Chapter 3: The Internal Environment

Chapter 3 The Internal Environment: Resources, Capabilities, and Core Competencies

KNOWLEDGE OBJECTIVES 1. 2. 3. 4. 5. 6. 7. 8. Explain the need for organizations to study and understand their internal environments. Define value and discuss its importance. Describe the differences between tangible and intangible resources. Define capabilities and discuss how they are developed. Describe four criteria used to determine whether resources and capabilities are core competencies. Explain how value-chain analysis is used to identify and evaluate resources and capabilities. Define outsourcing and discuss the reasons for its use. Discuss the importance of preventing core competencies from becoming core rigidities.

CHAPTER OUTLINE Opening Case Reputation as a Source of Competitive Advantage THE IMPORTANCE OF INTERNAL ANALYSIS Creating Value Resources Capabilities Strategic Focus Microsofts Resources and Capabilities Core Competencies BUILDING CORE COMPETENCIES Four Criteria of Sustainable Competitive Advantage Value Chain Analysis Strategic Focus Significant Changes in the Value Chains of Pharmaceutical Firms OUTSOURCING Strategic Focus Outsourcing Is an International Trend CORE COMPETENCIES: CAUTIONS AND REMINDERS STRATEGIC INPUTS AND STRATEGIC ACTIONS SUMMARY REVIEW QUESTIONS EXPERIENTIAL EXERCISE NOTES The Opening Case illustrates one way that firms can achieve a competitive advantage. While many firms may concentrate their efforts on tangible assets or develop strategies that focus purely on external factors such as competitive moves and countermoves, the firms described in the Opening Case recognize the potential competitive advantage of reputation.

OPENING CASE Reputation as a Source of Competitive Advantage A firms reputation is an intangible resource that establish the foundation of core competencies. Reputations have been valued as follows: Coca-Cola ($52 billion), Gillette ($12 billion), Eastman Kodak ($11 billion), Campbell Soup ($9 billion), and Wrigleys Gum ($4 billion). Firms can base their reputation on emotional appeal (e.g., Southwest Airlines), social responsibility (e.g., The Body Shop, 3M, DuPont),

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Chapter 3: The Internal Environment financial performance (e.g., GE), vision and leadership (e.g., GE, Apple), workplace environment (Merck & Co.), and products and services (e.g., Coca-Cola and Microsoft).

TABLE 3-1 Fortunes Most Admired Corporate Rankings in 2001, 2000, and 1999 As Table 3-1 points out, corporate reputations can be an extremely valuable asset to a firm and its global competitiveness. This table lists the top 10 reputations in each of three years2001, 2000, and 1999. It is interesting to see how those near the top have been able to maintain their position, suggesting that the momentum of previous years is helpful. However, it is also interesting to note the firms that have fallen out of the top 10 over the years.

OPENING CASE Brands as a Source of Competitive Advantage A brand is one of the most valuable and sustainable sources of competitive advantage. The Coca-Cola company owns some of the worlds most valuable brands, including the following: Fruitopia, Barqs, Fanta, Fresca, Sprite, Surge, Mello Yello, and Coca-Cola. In the early 1990s, some analysts claimed that given only the brand as collateral, Coca-Cola would be able to borrow $100 billion. After some image-tainting quality problems in 1999, this value has fallen, but it still remains well above number-two Microsoft ($57 billion). Financial sector companies have a hard time branding themselves in distinct ways and do not possess any of the 60 most valuable brands. A few exceptions are the following: Goldman Sachs has a reputation as the global investment banking leader. Citibank and American Express have strong reputations in the general financial sector. Fidelity is attempting to become the leading mutual fund brand. Brands are intangible assets and as such are difficult to imitate by competitors. Cash flow streams can be assigned to brands to calculate a net present value for the brand. Some of the worlds most successful brands were the work of highly-motivated persons who sought to attach a loyalty-inspiring identity to an

For large global brands, brand rationalization is an ongoing challenge. Consider Nestle Nestl SA has more than 8,000 brands worldwide. Nestl has created a brand umbrella with subgroupings such as world-wide corporate, world-wide strategic, regional strategic, and local. To date, young Internet shoppers are not brand loyal--they prefer site/product utility features to simple branding. In the future, however, the Internet may generate value through brands. Several features of the global economy, such as technological changes, can result in the erosion of the competitive advantage of established competitors. The Internet is undermining the competitive advantage of brick-and-mortar rivals. Scanners at the checkout provide retailers with information about effects of price promotions on sales. Retailers gained bargaining power over providers of brand name products.

