BMGT Slides Exam

BMGT | Winter semester 2017/18
Lecture 3&4: Evaluating a Company’s External Environment
Dr. Le Minh Hanh

Outline
1. An overview of environment analysis

2. Macro environment analysis
3. Industry analysis
A- Five Forces Framework
B- Industry’s driving forces
C - Strategic group analysis
D- Competitor analysis
E – Key success factors and attractiveness of an industry
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Outline

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Environment analysis and planning
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Environment analysis and control
1. Every strategy is based on certain planning premises. Thus, premise

control is a component of strategic management control system.
2. Strategic control refers to management efforts to track a strategy as it

is being implemented, detect problems or changes in its underlying
premises, and make necessary adjustments
3. Premise control is the management process of systematically and

continuously checking to determine whether premises upon which the
strategy is based upon are still valid.
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Tasks in scanning environment
• Identify potentially important external and internal developments
• Assess their impacts and influences
• Adapt a company’s direction and strategy as needed
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Outline

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The Seven Components of the Macro-Environment
Component Description
Demographics The size, growth rate, and age distribution of different sectors of the population. It
includes the geographic distribution of the population, the distribution of income
across the population, and trends in these factors.
Social forces Societal values, attitudes, cultural factors, and lifestyles that impact businesses.
Social forces vary by locale and change over time.
Political, legal, Political policies and processes, as well as the regulations and laws with which
and regulatory companies must comply—labor laws, antitrust laws, tax policy, regulatory policies,
factors the political climate, and the strength of institutions such as the court system.
Natural Ecological and environmental forces such as weather, climate, climate change, and
environment associated factors like water shortages.
Technological The pace of technological change and technical developments that have the
factors potential for wide-ranging effects on society, such as genetic engineering, the rise of
the Internet, changes in communication technologies, and knowledge and
controlling the use of technology,
Global forces Conditions and changes in global markets, including political events and policies
toward international trade, sociocultural practices and the institutional environment
in which global markets operate.
General Rates of economic growth, unemployment, inflation, interest, trade deficits or
economic surpluses, savings, per capita domestic product, and conditions in the markets for
conditions stocks and bonds affecting consumer confidence and discretionary income.
PESTEL Analysis
Focuses on principal components of strategic significance in the

macro-environment
 Political factors
 Economic conditions (local to worldwide)
 Sociocultural forces
 Technological factors
 Environmental factors (the natural environment)
 Legal and regulatory conditions
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A macro-environment analysis framework framework
Political Economic Social T

echnological Environmental Legal
Local
National
Global
Sambrook (2007)
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Outline

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Industry analysis
1. How strong are the industry’s competitive forces?
2. What are the driving forces in the industry, and what impact will they
have on competitive intensity and industry profitability?
3. What market positions do industry rivals occupy—who is strongly

positioned and who is not?
4. What strategic moves are rivals likely to make next?
5. What are the industry’s key success factors?
6. Is the industry outlook conducive to good profitability?
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Outline

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THE FIVE FORCES FRAMEWORK
 The five competitive forces

 Competition from rival sellers
 Competition from potential new entrants
 Competition from producers of substitute products
 Supplier bargaining power
 Customer bargaining power
 Objectives are to identify
 Main sources of competitive forces
 Strength of these forces
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The Five-Forces Model (Porter, 1980)
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Analysis framework
For each of the five forces, identify the different parties

Step 1 involved, along with the specific factors that bring about
competitive pressures.
Evaluate how strong the pressures stemming from

Step 2
each of the five forces are (strong, moderate, or weak).
Determine whether the five forces, overall, are

Step 3
supportive of high industry profitability.
Rivalry forces
Competitive rivals are organizations with similar products and services

aiming at the same customer group.
 Typical sources of rivalry forces:
• Lower prices
• More appealing features
• Better product performance
• Higher quality
• Strong brand image and appeal
• Better customer service capabilities
• Wider product selection
• Bigger/better dealer network
• Stronger product innovation capabilities
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Determinants of the rivalry forces
1.Concentration rate and relative size of the competitors

More concentrated industry means more interdependence amongst
incumbents , resulting in restraining rivalry. An industry with equally sized
players promises a higher degree of rivalry than an industry with the
presence of a dominant competitor.
2. Industry’s basic conditions
An industry with high fixed cost, excess capacity, slow growth and lack of
product differentiation is often featured with high degree of rivalry
3. Behavioral determinants
4. Switching cost
5. Exit barriers
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Factors Affecting the Strength of Rivalry
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Threat of new entrants
 Entry threat considerations

• Expected defensive reactions of incumbent firms
• Strength of barriers to entry
• Attractiveness of a particular market’s growth
in demand and profit potential
• Capabilities and resources of potential entrants
• Entry of existing competitors into market segments
in which they have no current presence
 Barriers exist when
• Newcomers confront obstacles
• Economic factors put potential entrant at a disadvantage relative to
incumbent firms
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Market entry barriers facing new entrants
 Incumbent cost advantages related to learning and experience,

proprietary patents and technology, favorable locations, and lower
fixed costs
 Strong brand preferences and customer loyalty
 Strong “network effects” in customer demand
 High capital requirements
 Building a network of distributors or dealers and securing adequate
space on retailers’ shelves
 Restrictive regulatory and trade policies
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STRATEGIC MANAGEMENT PRINCIPLE (1 of 8)
• Whether an industry’s entry barriers ought to be considered high or

low depends on the resources and capabilities possessed by the pool
of potential entrants.
• High entry barriers and weak entry threats today do not always
translate into high entry barriers and weak entry threats tomorrow.
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Factors Affecting the Threat of Entry
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Competitive pressures from substitute products
Substitutes are products or services that offer a similar function to an

industry’s products or services, but by a different process.
 Substitute products considerations

• Readily available and attractively priced?
• Comparable or better in terms of quality, performance, and other
relevant attributes?
• Offer lower switching costs to buyers?
 Indicators of substitutes’ competitive strength

• Increasing rate of growth in sales of substitutes
• Substitute producers adding new output capacity
• Increasing profitability of substitute producers
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Factors Affecting Competition from
Substitute Products
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Competitive pressures from supplier bargaining power
 Supplier bargaining power depends on:

• Strength of demand for and availability of suppliers’ products
• Whether suppliers provide a differentiated input that enhances the
performance of the industry’s product
• Industry members’ costs for switching among suppliers
• Size and number of suppliers relative to industry members
• Possibility of backward integration into suppliers’ industry
• Fraction of the cost of the supplier’s product relative to the total
cost of the industry’s product
• Availability of good substitutes for suppliers’ products
• Whether industry members are major customers of suppliers
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Factors Affecting the Bargaining
Power of Suppliers
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Competitive pressures from buyer bargaining power
 Buyer bargaining power considerations

• Strength of buyers’ demand for sellers’ products
• Degree to which industry goods are differentiated
• Buyers’ costs for switching to competing sellers or substitutes
• Number and size of buyers relative to number of sellers
• Threat of buyers’ integration into sellers’ industry
• Buyers’ knowledge of products, costs and pricing
• Buyers’ discretion in delaying purchases
• Buyers’ price sensitivity due to low profits, size of purchase, and
consequences of purchase
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Factors Affecting the Bargaining Power of Buyers
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IS THE COLLECTIVE STRENGTH OF THE FIVE
COMPETITIVE FORCES CONDUCIVE TO GOOD
PROFITABILITY?
 Is the state of competition in the industry stronger than normal?
 Can industry firms expect to earn decent profits given prevailing
competitive forces?
 Are some of the competitive forces sufficiently powerful to undermine

industry profitability?
• Even one powerful force may be enough to make the industry

unattractive in terms of its profit potential
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Five forces review
 The strongest of the five forces determines the extent of the downward
pressure on an industry’s profitability.
 Having more than one strong force means that an industry has
multiple competitive challenges with which to cope.
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The sixth force- Complements
• Complementors are the opposite of substitutes in that they increase the

demand or willingness of customer to pay for good or service of the
industry since they sell the complementary/compatible goods or
services to/with the industry’s products. Complementors are producers
of products that enhance the value of the focal firm’s products when
they are used together
• Example: Cars and roads; software applications and microprocessor;…
• Complementors belong to a new category of industry participant.
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MATCHING COMPANY STRATEGY TO
COMPETITIVE CONDITIONS
 Effectively matching a firm’s business strategy to prevailing

competitive conditions has two aspects:
 Pursuing avenues that shield the firm from as many competitive

pressures as possible
 Initiating actions calculated to shift competitive forces in the firm’s

favor by altering underlying factors driving the five forces
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A company’s strategy is increasingly effective the more it provides some

insulation from competitive pressures, shifts the competitive battle in the
company’s favor, and positions firms to take advantage of attractive
growth opportunities.
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Outline

