from a “heavyweight” team manager who was able
to protect the team from undue corporate influence.47 Such teams have proven
effective in deploying a broad range of specialist knowledge and, most impor-
tantly, integrating that knowledge flexibility and quickly—for example, through
rapid prototyping and concurrent engineering.48

● Product champions allow individual creativity to be embedded within organiza-
tional processes and to link invention to its subsequent commercialization. The
key is to permit the individuals who generate creative ideas to lead the teams,
which develop those ideas—and to allow this leadership to continue into the
commercialization phases. Companies that are consistently successful in inno-
vation typically have organizational processes that capture and exploit individ-
uals’ drive for achievement and their commitment to their innovations. These
committed individuals can overcome resistance to change within their organi-
zations and infect others with their enthusiasm. A study of 15 major inventions
of the 20th century concluded: “a new idea either finds a champion or dies.”49

244 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

A British study of 43 matched pairs of successful and unsuccessful innovations
found that successful innovations were distinguished by entrepreneurial leader-
ship from a “business innovator.”50 3M Corporation has a long tradition of using
product champions to develop new product ideas and grow them into new
businesses (Strategy Capsule 9.5).

● Corporate incubators are business development units that fund and nurture
new businesses based upon technologies that have been developed inter-
nally but have limited applications within a company’s established businesses.
Despite their popularity as a means by which established companies could
participate in the tech-boom of the late 1990s, few of these incubators have
achieved sustained success.51 Among the successful ones, many have been sold
to venture capital firms. A key problem, according to Hamel and Prahalad, is
that: “Many corporate incubators became orphanages for unloved ideas that
had no internal support or in-house sponsorship.”52 Among the more successful

STRATEGY CAPSULE 9.5

The Role of the Product Champion at 3M: Scotchlite

We don’t look to the president or the vice-president for

R&D to say, all right, on Monday morning 3M is going to

get into such-and-such a business. Rather, we prefer

to see someone in one of our laboratories, or marketing,

or manufacturing units bring forward a new idea that

he’s been thinking about. Then, when he can convince

people around him, including his supervisor, that he’s

got something interesting, we’ll make him what we call

a “project manager” with a small budget of money and

talent, and let him run with it.

Someone asked the question, “Why didn’t 3M make

glass beads, because glass beads were going to find

increasing use on the highways?” . . . I had done a little work

on trying to color glass beads and had learned a little about

their reflecting properties. And, as a little extra-curricular

activity, I’d been trying to make luminous house numbers.

From there, it was only natural for us to conclude that,

since we were a coating company, and probably knew

more than anyone else about putting particles onto a

web, we ought to be able to coat glass beads very accu-

rately on a piece of paper.

So, that’s what we did. The first reflective tape we

made was simply a double-coated tape—glass beads

sprinkled on one side and an adhesive on the other.

We took some out here in St. Paul and, with the cooper-

ation of the highway department, put some down. After

the first frost came, and then a thaw, we found we didn’t

know as much about adhesives under all weather condi-

tions as we thought . . .

We looked around inside the company for skills in

related areas. We tapped knowledge that existed in our

sandpaper business on how to make waterproof sand-

paper. We drew on the expertise of our roofing people

who knew something about exposure. We reached into

our adhesive and tape division to see how we could

make the tape stick to the highway better.

The resulting product became known as “Scotchlite.”

Its principal application was in reflective signs; only later

did 3M develop the market for highway marking. The

originator of the product, Harry Heltzer, interested the

head of the New Products Division in the product, and

he encouraged Heltzer to go out and sell it. Scotchlite

was a success and Heltzer became the general manager

of the division set up to produce and market it.

Source: “The Technical Strategy of 3M: Start More Little
Businesses,” Innovation 5 (1969).

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 245

incubators, Cisco System’ Emerging Markets Technology Group was established
in 2006 to detect emerging market trends, conceive of opportunities to exploit
them, and organically grow new ventures inside the company. Within the
first two years, over 2,000 ideas for new businesses had been posted on the
Cisco wiki and several were under development. A key feature of Cisco’s incu-
bator is its close linkage with the rest of the company—especially with senior
management.53

Summary

In emerging and technology-based industries, nurturing and exploiting innovation is the fundamental
source of competitive advantage and the focus of strategy formulation. Yet the fundamental strategic
issues in these industries—the dynamics of competition, the role of the resources and capabilities in
establishing competitive advantage, and the design of structures and systems to implement strategy—
are ones we have already encountered and require us to apply our basic strategy toolkit.

However, the unpredictability and instability of these industries mean that strategic decisions in
technology-driven industries have a very special character. The remarkable dynamics of these industries
mean that the difference between massive value creation and total failure may be the result of small
differences in timing or technological choices.

The speed and unpredictability of change in these markets means that sound strategic
decision-making can never guarantee success. Yet, managing effectively amidst such uncertainty is
only possible with a strategy based upon understanding technological change and its implications for
competitive advantage.

In this chapter I have distilled what we have learned in recent decades—about strategies to success-
fully manage innovation and technological change. The key lessons learned relate to:

◆ how the value created by innovation is shared among the different players in a market, including
the roles of intellectual property, tacitness and complexity of the technology, lead time, and com-
plementary resources;

◆ the design of innovation strategies, including whether to be an early mover or a follower; whether
to exploit an innovation through licensing, an alliance, a joint venture, or internal development; and
how to manage risk;

◆ competing for standards and platform leadership in markets subject to network externalities;

◆ how to implement strategies for innovation, including organizing to stimulate creativity, access inno-
vation from outside, and developing new products.

Many of the themes we have dealt with—such as appropriating value from innovation and recon-
ciling creativity with commercial discipline—are general issues in the strategic management of tech-
nology. Ultimately, however, the design and implementation of strategies in industries where innovation
is a key success factor requires strategy to be closely tailored to the characteristics of technology, market
demand, and industry structure. BCG’s list of the world’s most innovative companies includes among its
top ten Apple, Samsung, Amazon, Toyota, and Facebook. While all these companies have been highly
successful in using innovation to build competitive advantage, the strategies each has deployed have
been closely tailored to their individual circumstances.

246 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

Notes

1. D. Stokes, Pasteur’s Quadrant: Basic Science and Techno-
logical Innovation (Washington, DC: Brookings Institution
Press, 1997).

2. R. E. Dugan and K. J. Gabriel, “Special Forces Innovation:
How DARPA Attacks Problems,” Harvard Business Review
(October 2013).

3. In the United States, the return on R&D spending was
estimated at between 3.7% and 5.5%. See M. Warusawitha-
rana, “Research and Development, Profits and Firm Value:
A Structural Estimation,” Discussion Paper (Washington,
DC: Federal Reserve Board, September, 2008). See also: K.
W. Artz, P. M. Norman, D. E. Hatfield, and L. B. Cardinal,
“A Longitudinal Study of the Impact of R&D, Patents, and

Product Innovation on Firm Performance,” Journal of
Product Innovation Management 27 (2010): 725–740.

4. A. Gambardella and E. von Hippel, “Open Inputs as a
Profit-Maximizing Strategy by Customers” (October 2,
2017). https://ssrn.com/abstract=3046727; accessed
January 11, 2018.

5. F. T. Rothermael, “Incumbent Advantage through Exploit-
ing Complementary Assets via Interfirm Cooperation,”
Strategic Management Journal 22 (2001): 687–699.

6. R. C. Levin, A. K. Klevorick, R. R. Nelson, and S. G. Winter,
“Appropriating the Returns from Industrial Research and
Development,” Brookings Papers on Economic Activity 18,
no. 3 (1987): 783–832.

Self-Study Questions

1. Trevor Baylis, a British inventor, submitted a patent application in November 1992 for a wind-
up radio for use in Africa in areas where there was no electricity supply and people were too
poor to afford batteries. He was excited by the prospects for radio broadcasts as a means of
disseminating health education in areas of Africa devastated by AIDS. After appearances on
British and South African TV, Baylis attracted a number of entrepreneurs and companies inter-
ested in manufacturing and marketing his clockwork radio. However, Baylis was concerned
by the fact that his patent provided only limited protection for his invention: most of the main
components—a clockwork generator and transistor radio—were long-established technol-
ogies. What advice would you offer Baylis as to how he can best exploit his invention?

2. Table 9.1 shows that:

a. patents have been more effective in protecting product innovations in drugs and medical
equipment than in food or electronic components;

b. patents are more effective in protecting product innovations than process innovations.

Can you suggest reasons why?

3. Page 228 refers to James Dyson’s difficulties in licensing his innovative vacuum cleaner (see
http://www.cdf.org/issue_journal/dyson_fills_a_vacuum.html for further information). What
lessons would you draw from Dyson’s experience concerning the use of licensing by small
firms to exploit innovation?

4. From the evidence presented in Table  9.2, what conclusions can you draw regarding the
factors that determine whether leaders or followers win out in the markets for new products?

5. In the market for ride sharing services, Uber is the market leader, followed by Lyft, Curb, and
Sidecar. In each overseas country where Uber operates, it faces local competitors: UK rivals
include BlaBlaCar, Carpooling.com, and Hailo. What are the sources of network externalities
in this market? Do they operate at the city, national, or global level? Does the strength of these
network effects mean that Uber’s competitors are doomed to failure?

CHAPTER 9 TECHNOlOGY-BASED INDUSTRIES AND THE MANAGEMENT OF INNOVATION 247

7. P. Grindley and D. J. Teece, “Managing Intellectual Capital:
Licensing and Cross-Licensing in Semiconductors and
Electronics,” California Management Review 39 (Winter
1997): 8–41.

8. R. Adner, “Match your Innovation Strategy to your Inno-
vation Ecosystem,” Harvard Business Review (April
2006): 17–37.

9. S. Shulman, The Telephone Gambit (New York:
Norton, 2008).

10. “The Human Genome Race,” Scientific American (April
24, 2000).

11. “EMI and the CT Scanner,” Harvard Business School Case
No. 383-194 ( June 1983).

12. C. Markides and P. A. Geroski, Fast Second (San Francisco:
Jossey-Bass, 2005).

13. D. Sull, “Strategy as Active Waiting,” Harvard Business
Review (September 2005): 120–129.

14. For example, data on penetration rates for electric tooth-
brushes and CD players were used to forecast the market
demand for HDTVs in the United States (B. L. Bayus,
“High-Definition Television: Assessing Demand Forecasts
for the Next Generation Consumer Durable,” Management
Science 39 (1993): 1319–1333).

15. G. Rowe and G. Wright, “The Delphi Technique as a Fore-
casting Tool: Issues and Analysis,” International Journal
of Forecasting 15 (1999) 353–375.

16. E. Von Hippel, “Lead Users: A Source of Novel Product
Concepts,” Management Science 32 ( July, 1986).

17. In electronic instruments, customers’ ideas initiated most
of the successful new products introduced by manufac-
turers. See E. Von Hippel, “Users as Innovators,” Tech-
nology Review 5 (1976): 212–239.

18. E. D. Beinhocker, “Robust Adaptive Strategies,” Sloan
Management Review (Spring 1999): 95–106; E. D.
Beinhocker, “Strategy at the Edge of Chaos,” McKinsey
Quarterly (Winter 1997).

19. For a discussion on the role of standards see: European
Patent Office, “The importance of industry standards”
(April 2017); https://www.epo.org/news-issues/issues/
standards.html (accessed January 9, 2018).

20. A. Friedlander, The Growth of Railroads (Arlington, VA:
CNRI, 1995).

21. S. J. Liebowitz and S. E. Margolis, “Network Externality: An
Uncommon Tragedy,” Journal of Economic Perspectives 8
(Spring 1994): 133–150 refer to these user-to-user exter-
nalities as direct externalities.

22. M. Gladwell, The Tipping Point (Boston: Little, Brown and
Company, 2000).

23. P. David, “Clio and the Economics of QWERTY,” American
Economic Review 75 (May 1985): 332–337; S. J. Gould,
“The Panda’s Thumb of Technology,” Natural History
96, no. 1 (1986): 14–23. For an alternative view see
S. J. Liebowitz and S. Margolis, “The Fable of the Keys,”
Journal of Law and Economics 33 (1990): 1–26.

24. C. Shapiro and H. R. Varian, “The Art of Standards Wars,”
California Management Review 41 (Winter 1999): 8–32.

25. “Competition in Video Game Consoles, 2018.” In R.M.
Grant, Contemporary Strategy Analysis: Text and Cases
(Hoboken, NJ: Wiley, 2019).

26. R. M. Grant, “The DVD War of 2006–8: Blu-Ray vs. HD-
DVD.” Available from the author.

27. C. Shapiro and H. R. Varian, “The Art of Standards Wars,”
California Management Review 41 (Winter 1999): 15–16.

28. Ibid: 16–18.
29. For recent research into network effects see: and

platform-based competition, see: D.P. McIntyre and A.
Srinivasan, “Networks, Platforms, and Strategy: Emerging
Views and Next Steps,” Strategic Management Journal 38
(2017): 141–160; P. C. Evans and A. Gawer, The Rise of
the Platform Enterprise: A Global Survey, (New York: The
Center for Global Enterprise, January 2016); and A. Hagiu
and S. Rothman, “Network Effects Aren’t Enough,” Har-
vard Business Review 94 (April 2016): 64–71.

30. R. Katila and S. Shane, “When Does Lack of Resources
Make New Firms Innovative?” Academy of Management
Journal 48 (2005): 814–829.

31. J. M. George, “Creativity in Organizations,” Academy of
Management Annals 1 (2007): 439–477.

32. M. L. Tushman, “Managing Communication Networks in
R&D Laboratories,” Sloan Management Review 20 (Winter
1979): 37–49.

33. D. Dougherty and C. H. Takacs, “Team Play: Heedful
Interrelating as the Boundary for Innovation,” Long Range
Planning 37 (December 2004): 569–590.

34. S. Thomke, “Enlightened Experimentation: The New
Imperative for Innovation,” Harvard Business Review
(February 2001): 66–75.

35. R. Florida and J. Goodnight, “Managing for Creativity,”
Harvard Business Review ( July/August 2005): 124–131.

36. G. von Krogh, S. Haefliger, S. Spaeth, and M. W. Wallin,
“Carrots and Rainbows: Motivation and Social Practice in
Open Source Software Development,” MIS Quarterly 36
(2012): 649–676.

37. D. Leonard and S. Straus, “Putting Your Company’s Whole
Brain to Work,” Harvard Business Review (August 1997):
111–121; D. Leonard and P. Swap, When Sparks Fly:
Igniting Creativity in Groups (Boston: Harvard Business
School Press, 1999).

38. J. and S. DeGraff, The Innovation Code: The Creative
Power of Constructive Conflict (Oakland CA: Berrett-
Koehler, 2017).

39. A. J. Slywotzky, Demand: Creating What People Love
Before They Know They Want It (Paris: Hachette, 2012).

40. E. Von Hippel, The Sources of Innovation (New York:
Oxford University Press, 1988).

41. S. Thomke and E. Von Hippel, “Customers as Innovators:
A New Way to Create Value,” Harvard Business Review
(April 2002).

42. https://shop.lego.com/en-US/Ship-in-a-Bottle-21313;
accessed January 11, 2018.

43. M. Dodgson, “Technological Collaboration and
Innovation,” in M. Dodgson and R. Rothwell (eds.), The
Handbook of Industrial Innovation (Cheltenham: Edward
Elgar, 1994); A. Arora, A. Fosfur, and A. Gambardella,
Markets for Technology (Cambridge, MA: MIT Press,
2001); S.  Breschi and F. Malerba, Clusters, Networks and
Innovation (Oxford: Oxford University Press, 2005).

44. H. Chesbrough, Open Innovation: The New Imperative for
Creating and Profiting from Technology (Boston: Harvard
Business School Press, 2003). See also, B. Cassiman and
G. Valentini, “What is Open Innovation, Really?” Bocconi
University working paper (2014).

248 PART III BUSINESS STRATEGY AND THE QUEST FOR COMPETITIVE ADVANTAGE

45. G.P. Pisano, “You Need an Innovation Strategy,” Harvard
Business Review ( June 2015): 44–54.

46. “How to Manage a Dream Factory,” Economist ( January
16, 2003).