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Chapter 3: The Internal Environment The sustainability of a competitive advantage is a function of three factors: the obsolescence of a core competence--the basis of the value-creating strategy--as a result of environmental changes the availability of substitutes for the core competence, or the extent to which competitors can use different core competencies to overcome value created by the original core competence the imitability of the core competence, or the abilities of competitors successfully to develop the same core competence To sustain a competitive advantage, firms must be able to manage current core competencies while simultaneously developing new competencies. In other words, strategists must continuously make investments that will both enhance the value of current competencies while striving to develop new ones, a topic that will be discussed further in Chapter 5. This chapter represents the next phase in the strategy development process: what a firm can do. It is linked to the understanding that managers gain by assessing the external environment to determine what the firm might do, or to identify opportunities that might be pursued. As was noted earlier, the sustainability of any competitive advantage achieved will be determined by how successfully other firms imitate a firms strategies. Thus, a major challenge is that firms must continuously search for additional sources of competitive advantage and continuously implement them to stay ahead of competitors. FIGURE 3-1 Outcomes from External and Internal Environmental Analyses As Figure 3-1 illustrates the following: Analyzing the external environment enables a firm to identify what it might do by identifying what opportunities exist. Analyzing the internal environment enables a firm to identify what it can do or is capable of doing.

The challenge is for firms to achieve a match between what the firm might do and what it can do. This match allows the development of a firms strategic intent and strategic mission, as well as the subsequent implementation of value-creating strategies that will result in strategic competitiveness and above-average returns. Thus, the outcomes of the external and internal analyses of a firm's environment must be linked and not treated as separate and distinct. Analyzing the external environment enables strategists to identify opportunities that the firm can choose to pursue if it is capable of doing so successfully. This capability is determined by a careful analysis of the firm's internal environment, or by determining whether or not it has the resources, capabilities, and core competencies that will enable it to successfully implement valuecreating strategies that fit with its strategic mission and strategic intent (previously discussed in Chapter 1 and illustrated by Figure 1-1).

Explain the need for organizations to study and understand their internal environments.

THE IMPORTANCE OF INTERNAL ANALYSIS Internal analysis is important because the 21st-century competitive landscape makes it more difficult for firms to expect that they can sustain a level of strategic competitiveness strictly by managing the costs of

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Chapter 3: The Internal Environment labor, capital, and raw materials (because, in a global environment, all firms potentially can do this, as will be discussed in more detail in Chapter 8). Internal analysis adopts the position that the Resource-Based model of competitive advantage--discussed in Chapter 1--may be the key to a firm's ability to achieve strategic competitiveness, by treating each firm as a bundle or set of heterogeneous resources and capabilities. In other words, resources and capabilities are not equally distributed among firms as is assumed by the I/O model of strategic competitiveness. By using or exploiting their core competencies, firms are in a position to develop and perform valuecreating strategies better than their competitors or to create and perform value-creating strategies that competitors either are unable or unwilling to imitate. To make effective decisions, organizations must learn to: Manage change (e.g., such as Polaroids shift from analog to digital imaging capabilities) Develop a new mindset (e.g., Nassers push to change top-management thinking at Ford) Manage resources toward core competencies (see Figure 3-2)

FIGURE 3-2 Components of Internal Analysis Leading to Competitiveness

Competitive Advantage and Strategic

As illustrated in Figure 3-2, a firm's tangible and intangible resources (for example, its facilities and corporate culture, respectively) represent sources of capabilities these capabilities (teams or bundles of resources) represent sources of core competencies when exploited and nurtured (and valuable, imperfectly imitable, rare, and non-substitutable), core competencies are potential sources of competitive advantage if a firm is able to use its core competencies to achieve a competitive advantage, it will achieve strategic competitiveness and earn above-average returns so long as competitors are unable or unwilling to imitate them successfully Review Question 1: Why is it important for a firm to study and understand its internal environment?

Define value and discuss its importance.

Creating Value Some thoughts on value: Firms create value by exploiting core competencies and meeting the standards of global competition. Value is measured by the products performance characteristics and by its attributes for which customers are willing to pay. Ultimately, then, value is the foundation for earning above-average profits. The Challenge of Internal Analysis Correctly identifying, developing, deploying, and protecting firm resources, capabilities, and core competencies requires managers to make difficult decisions. In part, these challenges are a result of characteristics of both the internal and external environments of the firm. This challenge is multiplied because of three conditions that characterize important, strategic decisions.