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Industry’s driving forces
Driving forces are the major underlying causes of change in industry and
competitive conditions.
 Driving forces analysis has three steps

• Identifying what the driving forces are
• Assessing whether the drivers of change are, on the whole, acting
to make the industry more or less attractive
• Determining what strategy changes are needed to prepare for the
impact of the driving forces
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THE MOST COMMON DRIVERS OF INDUSTRY
CHANGE
• Changes in the long-term industry growth rate

• Increasing globalization
• Emerging new Internet capabilities and applications
• Shifts in buyer demographics
• Technological change and manufacturing process innovation
• Product and marketing innovation
• Entry or exit of major firms
• Diffusion of technical know-how across companies and countries
• Changes in cost and efficiency
• Reductions in uncertainty and business risk
• Regulatory influences and government policy changes
• Changing societal concerns, attitudes, and lifestyles
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The most important part of driving forces analysis is to determine whether

the collective impact of the driving forces will increase or decrease market
demand, make competition more or less intense, and lead to higher or
lower industry profitability.
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Assessing the impact of factors driving the changes in
an industry
• Are the driving forces, on balance, acting to cause demand for the
industry’s product to increase or decrease?
• Is the collective impact of the driving forces making competition more

or less intense?
• Will the combined impacts of the driving forces lead to higher or lower
industry profitability?
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The real payoff of driving-forces analysis is to help managers understand

what strategy changes are needed to prepare for the impacts of the
driving forces.
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ADJUSTING STRATEGY TO PREPARE FOR THE IMPACTS OF
DRIVING FORCES
 What strategy adjustments will be needed to deal with the

impacts of the driving forces?
• What adjustments must be made immediately?
• What actions currently being taken should be halted or
abandoned?
• What can we do now to prepare for adjustments we anticipate

making in the future?
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Outline

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STRATEGIC GROUP ANALYSIS
 A strategic group is a cluster of industry rivals that have similar

competitive approaches and market positions.
• Having comparable product-line breadth
• Emphasizing the same distribution channels
• Depending on identical technological approaches
• Offering the same product attributes to buyers
• Offering similar services and technical assistance
 Strategic group mapping is a technique for displaying the different
market or competitive positions that rival firms occupy in the industry.
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USING STRATEGIC GROUP MAPS TO ASSESS THE
MARKET POSITIONS OF KEY COMPETITORS
 Constructing a strategic group map

 Identify the competitive characteristics that delineate strategic
approaches used in the industry.
 Plot the firms on a two-variable map using pairs of competitive
characteristics.
 Assign firms occupying about the same map location to the same
strategic group.
 Draw circles around each strategic group, making the circles
proportional to the size of the group’s share of total industry sales
revenues.
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TYPICAL VARIABLES USED IN
CREATING GROUP MAPS
• Price and quality range (high, medium, low)
• Geographic coverage (local, regional, national, global)

• Product-line breadth (wide, narrow)
• Degree of service offered (no frills, limited, full)

• Distribution channels (retail, wholesale, Internet, multiple)
• Degree of vertical integration (none, partial, full)
• Degree of diversification into other industries (none, some,

considerable)
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GUIDELINES FOR CREATING GROUP MAPS
1. Variables selected as map axes should not be highly correlated.

2. Variables should reflect important (sizable) differences among rival
approaches.
3. Variables may be quantitative, continuous, discrete, or defined in
terms of distinct classes and combinations.
4. Drawing group circles proportional to the combined sales of firms in
each group will reflect the relative sizes of each strategic group.
5. Drawing maps using different pairs of variables will show the different
competitive positioning relationships present in the industry’s
structure.
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Comparative Market Positions of Selected Firms in the Casual
Dining Industry: A Strategic Group Map Example
Footnote: Circles are drawn roughly proportional to the sizes of the chains, based on revenues.
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Strategic group maps reveal which firms are close competitors and which
are distant competitors.
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Some strategic groups are more favorably positioned than others

because they confront weaker competitive forces or because they are
more favorably impacted by industry driving forces.
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THE VALUE OF STRATEGIC GROUP MAPS
 Maps are useful in identifying which industry members are close rivals
and which are distant rivals.
 Not all map positions are equally attractive
 Prevailing competitive pressures from the industry’s five forces
may cause the profit potential of different strategic groups to
vary.
 Industry driving forces may favor some strategic groups and
hurt others.
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Outline

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COMPETITOR ANALYSIS
 Competitive intelligence
• Information about rivals that is useful in anticipating their next
strategic moves
 Signals of the likelihood of strategic moves

• Rivals under pressure to improve financial performance
• Rivals seeking to increase market standing
• Public statements of rivals’ intentions
• Profiles developed by competitive intelligence units
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STRATEGIC MANAGEMENT PRINCIPLE (7 or 8)
Studying competitors’ past behavior and preferences provides a valuable

assist in anticipating what moves rivals are likely to make next and
outmaneuvering them in the marketplace.
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A Framework for Competitor Analysis
Jump to Appendix 12 long image description
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A FRAMEWORK FOR COMPETITOR
ANALYSIS
 Indicators of a rival firm’s likely strategic moves and

countermoves
• The rival firm’s current strategy
• The rival firm’s objectives
• The rival firm’s capabilities
• The rival firm’s assumptions about itself and its industry
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USEFUL QUESTIONS TO HELP PREDICT THE LIKELY
ACTIONS OF IMPORTANT RIVALS
• Which competitors’ strategies are achieving good results?

• Which competitors are losing in the marketplace or badly need to
increase unit sales and market share?
• Which rivals are likely make major moves to enter new geographic
markets or to increase sales and market share in a particular
geographic region?
• Which rivals can expand product offerings to enter new product
segments where they do not have a presence?
• Which rivals can be acquired? Which rivals are financially able and
looking to make an acquisition?
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CREATING A STRATEGIC PROFILE OF A RIVAL
COMPETITOR FIRM (1 of 2)
 Current strategy
• How is the competitor positioned in the market?
• What is the basis for its competitive advantage?
• What kinds of investments is it making (as an indicator of its
expected growth trajectory)?
 Objectives
• What are its financial performance objectives?
• What are its strategic objectives?
• How well is it performing in meeting its objectives?
• Is it under pressure to improve its performance?
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CREATING A STRATEGIC PROFILE OF A RIVAL
COMPETITOR FIRM (2 of 2)
 Resources and capabilities

• What is the competitor’s current set of resources and capabilities?
• What weaknesses does it have?
• Which capabilities is it making efforts to obtain?
 Assumptions
• What do the competitor’s top managers believe about their
strategic situation?
• How will their beliefs affect the competitor’s behavior in the market?
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Outline

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KEY SUCCESS FACTORS
 Key success factors (KSFs)

• Are the strategy elements, product and service attributes,
operational approaches, resources, and competitive capabilities
that are necessary for competitive success by any and all firms in
an industry.
• These vary from industry to industry, and over time within the same
industry, and in importance as drivers of change and competitive
conditions change.
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IDENTIFICATION OF KEY
SUCCESS FACTORS
 On what basis do buyers of the industry’s product choose between the

competing brands of sellers? What product attributes and service
characteristics are crucial to competitive success?
 Given the nature of competitive rivalry prevailing in the marketplace,
what resources and competitive capabilities must a firm have to be
competitively successful?
 What shortcomings are almost certain to put a firm at a significant
competitive disadvantage?
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THE INDUSTRY OUTLOOK FOR
PROFITABILITY
 An industry environment is fundamentally attractive if it presents a

company with good opportunity for above-average profitability.
 An industry environment is fundamentally unattractive if a firm’s profit

prospects in the industry are unappealingly low.
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FACTORS TO CONSIDER IN ASSESSING INDUSTRY
ATTRACTIVENESS
 How the firm is impacted by the state of the macro-environment