47. K. Clark and T. Fujimoto, Product Development
Performance: Strategy, Organization, and Management
in the World Auto Industry (Boston: Harvard Business
School Press, 1991).

48. K. Imai, I. Nonaka, and H. Takeuchi, “Managing the New
Product Development Process: How Japanese Companies
Learn and Unlearn,” in K. Clark, R. Hayes, and C. Lorenz
(eds.), The Uneasy Alliance (Boston: Harvard Business
School Press, 1985).

49. D. A. Schön, “Champions for Radical New Inventions,”
Harvard Business Review (March/April, 1963): 84.

50. R. Rothwell, C. Freeman, A. Horlsey, V. T. Jervis, A. B.
Robertson, and J. Townsend, “SAPPHO Updated: Project
SAPPHO Phase II,” Research Policy 3 (1974): 258–291.

51. A. Campbell and J. Birkinshaw, “Know the Limits of
Corporate Venturing,” Financial Times (August 8, 2004).

52. G. Hamel and C. K. Prahalad, “Nurturing Creativity:
Putting Passions to Work,” Shell World (Royal Dutch Shell,
September 14, 2007): 1–12.

53. R.C. Wolcott and M.J. Lippitz, Grow From Within:
Mastering Corporate Entrepreneurship and Innovation
(McGraw Hill, 2010).

10 Vertical Integration and the Scope of the Firm

11 Global Strategy and the Multinational Corporation

12 Diversification Strategy

13 Implementing Corporate Strategy: Managing the Multi-
business Firm

14 External Growth Strategies: Mergers, Acquisitions,
and Alliances

15 Current Trends in Strategic Management

IV
CORPORATE
STRATEGY

10

Do what you do best and outsource the rest!

—PETER DRUCKER, MANAGEMENT GURU, 1909–2005

Bath Fitter has control of the product from raw material to installation. This control
allows them to better guarantee the quality by knowing exactly how it is made,
not outsourcing it to someone that could take shortcuts …. Also, they control the
measuring, installation, and customer facing representative. By doing this, Bath Fitter
would be able to get accurate and fast feedback about how the product is being used,
quality issues, or the ease of installation.

—“BATH FITTER HAS VERTICAL INTEGRATION,” HTTP://BEYONDLEAN.WORDPRESS.COM/2011/08/29/

Vertical Integration and
the Scope of the Firm

◆ Introduction and Objectives

◆ Transaction Costs and the Scope of the Firm

◆ The Benefits and Costs of Vertical Integration

● The Benefits from Vertical Integration

● The Costs of Vertical Integration

● Applying the Criteria: Deciding Whether to Make
or Buy

◆ Designing Vertical Relationships

● Different Types of Vertical Relationship

● Choosing Among Alternative Vertical Relationships

● Recent Trends

◆ Summary

◆ Self-Study Questions

◆ Notes

O U T L I N E

252 PART IV CORPORATE STRATEGY

Transaction Costs and the Scope of the Firm

Although the capitalist economy is frequently referred to as a “market economy,” it
actually comprises two forms of economic organization. One is the market mechanism,
where individuals and firms, guided by market prices, make independent decisions to
buy and sell goods and services. The other is the administrative mechanism of firms,
where decisions concerning production and resource allocation are made by man-
agers and carried out through hierarchies. The market mechanism was characterized
by Adam Smith as the “invisible hand” because its coordinating role does not require

Introduction and Objectives

Chapter  1 introduced the distinction between corporate strategy and business strategy. Corporate
strategy is concerned with where a firm competes; business strategy is concerned with how a firm com-
petes within a particular area of business.1 So far, the primary focus of the book has been business
strategy. In this final part, we shift our attention to corporate strategy: decisions that define the scope
of the firm, including:

◆ Product scope: How specialized should the firm be in terms of the range of products it supplies?
Coca-Cola (soft drinks) and H&M (fashion retailing) are engaged in a single industry sector; Amazon
and Tata Group are diversified across multiple industries.

◆ Geographical scope: What is the optimal geographical spread of activities for the firm? In the chocolate
industry, Hershey is heavily focused on North America; Nestlé operates globally.

◆ Vertical scope: What range of vertically linked activities should the firm encompass? In electric cars,
Tesla is highly integrated—about 80% of the value of its cars are produced internally. Ford’s Focus
Electric is heavily outsourced—its entire drive train is supplied by Magna and its batteries by LG.

In this chapter, we begin by considering the overall scope of the firm. We then focus specifically on
vertical integration. In the next two chapters, we shall consider geographical scope (multinationality)
and product scope (diversification). However, as we shall discover, our analysis of all three dimensions of
scope will draw upon several common concepts: economies of scope, transaction costs, and the costs
of corporate complexity.

By the time you have completed this chapter, you will be able to:

◆ Recognize the role of firms and markets in organizing economic activity and apply trans-
action cost analysis to explain the boundaries between the two.

◆ Understand the benefits and costs of vertical integration and make decisions over whether
a particular activity should be undertaken internally or outsourced.

◆ Identify alternative ways of organizing vertical transactions and, given the characteristics
and circumstances of a transaction, recommend the most suitable transaction mode.

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 253

conscious planning. Alfred Chandler referred to the administrative mechanism of firms
as the “visible hand” because it involves active planning and direction.2

Firms and markets may be viewed as alternative institutions for organizing produc-
tion. Firms are distinguished by the fact they comprise a number of individuals bound
by employment contracts with a central contracting authority. However, production
can also be organized through market transactions. When I remodeled my basement,
I contracted a self-employed builder to undertake the work. He in turn subcontracted
parts of the work to a plumber, an electrician, a joiner, a drywall installer, and a painter.
Although the job involved the coordinated activity of several individuals, these self-
employed specialists were not linked by employment relations but by market contracts
(“$4,000 to install wiring, lights, and power outlets”).

The relative roles of firms and markets vary between countries, industries, and seg-
ments within an industry. Some countries are dominated by a few diversified business
groups: Samsung and LG in South Korea; Koc and Sabanci in Turkey. In the US computer
industry, the production of mainframes is organized very differently from that of PCs.
IBM’s System z mainframe computers are assembled by IBM using IBM microprocessors
and IBM’s z/OS operating system, and run IBM applications software. IBM also under-
takes distribution, marketing, and customer support. HP’s laptop computers are manu-
factured by Flextronics, Quanta, and other companies using components produced by
firms such as Intel, Seagate, Nvidia, and Samsung. Customer support is also outsourced.

What determines the relative roles of firms and markets? Ronald Coase’s answer was
the relative cost of organizing within firms as compared to organizing within markets.3
Markets are not costless: the transaction costs of markets include the costs of search,
negotiation, drawing up contracts, and monitoring and enforcing contracts (including
the costs of litigation should a dispute arise). Conversely, if an activity is internalized
within a firm, then the firm incurs certain administrative costs. If the transaction costs
of organizing an activity through the market are more than the administrative costs of
organizing it within a firm, we can expect that activity to be encompassed within a firm.

Consider the examples shown in Figure 10.1. With regard to vertical scope, which
is a more efficient way to produce electric cars: three separate companies, one

Specialized �rms Single integrated �rm

Vertical
scope:
Electric
cars

Product
scope:
Entertainment

Geographical
scope:
Banking

LG (Battery)

Ford (Final assembly)

Magna (Drivetrain)

S Video games
O Consumer
N electronics
Y Movies

Wells Fargo (US)

Banco Bradesco (Brazil)

Lloyds Banking Group (UK)

T Battery
E
S Drivetrain
L
A Assembly

Nintendo (Video games)

MGM (Movies)

Panasonic (Consumer electronics)

Ford
Focus
Electric

H US
S UK
B Brazil
C +other countries

FIGURE 10.1 The scope of the firm: Specialization versus integration

254 PART IV CORPORATE STRATEGY

STRATEGY CAPSULE 10.1

The Rise of the modern Corporation

ORIGInS OF THE mOdERn
CORPORATIOn

The large corporation, the dominant feature of advanced

capitalist economies, is of recent origin. At the beginning

of the 19th century, most production, even in Britain, the

most industrially advanced economy of that time, was by

individuals and families working in their own homes. Even

by the mid-19th century, the biggest business organiza-

tions in the US were family-owned farms, notably the large

plantations of the South. The business corporation resulted

from two key developments during the 19th century:

1 Technology. Mechanization caused the shift of

manufacturer from the home to the factory, while

developments in transportation—canals and rail-

ways—expanded the size of markets.

2 Limited liability. A corporation is an enterprise that

has a separate legal identity from its owners: it can

own property, enter into contracts, sue, and be

sued. The earliest business corporations were colo-

nial trading companies created by royal decree: the

British East India Company (1600), the Dutch East

India Company (1602), and Hudson’s Bay Company

(1670). The introduction of limited liability during

the mid-19th century, insulated the shareholders

from the debts of the companies they owned,

encouraging large-scale equity financing of railroad

and manufacturing corporations.

Emergence of giant industrial companies was a feature

of the “second industrial revolution,” which occurred in

the United States in the late 19th and early 20th centuries.

Its drivers were technological innovations—electricity,

the telephone, and the automobile—and organizational

and management innovations. Management innovations

included Winslow Taylor’s scientific management—a

systematic, empirically based approach to job design and

production management; Ford’s assembly line system of

mass production; techniques of mass marketing; and sys-

tems of cost and management accounting.

Organizational innovations included:

◆ Line-and-staff structure: Most companies comprised

a single establishment. The railroad companies were

the first to create geographically separate operating

units managed by an administrative headquar-

ters. This structure—“line” employees in operating

units coordinated by a head office “staff ” of admin-

istrators and functional specialists—developed into

more complex functional structures. Sears Roebuck

& Co. and Shell Transport and Trading comprised

numerous operating units and headquarters made

up of specialized functional departments.

◆ The holding company: The biggest companies at

the beginning of the 20th century were holding

companies built through mergers and acquisitions

(e.g., American Tobacco, US Steel, and Standard Oil).

In a holding company, the parent company owns

controlling equity stakes in a number of subsidiary

companies allowing the parent to appoint the

boards of the subsidiaries and receive dividends, but

with limited managerial control.

THE 20TH CEnTURY: EXPAndInG
SCAlE And SCOPE

Large holding companies and functionally organized

companies increasingly adopted multidivisional struc-

tures. At DuPont, increasing size and a widening product

range strained its functional structure and overloaded

top management. Pierre Du Pont’s solution was to

decentralize: 10 product divisions were created, each

with its own R&D, production, and sales; a corporate

supplying batteries, another producing drivetrains, a third undertaking assembly (as
in the case of the Ford Focus Electric), or a single company undertaking all three
stages (as in the case of Tesla)? In relation to product scope, is it more efficient for
video games, consumer electronic products, and movies to be produced by a single
firm (such as Sony), or for each product to be produced by a separate company?

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 255

head office led by an executive committee undertook

coordination, strategy, and resource allocation. Shortly

after, in 1924, General Motors, a holding company built

by acquisition, also adopted a multidivisional structure to

solve its problems of weak financial control and a con-

fused product line. During the next 50 years, the multi-

divisional structure became the dominant organizational

form for large corporations.

During the first half of the 20th century, large com-

panies grew mainly through vertical integration and

horizontal integration (i.e., increasing market share within

existing markets). After World War II, diversification and

international expansion were the main sources of corpo-

rate growth. By the 1960s, the increasing dominance of

giant corporations pointed to the replacement of market

capitalism by a system of managerial capitalism.

However, by the 1980s, this trend went into reverse.

Increasing emphasis on shareholder value and core com-

petences resulted in a shift from vertical integration to

outsourcing and from diversification to “core business

focus.” Increasingly, companies used collaborative rela-

tionships with other companies to achieve the bene-

fits of vertical, horizontal, and cross-border integration.

Figure 10.2 illustrates the trends.

Sources: A. D. Chandler, The Visible Hand: The Managerial Rev-
olution in American Business (Cambridge, MA: MIT Press, 1977).
J.  Micklethwait and A. Wooldridge, The Company: A Short His-
tory of a Revolutionary Idea (New York: Modern Library, 2005).
A. D.  Chandler, Strategy and Structure (Cambridge: MIT Press, 1962).

In the case of geographical scope, is it better to have banking services provided by
separate banks in each country, or by a single multinational bank (such as HSBC) that
operates across multiple countries?

The answers to these question have changed over the past 200 years. As Strategy
Capsule 10.1 explains, these shifts can be linked to the factors that have influenced the

0

2

4

6

8

10

12

14

16

First Industrial
Revolution:
Mechanization
and the factory
system

Expanding Scale and Scope
• scale economies from new
technologies
• new management tools
• multidivisional structure
• computers
• international expansion

Restructuring, Refocusing, and
Downsizing:
• Quest for shareholder value:
focus on core competences
and core businesses
• Turbulent business
environment: in�exibility of
large, complex hierarchies
• Digital revolution

Top 100
companies’
share of
total
employment
(%)

Consolidation
through mergers
and acquisitions
Quest for scale
and market
dominance in
both mature and
hi-tech sectors

Second Industrial
Revolution: Growth of
industrial giants
assisted by electricity,
the telephone,
innovations in
management and
organization

Railways,
canals, and
telegraph
expand �rms
geographical
reach

18
00

18
20

18
40

18
60

18
80

19
00

19
20

19
40

19
60

19
80

20
00

20
20

FIGURE 10.2 The widening scale and scope of large US companies

Sources: Author’s estimates based upon various sources including: A. Chandler Jr., The Visible Hand (Cambridge, MA: MIT
Press, 1977); L. J. White and J. Yang, “What Has Been Happening to Aggregate Concentration in the U.S. Economy in the
21st Century?”Stern School of Business, New York University, 2017. S. Kim “The Growth of Modern Business Enterprises in
the Twentieth Century,” Research in Economic History 19 (1999): 75–110.

256 PART IV CORPORATE STRATEGY

relative efficiencies of firms relative to markets. For most of the 19th and 20th centuries,
new technologies—including innovations in management and organization—have
favored large firms. Around the mid-1970s, this trend went into reverse: a more turbulent
business environment and new information and communications technologies favored
more focused enterprises coordinated through markets.

The Benefits and Costs of Vertical Integration

So far, we have considered the overall scope of the firm. Let us focus now on just one
dimension of corporate scope: vertical integration. The question we seek to answer
is this: Is it better to be vertically integrated or vertically specialized? With regard to a
specific activity, this translates into: To make or to buy? First, we must be clear what we
mean by vertical integration.

Vertical integration is a firm’s ownership and control of multiple vertical stages in
the supply of a product. The extent of a firm’s vertical integration is indicated by the
number of stages of the industry’s value chain that it spans, and can be measured by
the ratio of its value added to sales revenue.4

Vertical integration can be either backward (or upstream) into its suppliers’ activ-
ities or forward (or downstream) into its customers’ activities. Vertical integration
may also be full or partial. Some California wineries are fully integrated: they pro-
duce wine only from the grapes they grow, and sell it all through direct distribution.
Most are partially integrated: their homegrown grapes are supplemented with pur-
chased grapes; they sell some wine through their own tasting rooms but most through
independent distributors.

Strategies toward vertical integration have been subject to shifting fashions. For most
of the 20th century, the prevailing wisdom was that vertical integration was beneficial
because it allowed superior coordination and reduced risk. Yet, by the 1990s, opinions
had changed. In 1992, management guru Tom Peters observed: “The idea of vertical
integration is anathema to an increasing number of companies.”5 Outsourcing could
reduce cost, enhance flexibility and allow firms to concentrate on those activities that
they performed best. Moreover, many of the benefits of vertical integration could be
achieved through collaboration with suppliers and buyers.

Inevitably, the truth is more nuanced. Even within the same industry, companies
make different choices over vertical integration and outsourcing. Strategy Capsule 10.2
compares Disney’s vertical integration between content production and distribution
with the system of licensing contracts with which J. K. Rowling’s Harry Potter is com-
mercialized through multiple channels.

Our task is to identify the factors that determine whether vertical integration or out-
sourcing is the better strategy for a particular company in a particular situation.

The Benefits from Vertical Integration

Technical Economies from the Physical Integration of Processes Proponents
of vertical integration have often emphasized the technical economies it offers: cost
savings that arise from the physical integration of processes. Thus, most steel sheet is
produced by integrated producers in plants that first produce steel and then roll hot
steel into sheet. Linking the two stages of production at a single location reduces trans-
portation and energy costs. Similar technical economies arise in integrating pulp and
paper production and from linking oil refining with petrochemical production.