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FIGURE 3-3 Conditions Affecting Managerial Decisions The conditions or decision characteristics presented in Figure 3-3 are: Uncertainty regarding the assessment of the general and industry environments, assessments, and predictability of competitive actions, and customer preferences Complexity regarding the nature of any interrelatedness of the causes of change in the environment and how the environments are perceived, especially regarding decisions as to which of the firms resources and capabilities might serve as the foundation for competitive advantage Intraorganizational conflicts among managers making decisions about which core competencies are to be nurtured and about how the nurturing should take place Uncertainty is present because of the inherent difficulty in identifying, assessing, and predicting changes and trends in characteristics of the external environment. Among these characteristics are correctly predicting the extent, direction, and timing of changes in the general environment, such as societal values, political and economic conditions, customer preferences, and emerging technologies from other industries (and how they might ultimately affect the firm). Complexity is increased because of the uncertain nature of interrelationships among the characteristics of the external environment and the related challenge regarding how to assess the effects of changes in one set of characteristics on other characteristics. The issue becomes more complex when managers must relate the complex external environment to their assessment of the firm's internal environment and thus affects decisions regarding the firm's resources, capabilities, and core competencies, and their relationship to opportunities in the external environment that can be exploited successfully to achieve a competitive advantage. Intraorganizational conflicts often develop as a result of uncertainty and complexity. When managers make decisions regarding the identification of the firm's capabilities and choose to nurture them (with resources) to develop core competencies that can be exploited to achieve a competitive advantage, they must make these important decisions without absolute certainty that the decision is correct. And, such decisions may result in changes or shifts in power and interrelationships among individuals and groups within the firm. When this occurs, there may be conflict as those who are affected adversely--or perceive that they will be so affected--may resist these changes. In some cases, managers faced with decisions that may have unpleasant consequences or are uncomfortable often experience denial, an unconscious coping mechanism used to block out and not initiate major changes that may have some pain associated with them. Thus, managers that must make decisions under conditions of uncertainty, complexity, and intraorganizational conflict must exercise judgment, a capacity for making a successful decision in a timely manner when no correct model is available or when relevant data are unreliable or incomplete. Review Question 2: What is value? Why is it critical for a firm to create value? How does it do so?

Describe the differences between tangible and intangible resources.

RESOURCES, CAPABILITIES, AND CORE COMPETENCIES This section develops the background and relationships between resources, capabilities, and core competencies that represent potential sources upon which a firm can build the foundation for a sustainable competitive advantage. Resources

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It might be said that resources represent that with which the firm has to work: its assets, including its people, and the value of its brand--a variety of individual, social, and organizational phenomena. To put it more succinctly, resources represent inputs into a firm's production process, such as capital equipment, the skills of individual employees, brand names, financial resources, and talented managers. By themselves--or individually--resources generally will not enable a firm to achieve a competitive advantage. They must be combined or integrated with other firm resources to establish a capability. When these capabilities are identified and nurtured, they can result in core competencies, which may lead to a competitive advantage. A firm's resources can be classified either as tangible or intangible. Tangible Resources Tangible resources are assets that can be seen or quantified, such as a firm's physical assets (e.g., its plant and equipment). Tangible resources can be classified in one of four ways, as illustrated in Table 3-2. TABLE 3-2 Tangible Resources A firm's tangible resources generally can be placed into one of four categories: Financial resources, such as borrowing capacity Organizational resources, such as its formal reporting structure and systems Physical resources, such as location Technological resources, such as patents and trademarks Intangible Resources A firm's intangible resources may be less visible, but they are no less important. In fact, they may be more important if a firm expects to achieve a competitive advantage. Intangible resources range from innovation resources, such as knowledge, trust, and organizational routines, to the firm's people-dependent or subjective resources of know-how, networks, organizational culture, to the firm's reputation for its goods and services and the way it interacts with others (such as employees, suppliers, or customers). Three classifications of intangible resources are presented in Table 3-3. TABLE 3-3 Intangible Resources A firm's intangible resources can be classified as: Human resources, such as knowledge, trust, and managerial capabilities Innovation resources, such as scientific capabilities and capacity to innovate Reputational resources, such as the firm's reputation with customers or suppliers Because tangible resources are those that can be seen (such as plants), touched (such as equipment), documented (such as contracts with suppliers of raw materials), or quantified (such as the value of a specific asset), they generally will not, by themselves, represent capabilities that will serve as sources of core competencies. However, they still have value and will contribute to development of capabilities and core competencies. Thus, the strategic value of tangible and intangible resources is important. The strategic value of resources is indicated by the degree or extent to which the resource(s) contribute to the development of capabilities, core competencies, and ultimately, to a competitive advantage for the firm. This is another way of saying that a single resource--tangible or intangible--has strategic value only if, in combination with other resources, a capability is established.