 Whether strong competitive forces are squeezing industry profitability
to subpar levels
 Whether the presence of complementors and the possibility of
cooperative actions improve the company’s prospects
 Whether industry profitability will be favorably or unfavorably affected
by the prevailing driving forces
 Whether the firm occupies a stronger market position than rivals
 Whether this is likely to change in the course of competitive
interactions
 How well the firm’s strategy delivers on industry key success factors
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The degree to which an industry is attractive or unattractive is not the

same for all industry participants and all potential entrants.
• Industry outsiders may conclude that they have the resources to easily
hurdle the barriers to entering an attractive industry while other
outsiders may find the same industry unattractive because they do not
want to challenge market leaders and have better opportunities
elsewhere.
• A particular industry’s attractiveness depends in large part on whether
a company has the resources and capabilities to be competitively
successful and profitable in that environment.
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WHAT SHOULD A CURRENT COMPETITOR DECIDE
ABOUT ITS INDUSTRY?
 When a competitor decides an industry is attractive, it should invest

aggressively to capture the opportunities it sees and to improve its
long-term competitive position in the business.
 When a strong competitor concludes its industry is relatively

unattractive and lacking in opportunity, it may elect to protect its
present position, investing cautiously if at all and looking for
opportunities in other industries.
 A competitively weak company in an unattractive industry may see its

best option as finding a buyer, perhaps a rival, to acquire its business.
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Outline

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Q&A
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BMGT | Winter semester 2017/18
Lecture 5&6: Evaluating a Company’s Resources,
Capabilities and Competitiveness
Dr. Le Minh Hanh

Outline
1. Current strategy examinaton
2. Resource and capability analysis

3. SWOT analysis
4. Value chain analyis

5. Overall competitiveness
6. Alarming strategic issues and problems
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Outline

3. SWOT analysis

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QUESTION 1: HOW WELL IS THE FIRM’S PRESENT STRATEGY
WORKING?
The three best indicators of how well a company’s strategy is

working are:
1. Whether the company is achieving its stated financial and
strategic objectives
2. Whether its financial performance is above the industry average
3. Whether it is gaining customers and increasing its market share
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SPECIFIC INDICATORS OF STRATEGIC SUCCESS
• Trends in the firm’s sales and earnings growth

• Trends in the firm’s stock price
• The firm’s overall financial strength
• The firm’s customer retention rate
• The rate at which new customers are acquired
• Evidence of improvement in internal processes such as defect rate,
order fulfillment, delivery times, days of inventory, and employee
productivity
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Sluggish financial performance and second-rate market accomplishments

almost always signal weak strategy, weak execution, or both.
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Key Financial Ratios: How to Calculate Them
and What They Mean (1 of 8)
Profitability
How Calculated What It Shows
Ratios
Gross profit margin Sales revenues − Cost of goods sold Shows the percentage of
Sales revenues revenues available to cover
operating expenses and yield a
profit.
Operating profit Sales revenues − Operating expenses Shows the profitability of current
margin (or return on Sales revenues operations without regard to
sales) or interest charges and income
taxes. Earnings before interest
Operating income and taxes is known as EBIT in
Sales revenues financial and business
accounting.
Net profit margin (or Profits after taxes Shows after-tax profits per dollar
net return on sales) Sales revenues of sales.
Total return on Profits after taxes + Interest A measure of the return on total
assets Total assets investment in the enterprise.
Interest is added to after-tax
profits to form the numerator,
7 since total assets are financed
by creditors as well as by
stockholders.
Profitability Ratios How Calculated What It Shows
Net return on total assets Profits after taxes A measure of the return
(ROA) Total assets earned by stockholders on
the firm’s total assets.
Return on stockholders’ Profits after taxes The return stockholders are
equity (ROE) Total stockholders’ equity earning on their capital
investment in the enterprise.
A return in the 12%–15%
range is average.
Return on invested Profits after taxes A measure of the return that
capital (ROIC)— Long-term debt + shareholders are earning on
sometimes referred to as Total stockholders’ equity the monetary capital invested
return on capital in the enterprise. A higher
employed (ROCE) return reflects greater
bottom-line effectiveness in
the use of long-term capital.
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Liquidity Ratios How Calculated What It Shows
Current ratio Current assets Shows a firm’s ability to pay
Current liabilities current liabilities using assets
that can be converted to cash in
the near term. Ratio should be
higher than 1.0.
Working capital Current assets − Current liabilities The cash available for a firm’s
day-to-day operations. Larger
amounts mean the company has
more internal funds to (1) pay its
current liabilities on a timely
basis and (2) finance inventory
expansion, additional accounts
receivable, and a larger base of
operations without resorting to
borrowing or raising more equity
capital.
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Leverage Ratios How Calculated What It Shows
Total debt-to-assets Total debt Measures the extent to which borrowed
ratio Total assets funds (both short-term loans and long-
term debt) have been used to finance the
firm’s operations. A low ratio is better—a
high fraction indicates overuse of debt
and greater risk of bankruptcy.
Long-term debt-to- Long-term debt A measure of creditworthiness and
capital ratio Long-term debt + balance-sheet strength. It indicates the
Total stockholders’ percentage of capital investment that has
equity been financed by both long-term lenders
and stockholders. A ratio below 0.25 is
preferable since the lower the ratio, the
greater the capacity to borrow additional
funds. Debt-to-capital ratios above 0.50
indicate an excessive reliance on long-
term borrowing, lower creditworthiness,
10 and weak balance- sheet strength.
Leverage
How Calculated What It Shows
Ratios
Debt-to-equity ratio Total debt Shows the balance between debt (funds
Total stockholders’ equity borrowed, both short term and long term)
and the amount that stockholders have
invested in the enterprise. The further the
ratio is below 1.0, the greater the firm’s
ability to borrow additional funds. Ratios
above 1.0 put creditors at greater risk,
signal weaker balance sheet strength, and
often result in lower credit ratings.
Long-term debt-to- Long-term debt Shows the balance between long-term debt
equity ratio Total stockholders’ equity and stockholders’ equity in the firm’s long-
term capital structure. Low ratios indicate a
greater capacity to borrow additional funds
if needed.
Times-interest- Operating income Measures the ability to pay annual interest
earned (or Interest expenses charges. Lenders usually insist on a
coverage) ratio minimum ratio of 2.0, but ratios above 3.0
signal progressively better
Activity Ratios How Calculated What It Shows
Days of inventory Inventory Measures inventory management
Cost of goods sold ÷ efficiency. Fewer days of inventory are
365 better.
Inventory turnover Cost of goods sold Measures the number of inventory turns
Inventory per year. Higher is better.
Average collection Accounts receivable Indicates the average length of time the
period Total sales ÷ 365 firm must wait after making a sale to
or receive cash payment. A shorter collection
Accounts receivable time is better.
Average daily sales
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Other Ratios How Calculated What It Shows
Dividend yield Annual dividends A measure of the return that shareholders
on common per share receive in the form of dividends. A “typical”
stock Current market price dividend yield is 2%–3%. The dividend yield
per share for fast-growth companies is often below 1%;
the dividend yield for slow-growth companies
can run 4%–5%.
Price-to- Current market price P/E ratios above 20 indicate strong investor
earnings (P/E) per share confidence in a firm’s outlook and earnings
ratio Earnings per share growth; firms whose future earnings are at
risk or likely to grow slowly typically have
ratios below 12.
Dividend payout Annual dividends Indicates the percentage of after-tax profits
ratio per share paid out as dividends.
Earnings per share
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Key Financial Ratios: How to Calculate Them and
What They Mean (8 of 8)
Other Ratios How Calculated What It Shows

Internal cash flow After-tax profits + A rough estimate of the cash a company’s
Depreciation business is generating after payment of
operating expenses, interest, and taxes. Such
amounts can be used for dividend payments or
funding capital expenditures.
Free cash flow After-tax profits + A rough estimate of the cash a company’s
Depreciation – business is generating after payment of
Capital expenditures – operating expenses, interest, taxes, dividends,
Dividends and desirable reinvestments in the business.
The larger a company’s free cash flow, the
greater its ability to internally fund new
strategic initiatives, repay debt, make new
acquisitions, repurchase shares of stock, or
increase dividend payments.
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Outline