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 257

STRATEGY CAPSULE 10.2

Vertical Integration in the Entertainment Industry: Frozen versus
Harry Potter

Over the past two decades, integration between content

producers (film studios, music publishing) and distribu-

tion companies (theaters, TV broadcasting, cable com-

panies, satellite TV, digital streaming) has reshaped the

entertainment industry.

Content producers such as Walt Disney Company,

Time Warner, and News Corporation have forward

integrated into distribution (TV broadcasting, cable,

satellite TV, and movie distribution). Cable companies

and broadcasters (such as Comcast and Viacom) have

backward integrated into movie and TV production.

The mergers creating these integrated production

and distribution companies have not all been successful:

AOL’s 2000 merger with Time Warner and the acquisition

spree that transformed Compagnie Générale des Eaux

into Vivendi Universal were disasters.

Yet, the urge for vertical integration continues: the

leading providers of video streaming services, Netflix

and Amazon, are both investing heavily in content pro-

duction, while communications giant AT&T has acquired

Time Warner.

To illustrate the relative merits of vertical integration

and market-based contracts, consider the commercial

exploitation of the fictional characters from Harry Potter

with those of Frozen.

HARRY POTTER

◆ Seven Harry Potter novels written by J. K. Rowling were

published by Bloomsbury in the United Kingdom and

Scholastic Press in the United States between 1997

and 2007 with total sales of 400 million (to 2017).

◆ Film rights were acquired by Warner Bros., which pro-

duced eight movies generating $7.7 billion in box

office receipts.

◆ 11 Harry Potter video games were produced by

Electronic Arts.

◆ A Harry Potter attraction opened at Comcast’s

Universal Orlando Resort in 2010, while a Warner

Bros. Harry Potter studio tour opened in the

UK in 2012.

◆ Harry Potter copyrights and trademarks were

licensed to Mattel, Coca-Cola, Lego, Hasbro, John-

son & Johnson, Lochaven of Scotland, and other

companies for the production of toys, clothing, and

other products.

FROZEn

Frozen is a computer-animated film inspired by Hans

Christian Andersen’s The Snow Queen, produced by Walt

Disney Animation Studios, and released by Walt Disney

Pictures in 2013. It generated $1.3  billion in worldwide

box office revenue. Prior to release, Frozen was pro-

moted heavily at Disney theme parks. Commercial spi-

noffs from the movie and its lead characters, Elsa and

Anna, include:

◆ a range of merchandise including dolls, cos-

tumes and “home décor, bath, textile, footwear,

sporting goods, consumer electronics, and pool

and summer toys” developed by Disney Consumer

Products and sold through Disney Stores and

independent channels;

◆ DVD and Blu-ray releases by Walt Disney Studios

Home Entertainment;

◆ a video game launched by Disney Mobile for hand-

held devices;

◆ a Disney-On-Ice touring Frozen show and a Broadway

stage musical adaptation by Disney Theatrical;

◆ Frozen Ever After ride at Walt Disney World, Florida.

258 PART IV CORPORATE STRATEGY

However, although these considerations explain the need for the co-location of
plants, they do not explain why vertical integration in terms of common ownership is
necessary. Why can’t steel and steel strip production or pulp and paper production be
undertaken by separate firms that own facilities which are physically integrated with
one another? To answer this question, we must look beyond technical economies and
consider the implications of linked processes for transaction costs.6

Avoiding Transaction Costs in Vertical Exchanges Consider the value chain for
steel cans that extends from mining iron ore to the use of cans by food-processing com-
panies (Figure 10.3). There is vertical integration between some stages; other stages are
linked by market contracts between specialist firms. In the final linkage—between can
producing and canning—most cans are produced by specialist packaging companies
(such as Crown Holdings and Ball Corporation).7 An analysis of transaction costs can
explain these different arrangements.

The predominance of market contracts between the producers of steel strip and the
producers of cans reflects low transaction costs in the market for steel strip: there are
many buyers and sellers, information is readily available, and the switching costs for
buyers and suppliers are low. The same is true for many other commodity products: few
jewelry companies own gold mines; flour-milling companies seldom own wheat farms.

To understand why vertical integration predominates across steel production and
steel strip production, let us see what would happen if the two stages were owned by
separate companies. Because there are technical economies from hot-rolling steel as
soon as it is poured from the furnace, steel makers and strip producers must invest in
integrated facilities. A competitive market between the two stages is impossible; each
steel strip producer is tied to its adjacent steel producer. In other words, the market
becomes a set of bilateral monopolies.

The reason these relationships between steel producers and strip producers are
problematic is that each steel supplier must negotiate with a single buyer; there is no
market price: it all depends on relative bargaining power. Such bargaining is costly: the
mutual dependency of the two parties encourages opportunism and strategic misrep-
resentation as each company seeks to enhance and exploit its bargaining power at the
expense of the other. Thus, once we move from a competitive market situation to one
where individual buyers and sellers are locked together in close bilateral relationships,
the efficiencies of competitive markets are lost.

The culprits in this situation are transaction-specific investments. When the steel
producer and the strip producer build adjoining plants, each plant is totally dependent

Steel strip
production

Can-
making

Steel
production

Iron ore
mining

Canning of
food, drink,

oil, etc.

MARKET
CONTRACTS

VERTICAL
INTEGRATION

MARKET
CONTRACTS

VERTICAL
INTEGRATION
AND MARKET
CONTRACTS

FIGURE 10.3 The value chain for steel cans

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 259

on the continuing business of the other party—each party has the potential to hold
up the other (i.e., each party can threaten the other with withholding business). Con-
versely, when a steel strip producer supplies a can maker, neither needs to invest in
equipment nor technology that is specific to the needs of the other party.

If the future were predictable, these issues could be resolved in advance. However,
in an uncertain world, it is impossible to write a complete contract that covers every
possible eventuality over the entire life span of the capital investments being made.

Empirical research confirms the tendency for transaction-specific investments to
encourage vertical integration.8 Among automakers, specialized components are more
likely to be manufactured in-house than commodity items such as tires and spark
plugs.9 Similarly, in aerospace, company-specific components are more likely to be
produced in-house rather than purchased externally.10

Coordination Benefits The tendency for changing circumstances to impose
transaction costs points to the coordination benefits of vertical integration, Consider
Tesla’s development and production of its electric cars. As noted in Figure  10.1,
Tesla makes its own batteries and powertrains—indeed it produces in-house about
80% of its components and sub-assemblies (including seats). The reason is that
Tesla cars are revolutionary designs that require specially-designed components.
In-house production relieves Tesla’s engineers and managers of the need for con-
tinuous, time-consuming communication and coordination with suppliers. Similar
considerations explain relationships between semiconductor designers and fabri-
cators. Companies that produce highly complex chips that require close technical
collaboration between designer and fabricator tend to be vertically integrated (e.g.,
Intel and STMicroelectronics).11

The Costs of Vertical Integration

Market contracts incur transaction costs, but vertical integration imposes administrative
costs. The extent of these costs depends on several factors.

Differences in Optimal Scale between Different Stages of Production UPS’s
delivery vans are manufactured to its own specifications by Morgan Olson (which also
supplies walk-in vans to FedEx, Amazon, US Postal Service, and other customers).
Should UPS build its own vans and trucks? Almost certainly not: the transaction costs
avoided by UPS will be trivial compared with the inefficiencies incurred in manu-
facturing its own vans: the 20,000 vans UPS purchases each year are well below the
minimum efficient scale of an assembly plant. Similarly, specialist brewers such as
Anchor Brewing of San Francisco or Adnams of Suffolk, England do not make their
own containers (as does Anheuser-Busch InBev). Small brewers lack the scale to man-
ufacture cans and bottles efficiently.

The Need to Develop Distinctive Capabilities Another reason for UPS not mak-
ing its own vans is that it is likely to be a poor vehicle manufacturer. A key advantage
of a company specializing in a few activities is its ability to develop distinctive capa-
bilities in those activities. Even large, technology-based companies such as Boeing,
Intel, and Philips cannot maintain IT capabilities that match those of IT services
specialists such as IBM, TCS, and Accenture. A major advantage of these IT spe-
cialists is the learning they gain from working with multiple clients. If Boeing’s IT
department only serves the in-house needs of Boeing, this limits the development of
its IT capabilities.

260 PART IV CORPORATE STRATEGY

However, this assumes that capabilities in different vertical activities are independent
of one another and that the required capabilities are generic rather than highly cus-
tomized. Where one capability is closely integrated with capabilities in adjacent activ-
ities, vertical integration may help develop these integrated, system-wide capabilities.
Thus, Walmart keeps most of its IT in-house. The reason is that real-time information
is central to Walmart’s supply chain management, in-store operations, and upper-level
managerial decision-making. Walmart’s tightly integrated IT services are customized to
meet the needs of its unique business system.

Problems of Managing Strategically Different Businesses These problems of
differences in optimal scale and developing distinctive capabilities are part of a wider
set of problems—that of managing vertically-related businesses that are strategically
very different. A major disadvantage of UPS owning a truck-manufacturing company is
that the management systems and organizational capabilities required for truck man-
ufacturing are very different from those required for express delivery. These consid-
erations explain the lack of vertical integration between manufacturing and retailing.
Firms that are integrated across manufacturing, and retailing, such as Zara (Inditex S.A.)
and Gucci (Kering S.A.), are unusual. Most of the world’s leading retailers—Walmart,
Gap, Carrefour—do not manufacture. Similarly, few manufacturing companies retail
their own products. Not only do manufacturing and retailing require very different
organizational capabilities, but they also require different strategic planning systems,
different approaches to control and human resource management, and different top-
management styles and skills.

These strategic dissimilarities are a key factor in the trend to vertically de-integrate.
Marriott’s split into two separate companies, Marriott International and Host Marriott,
was influenced by the belief that owning hotels is a strategically different business
from operating hotels. Similarly, the Coca-Cola Company spun off its bottling activities
as Coca-Cola Enterprises Inc. partly because managing local bottling and distribution
operations is very different from managing the global Coca-Cola brand and producing
and distributing concentrates.

Incentive Problems Vertical integration changes the incentives between vertically-
related businesses. Where a market interface exists between a buyer and a seller, profit
incentives ensure that the buyer is motivated to secure the best possible deal and the
seller is motivated to pursue efficiency and service in order to attract and retain the
buyer—these are termed high-powered incentives. With vertical integration, internal
supplier–customer relationships are subject to low-powered incentives. When my office
computer malfunctions, I call the university’s IT department. The incentives for the
in-house technicians to respond promptly to my email and voice messages are weak.
If I were free to use an outside IT specialist, that specialist would only get the business
if they were able to offer same-day service and would only get paid once the problem
was resolved.

One approach to creating stronger performance incentives within vertically-
integrated companies is to open internal divisions to external competition. As we shall
examine more fully in Chapter 13, many large corporations have created shared-service
organizations, where internal suppliers of corporate services—such as IT, training, and
engineering—compete with external suppliers of the same services to serve internal
operating divisions.

Competitive Effects For a monopolist, one of the supposed benefits of vertical
integration is to extend a monopoly position at one stage of an industry’s value chain to
adjacent stages. Classic cases of this are Standard Oil and Alcoa. However, economists

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 261

have shown that there is no additional monopoly profit to be extracted by extending a
monopoly to adjacent stages of the value chain.12

For a firm that is not monopolist, vertical integration risks damaging its competi-
tive position in its core business. If it forward integrates, it becomes a competitor of
its customers (or, if it backwards integrates, a competitor of its suppliers), potentially
damaging its attractiveness as a business partner. When Google acquired cell phone
maker, Motorola, a major risk was that other handset makers that were customers for its
Android operating system (Samsung in particular) might regard Google more as a com-
petitor and less as a reliable supplier and be inclined to find an alternative operating
system to Android.13

Flexibility Both vertical integration and market transactions can claim advantage
with regard to different types of flexibility. Where the required flexibility is rapid
responsiveness to uncertain demand, there may be advantages in market transactions.
The lack of vertical integration in the construction industry allows flexibility in adjust-
ing both to fluctuations of demand and to the different requirements of each project.14
Vertical integration may also be disadvantageous in responding quickly to new prod-
uct development opportunities that require new combinations of technical capabil-
ities. Some of the most successful new electronic products of recent years—Apple’s
iPod, Microsoft’s Xbox, Amazon’s Echo—have been produced by contract manufac-
turers. Extensive outsourcing has been a key feature of fast-cycle product development
throughout the electronics sector.

Yet, where system-wide flexibility is required, vertical integration may allow for speed
and coordination in achieving simultaneous adjustment throughout the value chain.
Inditex, owner of Zara, has pioneered the fast-fashion model of vertical integration to
achieve unprecedented flexibility and speed to market. Zara feeds market information
from its directly owned and managed retail stores to its designers, and in-house pro-
duction and distribution to supply products twice-weekly to its retail stores. The time
period from initial design to retail shelf is about three weeks, compared to four to six
months for fashion clothing companies that outsource production.

Investing in an Unattractive Business Finally, one of the biggest disadvantages of
vertical integration is that it may involve investing in an inherently unattractive industry.
Irrespective of transaction costs and coordination benefits, McDonald’s chooses not to
backward integrate into cattle ranching and potato growing, because agriculture is a
low-margin industry.

Compounding Risk To the extent that it ties a company to its internal suppliers and
internal customers, vertical integration represents a compounding of risk: problems at
any one stage of production threaten production and profitability at all other stages.
When union workers at a General Motors brake plant went on strike in 1998, GM’s 24
US assembly plants were soon brought to a halt. Disney’s animation studios produce
blockbuster movies—Lion King, Frozen, Cars—that feed DVD sales, Disney Channel
TV shows, live performances, theme park rides, and merchandise sales. If the studios
produce a series of flops, the entire Disney system suffers.

Applying the Criteria: Deciding Whether to Make or Buy

Vertical integration is neither good nor bad. As with most questions of strategy, it all
depends upon the specific context. The value of our analysis is that we can identify the
factors that determine the relative advantages of the market transactions versus inter-
nalization. Figure 10.4 summarizes some of the key criteria.

262 PART IV CORPORATE STRATEGY

The greater the number of f irms, the less advantageous is VI
How many f irms are in the
vertically adjacent activity?

The greater the need for transaction-specif ic investments, the
greater the advantages of VI

Do transaction-specif ic investments
need to be made by either party?

The greater is the need for coordination, the greater the
advantages of VI

How great is the need for coordination
between the two stages?

How great is uncertainty over the period
of the relationship?

The greater the uncertainty, the more incomplete is the contract
and the greater the advantages of VI

How critical is the continual upgrading
of capabilities in the adjacent activity?

The greater the need for capability development, the greater the
disadvantages of VI

How important are prof it incentives to
performance in the adjacent activity?

The greater the need for high-powered incentives, the greater
the disadvantages of VI

How uncertain is market demand? The more unpredictable is demand, the less advantageous is VI

How great is the risk that each stage
is an unreliable supplier to (or buyer
from) adjacent stages?

The greater the risks at each stage, the more VI compounds the
�rm’s overall risk

How similar are two stages in terms of
the optimal scale of the operation?

The greater the dissimilarity, the less advantageous is VI

How strategically similar are the
stages?

Characteristics of the
vertical relationship

Implication

FIGURE 10.4 Vertical integration (VI) versus outsourcing: Key considerations

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 263

However, our analysis is not yet complete; we must consider some additional factors
that influence the choice of vertical strategy, and in particular the fact that vertical rela-
tionships are not limited to the binary choice of make or buy.

Designing Vertical Relationships

Our discussion so far has compared vertical integration with arm’s-length market
contracts. In practice, the adjacent stages in a value chain can be linked through a
variety of relationships. Figure 10.5 shows a number of different types of relationship
between buyers and sellers. These relationships may be classified in relation to two
characteristics. First, the extent to which the buyer and seller commit resources to the
relationship: arm’s-length, spot contracts involve no resource commitment beyond the
single deal; vertical integration typically involves a substantial investment. Second,
the formality of the relationship: long-term contracts and franchises are formalized by
the complex written agreements they entail; spot contracts typically involve little or no
documentation and are governed by common law; collaborative agreements between
buyers and sellers are usually informal—they are trust-based; vertical integration allows
management discretion to replace legal formality.