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Because they cannot be quantified, touched, or seen, and are more difficult to explain, intangible resources are more likely to be sources of sustainable competitive advantage. And, if they also are difficult for competitors to identify and/or understand, they also may represent the most likely source(s) of a firm's capabilities, core competencies, and sustained competitive advantage. A Mini-Lecture on the Value of Brands One intangible resource that may enable a firm to create a reputation and serve as a source of competitive advantage is a brand name. Specifically, what a brand name communicates to customers about the performance characteristics or attributes of a firm's product(s) represents a direct link to a firm's reputation with its customers. When the brand name communicates positive characteristics of a product (for example, superior performance, high quality, or superior value), consumers will tend to purchase the brand name product rather than similar products offered by competing firms. Thus, it is important that companies with strong brand names nurture the core competencies that provide the brand name with value and continually communicate that value through consistent advertising messages. When a firm has a brand name that serves as a foundation for competitive advantage, the firm often will try to leverage the power of that brand name. For example, Harley Davidson's name now adorns a limited edition Barbie doll, a popular restaurant in New York City, and a line of LOreal cologne. Moreover, Harley-Davidson Motorclothes generates over $100 million in revenue for the firm each year, and the Harley brand adorns a wide range of clothing items, from black leather jackets to fashions for tots. The value of a brand name can be lessened or reduced by competitive actions, which the firm either does not recognize or to which it fails to respond. In the consumer goods segment, national brands are under attack by private label store brands. And, some appear to be losing the battle as customer preferences are shifting toward private labels that may be perceived as providing more value than the national brands. In many cases, national brands have reacted to such threats by cutting prices. However, cost-cutting is not the only strategy that can be used to safeguard a brand. For companies whose brand names are expected to thrive and continue to provide a competitive advantage (such as Nike or Hanes), their challenge is to nurture and exploit the resources, capabilities, and core competencies that are the source of competitive advantage. For companies whose brands are under fire (such as Marlboro or Budweiser), the challenge is to re-establish the value of the brand. Their challenge is to reconfigure their existing bundle of resources, capabilities, and core competencies to renew them as sources of competitive advantage. For companies whose brands are troubled (such as Dell Computer and Purina), because the brands are no longer a source of competitive advantage, the challenge is even greater: they must identify and develop new bundles of resources, capabilities, and core competencies and nurture them to establish a new source of competitive advantage. Firms also may choose to package their brand as a way to differentiate themselves from competitors, as Century 21 Real Estate has done by using technology to make its offices virtual home stores by offering a variety of discounted home services, including cable service, appliances, insurance, and mortgages. Other firms (e.g., Procter & Gamble, General Motors, and Philip Morris) support their brand-name products through heavy advertising expenditures.

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Chapter 3: The Internal Environment Review Question 3: What are the differences between tangible and intangible resources? Why is it important for decision makers to understand these differences? Are tangible resources linked more closely to the creation of competitive advantages than intangible resources, or is the reverse true? Why?

Define capabilities and discuss how they are developed.

Capabilities As implied in the definition, a firm's capabilities represent its capacity to integrate individual firm resources to achieve a desired objective. However, this ability does not emerge overnight. Capabilities develop over time as a result of complex interactions that take advantage of the interrelationships between a firm's tangible and intangible resources that are based on the development, transmission, and exchange or sharing of information and knowledge as carried out by the firm's employees (its human capital). A firm's ability to achieve a competitive advantage is thus reflected in its knowledge base and the ability of its human capital to successfully exploit firm capabilities. Thus, human capital is of significant value in the firm's ability to develop capabilities and core competencies to achieve strategic competitiveness. STRATEGIC FOCUS Microsofts Resources and Capabilities Microsoft, the worlds leading software development company, has more than $30 billion in cash that is generated by sales of its core products, and the firm is using this hoard to fund new product development (e.g., MSN.com, the X-box) and to expand through strategic acquisitions, such as the purchase of Great Plains Software. Microsoft does an excellent job of using its tangible assets to support its intangible assets in a way that expands the firms already enormous competitive advantage. The cycle is self-reinforcing. The knowledge possessed by the firm's human capital may be one of the most significant sources of a firm's competitive advantage because it represents everything that the firm has learned, and thus everything that it knows about successfully linking or bundling sets of individual resources to develop capabilities as a foundation for developing core competencies and, ultimately, to achieve a competitive advantage. Establishing and nurturing the skills and abilities of the workforce is of critical importance to a firm's ability not only to establish, but to sustain a competitive advantage by acquiring new knowledge and developing new skills that will both enhance existing capabilities and core competencies, as well as aid in the development of new ones. Many firms are hiring Chief Learning Officers (CLO) to find ways for the organization to acquire, internalize, and share knowledge in competitively relevant ways. Managing knowledge is critical since enterprises view this as their primary source of competitive advantage and believe it should be used in ways that will create value for customers Firms also have functional area capabilities that have been nurtured and are now considered as core competencies. As a result, these core competencies provide the foundation for the firms competitive advantage. TABLE 3-4 Examples of Firms Capabilities

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Chapter 3: The Internal Environment Table 3-4 provides examples of functional areas, capabilities, and firm examples across a variety of industries. It indicates that a number of functional area capabilities have the potential to serve as the foundation for a firms competitive advantage.