3. SWOT analysis

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QUESTION 2: WHAT ARE THE FIRM’S MOST IMPORTANT RESOURCES
AND CAPABILITIES, AND WILL THEY GIVE THE FIRM A LASTING
COMPETITIVE ADVANTAGE OVER RIVAL COMPANIES?
 Competitive assets
• Are the firm’s resources and capabilities
• Are the determinants of its competitiveness and ability to succeed
in the marketplace
• Are what a firm’s strategy depends on to develop sustainable
competitive advantage over its rivals
 A resource is a productive input or competitive asset that is owned or
controlled by a firm (e.g., a fleet of oil tankers)
 A capability or competence is the capacity of a firm to perform an
internal activity competently through deployment of a firm’s
resources(e.g., superior skills in marketing)
 A resource bundle is a linked and closely integrated set of competitive
assets centered around one or more cross-functional capabilities.
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Resource and capability analysis is a powerful tool for sizing up a firm’s

competitive assets and determining if they can support a sustainable
competitive advantage over market rivals.
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Types of Company Resources (1 of 2)
Tangible resources
• Physical resources: land and real estate; manufacturing plants, equipment, or

distribution facilities; the locations of stores, plants, or distribution centers,
including the overall pattern of their physical locations; ownership of or access
rights to natural resources (such as mineral deposits)
• Financial resources: cash and cash equivalents; marketable securities; other

financial assets such as a company’s credit rating and borrowing capacity
• Technological assets: patents, copyrights, production technology, innovation

technologies, technological processes
• Organizational resources: IT and communication systems (satellites, servers,

workstations, etc.); other planning, coordination, and control systems; the
company’s organizational design and reporting structure
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Types of Resources (2 of 2)
Intangible resources
• Human assets and intellectual capital: the education, experience, knowledge, and
talent of the workforce, cumulative learning, and tacit knowledge of employees; collective
learning embedded in the organization, the intellectual capital and know-how of
specialized teams and work groups; the knowledge of key personnel concerning
important business functions; managerial talent and leadership skill; the creativity and
innovativeness of certain personnel
• Brands, company image, and reputational assets: brand names, trademarks, product
or company image, buyer loyalty and goodwill; company reputation for quality, service,
and reliability; reputation with suppliers and partners for fair dealing
• Relationships: alliances, joint ventures, or partnerships that provide access to

technologies, specialized know-how, or geographic markets; networks of dealers or
distributors; the trust established with various partners
• Company culture and incentive system: the norms of behavior, business principles,
and ingrained beliefs within the company; the attachment of personnel to the company’s
ideals; the compensation system and the motivation level of company personnel
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IDENTIFYING CAPABILITIES
 An organizational capability
• Is the intangible but observable capacity of a firm to perform a
critical activity proficiently using a related combination (cross-
functional bundle) of its resources
• Is knowledge-based, residing in people and in a firm’s intellectual
capital or in its organizational processes and systems, emboding
tacit knowledge
20
VRIN TESTING: RESOURCES AND CAPABILITIES
 Identifying the firm’s resources and capabilities by testing the

competitive power of its resources and capabilities:
• Is the resource (or capability) competitively valuable?
• Is the resource rare—is it something rivals lack?
• Is the resource hard to copy (inimitable)?
• Is the resource invulnerable to the threat of substitution of different
types of resources and capabilities (non-substitutable)?
21
VRIN: FOUR TESTS OF A RESOURCE’S COMPETITIVE
POWER
Support for competitive Support for sustained

advantage? competitive advantage?
Valuable Inimitable
Resource
Rare Nonsubstitutable
22
A firm requires a dynamically evolving portfolio of resources and

capabilities to sustain its competitiveness and help drive improvements in
its performance.
A dynamic capability is the ongoing capacity of a firm to modify its existing

resources and capabilities or create new ones by:
• Improving existing resources and capabilities incrementally
• Adding new resources and capabilities to the firm’s competitive asset
portfolio
23
MANAGING RESOURCES AND CAPABILITIES
DYNAMICALLY
 Threats to resources and capabilities

• Rivals providing better substitutes over time
• Capabilities decaying from benign neglect
• Disruptive competitive environment change
 Manage capabilities dynamically by:
• Attending to the ongoing modification of existing competitive assets
• Taking advantage of any opportunities to develop totally new kinds
of capabilities
24
Outline

3. SWOT analysis

25
QUESTION 3: WHAT ARE THE FIRM’S STRENGTHS
AND WEAKNESSES IN RELATION TO MARKET
OPPORTUNITIES AND EXTERNAL THREATS?
 SWOT Analysis
• Is a powerful tool for sizing up a firm’s:
 Internal strengths (the basis for strategy)
 Internal weaknesses (deficient capabilities)
 Market opportunities (strategic objectives)
 External threats (strategic defenses)
26
Basing a company’s strategy on its most competitively valuable strengths

gives the company its best chance for market success.
27
IDENTIFYING A COMPANY’S INTERNAL STRENGTHS
 A competence:
• Is an activity that a firm has learned to perform with proficiency—a
true capability
 A core competence:
• Is a proficiently performed internal activity that is central to a firm’s
strategy and competitiveness
 A distinctive competence:
• Is a competitively valuable activity that a firm performs better than
its rivals
28
IDENTIFYING A FIRM’S WEAKNESSES AND
COMPETITIVE DEFICIENCIES
 A weakness (competitive deficiency):

• Is something a firm lacks or does poorly (in comparison to others)
or a condition that puts it at a competitive disadvantage in the
marketplace
 Types of weaknesses
• Inferior skills, expertise, or intellectual capital
• Deficiencies in physical, organizational, or intangible assets
• Missing or competitively inferior capabilities in key areas
29
IDENTIFYING A COMPANY’S MARKET
OPPORTUNITIES
 Characteristics of market opportunities:

• An absolute “must pursue” market: Represents much potential but
is hidden in “fog of the future”
• A marginally interesting market: Presents high risk and
questionable profit potential
• An unsuitable or mismatched market: Is best avoided as the firm’s
strengths are not matched to market factors
30
A company is well advised to pass on a particular market opportunity

unless it has or can acquire the competencies needed to capture it.
31
IDENTIFYING THREATS TO A FIRM’S FUTURE
PROFITABILITY
 Types of threats:
• Normal course-of-business threats
• Sudden-death (survival) threats
 Considering threats
• Identify the threats to the firm’s future prospects
• Evaluate what strategic actions can be taken to neutralize or lessen
their impact
32
What to Look for in Identifying a Company’s Strengths,
Weaknesses, Opportunities, and Threats (1 of 4)
Potential Strengths and Competitive Potential Weaknesses and Competitive
Assets Deficiencies
• Competencies that are well matched to • No clear strategic vision
industry key success factors
• Ample financial resources to grow the • No well-developed or proven core
business competencies
• Strong brand-name image or company • No distinctive competencies or competitively
reputation superior resources
• Economies of scale or learning- and • Lack of attention to customer needs
experience-curve advantages over rivals
• Other cost advantages over rivals • A product or service with features and
attributes that are inferior to those of rivals
• Attractive customer base • Weak balance sheet, few financial resources
to grow the firm, too much debt
• Proprietary technology, superior • Higher overall unit costs relative to those of
technological skills, important patents key competitors
33
Potential Strengths and Competitive Potential Weaknesses and Competitive
Assets (continued) Deficiencies (continued)
• Strong bargaining power over • Too narrow a product line relative to
suppliers or buyers rivals
• Resources and capabilities that are • Weak brand image or reputation
valuable and rare
• Resources and capabilities that are • Weaker dealer network than key rivals
hard to copy and for which there are or lack of adequate distribution
no good substitutes capability
• Superior product quality • Lack of management depth
• Wide geographic coverage or strong • A plague of internal operating problems
global distribution capability or obsolete facilities
• Alliances or joint ventures that • Too much underutilized plant capacity
provide access to valuable
technology competencies, or • Resources that are readily copied or
attractive geographic markets for which there are good substitutes
34
Potential External Threats to a
Potential Market Opportunities Company’s Future Profitability
• Meeting sharply rising buy demand for • Increasing intensity of competition
the industry’s product among industry rivals—may
squeeze profit margins
• Serving additional customer groups or • Slowdowns in market growth
market segments
• Expanding into new geographic markets • Likely entry of potent new
competitions
• Expanding the company’s product line to • Growing bargaining power of
meet a broader range of customer needs customers or suppliers
• Utilizing existing company skills or • A shift in buyer needs and tastes
technological know-how to enter new away from the industry’s product
product lines or new businesses
• Adverse demographic changes
that threaten to curtail demand for
the industry’s product
35
Potential External Threats to a
Potential Market Opportunities Company’s Future Profitability
(continued) (continued)
• Taking advantage of failing trade • Adverse economic conditions that
barriers in attractive foreign markets threaten critical suppliers or
distributors
• Acquiring rival firms or companies with • Changes in technology—particularly
attractive technological expertise or disruptive technology that can
capabilities undermine the company’s distinctive
competencies
• Taking advantage of emerging • Restrictive foreign trade policies
technological developments to • Costly new regulatory requirements
innovate • Tight credit conditions
• Entering into alliances or joint ventures • Rising prices on energy or other key
to expand the firm’s market coverage inputs
or boost its competitive capability
36
Simply making lists of a company’s strengths, weaknesses, opportunities,