Different Types of Vertical Relationship

Different vertical relationships offer different combinations of advantages and disad-
vantages. For example:

● Long-term contracts: Market transactions can be either spot contracts—Shell
buying a cargo of crude oil on the Rotterdam petroleum market—or long-term
contracts—Shell contracting to buy specific quantities of crude oil from Saudi
Aramco over a five-year period. Spot transactions work well under competi-
tive conditions (many buyers and sellers and a standard product) where there
is no need for transaction-specific investments by either party. Where closer
supplier–customer ties are needed, particularly when one or both parties need

High

Fo
rm

al
iz

at
io

n

Low

Spot sales/
purchases

Low
HighDegree of Commitment

Long-term
contracts

Agency
agreements

Franchises

Joint
ventures

Vertical
integration

Informal
supplier/
customer

relationships

Value
adding
vertical

partnerships

FIGURE 10.5 Different types of vertical relationship

264 PART IV CORPORATE STRATEGY

to make transaction-specific investments, a longer-term contract can help
avoid opportunism and provide the security needed to make the necessary
investment. However, long-term contracts face the problem of anticipating the
circumstances that may arise during the life of the contract: either they are too
restrictive or so loose that they give rise to opportunism and conflicting inter-
pretation. Long-term contracts often include provisions for the arbitration of
contract disputes.

● Vertical partnerships: The greater the difficulties of specifying complete con-
tracts for long-term supplier–customer deals, the greater the advantage of
vertical relationships based on trust and mutual understanding. Such relation-
ships can provide the security needed to support transaction-specific invest-
ments, the flexibility to meet changing circumstances, and the incentives to
avoid opportunism. Such arrangements may be entirely relational contracts,
with no written contract at all. The model for vendor partnerships has been
the close collaborative relationships that many Japanese companies have with
their suppliers. Japanese automakers have been much less backward integrated
than their US or European counterparts but have also achieved close collabo-
ration with component makers in technology, design, quality, and production
scheduling.15

● Franchising: A franchise is a contractual agreement between the owner of a
business system and trademark (the franchiser) that permits the franchisee
to produce and market the franchiser’s product or service in a specified area.
Franchising brings together the brand, marketing capabilities, and business sys-
tems of the large corporation with the entrepreneurship and local knowledge
of small firms. The franchising systems of companies such as McDonald’s,
Century 21 real estate, Hilton Hotels, and 7-Eleven convenience stores combine
the advantages of vertical integration in terms of coordination and investment
in transaction-specific assets with advantages of market contracts in terms of
high-powered incentives, flexibility, and separate ownership of strategically dis-
similar businesses.

Choosing Among Alternative Vertical Relationships

The criteria listed in Figure 10.4 establish the basic features of the vertical relation that
favor either market transactions or vertical integration. However, the availability of
other types of vertical relationships, such as franchises and vendor partnerships, mean
that vertical integration is not the sole solution to problems of transaction costs. More-
over, many of these relational contracts and hybrid arrangements can combine the
advantages of both vertical integration and market contracts.

Choosing the optimal vertical relationships needs to take account of additional
factors to those listed in Figure 10.4. In particular:

● Resources, capabilities, and strategy: Within the same industry, different com-
panies will choose different vertical arrangements according to their relative
resource and capability strengths and the strategies they pursue. Thus, in
fashion clothing, Zara’s high level of vertical integration compared to H&M’s
or Gap’s reflects strategy based upon fast-cycle new-product development and
tight integration between its retail stores, designers, and manufacturers. While
most fast-food chains have expanded through franchising, Chipotle Mexican
Grill and California-based In-N-Out Burger seek to maintain their unique

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 265

culture and distinctive business practices by directly owning and managing
their restaurants. While most banks outsource IT to companies such as IBM
and EDS, credit card group Capital One sees IT as a key source of competitive
advantage: “IT is our central nervous system … if we outsourced tomorrow we
might save a dollar or two on each account, but we would lose flexibility and
value and service levels.”16

● Allocation of risk: Any arrangement beyond a spot contract must cope with
uncertainties over the course of the contract. A key feature of any contract is
that its terms allocate (often implicitly) risks between the parties. How risk is
shared is dependent partly on bargaining power and partly on efficiency con-
siderations. In franchise agreements, the franchisee (as the weaker partner)
bears most of the risk—it is the franchisee’s capital that is at risk and the fran-
chisee pays the franchiser a flat royalty based on sale revenues. In oil explora-
tion, outsourcing agreements between the national oil companies (e.g., Kuwait
Petroleum, Petronas, and Statoil) and drilling companies (e.g., Schlumberger and
Halliburton) have moved from fee-for-service contracts to risk service contracts
where the drilling company bears much more of the risk.

● Incentive structures: Incentives are central to the design of vertical relation-
ships. Market contracts provide powerful motivations to the parties involved,
but may also induce opportunistic behavior. Weak performance incentives are
a key problem of vertical integration. Hence, hybrid and intermediate gover-
nance modes may offer the best solutions to the design of incentives. Toyota,
Benetton, Boeing, and Starbucks have relationships with their vendors that
may involve formal contracts, but their essence is that they are long-term and
trust-based. The key to these relationships is that the promise of a long-term,
mutually-beneficial relationship trumps short-term opportunism.

Recent Trends

The main feature of recent years has been a growing diversity of hybrid vertical rela-
tionships that have attempted to combine the flexibility and incentives of market
transactions with the close collaboration provided by vertical integration. These col-
laborative vertical arrangements we have described as “vertical partnerships” have also
been denoted “virtual vertical integration” and “value-adding partnerships.” Leading
models have included Toyota’s supply chain with its three tiers of suppliers17 and Dell’s
build-to-order, direct sales model involving close coordination among a small group
of suppliers. In Apple’s “ecosystem,” Apple leads product development and tightly
controls its intellectual property but integrates the capabilities and innovations of a
broad network of firms that include component suppliers and contract assemblers and
a developer community responsible for over one million applications for the macOS
and iOS platforms.

Although these collaborative vertical relationships are viewed as a recent
phenomenon—associated with microelectronics, biotechnology, and other hi-tech
sectors—local clusters of vertically collaborating firms have long been a feature of
European industries—in northern Italy, the localized firm networks in traditional indus-
tries such as clothing, footwear, and furniture are also apparent in newer sectors such
as packaging equipment18 and motorcycles.19

Collaborative vertical partnerships have allowed the scope of outsourcing to extend
from raw materials and basic components to more complex products and business
services that represent whole chunks of the value chain. In electronics, contract

266 PART IV CORPORATE STRATEGY

manufacturers, such as Flextronics and Foxconn (a subsidiary of Hon Hai Precision
Industry Co.), design and manufacture entire products. Business services and corpo-
rate functions such as payroll, IT, training, customer service and support, and external
communications are often outsourced to specialist providers.

However, there seem to be limits to the extent to which a firm can outsource activ-
ities while still retaining the capabilities needed to develop and evolve. The virtual
corporation, a firm whose sole function is to coordinate the activities of a network of
partners, remains an abstract concept rather than a tangible reality.20 Companies such
as Boeing, Toyota, Amazon, Hewlett Packard, and McDonalds have the role of systems
integrators—they orchestrate the activities and components of many suppliers and
partners. However, empirical research shows that sustaining that role requires, not
only that these companies continue to develop their systems know-how (“architec-
tural capabilities”), but that they also need to keep abreast of the technologies being
deployed by their suppliers and partners (“component capabilities”).21 The complex-
ities of managing a network of suppliers during a period of rapid technological change
is indicated by Boeing’s difficulties in developing its 787 Dreamliner.22

Summary

The size and scope of firms reflects the relative efficiencies of markets and firms in organizing produc-
tion. Over the past 200 years, the trend has been for firms to grow in size and scope as a result of tech-
nology and advances in management, causing the administrative costs of firms to fall relative to the
transaction costs of markets.

In relation to vertical scope, there is no universal best solution. A firm must compare benefits of
vertical integration in avoiding transaction costs and permitting superior coordination against the ben-
efits of outsourcing in allowing the firm to focus on what it does best.

The dominant trend of the past three decades is for firms to concentrate on fewer stages of their
value chains and outsource the rest. However, this involves replacing vertical integration, not with arm’s-
length market contracts but with collaborative arrangements which combine the specialization bene-
fits of outsourcing with the coordination and knowledge-sharing benefits of vertical integration.

In subsequent chapters, we shall return to issues of vertical integration. In the next chapter, we shall
consider offshoring firms locating different value chain activities in different countries. In Chapter 14, we
shall look more closely at alliances—including the vertical partnering that characterizes modern supply
chains.

Self-Study Questions

1. Can the expanding scale and scope of large companies between the late 19th century and the
1970s be explained by factors which reduced the administrative costs of firms relative to the
transaction costs of markets?

2. Figure  10.2 shows that during 1980–2000 large US companies accounted for a smaller
percentage of total employment—a development that is attributed to “a more turbulent business

CHAPTER 10 VERTICAl InTEGRATIOn And THE SCOPE OF THE FIRm 267

Notes

1. In practice, there is no clear boundary between business
strategy and corporate strategy: it depends on where we
draw the boundaries of industries and markets.

2. A. Chandler Jr., The Visible Hand: The Managerial Rev-
olution in American Business (Cambridge, MA: MIT
Press, 1977).

3. R. H. Coase, “The Nature of the Firm,” Economica 4
(1937): 386–405.

4. The more of its inputs a firm makes rather than buys, the
greater is its value added relative to its sales revenue. See
Ruth Maddigan, “The Measurement of Vertical Integration,”
Review of Economics and Statistics 63 (August, 1981).

5. Tom Peters, Liberation Management (New York:
Knopf, 1992).

6. O. E. Williamson, Markets and Hierarchies: Analysis and
Antitrust Implications (New York: Free Press, 1975); O. E.
Williamson, The Economic Institutions of Capitalism:
Firms, Markets and Relational Contracting (New York:
Free Press, 1985).

7. Some large food processors, such as Campbell Soup
and H. J. Heinz, have backward integrated into can
production.

8. For a review of empirical evidence on transaction costs
and vertical integration see J. T. Macher and B. D. Rich-
man, “Transaction Cost Economics: An Assessment of
Empirical Research in the Social Sciences,” Business
and Politics 10 (2008): Article 1; and M. D, Whinston,
“On the Transaction Cost Determinants of Vertical
Integration,” Journal of Law, Economics & Organization
19 (2003): 1–23.

9. K. Monteverde and J. J. Teece, “Supplier Switching Costs
and Vertical Integration in the Automobile Industry,” Bell
Journal of Economics 13 (Spring 1982): 206–213.

10. S. Masten, “The Organization of Production: Evidence
from the Aerospace Industry,” Journal of Law and Eco-
nomics 27 (October 1984): 403–417.

11. J. T. Macher, “Technological Development and the Bound-
aries of the Firm: A Knowledge-based Examination in
Semiconductor Manufacturing,” Management Science 52
(2006): 826–843; K. Monteverde, “Technical Dialogue as
an Incentive for Vertical Integration in the Semiconductor
Industry,” Management Science 41 (1995): 1624–1638.

12. R. Rey and J. Tirole, “A Primer on Foreclosure,” Chapter 33
in M. Armstrong and R. H. Porter (eds), Handbook of
Industrial Organization: Vol. 3 (Amsterdam: Elsevier, 2007).

13. “Would Samsung ever leave Android? New CEO drops
hints,” CNET ( June 16, 2012), http://www.cnet.com/uk/
news/would-samsung-ever-leave-android-new-ceo-drops-
hints/, accessed July 20, 2015.

14. However, E. Cacciatori and M. G. Jacobides (“The
Dynamic Limits of Specialization: Vertical Integration
Reconsidered,” Organization Studies 26 (2005): 1851–
1883) point to changes in construction that are causing
reintegration.

15. J. H. Dyer, “Effective Interfirm Collaboration: How Firms
Minimize Transaction Costs and Maximize Transaction
Value,” Strategic Management Journal 18 (1997): 535–556;
J. H. Dyer, “Specialized Supplier Networks as a Source of
Competitive Advantage: Evidence from the Auto Industry,”
Strategic Management Journal 17 (1996): 271–292.

environment and new information and communications technologies” (p. 256). Explain why
these factors might cause large corporations to reduce their size and scope.

3. A large proportion of major corporations outsource their IT functions to specialist suppliers
of IT services, such as IBM, HP, Accenture, and Capgemini. What benefits do corporations
derive from outsourcing their IT requirements? What transaction costs might arise from these
arrangements?

4. Strategy Capsule 10.2 compares alternative strategies for exploiting children’s characters. Hello
Kitty is owned by the Japanese company Sanrio Co. Ltd. and is exploited throughout the world
through licensing contracts with toy makers, jewelry companies, fashion companies, restau-
rants, theme parks, retail stores, and many other types of businesses. Could Hello Kitty be
exploited more effectively by a vertically-integrated entertainment company, such as Disney?

5. For its Zara brand, Inditex manufactures the majority of the garments it sells and undertakes
all of its own distribution from manufacturing plants to its directly managed retail outlets.
The Gap outsources its production and focuses upon design, marketing, and retail distribu-
tion. Applying the considerations listed in Figure 10.4, should Gap backward integrate into
manufacture?

268 PART IV CORPORATE STRATEGY

16. L. Willcocks and C. Sauer, “High Risks and Hidden Costs
in IT Outsourcing,” Financial Times (May 23, 2000): 3.

17. J. H. Dyer and K. Nobeoka, “Creating and Managing
a High-performance Knowledge-sharing Network:
The Toyota Case,” Strategic Management Journal 21
(2000): 345–368.

18. G. Lorenzoni and A. Lipparini, “The Leveraging of Inter-
firm Relationships as Distinctive Organizational Capabil-
ities: A Longitudinal Study,” Strategic Management Journal
20 (1999): 317–338.

19. A. Lipparini, G. Lorenzoni, and S. Ferriani, “From Core to
Periphery and Back: A Study on the Deliberate Shaping of

Knowledge Flows in Interfirm Dyads and Networks,” Stra-
tegic Management Journal 35 (2014): 578–595.

20. H. W. Chesborough and D. J. Teece, “When is Virtual
Virtuous? Organizing for Innovation,” Harvard Business
Review (May/June 1996): 68–79.

21. S. Brusoni, A. Prencipe, and K. Pavitt, “Knowledge
Specialization, Organizational Coupling and the Bound-
aries of the Firm: Why Do Firms Know More than
They Make?” Administrative Science Quarterly 46
(2001): 597–621.

22. “Boeing 787’s Problems Blamed on Outsourcing, Lack of
Oversight,” Seattle Times (February 3, 2013).

11

Shenzhen: World Hub for Electronics. When the Chinese government made
Shenzhen a Special Economic Zone in 1980, it was a small town with 94,100 inhabitants
located close to China’s border with Hong Kong. By 2017, it was among the world’s top
20 most populous cities with over 18 million inhabitants (including migrants) and the
highest GDP per head of any city in China. Shenzhen’s remarkable growth is a result of
it becoming the world’s leading hub for the manufacturing of electronic products and
home to Huawei, Tencent, ZTE, BYD, Skyworth, TP-Link, and OnePlus. It makes 60% of
the world’s computer magnetic heads. 60% of its laser pickups, 45% of its clocks and
watches, 38% of its shipping containers, and 10% of its hard drives.