STRATEGIC FOCUS Knowledge Management and Sustainable Competitive Advantage Firms are placing an increasingly high value on the contributions of chief learning officers (CLOs) those responsible for helping the organization acquire, develop, share, and exploit knowledge. Data are simple facts without interpretation. Information is data that have been processed, manipulated, categorized, or classified. Knowledge is information interpreted with experience, values, judgment, or intuition. Knowledge management is the process of cataloguing and distributing the knowledge that resides in the organizational intellect so that its full value is leveraged across multiple activities. Siemens tries to infuse its store of customer knowledge into its manufacturing, development, logistics, and sales systems/processes. Current research suggests four methods by which knowledge is transferred within an organization: Socialization common with apprenticeships and mentors, this occurs by observation and practice. Externalization this is the process used to convert tacit knowledge into explicit terms, a type of metaphorical model-building. Combination this considers knowledge stores in different groups within the organization to try to meld the knowledge and distribute it to other groups. Internalization the process by which knowledge generated by the other three methods gets embedded into the employees of the organization. Newly internalized knowledge becomes a base upon which the cycle of knowledge creation, transfer, and embedding repeats itself. Review Question 4: What are capabilities? What must firms do to create capabilities?

Describe four criteria used to determine whether resources and capabilities are core competencies.

Core Competencies Once a firm has identified its resources and capabilities, it is ready to identify its core competencies, the resources and capabilities that are a source of competitive advantage for the firm over its competitors. Remember, resources and capabilities serve as the foundation upon which firms formulate and implement value-creating strategies so that the firm can achieve strategic competitiveness and earn above-average returns. However, not all of a firm's resources and capabilities represent strategic assets--assets that have competitive value and the potential to serve as a source of competitive advantage. If the firm has a deficiency in some of its resources, it may not be able to achieve strategic competitiveness. For example, insufficient financial resources may prevent the firm from implementing the processes or integrating the activities required to add superior value by limiting the firm's ability to hire workers with the necessary skills or to invest in the capital assets (facilities and equipment) that are needed.

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Thus, firms not only are challenged to scan the external environment to identify opportunities that can be exploited, but also to have an in-depth understanding of firm resources and capabilities. This will enable the firm to develop strategies that enable it to exploit external opportunities but also to avoid competing in areas where the firm's resources and capabilities are inadequate. When the firm's resources and capabilities result in a core competence, the firm will be able to produce goods or services with features and characteristics that are valued by customers. This implies that firms can implement value-creating strategies only when its capabilities and resources can be combined to form core competencies. The question is asked: "How many core competencies are required for a competitive advantage?" McKinsey & Company recommends that firms identify 3 or 4 competencies around which to frame their strategic actions. BUILDING CORE COMPETENCIES The following section discusses two conceptual tools or frameworks available to firms as they search for competitive advantage: Four criteria which determine which of the firms resources and capabilities are core competencies Value chain analysis, a framework for determining which value-creating competencies should be maintained upgraded and developed and which should be outsourced. Four Criteria for Sustainable Competitive Advantage Four criteria should be used to determine whether or not a firms capabilities are core competencies and can be a source of competitive advantage. TABLE 3-5 Four Criteria for Determining Strategic Capabilities Before they can be sources of competitive advantage, capabilities must be: valuable rare costly-to-imitate nonsubstitutable

FIGURE 3-4 Core Competence as a Strategic Capability Figure 3-4 illustrates the relationship between resources, capabilities, and the decision point at which managers determine whether capabilities are (or are not) core competencies. This decision point--whether or not the four criteria of sustainable competitive advantage are met--will be discussed in the next sections. It is important to understand that a firm's capabilities must meet all four of the criteria noted earlier before they can be core competencies and enable the firm to achieve a sustainable competitive advantage. However, a short-term competitive advantage is available when firm capabilities are valuable, rare, and non-substitutable. The length of time that a firm possessing such capabilities can expect to sustain a competitive advantage depends on how long it takes for competitors to successfully imitate the valuecreating activity or process, or reproduce valued features or characteristics of the product or service. Thus, the ability to sustain a competitive advantage is dependent on firm capabilities being valuable, rare, non-substitutable, and costly to imitate. Valuable 3-10

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Capabilities that are valuable help a firm exploit opportunities and/or neutralize threats in the external environment. Valuable capabilities enable a firm to develop and implement strategies that create value for customers. For example, Sony uses its valuable capabilities to design, manufacture, and market miniaturized electronic technology to add value for consumers (or to serve as a joint venture partner or perform outsourced activities for other manufacturers who do not possess these valuable capabilities). Rare Capabilities are rare when they are possessed by few, if any, current or potential competitors. If many firms have the same capabilities, the same value-creating strategies will be selected. As a result, none of the firms will be able to achieve a sustainable competitive advantage. A competitive advantage will be achieved by firms that develop and nurture capabilities that are different from those held by other firms. Costly-to-Imitate Capabilities are costly to imitate when other firms are unable to develop them except at a cost disadvantage relative to firms that already have them. This usually is a result of one or a combination of three conditions: 1. Unique historical conditions such as establishing facilities in a key location that preempts competition when no other locations have the same or similar value-related characteristics or developing a unique organizational culture in the early stages of the organization's life that cannot be duplicated by cultures developed at different times. A unique culture can not only serve as a source of competitive advantage, but also may be a source of competitive disadvantage. The latter may be the case when a firm's culture prevents it from recognizing or successfully adapting to changes in a turbulent environment. As an example, use the texts description of McKinsey & Co.s culture as it successfully competes in the faced-paced, fragmented, and highly competitive business of management consulting. Many of its supporters--as well as its critics and competitors--indicate that McKinsey's culture provides it with a sustainable competitive advantage. Their culture is centered on the client. The interests of clients come before those of McKinsey. Confidentiality about a clients business operations must be maintained. Challenge the clients opinion, but always be truthful. Perform only work that is in the clients best interests and that McKinsey can do well. 2. Causal ambiguity also may prevent competitors from perfectly imitating a competency if the link between a firm's resources, capabilities, and core competencies is not identified or understood. Also, competitors may not be able to identify or determine how a firm uses its competencies to achieve a sustainable competitive advantage. 3. Social complexity means that a firm's capabilities are the product of complex social phenomena such as interpersonal relationships within the firm (e.g., how managers and subordinates at HewlettPackard work with each other) or between the firm and its customers and suppliers. Nonsubstitutable Capabilities A firm's capabilities are nonsubstitutable when they do not have strategic equivalents. In addition, if capabilities are invisible, it is even more difficult for competitors to identify viable substitutes. Examples