and threats is not enough. The payoff from SWOT analysis comes from
the conclusions about a company’s situation and the implications for
strategy improvement that flow from the four lists.
37
WHAT DO SWOT LISTINGS REVEAL?
SWOT analysis involves:

• Drawing conclusions from the SWOT listings about the firm’s
overall situation
• Translating these conclusions into strategic actions by the firm that:
 Match its strategy to its internal strengths and to market
opportunities
 Correct important weaknesses and defend it against external
threats
38
The Steps Involved in SWOT Analysis: Identify the Four
Components of SWOT, Draw Conclusions, Translate Implications
into Strategic Actions
39
USING SWOT ANALYSIS
• What are the attractive aspects of the firm’s situation?

• What aspects are of the most concern?
• Are the firm’s internal strengths and competitive assets sufficiently
strong to enable it to compete successfully?
• Are the firm’s weaknesses and competitive deficiencies correctable, or
could they be fatal if not remedied soon?
• Do the firm’s strengths outweigh its weaknesses by an attractive
margin?
• Does the firm have attractive market opportunities that are well suited
to its internal strengths?
• Does the firm lack the competitive assets (internal strengths) to pursue
the most attractive opportunities?
• Where on a scale of 1 to 10 (1 = weak and 10 = strong)
do the firm’s overall situation and future prospects rank?
40
Outline

3. SWOT analysis

41
QUESTION 4: HOW DO A FIRM’S VALUE CHAIN
ACTIVITIES IMPACT ITS COST STRUCTURE AND
CUSTOMER VALUE PROPOSITION?
 Signs of a firm’s competitive strength:

• Its prices and costs are in line with rivals
• Its customer-value proposition is competitive and cost effective
• Its bundled capabilities are yielding a sustainable competitive
advantage
42
The higher a firm’s costs are above those of close rivals, the more
competitively vulnerable it becomes. Conversely, the greater the amount
of customer value that a firm can offer profitably relative to close rivals,
the less competitively vulnerable the firm becomes.
43
THE CONCEPT OF A COMPANY VALUE CHAIN
A company’s value chain identifies the primary activities and related

support activities that create customer value.
• Permits a deep look at the firm’s cost structure and its ability to
profitably offer low prices
• Reveals the emphasis that a firm places on activities that enhance

differentiation and support higher prices
44
A Representative Company Value Chain
45
COMPARING THE VALUE CHAINS OF
RIVAL FIRMS
 Value chain analysis

• Facilitates a comparison, activity-by-activity, of how effectively and
efficiently a firm delivers value to its customers, relative to its
competitors
 The value chain analysis process:
• Segregates the firm’s operations into different types of primary and
secondary activities to identify the major components of its internal
cost structure
• Uses activity-based costing to evaluate the activities
• Does the same for significant competitors
46
VALUE CHAIN SYSTEM FOR AN ENTIRE
INDUSTRY
 Industry value chain

• The firm’s internal value chain
• The value chains of industry suppliers
• The value chains of channel intermediaries
 Effects of the industry value chain
• Costs and margins of suppliers and channel partners can affect
prices to end consumers
• Activities of channel partners can affect industry sales volumes and
customer satisfaction
47
A Representative Value Chain System
48
A firm’s cost competitiveness depends not only on the costs of internally

performed activities (its own value chain) but also on costs in the value
chains of its suppliers and distribution channel allies.
50
USING BENCHMARKING TO ASSESS A FIRM’S VALUE
CHAIN ACTIVITIES
 Benchmarking involves improving a firm’s internal activities based on

learning from other firms’ “best practices”
 Sources of benchmarking information
• Reports, trade groups, analysts, and customers
• Visits to benchmark companies
• Data from consulting firms
51
Benchmarking the costs of a firm's activities against those of rivals

provides hard evidence of whether the firm is cost-competitive.
52
STRATEGIC OPTIONS FOR REMEDYING A COST OR VALUE
DISADVANTAGE
 Areas in the total value chain system for a firm to look for ways to
improve its efficiency and effectiveness:
• The firm’s own internal activity segments
• The suppliers’ part of the value chain system
• The forward channel portion of the value chain system
53
IMPROVING INTERNALLY PERFORMED VALUE CHAIN ACTIVITIES
 Implement best practices throughout the firm, particularly for high-cost

activities.
 Eliminate cost-producing activities altogether by redesigning products
and revamping the internal value chain.
 Relocate high-cost activities to areas where they can be performed
more cheaply.
 Outsource activities that can be performed by vendors or contractors
more cheaply than if done in-house.
 Invest in productivity-enhancing, cost-saving technological
improvements.
 Find ways to detour around activities or items where costs are high.
 Redesign products or components to facilitate speedier and more
economical manufacture or assembly.
54
IMPROVING THE EFFECTIVENESS OF THE CUSTOMER
VALUE PROPOSITION AND ENHANCING DIFFERENTIATION
 Implement best practices for quality of high-value activities.

 Adopt best practices and technologies that spur innovation, improve
design, and enhance creativity.
 Implement the best practices in providing customer service.
 Reallocate resources to activities having the most impact on value for
the customer and their most important purchase criteria.
 For intermediate buyers, gain an understanding of how the activities
the firm performs impact the buyer’s value chain.
 Adopt best practices for marketing, brand management, and
enhancing customer perceptions.
55
IMPROVING SUPPLIER-RELATED VALUE CHAIN
ACTIVITIES
 Pressure suppliers for lower prices.

 Switch to lower-priced substitute inputs.
 Collaborate closely with suppliers to identify mutual cost-saving
opportunities.
 Work with suppliers to enhance the firm’s differentiation.
 Select and retain suppliers who meet higher-quality standards.
 Coordinate with suppliers to enhance design or other features desired
by customers.
 Provide incentives to suppliers to meet higher-quality standards, and
assist suppliers in their efforts to improve.
56
IMPROVING VALUE CHAIN ACTIVITIES OF DISTRIBUTION
PARTNERS
 Achieving cost-based competitiveness

• Pressure forward channel allies to reduce their costs and markups.
• Collaborate with forward channel allies to identify win-win
opportunities to reduce costs.
• Change to a more economical distribution strategy, including
switching to cheaper distribution channels.
57
ENHANCING DIFFERENTIATION THROUGH ACTIVITIES AT THE
FORWARD END OF THE VALUE CHAIN SYSTEM
 Engage in cooperative advertising and promotions with forward

channel allies.
 Use exclusive arrangements with downstream sellers or other
mechanisms that increase their incentives to enhance delivered
customer value.
 Create and enforce standards for downstream activities and assist in
training channel partners in business practices.
58
Performing value chain activities with capabilities that permit the firm to
either outmatch rivals on differentiation or beat them on costs will give the
firm a competitive advantage.
59
OPTION 1 FOR TRANSLATING PROFICIENT PERFORMANCE
OF VALUE CHAIN ACTIVITIES INTO COMPETITIVE
ADVANTAGE
60
OPTION 2 FOR TRANSLATING PROFICIENT PERFORMANCE OF
VALUE CHAIN ACTIVITIES INTO COMPETITIVE ADVANTAGE
61
Outline