Global Strategy and
the Multinational
Corporation

O U T L I N E

◆ Introduction and Objectives

◆ Implications of International Competition for
Industry Analysis

● Patterns of Internationalization

● Implications for Competition

◆ Analyzing Competitive Advantage in an
International Context

● National Influences on Competitiveness: Comparative
Advantage

● Porter’s National Diamond

● Consistency between Strategy and National
Conditions

◆ Internationalization Decisions: Locating
Production

● Determinants of Geographical Location

● Location and the Value Chain

◆ Internationalization Decisions: Entering a Foreign
Market

◆ Multinational Strategies: Global Integration versus
National Differentiation

● The Benefits of a Global Strategy

● The Need for National Differentiation

● Reconciling Global Integration with National
Differentiation

◆ Implementing International Strategy: Organizing
the Multinational Corporation

● The Evolution of Multinational Strategies and
Structures

● Recent Trends in Multinational Management

◆ Summary

◆ Self-Study Questions

◆ Notes

270 PART IV CORPORATE STRATEGY

Introduction and Objectives

Internationalization—the extension of business of across national borders—is a source of both
opportunities and problems. International expansion permits companies to grow beyond the limits
of their national markets. Embraer, once a struggling, state-owned Brazilian aircraft manufacturer, now
generates 85% of its revenues outside of Brazil and is the world’s third-biggest plane maker (after Boeing
and Airbus) and market leader in 70- to 130-seater commercial jets.

Internationalization is also a potent destroyer. For centuries, Sheffield, England, was the world’s
leading center of cutlery manufacture. By 2015, the industry employed only a few hundred people
there— production had shifted to China and other low-cost locations. Nor is it just the industries in the
mature industrial nations that have been ravaged by imports. Bulk imports of second-hand clothing
from Europe and North America (much of it from charities and churches) have been ruinous for East
Africa’s textile and apparel sector.

Internationalization occurs through two mechanisms: trade and direct investment. Both are driven
by firms seeking to exploit either market opportunities or resources and capabilities beyond their
own borders.

In this chapter, we shall consider the implications of internationalization for our strategic analysis. As
we shall see, once firms are no longer limited by national boundaries, the analysis of competition and
competitive advantage becomes much more complex. We shall examine two major aspects of firms’
internationalization strategies—where to locate production and how to enter foreign markets. Finally,
we shall consider the formulation and implementation of strategy within the multinational corporation.

We begin by exploring the implications of international competition, first for industry analysis and
then for the analysis of competitive advantage.

By the time you have completed this chapter, you will be able to:

◆ Use the tools of industry analysis to examine the impact of internationalization on industry
structure and competition.

◆ Analyze the implications of a firm’s geographical location for its competitive advantage.

◆ Select the optimal geographical location for a firm’s productive activity.

◆ Formulate strategies for exploiting overseas market opportunities.

◆ Formulate international strategies that achieve an optimal balance between global
integration and national differentiation.

◆ Design organizational structures and management systems appropriate to the pursuit of
international strategies.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 271

Implications of International Competition for Industry Analysis

Patterns of Internationalization

Internationalization occurs through trade—supplying goods and services from one
country to another—and direct investment—building or acquiring productive assets in
another country.1 On this basis, we can classify industries according to the extent and
mode of their internationalization (Figure 11.1):

● Sheltered industries are shielded from both imports and inward direct
investment by regulation and trade barriers, or because of the localized nature
of the goods and services they offer. Hence, they are served by indigenous
firms. Growing internationalization has made this category progressively smaller
over time. The remaining sheltered industries tend to be fragmented service
industries (dry cleaning, hairdressing, auto repair), some small-scale production
industries (handicrafts, residential construction), and industries producing prod-
ucts that are non-tradable because they are perishable (fresh milk, bread) or dif-
ficult to move (beds, garden sheds).

● Trading industries are those where internationalization occurs primarily through
imports and exports. Exporting from a single location is the most efficient
means to exploit overseas markets for products that are transportable, subject
to substantial scale economies, and are not nationally differentiated. Examples
include commercial aircraft, shipbuilding, and defense equipment. Trading
industries also include products whose inputs are available only in a few
locations (rare earths from China, caviar from Iran and Azerbaijan).

● Multidomestic industries are those that internationalize through direct
investment—either because trade is not feasible (e.g., service industries such as
banking, consulting, hotels) or because products are nationally differentiated
(e.g., frozen ready-meals, book publishing).

• house building
• laundries/dry cleaning
• hairdressing
• fresh milk

• frozen foods
• retail banking
• hotels
• wireless telephony

• shipbuilding
• military hardware
• diamond mining
• agriculture

TRADING
INDUSTRIES

SHELTERED
INDUSTRIES

• automobiles
• petroleum
• semiconductors
• alcoholic beverages

Foreign Direct Investment
HighLow

In
te

rn
at

io
na

l T
ra

de
Lo

w
H

ig
h GLOBAL

INDUSTRIES

MULTIDOMESTIC
INDUSTRIES

FIGURE 11.1 Patterns of industry internationalization

272 PART IV CORPORATE STRATEGY

● Global industries are those that feature high levels of both trade and direct
investment. These include most major manufacturing and extractive industries
that are populated by multinational corporations.

By which route does internationalization typically occur? The Uppsala Model pre-
dicts that firms internationalize in a sequential pattern, first exporting to countries with
the least “psychic distance” from their home markets (i.e., geographically or culturally
close), then broadening and deepening their engagement, and eventually establish-
ing manufacturing subsidiaries in foreign markets.2 However, different industries and
different firms follow different patterns. In service industries, exporting is not usu-
ally feasible, hence internationalization involves either direct investment (“greenfield
entry,” acquisition, or joint venture) or licensing (including franchising). Firms based
upon digital technologies are often “born global”—from the outset, PayPal, Spotify, and
Dropbox viewed their markets as worldwide.

Implications for Competition

Internationalization widens the market available to firms, increasing both the number
of potential customers and the diversity of their preferences. It also means more com-
petition, usually leading to lower industry profit margins. In 1976, the US automobile
market was dominated by GM, Ford, and Chrysler, with 84% of the market. By 2017,
there were 13 companies with auto plants within the United States; of these, the sole
indigenous producers were GM and Ford, with a combined market share of 32%.

Applying Porter’s five forces of competition framework, internationalization inten-
sifies competition from three sources:

● Potential entrants: Internationalization is both a cause and a consequence of
falling barriers to entry. Trade liberalization, falling transportation costs, and
converging customer preferences make it much easier for producers in one
country to supply customers in another. Entry barriers that are effective against
domestic entrants may be ineffective against established producers in other
countries.

● Rivalry among existing firms: Internationalization increases the number of firms
competing within each national market—it lowers seller concentration. The
western European market for motor scooters was once dominated by Piaggio
(Vespa) and Innocenti (Lambretta). There are now over 25 suppliers of scooters
to the European market, including BMW from Germany; Honda, Yamaha, and
Suzuki from Japan; Kwang Yang Motor Co (KYMCO) from Taiwan; Baotian,
Qingqi, and Znen from China; Bajaj from India; and Tomos from Slovenia.
Although internationalization typically triggers a wave of mergers and acqui-
sitions that reduce the global population of firms in an industry, the number
of competitors in each national market often increases.3 In addition, interna-
tionalization stimulates competition by increasing investments in capacity and
increasing the diversity of competitors within each national market.

● Increasing the bargaining power of buyers: The option of sourcing from over-
seas greatly enhances the power of industrial buyers. It also allows distributors
to engage in international arbitrage: pharmaceutical distributors have become
adept at searching the world for low-price pharmaceuticals for importation to
their domestic markets.

Figure 11.2 shows how internationalization affects the basic strategy model (from
Chapter 1). The right-hand arrow shows the impact on industry environment.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 273

Analyzing Competitive Advantage in an International Context

Growing international competition has been associated with some stunning rever-
sals in the competitive positions of different companies. In 1989, US Steel was the
world’s biggest steel company; in 2017, ArcelorMittal based in Luxemburg and India
was the new leader. In 2000, four of the world’s top five cell phone suppliers were
US or European based (Nokia, Motorola, Ericsson, and Siemens). By 2017, four of the
top five (Samsung, Huawei, Oppo, and Xiaomi) were based in East Asia, though a US
firm (Apple) was still global market share leader (even though it did not manufacture
any phones).

To understand how internationalization impacts a firm’s competitive position, we
need to extend our framework for analyzing competitive advantage to include the
influence of firms’ national environments. Competitive advantage, we have noted, is
achieved when a firm matches its internal strengths in resources and capabilities to
the key success factors within its industry. When competing firms are based in differ-
ent countries, competitive advantage depends not just on their internal resources and
capabilities but on the availability of resources within those countries. This impact of
national resource availability on a firm’s resources and capabilities is indicated by the
left-hand arrow of Figure 11.2.

National Influences on Competitiveness:
Comparative Advantage

The effect of national resource availability on international competitiveness is the
subject of the theory of comparative advantage. The theory states that a country
has a comparative advantage in those products which make intensive use of
those resources available in abundance within that country. Thus, Bangladesh has
an abundant supply of unskilled labor. Its comparative advantage lies in labor-
intensive products such as clothing, handicrafts, leather goods, and assembly of
consumer electronic products. The United States has an abundant supply of tech-
nological resources: trained scientists and engineers, research facilities, and uni-
versities. Its comparative advantage lies in technology-intensive products such as

THE FIRM

• Resources &
Capabilities

THE
INDUSTRY

ENVIRONMENT
STRATEGY

INTERNATIONALIZATION

• Wider market, more
diverse customer preferences
• More competitors
• Lower-entry barriers
• Increased buyer power

• National resource availability
(theory of comparative advantage)
• Impact of national context on
resource development
(Porter‘s national diamond)

FIGURE 11.2 How internationalization affects the basic strategy framework

274 PART IV CORPORATE STRATEGY

TABLE 11.1 Indexes of revealed comparative advantage for selected product categories, 2013

US UK Japan Switzerland Germany Australia China India

Cereals 2.1 0.4 0.0 0.0 0.3 4.3 0.3 3.5

Beverages 0.8 3.5 0.2 1.0 0.3 1.6 0.2 0.1

Mineral fuels 0.7 0.4 0.2 0.0 0.2 4.3 0.0 1.1

Pharmaceuticals 1.0 2.5 0.2 6.9 1.8 0.4 0.1 3.5

Vehicles 1.0 1.5 2.6 0.1 2.2 0.1 0.3 0.7

Aerospace 4.5 1.2 0.4 0.3 1.7 0.4 0.05 0.6

Electrical and electronic equipment 0.8 0.4 1.1 0.3 0.7 0.1 2.6 0.2

Optical, medical, and
scientific equipment

1.7 1.2 1.7 1.5 1.5 0.4 0.9 0.2

Clocks and watches 0.3 0.8 0.6 21.1 0.5 0.2 2.2 0.2

Apparel (knitted) 0.1 0.6 0.1 0.1 0.4 0.1 2.8 2.3

Note:
Country X’s revealed comparative advantage within product category A is measured as: Country X’s share of world exports in product
category A / Country X’s share of world exports in all products. A number greater than 1 indicates a comparative advantage in that prod-
uct category.
Source: International Trade Center.

microprocessors, computer software, pharmaceuticals, medical diagnostic equip-
ment, and management consulting services.

The term comparative advantage refers to the relative efficiencies of producing differ-
ent products. So long as exchange rates are well behaved (i.e., they do not deviate far from
their purchasing power parity levels), then comparative advantage translates into competitive
advantage. Comparative advantages are revealed in trade performance. Table 11.1 shows
revealed comparative advantages for several product categories and several countries.4

Trade theory initially looked to natural resource endowments, labor supply, and
capital stock as the main determinants of comparative advantage. Emphasis has shifted
to the central role of knowledge (including technology, human skills, and management
capability) and the resources needed to commercialize that knowledge (capital mar-
kets, communications facilities, and legal systems).5 For industries where scale econ-
omies are important, a large home market is an additional source of comparative
advantage (e.g., the United States in aerospace).6

Porter’s National Diamond

Michael Porter has extended the traditional theory of comparative advantage by pro-
posing that the key role of the national environment upon a firm’s potential for interna-
tional competitive advantage is its impact upon the dynamics through which resources
and capabilities are developed.7 Porter’s national diamond framework identifies four
key factors that determine whether firms from a particular country can establish com-
petitive advantage within their industry sector (Figure 11.3).8

1 Factor conditions: Whereas the conventional analysis of comparative advantage
focuses on endowments of broad categories of resource, Porter emphasizes the
role of highly specialized resources, many of which are “home grown” rather

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 275

than “endowed.” For example, the United States’ pre-eminence in producing
movies and TV shows is based upon the concentration in Los Angeles of highly
skilled labor and supporting institutions including financiers and film schools.

2 Related and supporting industries: National competitive strengths tend to
be associated with “clusters” of industries. Silicon Valley’s cluster comprises
semiconductor, computer, software, and venture capital firms. For each industry,
closely related industries are sources of critical resources and capabilities. Denmark’s
global leadership in wind power is based upon a cluster comprising wind turbine
manufacturers, offshore wind farm developers and operators, and utilities.

3 Demand conditions: In the domestic market these provide the primary driver of
innovation and quality improvement. For example:

● Switzerland’s pre-eminence in watches is supported by the obsessive punctu-
ality of the Swiss.

● Japan’s dominant share of the world market for cameras by companies owes
much to the Japanese enthusiasm for amateur photography and customers’
eager adoption of innovation in cameras.

● German dominance of high-performance automobiles (Daimler, BMW,
Porsche, VW-Audi) reflects German motorists’ love of quality engineering and
their irrepressible urge to drive on autobahns at terrifying speeds.

4 Strategy, structure, and rivalry: International competitive advantage depends
upon how firms within a particular sector interact within their domestic markets.
Porter observes that intense competition within the domestic market drives inno-
vation, quality, and efficiency. The global success of Japanese companies in cars,
cameras, consumer electronics, and office equipment during the last two decades
of the 20th century was based upon domestic industries where five or more
major producers competed strongly with one another. Conversely, European
failure in many hi-tech industries may be a result of European governments’ pro-
pensity to kill domestic competition by creating national champions.

Consistency between Strategy and National Conditions

Establishing competitive advantage in global industries requires congruence bet-
ween business strategy and the pattern of the country’s comparative advantage. In

DEMAND
CONDITIONS

RELATED AND
SUPPORTING
INDUSTRIES

FACTOR CONDITIONS

STRATEGY, STRUCTURE,
AND RIVALRY

FIGURE 11.3 Porter’s national diamond framework

276 PART IV CORPORATE STRATEGY

semiconductors, US companies such as Intel, Texas Instruments, Nvidia, and Qualcomm
tend to focus upon sophisticated microprocessors, digital signal processing chips,
graphics chips, and application-specific integrated circuits, and emphasize design
rather than manufacture. Chinese semiconductor producers tend to focus upon less
sophisticated memory and logic chips, on older generations of analog integrated cir-
cuits and microcontrollers, and emphasize fabrication rather than design.

Similarly in footwear. The world’s three leading exporters, after China, are Italy, Viet-
nam, and Germany. Each country’s shoe producers exploit the resource strengths of
their home country. Italian shoe producers such as Tod’s, Fratelli Rosetti, and Santoni
emphasize style and craftsmanship; Germany’s shoe companies such as Adidas, Puma,
and Brütting emphasize technology; and Vietnam’s shoe industry uses low-cost labor
to produce vast numbers of cheap casual shoes.

Among national resources, national culture can be an especially potent source of
a firm’s international competitive advantage. The success of US companies in many
areas of high technology, including computer software and biotechnology, owes
much to a system of entrepreneurial capitalism that embodies a national culture that
emphasizes individuality, opportunity, and wealth acquisition. The global success of
Korean corporate giants such as Samsung and LG reflects organizational structures
and management systems that embody Korean cultural characteristics such as loyalty,
respect for authority, conformity to group norms, commitment to organizational goals,
and a strong work ethic.9

Internationalization Decisions: Locating Production

To examine how national resource conditions influence company strategies, we will
look at two types of strategic decision-making in international business: first, where to
locate production activities and, second, how to enter a foreign market. Let us begin
with the first of these.

Firms move beyond their national borders not only to seek foreign markets but
also to access the resources and capabilities available in other countries. Tradition-
ally, multinationals established plants to serve local markets. Increasingly, decisions
concerning where to produce are being separated from decisions over where to sell.
For example, ST Microelectronics, the world leader in application-specific integrated
circuits (ASICs), is headquartered in Switzerland; production is mainly in France, Italy,
and Singapore; R&D is conducted mainly in France, Italy, and the United States; and
the biggest markets are the United States, Japan, the Netherlands, and Singapore.