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Chapter 3: The Internal Environment of capabilities that can be difficult to identify or to find suitable substitutes for include firm-specific knowledge and trust-based working relationships. TABLE 3-6 Outcomes from Combinations of the Criteria for Sustainable Competitive Advantage Highlights from Table 3-7 are: Resources and capabilities that are neither valuable, rare, costly-to-imitate, nor nonsubstitutable mean that the firm will be at a competitive disadvantage and will earn below-average returns. Resources and capabilities that are valuable, but are neither rare nor costly to imitate and may or may not be nonsubstitutable mean that the firm can achieve competitive parity and earn average returns. Resources and capabilities that are both valuable and rare, but are not costly to imitate and may or may not be nonsubstitutable, may enable the firm to achieve a temporary competitive advantage and will earn above-average to average returns. Resources and capabilities that are valuable, rare, costly-to-imitate, and nonsubstitutable will enable the firm to achieve a sustainable competitive disadvantage and earn above-average returns.

STRATEGIC FOCUS Trust: Is It Valuable, Rare, Costly to Imitate, and Nonsubstitutable? Trust and organizational success are closely linked. Trust benefits the organization in that it reduces the overall transaction costs (measured by organizational reporting relationships and formal contracts). There are many attributes to trust, the most prominent of which is risk. This risk can be divided into two categories: managerial risk the general risk of managerial decisions organizational risk characteristic of firms with volatile income streams Davis, Schoorman, Mayer, and Tan define trust as the willingness of a party (trustor) to be vulnerable to the actions of another party (trustee) based on the expectation that the trustee will perform an action important to the trustor, regardless of the trustors ability to monitor or control the trustee. Trust between general manager and employees may be a source of competitive advantage. This trust rests upon the trustors perception of the trustees: ability skills and competencies by which trustee may influence outcomes benevolence degree to which trustor believes trustee acts for the good of the trustor integrity belief that the trustee will follow a set of principles that are desired by the trustor The study by Davis, et al. suggests that these three factors of trust can contribute to competitive advantage of the firm. According to the findings of the study, we can conclude that trust satisfies at least three of the four (and conceivably all four) criteria for sustainable competitive advantage. Valuable the study demonstrated that trust increased profitability and reduced turnover. Rare this relationship dynamic between manger and employees is uncommon. Costly to imitate trust is an intangible social construct that can not easily be replicated. Nonsubstitutable this is a possibility, since trust is difficult for competitors to

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observe. Trust can reduce costs of monitoring employees and can also improve revenue via trustinduced motivation of employees. The following examples are provided as evidence that the trust structures as discussed above contribute to the above-average performance of each firm. Anderson & Associates practices open-book management, meaning that all financial data (including employee salaries) are readily accessible on the firms Intranet. The companys CEO claims that this practice contributes to employee loyalty. Radius, a French restaurant in Boston, relies upon trust to sustain one of its competencies--excellent teamwork. MTW Corp., a software and Internet applications provider, relies upon expectation agreements among the boss, an employee, and his or her work team (all of whom may be in different geographical areas and are dependent upon each other for success). Review Question 5. What are the four criteria used to determine which of a firms capabilities are core competencies? Why is it important for these criteria to be used?

Explain how value-chain analysis is used to identify and evaluate resources and capabilities.

Value Chain Analysis A framework that firms can use to identify and evaluate the ways in which their resources and capabilities can add value is value chain analysis. This framework is useful because it enables firms to understand which parts of their operations or activities create value by segmenting the value chain into primary and secondary activities as illustrated in Figure 3-6. FIGURE 3-5 The Basic Value Chain Figure 3-5 illustrates how the value-creating activities performed by the firm can be separated into primary and secondary activities. Primary activities, shown vertically, represent traditional line activities such as inbound logistics, operations, outbound logistics, marketing and sales, and service. Support activities, shown horizontally, are represented by a firm's staff activities and include its financial infrastructure, human resource management practices, technological development, and procurement activities.