3. SWOT analysis

62
QUESTION 5: IS THE FIRM COMPETITIVELY STRONGER OR
WEAKER THAN KEY RIVALS?
 Assessing the firm’s overall competitive strength

• How does the firm rank relative to competitors on each of the
important factors that determine market success?
• Does the firm have a net competitive advantage or disadvantage
versus major competitors?
63
High-weighted competitive strength ratings signal a strong competitive

position and possession of competitive advantage; low ratings signal a
weak position and competitive disadvantage.
64
STEPS IN THE COMPETITIVE STRENGTH
ASSESSMENT PROCESS
1. Make a list of the industry’s key success factors and measures of
competitive strength or weakness.
2. Assign weights to each competitive strength measure based on its
perceived importance.
3. Score competitors on each competitive strength measure and multiply
by each measure by its corresponding weight.
4. Sum the weighted strength ratings on each factor to get an overall
measure of competitive strength for each company.
5. Use overall strength ratings to draw conclusions about the company’s
net competitive advantage or disadvantage and to take specific note
of areas of strength and weakness.
65
A Representative Weighted Competitive Strength
Assessment
Competitive Strength Assessment
(rating scale: 1 = very weak, 10 = very strong)
ABC Co. Rival 1 Rival 2
Key Success Factor/ Importance Strength Weighted Strength Weighted Strength Weighted
Strength Measure Weight Rating Score Rating Score Rating Score
Quality/product performance 0.10 8 0.80 5 0.50 1 0.10
Reputation/image 0.10 8 0.80 7 0.70 1 0.10
Manufacturing capability 0.10 2 0.20 10 1.00 5 0.50
Technological skills 0.05 10 0.50 1 0.05 3 0.15

Dealer network/distribution 0.05 9 0.45 4 0.20 5 0.25
capability
New product innovation capability 0.05 9 0.45 4 0.20 5 0.25
Financial resources 0.10 5 0.50 10 1.00 3 0.30

Relative cost position 0.30 5 1.50 10 3.00 1 0.30
Customer service capabilities 0.15 5 0.75 7 1.05 1 0.15
Sum of importance weights 1.00
Overall weighted competitive strength rating 5.95 7.70 2.10

A company’s competitive strength scores pinpoint its strengths and

weaknesses against rivals and point directly to the kinds of offensive and
defensive actions it can use to exploit its competitive strengths and
reduce its competitive vulnerabilities.
67
STRATEGIC IMPLICATIONS OF COMPETITIVE STRENGTH
ASSESSMENT
• The higher a firm’s overall weighted strength rating, the stronger its
overall competitiveness versus rivals.
• The rating score indicates the total net competitive advantage for a
firm relative to other firms.
• Firms with high competitive strength scores are targets for
benchmarking.
• The ratings show how a firm compares against rivals, factor by factor
(or capability by capability).
• Strength scores can be useful in deciding what strategic moves to
make.
68
Outline

3. SWOT analysis

69
QUESTION 6: WHAT STRATEGIC ISSUES AND PROBLEMS MERIT
FRONT-BURNER MANAGERIAL ATTENTION?
 Strategic priority “how to” issues

• How to meet challenges of new foreign competitors
• How to combat the price discounting of rivals
• How to both reduce high costs and prepare for price reductions
• How to sustain growth as buyer demand slows
• How to adapt to the changing demographics of the firm’s customer
base
70
Compiling a list of problems and roadblocks creates a strategic agenda of

problems that merit prompt managerial attention.
71
QUESTION 6: WHAT STRATEGIC ISSUES AND PROBLEMS MERIT
FRONT-BURNER MANAGERIAL ATTENTION?
 Strategic priority “should we” issues

• Expand rapidly or cautiously into foreign markets?
• Reposition the firm to move to a different strategic group?
• Counter increasing buyer interest in substitute products?
• Expand the firm’s product line?
• Correct the firm’s competitive deficiencies by acquiring a rival firm
with the missing strengths?
72
A good strategy must contain ways to deal with all the strategic issues
and obstacles that stand in the way of the company’s financial and
competitive success in the years ahead.
73
Outline

3. SWOT analysis

Q&A
74
BMGT – Management
Lecture 8&9: Strategies at business unit level
Dr. Le Minh Hanh | Winter semester 2017/18

Part 1: The five generic competitive strategy model by Michael Poter (1980)
(based on competitive advantage and market target)
Outline
1. An overview of business-level strategy
2. Broad low-cost provider strategy
3. Broad differentiation strategy
4. Best-cost provider strategy
5. Focused strategy
3
Outline
5. Focused strategy
4
Strategic business unit
 A strategic business unit (SBU) is a part of an organization for which there is a distinct
external market for goods or services that is different from another SBU.
 Criteria for SBU’s categorizing:
• Market-based criteria, i.e., customer types, channels, competitors, locations…
• Capabilities-based criteria
 Business strategy refers the way a strategic business unit competes in defined product market.
5
Business competitive advantage
 Competitive strategy is concerned with the basis on which a business unit might achieve
competitive advantage in its market
 Competitive advantage exists when a firm’s strategy gives it an edge in
• Attracting customers and
• Defending against competitive forces
 To convince the customers, a firm’s product / service offers superior value:
• A good product at a low price
• A superior product worth paying more for
• A best-value product
6
The Five Generic Competitive Strategies by Porter (1980)
WHY DO STRATEGIES DIFFER?
A firm’s competitive strategy deals exclusively with the specifics of its efforts to position itself in the
market-place, please customers, ward off competitive threats, and achieve a particular kind of
competitive advantage.
Is the firm’s market target

broad or narrow?
Key factors that
distinguish one strategy
from another
Is the competitive advantage
pursued linked to low costs
or product differentiation?
Outline
5. Focused strategy
9
Low-cost provider strategy
 A low-cost provider strategy strives to achieve lower overall costs than rivals and appealing to a
broad spectrum of price-sensitive customers, usually by under-pricing rivals.
 Targets of low-cost providers:
• Make achievement of meaningful lower costs than rivals
• Include features and services in product offering that buyers consider essential
• Find approaches to achieve a cost advantage in ways difficult for rivals to copy or match
 Options for low-cost providers:
• Under-price rivals and reap market share gains (price cut must be lower than cost advantage or
added gains in unit sales are large enough to bring in a bigger total profit despite lower margins
per unit sols) or
• Earn higher profit margin when selling at going price by using the lower-cost edge
10
Approaches to securing a cost advantage
1.Perform value chain activities more cost effectively than the rivals
2.Revamp value chain to bypass cost-producing activities that add little value from the buyer’s
perspective
11
Control cost drivers of value chain activities
• Capture all scale economies; avoid scale diseconomies

• Capture learning and experience curve effects
• Try to operate facilities at full capacity
• Spread cost by boosting sales volumes
• Improve supply chain efficiency
• Substitute the use of low-cost for high-cost materials.
• Apply on-line systems and sophisticated software and adopt labor-saving method to achieve
operating efficiency
• Consider the cost advantages of vertical integration and outsourcing
• Assess first-mover advantages vs. disadvantages
12
Revamp the value chain
• Bypass the activities and costs of distributors and dealers by selling direct to customers with
direct sales force or on-line selling using the company’s homepage
• Replacing certain value chain activities with faster and cheaper online technology
• Offer basic, no-frills product/service
• Offer limited product line
• Eliminate the low-value-added or unnecessary work steps and activities
• Find ways to bypass use of high-cost raw materials
• Relocate facilities closer to suppliers or customers
13
Example: Software Industry
A. Value Chain System of Software Developers

Using Traditional Wholesale-Retail Channels - Highest Cost
Software CD-ROM Warehousing and

Marketing and
development production and shipping of
promotion of
activities packaging wholesaler-retailer
software
activities orders
Activities of
Technical support Activities of wholesale
activities software retailers distributors of
software products
14
Example: Software Industry
B. Value Chain System of Software Developers
Using Direct Sales and Physical Delivery of CDs
CD-ROM Direct and Technical