Determinants of Geographical Location

Figure 11.2 shows that a firm’s resources and capabilities may be located either within
the firm, or may be available from the national environment(s) where it does business.
The sources of a firm’s resources and capabilities have important implications for where
the firm locates its production:

● Country-based resources: If a firm’s competitive advantage is based upon
resources and capabilities available within the national environment, it needs
to locate where these resources and capabilities can be accessed. For oil and
gas companies, this means exploring where petroleum reserves are located. For
software companies, it means locating where software engineers can be recruited.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 277

● Firm-based resources and capabilities: For firms whose competitive advantage is
based on internal resources and capabilities, optimal location depends on where
those resources and capabilities are situated and how mobile they are. Walmart has
experienced difficulty replicating its US-based logistics and merchandising capabil-
ities outside of North America. Conversely, Toyota and IKEA have been highly suc-
cessful in transferring their operational capabilities beyond their home bases.

However, these considerations presume that the firm has the flexibility to choose
where it locates its production. Most services—hairdressing, restaurant meals, banking,
and management consulting—are not tradable: they need to be produced in close
proximity to where they are consumed.

Location and the Value Chain

The production of most goods and services comprises a vertical chain of activities
where the input requirements of each stage vary considerably. Hence, different coun-
tries offer advantages at different stages of the value chain. Table 11.2 shows the pattern
of international specialization for the different stages of production for knitted clothing
(T-shirts, sweaters, etc.). Similarly with consumer electronics: component production
is research- and capital-intensive, the main production centers are the United States,
Japan, Korea, and Taiwan; assembly is labor-intensive and is concentrated in South-East
Asia and Latin America. China is the world leader in both.

A key feature of internationalization has been the international fragmentation of
value chains as firms seek to locate each activity where the resources required are
cheapest and most available.10 Table  11.3 shows the international composition of
Apple’s iPhone.

As the iPhone indicates, for technologically advanced goods and services, global
sourcing is determined more by the location of sophisticated know-how than by access-
ing low cost labor. Increasingly Western companies look to China, Taiwan, Korea,
Malaysia, and India for technical and engineering talent rather than for low cost pro-
duction. Chinese companies are increasingly world leaders in advanced manufacturing
processes while most leading Indian IT service companies operate at level 5 (the high-
est level of expertise) of the Capability Maturity Model.11

TABLE 11.2 Comparative advantages along the value chain for knitted apparel

Raw cotton Spun cotton yarn Knitted fabric Knitted apparel

United States +0.68 +0.85 +0.03 −0.89

Germany −1.00 −0.18 +0.30 −0.18

Korea −1.00 −0.28 +0.94 −0.34

China −0.99 −0.54 +0.70 +0.97

Bangladesh −0.98 −0.95 −0.96 +0.98

Note:
A country’s revealed comparative advantage in particular product is measured as (exports – imports)/(exports +
imports). The scale ranges from −1 to +1. (Note: This is a different measure of revealed comparative advantage from
that used in Table 11.1.)
Source: International Trade Commission.

278 PART IV CORPORATE STRATEGY

The benefits from fragmenting the value chain must be traded off against the
added costs of coordinating globally dispersed activities—the biggest of which is time.
Just-in-time scheduling often requires production activities to be carried out in close
proximity to one another. Companies that compete on speed and flexibility (e.g.,
Inditex) often forsake the cost advantages of a globally dispersed value chain in favor
of co-located activities. The trend toward US corporations “reshoring” manufacturing
activities is partly a result of the narrowing cost gap between the United States and
China, but also because of the flexibility benefits of shorter supply chains.12

Figure 11.4 summarizes the relevant criteria in location decisions.

Internationalization Decisions: Entering a Foreign Market

Firms enter foreign markets in pursuit of revenue and, ultimately, profitability. A firm’s
success in generating sales and profits in a foreign market depends on its ability
to establish a competitive advantage. How a firm can best establish a competitive
advantage will determine how it enters a foreign market.

There are two basic modes of entry into a foreign market: transactions or direct
investment. Figure  11.5 further divides these into a spectrum of market entry types

TABLE 11.3 Where does the iPhone X come from?

Item Supplier Location

Design and operating system Apple US

Flash memory Toshiba Japan

DRAM memory TSMC
SK Hynix

Taiwan
S. Korea

Chip sets and Processors Apple
Qualcomm

US
US

Baseband Qualcomm US

Cameras Sony
Genius Electronic Optical

Japan
Taiwan

Mixed signal chips NXP Neth.

Power management Dialog Semiconductor Germany/UK

Batteries Sunwoda Electronics China

Audio Cirrus Logic US

Touchscreen control Nissha Japan

Sensors STMicroelectronics
Bosch

Italy
Germany

E-compass Alps Electric Japan

Assembly Foxconn China

Source: various websites.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 279

involving progressively higher degrees of resource commitment. Thus, at one extreme,
a firm can export through individual sales transactions; at the other, it can establish a
wholly owned, fully integrated subsidiary.

How does a firm weigh the merits of different market entry modes? Five key factors
are relevant:

● Is the firm’s competitive advantage based on firm-specific or country-specific
resources? If the firm’s competitive advantage is country-based, the firm must
exploit an overseas market by exporting. If Shanghai Auto’s competitive
advantage in Western car markets is its low domestic cost base, it must produce

Where is the optimal location of X in terms
of the cost and availability of inputs?

The optimal location
of activity X considered

independently

The importance of links
between activity X and

other activities of the f irm

What government incentives/penalties
af fect the location decision?

What internal
resources and capabilities does the f irm

possess in particular locations?

What is the f irm’s business strategy
(e.g., cost vs. dif ferentiation advantage)?

How great are the coordination
benef its from colocating activities?

WHERE TO LOCATE
ACTIVITY X?

FIGURE 11.4 Determining the optimal location of value chain activities

Licensing
patents and

other IP

Franchising

TRANSACTIONS

Spot
sales

Foreign
agent/

distributor

Long-term
contract

Wholly-owned
subsidiary

Marketing and
distribution

only

Fully
integrated

HighResource commitmentLow

DIRECT INVESTMENT

Joint venture

Fully
integrated

Marketing and
distribution

only

Exporting Licensing

FIGURE 11.5 Alternative modes of overseas market entry

280 PART IV CORPORATE STRATEGY

in China and export to foreign markets. If Toyota’s competitive advantage is
its production and management capabilities then, as long as it can transfer
these capabilities, it can exploit foreign markets either by exports or by direct
investment.13

● Is the product tradable? If the product cannot be exported because of trans-
portation constraints or import restrictions, then accessing the foreign market
requires either direct investment or licensing the use of key resources to a
local company.

● Does the firm possess the full range of resources and capabilities needed for
success in the overseas market? Competing in an overseas market is likely to
require resources and capabilities that the firm does not possess, necessi-
tating collaboration with a local firm. The form of the collaboration depends,
in part, on the resources and capabilities required. If a firm needs marketing
and distribution capabilities, it might appoint a distributor or agent with
exclusive territorial rights. The Italian brewer, Menabrea, appoints exclusive
distributors in each of the 36 countries to which it exports. If a wider range
of capabilities is needed, the firm might license its product and/or its tech-
nology to a local manufacturer. Thailand’s Boon Rawd Brewery licenses its
Singha beer trademarks and recipes to Denmark’s Carlsberg Group. Alterna-
tively, a joint venture might be sought with a local manufacturing company.
Cobra beer is brewed in the United Kingdom by a joint venture between
Cobra India and Molson Coors.

● Can the firm directly appropriate the returns to its resources? The viability of
licensing in exploiting a foreign market depends on appropriability consider-
ations. In chemicals and pharmaceuticals, the patents protecting product inno-
vations tend to offer strong legal protection; in which case, offering licenses to
local producers can be an effective means of appropriating their returns. For
electronic hardware and medical devices, the protection offered by patents
and copyrights is looser, which encourages exporting rather than licensing
as a means of exploiting overseas markets. With all licensing arrangements,
the key considerations are the capabilities and reliability of the local licensee.
This is particularly important in licensing brand names, where the licenser
must carefully protect the brand’s reputation. Starbucks’ formation of a joint
venture with Tata Group to develop Starbucks outlets in India, was facilitated
by the two companies’ shared commitment to ethics and corporate social
responsibility.

● What transaction costs are involved? Transaction costs are fundamental to
the choice between alternative market entry modes. Barriers to exports
in the form of transport costs and tariffs constitute transaction costs that
may encourage direct investment. The choice between licensing and
direct investment also depends upon the transaction costs of negotiating,
monitoring, and enforcing licensing agreements. In the United Kingdom,
Starbucks owns and operates most of its coffee shops, while McDonald’s fran-
chises its burger restaurants. The McDonald’s business system can be specified
and enforced through a franchise agreement. The “ Starbucks experience,” by
contrast, is as much about intangibles such as ambiance and values as it is
about coffee. These are difficult to specify in a franchise contract. More gen-
erally, the presence of transaction costs both in product markets and in the
markets for resources and capabilities, are a major reason why multinational
enterprises predominate in many industries.14

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 281

Multinational Strategies: Global Integration versus National
Differentiation

So far, we have looked only at individual international strategic decisions concerning
locating production and entering foreign markets. However, international strategy
involves managing a firm’s overall geographical scope. What is the potential for such
“global strategies” to create competitive advantage over nationally focused rivals? In
what types of industry are they likely to be most effective? And how should they be
designed and deployed in order to maximize their potential?

The Benefits of a Global Strategy15

A global strategy is one that views the world as a single, if segmented, market. There
are five major sources of value from operating internationally.

Cost Benefits of Scale and Replication The primary advantage of companies
that compete globally over their local rivals is their access to scale economies in
purchasing, manufacturing, marketing, and new product development.16 Pankaj Ghe-
mawat refers to these as benefits from cross-border aggregation.17 Exploiting these
scale economies has been facilitated by the growing convergence of customer pref-
erences: “Everywhere everything gets more and more like everything else as the
world’s preference structure is relentlessly homogenized,” observed Ted Levitt.18 In
many industries—commercial aircraft, semiconductors, consumer electronics, video
games—firms have no choice: they must market globally to amortize the huge costs
of product development. In service industries, the cost efficiencies from multinational
operation derive primarily from economies of replication. Once a company has cre-
ated a knowledge-based asset or product—be it a recipe, a piece of software, or an
organizational system—it can be replicated in additional national markets at a fraction
of the cost of creating the original.19 Disneyland theme parks in Tokyo, Paris, Hong
Kong, and Shanghai replicate the rides and management systems that Disney develops
for its parks in Anaheim and Orlando. This is the appeal of franchising: if I create
a brilliantly innovative facial massage system that allows elderly people to maintain
the complexion of a 20-year-old, why limit myself to a single outlet in Beverly Hills,
California? Why not try to emulate Domino’s Pizza with its 14,000 outlets across 71
countries of the world?

Serving Global Customers In several industries (e.g., investment banking, audit
services, and advertising), the primary driver of globalization has been the need to ser-
vice global customers.20 Hence, auto-parts manufacturers have internationalized as they
follow the global spread of the major automobile producers. Law firms such as Baker
& McKenzie, Clifford Chance, and Linklaters have internationalized to better serve their
multinational clients.

Exploiting National Resources: Arbitrage Benefits As we have already seen,
firms internationalize not only to expand into new markets but also to access resources
outside their home countries.

Traditionally, this has meant a quest for raw materials and low-cost labor. Stan-
dard Oil’s initial internationalization during 1917–1923 followed its quest for crude

282 PART IV CORPORATE STRATEGY

oil reserves in Mexico, Colombia, Venezuela, and the Dutch East Indies. Nike’s
pursuit of low-cost manufacturing facilities has taken it from Japan, to Taiwan and
South Korea, to China, and, most recently, to Vietnam, Indonesia, and Bangladesh.
Ghemawat refers to this exploitation of differences in resource availability bet-
ween countries as arbitrage.21 Arbitrage strategies are conventionally associated
with exploiting wage differentials by offshoring production to low-wage locations;
increasingly arbitrage is about exploiting the distinctive knowledge available in dif-
ferent locations. Most of the world’s leading semiconductor firms have established
R&D facilities in California’s Silicon Valley.22

Arbitrage opportunities may arise not only from national resource conditions, but
from any distinctive advantages that a country possesses. Apple, Google, Amazon, and
Starbucks have been adept at ensuring that their profits accrue in countries which levy
the lowest corporate tax rates.23

Learning Benefits The learning benefits of multinational companies are not
simply accessing the knowledge available in different locations but also transferring
and integrating that knowledge and using the exposure to different national envi-
ronments to create new knowledge. IKEA’s success is based, not only on replicating
its unique business system, but also on its ability to learn from each country where
it does business and then transfer that learning to its global network. In Japan, IKEA
had to adjust to Japanese design preferences, modes of living, and consumers’ acute
quality- consciousness. IKEA was then able to transfer the quality and design capa-
bilities it developed in Japan to its global activities. According to the CEO of IKEA
Japan, “One reason for us to enter the Japanese market, apart from hopefully doing
very good business, is to expose ourselves to the toughest competition in the world.
By doing so, we feel that we are expanding the quality issues for IKEA all over
the world.”24

Recent contributions to the international business literature suggest that this
ability of multinational corporations to develop knowledge in multiple locations, to
synthesize that knowledge, and to transfer it across national borders may be their
greatest advantage over nationally focused companies.25 To exploit these learning
benefits a company must possess global infrastructure for managing knowledge
that permits new experiences, new ideas, and new practices to be integrated
and diffused.

Competing Strategically A major advantage of Julius Caesar and the Romans
over Asterix and the Gauls was the Romans’ ability to draw upon the military and
economic resources of the Roman Empire to suppress rebellious tribes. Similarly, mul-
tinational companies possess a key strategic advantage over their nationally-focused
rivals when engaging in competitive battles in individual national markets: they can
use resources from other national markets. In the battle for leadership of the Indian
online retail market, a key advantage of Amazon over its local rival, Flipkart, was
Amazon’s ability to use its US cash flow to finance losses in India. By selling a majority
stake to Walmart in 2018, Flipcart has leveled the field. Cross-subsidization of compet-
itive initiatives in one market using profits from other markets may involve predatory
pricing—cutting prices to a level that drives competitors out of business. More usually,
cross-subsidization involves using cash flows from other markets to finance aggres-
sive sales and marketing campaigns.26 Strategic competition between multinational
corporations can result in complex patterns of attack, retaliation, and containment.27

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 283

As the US and Chinese ecommerce giants, Amazon and Alibaba, internationalize each
is making forays into the other’s home market as well as battling in third countries
such as India.28

The Need for National Differentiation

For all the advantages of global strategy, national differences still frustrate firms’
attempts to design “global products” to meet the needs of the “global customer.” Even
globally standardized products such as the iPhoneX and the Big Mac vary from country
to country.29

In some industries, efforts toward globalization have met with little success. In
domestic appliances, national preferences have shown remarkable resilience. The
design and features of washing machines and cookers vary between the regions of
the world.30 Similarly in retail banking, despite some examples of successful inter-
nationalization (Banco Santander, HSBC), customer preferences and regulations vary
between countries and there are few economies from cross-border integration. As a
result, Citibank, HSBC, Barclays, and Deutsche Bank radically reduced their interna-
tional presence during 2010 to 2018.31

To identify and assess the extent of strategic differences between countries,
Ghemawat’s “CAGE’ framework identifies four dimensions of distance between
countries: cultural, administrative and political, geographical, and economic (see
Table 11.4).

These broad categories are only a starting point for navigating the national
idiosyncrasies that make international expansion such a minefield. Consumer prod-
uct firms must, not only adapt to differences in consumer preferences between

TABLE 11.4 Ghemawat’s CAGE framework for assessing country differences

Cultural distance
Administrative and
political distance Geographical distance

Economic
differences

Distance
between two
countries
increases with:

Different languages,
ethnicities, religions,
social norms

Lack of connective
ethnic or
social networks

Absence of shared
political or monetary
association

Political hostility.