TABLE 3-7 Examining the Value-Creating Potential of Primary Activities Table 3-7 presents value-creating issues to be addressed for each primary activity. Activities are rated as superior, equivalent, or inferior (relative to competitors). Students can refer to this table during your discussion. Inbound logistics: Examine all activities related to the receipt, control, warehousing, inventory, and distribution of raw materials or component parts into the production process.

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Operations: Activities to be examined are all of those necessary to convert the inputs (raw materials or components) available as a result of inbound logistics into finished products. Examples include machining, assembly, equipment maintenance, and packaging. Outbound logistics: This category represents the firm's activities involved with the collection, storage, and physical distribution of products to customers. Examples include warehousing or storage of finished products, material handling, and order processing. Marketing and sales: Several marketing and sales activities must be completed to both induce customers to purchase products and ensure that products are available. Activities include developing advertising and promotion campaigns; selecting and developing distribution channels; and selecting, training, developing, and supporting a sales force. Service: These are the activities that a firm offers to enhance or maintain a product's value, including installation, product use training, adjustment, repair, and warranty services.

TABLE 3-8 Examining the Value-Creating Potential of Support Activities Table 3-8 presents value-creating issues to be addressed for each support activity. Activities are rated as superior, equivalent or inferior, relative to competitors. Students can refer to this table during your discussion. Procurement: These are activities that are completed to purchase the inputs needed to produce a firm's products, including items consumed or used in the manufacturing process (such as raw materials or component parts), supplies, and fixed assets (machinery, equipment and facilities). Technological development: All activities that are completed to either improve a firm's products or its production processes. This includes basic research, process and equipment design, product design, and servicing procedures.

Human resource management: These activities are related to the recruiting, hiring, training, developing, and compensating (including performance assessment and reward systems) of a firm's employees. Firm infrastructure: These activities support the activities performed in the firm's value chain, including general management practices, planning, finance, accounting, legal, and government relations. By performing its infrastructure-related activities, a firm identifies external opportunities and threats, and internal strengths and weaknesses related to firm resources and capabilities, and supports or nurtures its core competencies. STRATEGIC FOCUS Significant Changes in the Value Chain of Pharmaceutical Firms The genetic revolution brought two new upstream steps to the value chain in the pharmaceutical industry: research into genes that cause disease and identification of proteins that those genes produce. Historically, smaller firms have filled these niches. Now, small upstream firms such as Millennium Pharmaceuticals are attempting to move downstream (e.g., into activities such as testing and delivery) where the larger firms are positioned. This has been accomplished mostly by partnerships between large and small firms, where the former provide financial depth and the latter demonstrate how information technology can be used to speed up drug trials. The Internet can speed up trials and reduce error checking, cutting costs dramatically. This strategic focus is helpful in illustrating how firms in the pharmaceutical industry, large and small, are using their advantages in the value chain to create expansion opportunities. For

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Chapter 3: The Internal Environment example, Millennium Pharmaceutical has exploited its opportunity to reduce costs in the research and exploration upstream stages in the value chain and has thereby created significant opportunity for itself. Because larger, more established pharmaceutical firms have recognized Millenniums capabilities, they have sought partnerships with the smaller contender to accelerate identifying genetic leads that facilitate cures using Millenniums platform for genetic exploration. Through partnering with firms such as Eli Lilly and Abbott Laboratories, Millennium has raised $1.8 billion, which, in turn, has helped the firm solidify its R&D platform even further. Smart management with value chain thinking can pay huge dividends.

STRATEGIC FOCUS Creating Value at FedEx and UPS Since its founding 30 years ago, FedEx has built its success upon its core competencies-speed and reliability. Founder Frederick W. Smith foresaw a high-speed economy in which these two competencies would be highly valued. This philosophy of making up in speed what its customers lacked in precision brought the firm great success during its first 20 years. However, increasing sophistication among its customers supply chain and logistics systems management may threaten this original value proposition. Companies who are better able to manage the variability of their supply chains no longer (or rarely) require urgent delivery of key inputs. In response to this change in its external environment, FedEx is trying to redefine itself as the most compelling end-to-end supply-chain solution provider in the industry. They hope to enable customers to outsource all or part of their supply chain to FedEx so that they can focus with confidence on their value-creating core competencies. The Internet has provided convenience for firms by enabling many more direct ordering opportunities, but it has also created a need for improved and capable distribution systems. FedEx hopes to capitalize on this need. UPS is a competitor which is trying to challenge FedEx. They have moved from a trucking company with technology to a technology company with trucks. Their core competencies are operational efficiency and uniformity, and they have used these to increase margins and invest heavily in technology. UPS is a supply manager for Fender Guitars, performing such tasks as coordinating freight shipments (land and sea using multiple carriers), inspections, inventory oversight, and order fulfillment. Both companies seek to increase customer value by helping to manage their supply chains. UPS is the prototype in many areas of the parcel delivery business because of its excellence in products, systems, marketing, and other operational business capabilities. However, some may suggest that the firm is gaining an edge over FedEx because of its fundamental competitive strength that derives from the organization's unique, nearly century-old culture, which grows deeper as time goes in. The culture of the firm provides a foundation for everything the company does, including training and development for employees and technological innovation.