Software Ware-housing
production and online marketing support and
development and shipping of
packaging and promotion customer
activities customer orders
activities activities service activities
C. Value Chain System of Software Developers

Using Online Sales and Internet Delivery - Lowest Cost
Systems to
accept credit Technical
Software
Online marketing card payment support and
development and allow
and promotion customer service
activities immediate
activities activities
download
15
Keys to success in achieving low-cost leadership
• Scrutinize each cost-creating activity and determine the cost drivers

• Use knowledge about cost drivers to manage costs of each activity down year after year
• Find ways to restructure value chain to eliminate nonessential work steps and low-value activities
• Work diligently to create cost-conscious corporate cultures via…
… featuring broad employee participation in continuous cost-improvement efforts and limited perks
for executives
… striving to operate with exceptionally small corporate staffs
• Aggressively pursue investments in resources and capabilities that promise to drive costs out of
the business
16
When does a low-cost provider strategy work best?
• Price competition is vigorous
• Product is standardized or readily available from many suppliers

• There are few ways to achieve differentiation that have value to buyers
• Most buyers use product in the same way

• Buyers incur low switching costs
• Buyers are large and have significant bargaining power

• Industry newcomers use introductory low prices to attract buyers and build customer base
17
Pitfalls of low-cost provider strategy
• Being overly aggressive in cutting price.
• Low cost methods are easily imitated by rivals

• Becoming too fixated on reducing costs and ignoring…
… buyer interest in additional features
… declining buyer sensitivity to price
… changes in how the product is used
• Technological breakthroughs open up cost reductions for rivals
18
Outline
5. Focused strategy
19
Broad differentiation strategy
 Broad differentiation strategy seeks to provide products or services that offer benefits that are
different from those of competitors and that are widely valued by buyers.
 Objective: Incorporate differentiating features that cause buyers to prefer firm’s product or
service over brands of rivals
 Keys to success:
 Find ways to differentiate that create value for strategic customers and are not easily matched
or cheaply copied by key rivals
 Not spending more to achieve differentiation than the price premium that can be charged and
being alert about the price-based competition vulnerability.
 Benefits of a successful differentiation strategy
 Command a premium price and/or
 Increase unit sales and/or
 Build brand loyalty
20
Approaches to differentiation
 Most appealing approaches to differentiation

• Those which are hardest for rivals to match or imitate
• Those which buyers will find most appealing
 Best choices for gaining a longer-lasting, more profitable competitive edge
• New product innovation
• Technical superiority
• Product quality and reliability
• Comprehensive customer service
• Unique competitive capabilities
21
Differentiation opportunities along the value chain
 Supply chain activities, i.e., Starbucks with strict specifications on coffee beans
 Product R&D and product design activities, i.e., expanding uses and applications, widening
the product variety and selection, adding user safety, enhancing environmental protection…
 Production process / technology-related activities, i.e., applying production methods safer

for environment, improving product quality, reliability and appearance, reducing defects…
 Distribution-related activities, i.e., having quicker delivery, fewer warehouse, more accurate
order filling…
 Marketing, sales, and customer service activities, i.e., offering superior technical assistance,
faster maintenance, more and better product information …
22
Approaches to secure differentiation-based competitive advantage
• Incorporate product features/attributes that lower buyer’s overall costs of using product by
reducing buyer’s raw material waste, reducing buyer’s inventory requirements, increasing
maintenance intervals and product reliability so as to lower buyer’s fix and maintenance cost,
using online selling system…
• Incorporate features/attributes that raise the product performance with greater reliability,
durability, convenience and ease of use.
• Incorporate features/attributes that enhance buyer satisfaction in non-economic or intangible

ways with brand reputation, environmental consciousness, ..
• Compete on the basis of superior competences and capabilities that rivals do not have or
cannot afford to match
23
Delivered value and perceived value
 Buyers seldom pay for the value they do not perceive. Price premium commanded by a
differentiation strategy reflects both the actually delivered value and perceived value.
 Incomplete knowledge of buyers causes them to judge value based on such signals as
• Price
 Attractive packaging
 Extensive advertising campaigns
 Advertisement content and image
 Quality of brochures and sales presentations
 Characteristics of seller
 Such signals of value may be as important as actual value when
 Nature of differentiation is subjectively hard to quantify
 Buyers are making first-time purchases
 Repurchase is infrequent
 Buyers are unsophisticated
24
When does a differentiation strategy work best?
• Buyer’s needs and uses of the product are diverse
• There exist many ways to differentiate a product that are valued by many people
• Few rivals are following a similar differentiation approach
• Technological change and product innovation are fast-paced
25
Pitfalls of a differentiation strategy
• Appealing product features are easily copied by rivals
• Buyers see little value in unique attributes of product
• Overspending on efforts to differentiate the product offering, thus eroding profitability
• Over-differentiating so that product features exceed buyers’ needs
• Charging a too high price premium
• Not striving to open up meaningful gaps in quality, service, or performance features vis-à-vis
rivals’ products
26
Competitive strategy principle
A low-cost producer strategy can defeat a differentiation strategy when buyers are satisfied with a
standard product and do not see extra attributes as worth paying additional money to obtain!
27
Outline
5. Focused strategy
28
Best-cost provider strategy
 Combine a strategic emphasis on low-cost with a strategic emphasis on differentiation. The
strategy follower is the low-cost provider of an upscale product.
 Best-cost strategy aims at giving customer more value for the money by incorporating attractive
or upscale attributes to the products at a lower cost than rivals. Hence, the target market for a
best-cost provider is value-conscious buyers (not budget-conscious buyers).
29
Approaches to best-cost provider strategy
• Incorporate attractive features at a lower cost than rivals whose product have similar features
• Manufacture a product of good-to-excellent quality at a lower cost than rivals
• Develop a product that delivers good-to-excellent performance at a lower cost than rivals
• Provide attractive customer service at a lower cost than rivals who provide comparably attractive
customer service
30
Competitive strength of a best-cost provider
 A best-cost provider’s competitive advantage comes from matching close rivals on key
product attributes and beating them on price
 A best-cost producer can often out-compete both a low-cost provider and a differentiator when
• Standardized features/attributes cannot meet diverse needs of buyers
• Many buyers are price and value sensitive
31
When does a best-cost provider strategy work best?
• Much greater volumes can be achieved than rivals so that profit margin may still be better
• Cost reduction opportunities are available outside its differentiated activities
• Best-cost provided strategy can be used as an entry strategy in a market with established
competitors
32
Risk of a best-cost provider strategy
 A best-cost provider may be defeated by…
… low-cost leaders who may be able to take customers away with a lower price
… high-end differentiators who may be able to steal customers away with better product attributes
 In order to be successful, a best-cost provider must…

… either offer significantly better product attributes in order to justify a price above what the low-
cost providers are charging
… or achieve significantly lower cost in providing upscale features to out-compete the high-end
differentiators
33
Outline
5. Focused strategy
34
Focused strategy
 Focused (or market niche) strategy involves concentrated attention on a narrow piece of the
whole market.
 The target segment can be defined by…
… geographic uniqueness
… specialized requirements in using the products
… special products attributes that appeal to a selected segment
 Keys to success:
• Choose a market niche where buyers have distinctive preferences, special requirements, or
unique needs
• Develop unique capabilities to serve needs of target buyer segment
 Approaches to focused strategy
1. Achieve lower costs than rivals in serving the segment  A low-cost strategy
2. Offer niche buyers something different from rivals A differentiation strategy
35
When is a focused strategy attractive?
• The target market niche is big enough to be profitable and offers good growth potential
• The market niche is not crucial to success of industry leaders
• It is costly or difficult for multi-segment competitors to meet specialized needs of niche members
• The industry has many different segments, thereby allowing a focuser to pick a competitively
attractive niche suited to its resource strengths and capabilities
• Few other rivals are specializing in same niche