Weak legal and
financial institutions

Lack of common border,
water-way access, adequate
transportation or communi-
cation links

Physical remoteness

Different
consumer incomes

Different costs and
quality of natural,
financial, and
human resources

Different information
or knowledge

Industries
most affected
by source
of distance:

Industries with high
linguistic content
(TV, publishing) and
cultural content (food,
wine, music)

Industries viewed
by government
as strategically
important
(e.g., energy,
defense, telecoms)

Products with low
value-to-weight (cement),
are fragile or perishable
(glass, milk), or dependent
upon communications
(financial services)

Products whose
demand is sensitive to
consumer income
levels (luxury goods)

Labor-intensive
products (clothing)

Sources: Based upon: P. Ghemawat, “Distance Still Matters: The Hard Reality of Global Expansion,” September 2001, pp. 137–47
and P. Ghemawat, “Differences and the CAGE Distance Framework.” https://www.ghemawat.com/wordpress/wp-content/
uploads/2016/10/DifferencesAndTheCAGEFramework.pdf.

284 PART IV CORPORATE STRATEGY

countries, they must also adapt to differences in distribution channels. Procter &
Gamble adapts its marketing and distribution of its toiletries and household prod-
ucts to take account of the fact that, in the United States, a few chains account for
a major share of its US sales; in southern Europe, most sales are through small,
independent retailers, while in Japan, it must sell through a multi-tiered hierarchy
of distributors. The closer an industry is to the final consumer, the more important
cultural factors are likely to be. Strategy Capsule 11.1 considers some dimensions
of national culture. These cultural differences explain why so few retailers have
been successful outside their home markets. Walmart, IKEA, H&M, and Gap are
among the few retailers that are truly global.

Reconciling Global Integration with National Differentiation

Formulating an international strategy involves trading off the benefits of global
integration with those of national adaptation. Figure  11.6 shows that this trade-off

STRATEGY CAPSULE 11.1

How do national Cultures differ?

How people differ between countries with regard to

beliefs, norms, and value systems has been the subject of

a number of research studies.

The best-known study of national cultural differ-

ences is by Geert Hofstede. The principal dimensions of

national values he identified were:

◆ Power distance: The extent to which inequality, and

decision-making power in particular, is accepted

within organizations and within society was high in

Malaysia, and most Latin American and Arab coun-

tries; low in Austria and Scandinavia.

◆ Uncertainty avoidance: Preference for certainty

and established norms was high in most southern

European and Latin American countries; tolerance

for uncertainty and ambiguity was high in Singa-

pore, Sweden, the United Kingdom, the United

States, and India.

◆ Individualism: Concern for individual over group

interests was highest in the United States, the United

Kingdom, Canada, and Australia. Identification with

groups and the collective interest was strongest in

Latin America and Asia (especially Indonesia, Paki-

stan, Taiwan, and South Korea).

◆ Masculinity/femininity: Hofstede identifies emphasis

on work and material goals and demarcation of

gender roles as masculine; emphasis on personal

relationships rather than efficiency and belief in

gender equality he viewed as feminine. Japan, Austria,

Venezuela, and Italy scored high on masculinity;

Scandinavia and the Netherlands scored very low.

Other scholars emphasize different dimensions of

national cultures. Fons Trompenaars (another Dutchman)

identifies the United States, Australia, Germany, Sweden

and the United Kingdom as universalist societies—rela-

tionships are governed by standard rules; Brazil, Italy,

Japan, and Mexico are particularist societies—social

relationships are strongly influenced by contextual and

personal factors. In affective cultures, such as Mexico and

the Netherlands, people display their emotions; in neutral

cultures, such as Japan and the United Kingdom, people

hide their emotions.

Sources: G. Hofstede, Culture’s Consequences: International Differ-
ences in Work-related Values (Thousand Oaks, CA: SAGE Publica-
tions, 1984); F. Trompenaars, Riding the Waves of Culture (London:
Economist Books, 1993).

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 285

varies greatly between industries. Jet engines and semiconductors are industries where
scale economies are huge and customer preferences vary little from country to country.
Firms in these industries can view the world as a single, global market. Conversely,
in industries such as retail banking and frozen foods, national preferences are pro-
nounced and meeting them does not impose prohibitive costs. This favors multidomestic
strategies involving distinct strategies for each national market. Indeed, in industries
where there are few benefits from global integration, multinational firms may be absent
(as in funeral services and laundries). Some of the most interesting and complex indus-
tries from an international strategy viewpoint are those that combine substantial ben-
efits from operating globally with the need to adapt to the requirements of individual
national markets, such industries include domestic appliances, military hardware, cos-
metics, and insurance.

Reconciling conflicting forces for global efficiency and national differentiation
represents one of the greatest strategic challenges facing multinational corporations.
The typical solution is to globally standardize product features and company activities
where scale economies are substantial, and locally differentiate where national prefer-
ences are strongest and where achieving them is not overly costly. The world’s leading
automobile companies design their cars around a few global platforms and common
components, then differentiate to meet national safety and environmental standards
and also local preferences for legroom, seat specifications, accessories, color, and trim.
McDonald’s, too, standardizes its core business system, then adapts to local cultural and
culinary preferences (Strategy Capsule 11.2).

Reconciling global efficiency with national adaptation requires disaggregating the
company by product and function. In retail banking, different products and services
have different potential for globalization. Credit cards and basic savings products

Jet engines

Autos

Cement

Consumer
electronics

Telecom
equipment

Investment
banking

Retail
banking

Benef its of national dif ferentiation

Benef its of
global

integration

Funeral
services

Auto
repair

FIGURE 11.6 Benefits of global integration versus national differentiation

286 PART IV CORPORATE STRATEGY

STRATEGY CAPSULE 11.2

Mcdonald’s Goes “Glocal”

McDonald’s has long been demonized by anti-

globalization activists. They allege that it crushes national

cuisines and independent, family-run restaurants with

the juggernaut of US fast-food, corporate imperialism. In

reality, its global strategy is a careful blend of global stan-

dardization and local adaptation.

McDonald’s menus feature an increasing number of

locally-developed items. These include:

◆ Australia: Gourmet Angus Truffle & Cheese, English

Brekkie Wrap, and Frozen Coke;

◆ France: Croque McDo, Le Blue Cheese and Bacon

Burger;

◆ Hong Kong: Mixed Veggies & Egg, Mini Twisty Pasta,

Mango Layer Cake;

◆ India: McSpicy Paneer and McAloo Wrap;

◆ Saudi Arabia: McArabia Kofta, McArabia Chicken;

◆ Switzerland: Quinoa Curry, Ovomaltine;

◆ UK: So Simple Apple and Cherry Porridge, Fish

Fingers,  Peri Peri Snack Wrap, Cadbury Crunchie

McFlurry;

◆ US: Sausage Burrito, Maple Bacon Dijon with Artisan

Grilled Chicken, Fruit and Yogurt Parfait.

There are differences too in restaurant decor, ser-

vice offerings (e.g., home delivery in India), and market

positioning (outside the United States McDonald’s is

more upmarket). In Israel, most McDonald’s are kosher:

there are no dairy products and it is closed on Satur-

days. In India, neither beef nor pork is served. In Ger-

many, France, and Spain, McDonald’s serves beer. A

key reason that most non-US outlets are franchised is

to facilitate adaptation to national environments and

access to local know-how.

Yet, the core features of the McDonald’s strategy

are identical throughout the world. McDonald’s

values and business principles are seen as universal

and invariant. Its emphasis on families and children is

intended to identify McDonald’s with fun and family

life wherever it does business. Community involve-

ment and the Ronald McDonald children’s charity are

also worldwide. Corporate trademarks and brands are

mostly globally uniform, including the golden arches

logo and “I’m lovin’ it” tag line. The business system

itself—franchising arrangements, training, restau-

rant operations, and supplier relations—is also highly

standardized.

McDonald’s international strategy has changed from

adapting its US model to local conditions to seeking and

encouraging local innovation everywhere, then using

its global network to transfer promising concepts more

widely. McCafés, gourmet coffeehouses within McDon-

ald’s restaurants, were first developed in Australia in

1993. By 2013, McCafés were operating in 30 countries.

Growing concern over nutrition and obesity has accel-

erated McDonalds’ reliance upon country initiatives to

drive global learning.

Has McDonald’s got the balance right between

global standardization and local adaptation? Simon

Anholt, a British marketing expert, argues: “By putting

local food on the menu, all you are doing is removing

the logic of the brand, because this is an American

brand. If McDonald’s serves what you think is a poor

imitation of your local cuisine, it’s going to be an insult.”

But according to McDonald’s CEO Jim Skinner: “We don’t

run our business from Oak Brook. We are a local business

with a local face in each country we operate in.” Chief

marketing officer, Mary Dillon, adds: “Globally we think

of ourselves as the custodian of the brand, but it’s all

about local relevance.”

Source: www.mcdonalds.com.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 287

such as certificates of deposit tend to be globally standardized; checking accounts
and mortgage lending are much more nationally differentiated. Similarly with business
functions: R&D, purchasing, IT, and manufacturing have strong globalization potential;
sales, marketing, customer service, and human resource management need to be much
more nationally differentiated. These differences have important implications for how
the multinational corporation is organized.

Implementing International Strategy: Organizing the
Multinational Corporation

These same forces that determine international strategies—exploiting global integration
while adapting to national conditions—also have critical implications for the design of
organizational structures and management systems to implement these strategies. As
we shall see, one of the greatest challenges facing the senior managers of multinational
corporations is aligning organizational structures and management systems to fit with
the strategies being pursued.

The Evolution of Multinational Strategies and Structures

Choices over international strategy have implications for firms’ organizational
structures. Christopher Bartlett and Sumantra Ghoshal describe the strategy-structure
configurations of multinational corporations as their administrative heritage and, once
established, this heritage creates a barrier to strategic and organizational change.32

They identify three eras in the development of the multinational corporation
(Figure 11.7):

● The early 20th century: era of the European multinationals. Companies such
as Unilever, Shell, ICI, and Philips were pioneers of multinational expan-
sion. Because of the conditions at the time of internationalization—poor

The Europeans:
Decentralized
Federations

The Japanese:
Centralized

Hubs

The Americans:
Coordinated
Federations

FIGURE 11.7 The development of the multinational corporation: Alternative
parent–subsidiaries relations

Note:

The density of shading indicates the concentration of decision making.

Source: C. A. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business
School Press, 1998). Copyright © 1989 by the Harvard Business School Publishing Corporation, all rights reserved.

288 PART IV CORPORATE STRATEGY

transportation and communications, highly differentiated national
markets—the companies created multinational federations: each
national subsidiary was operationally autonomous and undertook the full
range of functions, including product development, manufacturing, and
marketing.

● Post-Second World War: era of the American multinationals. US dominance
of the world economy was reflected in the pre-eminence of US multina-
tionals, such as GM, Ford, IBM, Coca-Cola, Caterpillar, and Procter & Gamble.
While their overseas subsidiaries were allowed considerable autonomy,
this was within the context of the dominant position of their US parent in
terms of finance, technology, and management. These US-based resources
and capabilities provided the foundation for their international competitive
advantages.

● The 1970s and 1980s: the Japanese challenge. Honda, Toyota, Matsushita, NEC,
and YKK pursued global strategies from centralized domestic bases. R&D and
manufacturing were concentrated in Japan; overseas subsidiaries undertook
sales and distribution. Globally standardized products manufactured in
large-scale plants provided the basis for unrivalled cost and quality advantages.
Over time, manufacturing and R&D were dispersed, initially because of trade
protection by consumer countries and the rising value of the yen against other
currencies.

These different administrative heritages have continued to set the strategic agendas
of these different groups of multinational corporations. The strength of European
multinationals is their ability to adapt to the requirements of individual national
markets. Their challenge has been to achieve greater integration of their sprawling
international empires. For Shell and Philips this has involved periodic reorganization
over the past three decades. The strength of the US multinationals is their ability to
transfer technology and proven new products from their domestic strongholds to their
national subsidiaries. The challenge for companies such as Ford, IBM, and Procter
& Gamble has been dispersing technology, design, and product development while
achieving a high level of global integration. During the 1980s, Japanese multinational
corporations exemplified the efficiency benefits of global standardization. Since then,
Japanese multinational corporations such as Sony, Panasonic, Nomura, Hitachi, and
NEC have taken major strides to becoming true insiders in the many countries where
they do business, yet have struggled to sustain leadership in product and process
innovation.

Recent Trends in Multinational Management

Despite the different heritages of the different groups of multinationals, all have
faced the same strategic and organizational challenge during recent decades: rec-
onciling global integration with national differentiation. Escalating costs of research
and new product development have made global strategies with global product plat-
forms essential. At the same time, meeting consumer needs in each national market
and responding swiftly to changing local circumstances requires greater decentral-
ization. Accelerating technological change further exacerbates these contradictory
forces: innovation needs to take place at multiple locations rather than at a centralized
R&D facility.

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 289

Bartlett and Ghoshal argue that reconciling these conflicting performance goals
has caused multinationals to adopt a new configuration of strategy and structure:
the transnational corporation. In the transnational corporation, the corporate
center is responsible for coordinating a global network where each national unit
is responsible for managing local affairs but also fulfils a global role based upon
its own distinctive capabilities (see Figure  11.8). Bartlett notes that the transna-
tional requires “a very different kind of internal management process than existed
in simpler multinational organizations… it’s the corporate equivalent of being able
to walk, chew gum, and whistle at the same time.”33 Ford Motor Company’s global
strategy and organization corresponds closely to this transnational model (see
Strategy Capsule 11.3).

Ghemawat recognizes that the challenge for multinationals in reconciling the
conflicting strategic goals is even more complex. He makes an important extension
to the Bartlett-Ghoshal framework.34 In addition to exploiting scale economies
from global integration through aggregation and meeting local demands through
adaptation, multinationals also need to exploit country-based advantages through
arbitrage. As we discussed earlier (pp. 281–282), opportunities for arbitrage arise not
only from the availability of different resources and capabilities in different countries,
but also from other national characteristics—including taxation systems, environ-
mental policies, and financial regulations. Strategy Capsule 11.4 outlines Ghemawat’s
“Triple-A” framework.

Over recent decades, the pressure of competition has required multinational
corporations to exploit multiple sources of value. For North American and
European multinational corporations, this has required a shift from a multidomes-
tic approach organized around national subsidiaries and regional groupings to
increased global integration involving the creation of worldwide product divisions.
However, designing organizational structures and management systems that can
achieve an optimal balance between the three dimensions of Ghemawat’s AAA tri-
angle is complex. Aggregation favors global product divisions, adaptation is best
achieved through semi-autonomous national subsidiaries, while arbitrage requires
the concentration of particular functions and activities in specific locations. More-
over, the trade-offs among these factors varies between products, functions, and
geographical markets.

For example, Procter & Gamble adopts global standardization for some of its prod-
ucts (e.g., Gillette razor blades and high-end fragrances); for others (e.g., hair care

Tight complex controls
and coordination and

a shared strategic
decision process

Heavy f lows of
technology, f inances,
people, and materials

between interdependent
units

FIGURE 11.8 Bartlett and Ghoshal’s transnational corporation

290 PART IV CORPORATE STRATEGY

products and laundry detergent), it allows significant national differentiation. Across
countries, P&G organizes global product divisions to serve most of the industrialized
world because of the similarities between their markets, while for emerging-market
countries (such as China and India) it operates through country subsidiaries in order
to adapt to the distinctive features of these markets. Among functions, R&D is globally
integrated, while sales are organized by national units that are differentiated to meet
local market characteristics.

STRATEGY CAPSULE 11.3

Ford Motor Company: A Transnational Corporation

Between 1970 and 2017, the Ford Motor Company

evolved from a “coordinated federation” with a dominant

US core and fairly autonomous overseas subsidiaries into

a globally integrated network. In the early 1970s, the

US parent exercised financial control over the overseas

subsidiaries and appointed their chief executives—but

product policy, operations, and marketing were mostly

in the hands of the country managers. In the United

Kingdom, the leading Ford models were the Cortina

and the Escort—both designed and manufactured by

Ford of Britain. Ford Germany’s leading model was the

Ford Taunus—again, designed and manufactured in

Germany. Ford Brazil’s leading models were the Concel

and the Aero.

Global integration began with the creation of

Ford of Europe in 1969 and continued with Ford’s

efforts to introduce global models. The 1992 Mondeo

(Contour in North America) was the first global model.