Using the value chain framework enables managers to study the firm's resources and capabilities in relationship to the primary and support activities performed to design, manufacture, and distribute products,

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Chapter 3: The Internal Environment and to assess them relative to competitors' capabilities. For these activities to be sources of competitive advantage, a firm must be able to: perform primary or support activities in a manner superior to the ways that competitors perform them perform a primary or support activity that no competitor is able to perform to create superior value for customers and achieve a competitive advantage This implies that, given that individual firms are comprised of unique or heterogeneous bundles of activities, reconfiguring the value chainor rebundling resources and capabilitiesmay enable a firm to develop unique value-creating activities. FIGURE 3-6 Prominent Application of the Internet In the Value Chain This is a very involved figure, but it helps to illustrate the vast potential of the Internet to change the way managers think about the value chain. Explaining the ins-and-outs of the figure will take a good bit of time, but it is worth the investment.

The managerial challenge is that the value-creation process is difficult and there is no one best way to assess a firm's primary and support activities or to evaluate the value-creating potential of those activities either within the firm or relative to competitors, because of incomplete or ambiguous data. However, by being objective, managers may be able to use the value chain framework to identify new, unique ways to combine resources and capabilities to create value that are difficult for competitors to recognize, understand, or imitate. The longer a firm is able to keep competitors "in the dark," as to how resources and capabilities have been combined to create value, the longer a firm will be able to sustain a competitive advantage. Firms can use outsourcing as an alternative to identify primary or support activities for which its resources and capabilities are not core competencies and do not enable the firm to add superior value and achieve competitive advantage. Review Question 6. What is value chain analysis? What does a firm gain when it successfully uses this tool?

Define outsourcing and discuss the reasons for its use.

OUTSOURCING Outsourcing describes a firm's decision to purchase a value-creating activity from an external supplier. Outsourcing has become important--and may become more important in the future--for two reasons: First, there are limits to the abilities of firms to possess all of the bundles of resources and capabilities that are required to achieve superior performance (relative to competitors) in all of its primary and support activities. Second, with limits to their resources and capabilities, firms can increase their ability to develop resources and capabilities to develop core competencies and achieve competitive advantage by nurturing only a few core competencies

As indicated in this strategic focus, international outsourcing is becoming an important strategic tool for firms in countries around the world. STRATEGIC FOCUS

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Chapter 3: The Internal Environment Outsourcing Is an International Trend Because of the downturn in the economy in Japan, many Japanese electronics firms are outsourcing some of their operations. They can no longer keep it all within the corporate family and remain competitive. In other words, they are disintegrating the value chain to take advantage of partners with complementary strengths (e.g., Fast Retailings focus on the selling of apparel in Japan and elsewhere). The trend also exists elsewhere. Evalueserve of India provides business processes (back-office work) to client firms in Europe and the U.S., and Indias wealth of software programming and technical skill is being harnessed abroad. Over time, firms shift back and forth between vertical integration and outsourcing, so managers need to make sure that this decision is consistent with the greater needs of the business. This strategic focus underscores the point that outsourcing is here to stay. Thus it is important to stress that managers involved in these outsourcing deals must learn to secure rights from external providers that can be fully used by internal managers. Furthermore, they must be able to oversee and govern the relationship with outsourcing partners. Outsourcing can change substantially how an organization operates, so managers administering these programs must be able to manage that change, including resolving the employee resistance that may result. When evaluating resources and capabilities, firms must be careful not to outsource activities in which they can create and capture value. Additionally, companies should not outsource primary and support activities that are used to neutralize environmental threats or complete necessary, ongoing organizational tasks. Review Question 7. What is outsourcing? Why do firms outsource? Will outsourcing's importance grow in the 21st century? If so, why? Discuss the importance of preventing core competencies from becoming core rigidities.

CORE COMPETENCIES: CAUTIONS AND REMINDERS Because they are generally knowledge-based, capabilities that are a firm's core competencies become more valuable as they are used over time. For example: Sharing knowledge--across people, jobs and organizational functions--may result in an increase in the value of that knowledge in ways that are competitively relevant. Core competencies can also become core rigidities (or core incompetencies). Core competencies must be strategically relevant, which means that firms must continually strive to develop new competencies. New competencies must be developed to meet the changes (and challenges) of the new competitive landscape as both technological and global factors are rapidly changing. Thus, nurturing existing competencies must be balanced by efforts to encourage the development of new competencies.

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