Under Alan Mullaly (CEO 2006–2014), Ford intensi-

fied its quest for global integration. Mullaly’s “One

Ford” strategy involved standardizing components,

reducing the number of platforms from 27 in 2007 to

8 in 2017, and developing global models for manu-

facture at multiple plants throughout the world. For

example, the 2017 (4th generation) Ford Focus was

developed by Ford’s design studios and technical cen-

ters in Europe and the United States and manufac-

tured at plants in Mexico, Germany, China, Thailand,

Russia, and Argentina.

At the same time, individual national subsidiaries

continue to introduce variations on these global

models. The Ford Mustang and its F-series pick-up

trucks are designed and manufactured in the United

States for sale primarily to North American customers.

Ford’s Chinese joint venture with Changan Auto

manufactures the Ford Escort, a long wheelbase ver-

sion of the 3rd generation Focus. The Ford Ka, sold

mainly in Europe, was originally manufactured by Fiat.

It is now built by Ford Brazil for sale in Latin America

and Europe.

This globally integrated strategy encouraged Ford

to reorganize around global functions—such as Global

Product Development, Global Manufacturing, Quality

and New Model Launch and Global Marketing—together

with regional divisions (The Americas; Europe, Middle

East, and Africa; and Asia Pacific). However, the key to the

One Ford strategy was for people to collaborate, share,

and innovate across organizational and geographical

boundaries.

Within this structure, Ford’s national units have both

local and global responsibility. Ford of Britain no longer

assembles Ford cars, but is responsible for marketing,

distribution, and customer support within the United

Kingdom, as well having global responsibilities for the

manufacture of 1.6-liter gasoline engines (at Bridgend)

and EcoBlue diesel engines (at Dagenham), transmis-

sions (at Halewood), and engine design (at Dunton

Technical Center).

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 291

The quest to exploit arbitrage opportunities has resulted in MNCs reallocating activ-
ities outside their home countries. When Philips adopted a product division structure,
it located responsibility for medical electronics in its US subsidiary and leadership in
consumer electronics in Japan. During 2017, Nomura, Morgan Stanley, and Goldman

STRATEGY CAPSULE 11.4

Ghemawat’s “AAA Triangle”

Ghemawat proposes that a multinational corpora-

tion’s strategy may be represented by its positioning

along the three dimensions of aggregation, adaptation,

and arbitrage—his “AAA triangle” (Figure  11.9). A firm

can be positioned by using proxy variables. Each stra-

tegic direction has different organizational implications:

aggregation requires strong cross-border integration, for

example, global product divisions and global functions;

adaptation requires country-based units with high levels

of autonomy; arbitrage requires activities to be located

according to the availability of resources and capabil-

ities. However, the managerial challenge of reconciling

these different organizational requirements means that

most firms are able to able to pursue two out the three

As.35 For example, among Indian IT service companies,

Tata Consultancy Services (TCS) has emphasized arbi-

trage and aggregation, while Cognizant is oriented

toward arbitrage and adaptation. In medical diagnos-

tics, General Electric Healthcare is unusual in terms of its

ability to achieve high levels along all three dimensions:

it achieves aggregation economies through the highest

R&D budget in the industry, arbitrage through locating

global production centers in low cost countries, and

adaptation by developing country-focused marketing

units and offering customer-focused solutions that com-

bine hardware with a range of services.

FIGURE 11.9 Ghemawat’s AAA Triangle

ADAPTATION

Cognizant
TCS

Proxy: Advertising-
to-sales ratio relative
to rivals

Proxy: R&D-to-sales
ratio relative to rivals

ARBITRAGE
Proxy: Labor cost to sales

ratio relative to rivals

AGGREGATION

Source: P. Ghemawat, “Managing Differences: The Central Challenge of Global Strategy,” Harvard Business
Review 85 (March 2007).

292 PART IV CORPORATE STRATEGY

Sachs shifted staff and activities from London to Frankfurt in anticipation of Brexit,
while other banks chose Dublin or Paris for their European Union bases. Exploiting
arbitrage opportunities of particular national locations may even require shifting corpo-
rate domicile.36 Burger King’s $11 billion acquisition of the Canadian chain Tim Hortons
was motivated in part by the tax advantages of shifting Burger King’s headquarters
to Canada.37

The tendency for MNCs to disperse previously centralized functions is particu-
larly evident in R&D. P&G operates 26 innovation centers throughout the world.
In Japan, it seeks to capitalize on Japanese obsessiveness over cleanliness, through
developing new household cleaning products such as Swiffer. Its Singapore innova-
tion center emphasizes biomedical research, while Cincinnati is its base for developing
new beauty products. A survey by McKinsey & Company found that 80% of executives
believed that R&D goals were best served by establishing satellite units that collabo-
rated as a network.38

To what extent are the benefits that MNCs derive from aggregation, adaptation,
and arbitrage outweighed by the administrative costs imposed by administrative com-
plexity? McKinsey found that successful MNCs underperformed successful “national
champions.” They pointed to a “globalization penalty” that reflected difficulties in
gaining consensus around a shared vision, encouraging innovation, and building
government and community relationships. Reconciling national differentiation with
local differentiation was an ongoing challenge:

Almost everyone we interviewed seemed to struggle with this tension, which often
plays out in heated internal debates. Which organizational elements should be
standardized? To what extent does managing high-potential emerging markets on a
country-by-country basis make sense? When is it better, in those markets, to leverage
scale and synergies across business units in managing governments, regulators, part-
ners, and talent?39

–5

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15

20

25
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FIGURE 11.10 The return on equity of MNCs and their local competitors, 2016

Source: Bloomberg; The Economist

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 293

Further evidence of deteriorating profitability of MNCs is indicated by a decline in
the rate of return on foreign direct investment by US and UK companies during 1988
to 2016 and the tendency for MNCs to be outperformed by their local rivals in most
sectors (see Figure 11.10).40

Sectors where scale economies mandate global scale—jet engines, semiconductors,
and telecom equipment—will inevitably be dominated by MNCs. Elsewhere the trend
is for MNCs to reduce their global scope—this is particularly evident in sectors where
the aggregation benefits of cross-border operation are small: banking, retailing, tel-
ecom services.

Summary

Moving from a national to an international business environment represents a quantum leap in
complexity. In an international environment, a firm’s potential for competitive advantage is deter-
mined not just by its own resources and capabilities, but also by the conditions of the national envi-
ronments in which it operates: including input prices, exchange rates, and institutional and cultural
factors.

International strategic decisions utilize the same basic tools of strategy analysis that we developed
in earlier chapters. For example, to determine whether a firm should enter an overseas market, we must
examine the profit implications of such an entry. This requires an analysis of (a) the attractiveness of the
overseas market using the familiar tools of industry analysis and (b) the potential of the firm to establish
competitive advantage in that overseas market.

However, establishing the potential for a firm to create value from internationalization is only a
beginning. Subsequent analysis needs to design an international strategy: do we enter an overseas market
by exporting, licensing, or direct investment? If the latter, should we set up a wholly owned subsidiary or
a joint venture? Once the strategy has been established, a suitable organizational structure needs to be
designed.

That so many companies that have been outstandingly successful in their home market have failed
so miserably in their overseas expansion demonstrates the complexity of international management. In
some cases, companies have failed to recognize that the resources and capabilities that underpinned
their competitive advantage in their home market could not be readily transferred or replicated in over-
seas markets. In others, the problems were in designing the structures and systems that could effec-
tively implement the international strategy.

As the lessons of success and failure from international business become recognized and dis-
tilled into better theories and analytical frameworks, so we advance our understanding of how to
design and implement strategies for competing globally. We are at the stage where we recognize
the issues and the key determinants of competitive advantage in an international environment.
However, there is much that we do not fully understand. Designing strategies and organizational
structures that can reconcile critical trade-offs between global scale economies versus local
differentiation, decentralized learning and innovation versus worldwide diffusion and replication,
and localized flexibilities versus international standardization remains a key challenge for senior
managers.

294 PART IV CORPORATE STRATEGY

Self-Study Questions

1. With reference to Figure  11.1, choose a sheltered industry—one that
has been subject to little penetration either by imports or foreign direct
investment. Explain why the industry has escaped internationalization. Are
there opportunities for profitable internationalization for firms within the
industry? If so, what strategy would offer the best chance of success?

2. With reference to Table  11.1, what characteristics of national resources
explain the different patterns of comparative advantage for the United States
and Japan?

3. According to Michael Porter’s Competitive Advantage of Nations, some of
the industries where British companies have an international advantage are:
advertising, auctioneering of antiques and artwork, distilled alcoholic bever-
ages, hand tools, and chemical preparations for gardening and horticulture.
Some of the industries where US companies have an international competi-
tive advantage are: aircraft and helicopters, computer software, oilfield ser-
vices, management consulting, cinema films and TV programs, healthcare
products and services, and financial services. For either the United Kingdom
or the United States, use Porter’s national diamond framework (Figure 11.3)
to explain the observed pattern of international competitive advantage.

4. When Porsche decided to enter the SUV market with its luxury Cayenne
model, it surprised the auto industry by locating its new assembly plant in
Leipzig in eastern Germany. Many observers believed that Porsche should
have located the plant either in central or eastern Europe where labor costs
were very low or (like Mercedes and BMW) in the United States where it
would be close to its major market. Using the criteria outlined in Figure 11.4,
can you explain Porsche’s decision?

5. British expatriates living in the United States frequently ask friends and
relatives visiting from the United Kingdom to bring with them bars of Cad-
bury chocolate on the basis that the Cadbury chocolate available in the
United States (manufactured under license by Hershey’s) is inferior to “the
real thing.” Should Mondelēz International (formerly Kraft Foods, which
acquired Cadbury in 2010) continue Cadbury’s licensing agreement with
Hershey or should it seek to supply the US market itself, either by export
from the United Kingdom or by establishing manufacturing facilities in the
United States?

6. Since 2013, McDonald’s sales have been falling. Has it got the balance
right between global standardization and national differentiation (Strategy
Capsule  11.2)? How much flexibility should it offer its overseas franchi-
sees with regard to new menu items, store layout, operating practices, and
marketing? Which aspects of the McDonald’s system should McDonald’s top
management insist on keeping globally standardized?

CHAPTER 11 GlObAl STRATEGY And THE MulTInATIOnAl CORPORATIOn 295

Notes

1. For the OECD countries (the developed, industrialized
nations) the ratio of total trade (imports + exports) to
GDP grew from 11% in 1960 to 58% in 2014 (OECD Fact-
book, 2017).

2. J. Johanson and J.-E. Vahlne, “The Uppsala Internationali-
zation Process Model Revisited: From Liability of Foreign-
ness to Liability of Outsidership,” Journal of International
Business Studies 40 (2009): 1411–1431.

3. P. Ghemawat and F. Ghadar, “Global Integration: Global
Concentration,” Industrial and Corporate Change 15
(2006): 595–624.

4. As Tables 11.1 and 11.3 show, revealed comparative
advantage can be measured in different ways.

5. E. E. Learner, Sources of International Comparative
Advantage: Theory and Evidence (Cambridge MA:
MIT Press).

6. P. Krugman, “Increasing Returns, Monopolistic Competi-
tion, and International Trade,” Journal of International
Economics (November 1979): 469–79.

7. M. E. Porter, The Competitive Advantage of Nations (New
York: Free Press, 1990).

8. For a review of the Porter analysis, see R. M. Grant, “Por-
ter’s Competitive Advantage of Nations: An Assessment,”
Strategic Management Journal 12 (1991): 535–548.

9. Korean business culture has been described as “dynamic
collectivism.” See: Y.-H. Cho and J. Yoon, “The Origin
and Function of Dynamic Collectivism: An Analysis of
Korean Corporate Culture,” Asia Pacific Business Review 7
(2001): 70–88.

10. See B. Kogut, “Designing Global Strategies and Compet-
itive Value-Added Chains,” Sloan Management Review
(Summer 1985): 15–38.

11. A. Y. Lewin, S. Massini, and C. Peeters, “Why Are Com-
panies Offshoring Innovation? The Emerging Global Race
for Talent,” Journal of International Business Studies 40
(2009): 901–925.

12. Willy C. Shih, “What It Takes to Reshore Manufacturing
Successfully,” MIT Sloan Management Review 56 (Fall
2014): 55–62.

13. The role of firm-specific assets in explaining the multina-
tional expansion is analyzed in R. Caves, “International
Corporations: The Industrial Economics of Foreign
Investment,” Economica 38 (1971): 127.

14. D. J. Teece, “Transactions Cost Economics and Multina-
tional Enterprise,” Journal of Economic Behavior and
Organization 7 (1986): 21–45.

15. This section draws heavily upon G. S. Yip and G. T. M.
Hult, Total Global Strategy, 3rd edn. (Upper Saddle River,
NJ: Prentice Hall, 2012).

16. T. Levitt, “The Globalization of Markets,” Harvard Business
Review (May/June 1983): 92–102.

17. P. Ghemawat, Redefining Global Strategy: Crossing Bor-
ders in a World Where Differences Still Matter (Boston:
Harvard Business School, 2007).

18. Levitt, op. cit., 94.
19. S. G. Winter and G. Szulanski, “Replication as Strategy,”

Organization Science 12 (2001): 730–743.

20. G. S. Yip and A. Bink, “Managing Global Accounts,” Har-
vard Business Review 85 (September 2007): 102–111.

21. P. Ghemawat, “The Forgotten Strategy,” Harvard Business
Review (November 2003): 76–84.

22. P. Almeida, “Knowledge Sourcing by Foreign Multina-
tionals: Patent Citation Analysis in the US Semiconductor
Industry,” Strategic Management Journal 17 (Winter
1996): 155–165.

23. See, for example, “Apple’s Tax Affairs Spark Transatlantic
Face-off,” Financial Times April 4, 2016.

24. Comments by Tommy Kullberg (IKEA Japan) in “The
Japan Paradox,” conference organized by the European
Commission, Director General for External Affairs
(December 2003): 62–3, http://www.deljpn.ec.europa.
eu/data/current/japan-paradox.pdf, accessed July 20,
2015. See also: A. Jonsson and N. J. Foss, “International
Expansion through Flexible Replication: Learning from
the Internationalization Experience of IKEA,” Journal of
International Business Studies 42 (2011): 1079–1102.

25. A. K. Gupta and P. Govindarajan, “Knowledge Flows
within Multinational Corporations,” Strategic Management
Journal 21 (April 2000): 473–496; P. Almeida, J. Song, and
R. M. Grant, “Are Firms Superior to Alliances and Markets?
An Empirical Test of Cross-Border Knowledge Building,”
Organization Science 13 (March/April 2002): 147–161.

26. G. Hamel and C. K. Prahalad, “Do You Really Have a
Global Strategy?” Harvard Business Review ( July/August
1985): 139–148.

27. I. C. Macmillan, A. van Ritten, and R. G. McGrath,
“Global Gamesmanship,” Harvard Business Review (May
2003): 62–71.

28. Amazon vs. Alibaba: Which Will Dominate Global Online
Retail? Internet Retailer, March 31, 2017. https://www.
digitalcommerce360.com/2017/03/31/amazon-vs-alibaba-
which-will-dominate-global-online-retail/https://www.
ft.com/content/625e7980-45fe-3bd7-b431-148727959ecc.

29. The iPhone7 is configured differently for network com-
patibility and its operating software is adapted to different
national languages. The Big Mac varies between countries
in size, ingredients, and calorie content.

30. C. Baden-Fuller and J. Stopford, “Globalization Frustrated,”
Strategic Management Journal 12 (1991): 493–507.

31. R. M. Grant and M. Venzin, “Strategic and Organizational
Challenges of Internationalization in Financial Services,”
Long Range Planning 42 (October 2009). “Big Banks
Giving Up on their Global Ambitions.” Financial Times,
October 20, 2014.

32. C. A. Bartlett and S. Ghoshal, Managing across Borders:
The Transnational Solution, 2nd edn (Boston: Harvard
Business School Press, 1998): 34.

33. C. Bartlett, “Building and Managing the Transnational:
The New Organizational Challenge,” in M. E. Porter
(ed.), Competition in Global Industries (Boston: Harvard
Business School Press, 1986): 377.

34. P. Ghemawat—“Managing Differences: The Central
Challenge of Global Strategy,” Harvard Business Review
85 (March 2007)—proposes a three-way rather than