• Focuser can defend against challengers via superior ability to serve niche members
36
Risks of a focused strategy
• Competitors find effective ways to match a focuser’s capabilities in serving niche
• Niche buyers’ preferences shift towards product attributes desired by majority of buyers – niche
becomes part of overall market
• Segment becomes so attractive it becomes crowded with rivals, causing segment profits to be
splintered
37
Distinguishing Features of the Five Generic Competitive Strategies (1 of 2)
Focused low-cost
Low-Cost Provider Broad Differentiation provider Focused differentiation Best-Cost Provider
Strategic A broad cross-section of A broad cross-section of A narrow market niche A narrow market niche Value-conscious buyers.
target the market the market where buyer needs and where buyer needs and Or, a middle-market range
preferences are distinctively preferences are
different distinctively different
Basis of Lower overall costs than Ability to offer buyers Lower overall cost than Attributes that appeal Ability to offer better goods
competitive competitors something attractively rivals in serving niche specifically to niche at attractive prices
strategy different from members members
competitors’ offerings
Product line A good basic product Many product variations, Features and attributes Features and attributes Items with appealing
with few frills wide selection, emphasis tailored to the tastes and tailored to the tastes and attributes and assorted
(acceptable quality and on differentiating features requirements of niche requirements of niche features; better quality, not
limited selection) members members best
Production A continuous search for Build in whatever A continuous search for cost Small-scale production or Build in appealing features
emphasis cost reduction without differentiating features reduction for products that custom-made products and better quality at lower
sacrificing acceptable buyers are willing to pay meet basic needs of niche that match the tastes and cost than rivals
quality and essential for; strive for product members requirements of niche
features superiority members
Distinguishing Features of the Five Generic Competitive Strategies (2 of 2)
Low-Cost Provider Broad Differentiation Focused low-cost provider Focused differentiation Best-Cost Provider
Marketing Low prices, good value Tout differentiating features. Communicate attractive Communicate how product Emphasize delivery of
emphasis Also, try to make a virtue out Also, charge a premium features of a budget-priced offering does the best job of best value for the money
of product features that lead price to cover the extra product offering that fits niche meeting niche buyers’
to low cost costs of differentiating buyers’ expectations expectations
features
Keys to Economical prices, good Stress constant innovation Stay committed to serving the Stay committed to serving the Unique expertise in
maintaining the value to stay ahead of imitative niche at the lowest overall cost; niche better than rivals; don’t simultaneously managing
strategy Also, strive to manage costs competitors don’t blur the firm’s image by blur the firm’s image by costs down while
down, year after year, in Also, concentrate on a few entering other market segments entering other market incorporating upscale
every area of the business key differentiating features. or adding other products to segments or adding other features and attributes
widen market appeal products to widen market
appeal.
Resources and Capabilities for driving costs Capabilities concerning Capabilities to lower costs on Capabilities to meet the highly Capabilities to
capabilities out of the value chain syste. quality, design, intangibles, niche goods Examples: Lower specific needs of niche simultaneously deliver
required Examples: large-scale and innovation Examples: input costs for the specific members lower cost and higher-
automated plants, an marketing capabilities, R&D product desired by the niche, Examples: custom production, quality or differentiated
efficiency-oriented culture, teams, technology batch production capabilities close customer relations. feature
bargaining power Examples: TQM
practices, mass
customization
SUCCESSFUL COMPETITIVE STRATEGIES ARE RESOURCE-BASED
 A firm’s competitive strategy is most likely to succeed if it is predicated on leveraging a

competitively valuable collection of resources and capabilities that match the strategy.
 Sustaining a firm’s competitive advantage depends on its resources, capabilities, and
competences that are difficult for rivals to duplicate and have no good substitutes.
 A company’s competitive strategy should be well-matched to its internal situation and predicated
on leveraging its collection of competitively valuable resources and capabilities.
Outline
3. Broad differentiation strategy Q&A

5. Focused strategy
41
BMGT – Management
Lecture 10&11: Strategies at corporate level

Outline
1. An overview of corporate-level strategy and corporate rationales
2. Diversification strategy
- Diversification strategy analysis
- Related diversification
- Unrelated diversification
- Evaluation of a diversified strategy
2
Outline
1. An overview of corporate-level strategy
3
Corporate-level strategy
Corporate strategy is the way a company creates value through the configuration and
coordination of its multimarket activities (Collis and Montgomery, 2005).
 Value creation: The ultimate purpose of corporate strategy is to add value to that created by its
business units
 Configuration: The strategy scope is multimarket focus regarding product, geographic and
vertical boundaries.
 Coordination: Emphasis is put on how the firm manages the activities and businesses that lie
within the corporate hierarchy
4
Corporate rationales
Portfolio managers Synergy managers Parental developers
Logic Agent for financial markets Synergy Competences used to create value in
Limited SBU value creation SBUs
Strategic Acquire assets Share resources/skills SBUs below potential (‘parenting

requirements Divest assets Identify bases for sharing opportunity’)
Low strategic role in SBU Identify benefits Relevant central resources
Suitable portfolio
Organisational Autonomous SBUs CollaborativeSBUs Understand SBUs (‘feel’)

requirements Small, low cost corporate staff Corporate staff as integrators Effective linkages
SBU performance-based Overcome resistance to sharing SBUs autonomous

incentives Corporate-based incentives SBU performance-based incentives
5
Value adding potential of corporate rationales
Source of image: Johnson et al. (2008)
6
Value creation and the corporate parent: Value-adding
Envisioning Strategic Intent Central Services and Resources

Focus Investment
Clarity to external stakeholders Scale advantages
Clarity to business units Transferable management capabilities
Provide expertise/services
Knowledge creation/sharing
Leverage
Brokering linkages/accessing external networks
Intervention at Business Level Coaching and Facilitating
Monitor performance Develop strategic capabilities
Action to improve performance Achieve synergies
Challenge/develop strategic ambitions
7
Value creation and the corporate parent: Value-destroying
• Adding management cost
• Adding bureaucratic complexity
• Obscuring financial performance
8
Strategic management control system for corporate - level strategy
Single industry Related diversified Unrelated diversified
Strategic planning Vertical - cum-Horizontal Vertical only
Budgeting: Low High

Relative control of SBU manager over
budget formulation
Importance attached to meeting the budget Low High
Transfer pricing importance High Low

Transfer sourcing flexibility Constrained Arm’s –length market pricing
Reward criteria Financial and non-financial Primarily financial
Reward approach Subjective Formula-based

Reward basis Both Corporate and SBU Primarily SBU performance
performance
Source: Anthony and Govindarajan (2007)
9
Outline
10
Strategic moves at corporate level – decisions about scope of operationas
• Sticking closely with the existing business lineup and pursuing opportunities presented by these
businesses
• Broadening the current scope of diversification by entering additional industries
• Retrenching to a narrower scope of diversification by divesting poorly performing businesses
• Broadly restructuring the entire firm by divesting some businesses and acquiring others to put a
whole new face on the firm’s business lineup
11
Signals for diversification
 A firm should consider diversifying when:
• Growth opportunities are limited as its principal markets reach their maturity and buyer
demand is either stagnating or set to decline.
• Changing industry conditions—new technologies, inroads being made by substitute

products, fast-shifting buyer preferences, or intensifying competition—are undermining the
firm’s competitive position.
12
What to expect from diversification?
1. Expand into businesses whose technologies and products complement present

business(es).
2. Employ current resources and capabilities as valuable competitive assets in other

businesses.
3. Reduce overall internal costs by cross-business sharing or transfers of resources and

capabilities.
4. Extend a strong brand name to the products of other acquired businesses to help drive up
sales and profits of those businesses.
13
Three Strategy Options for Pursuing Diversification
14
Portfolios of related and unrelated businesses
 Dominant-business enterprises: Have a major “core” firm that accounts for 50 to 80% of total
revenues and a collection of small related or unrelated firms that accounts for the remainder
 Narrowly diversified firms: Are comprised of a few related or unrelated businesses
 Broadly diversified firms: Have a wide-ranging collection of related businesses, unrelated
businesses, or a mixture of both
 Multibusiness enterprises: Have a business portfolio consisting of several unrelated groups of
related businesses
15
Tests for diversification strategies
Testing Whether Diversification

Will Add Long-Term Value
for Shareholders
The industry The The

attractiveness cost-of-entry better-off
test test test
16
Means for diversification
1. Merger and Acquisition

2. Internal start-up
3. Joint-ventures / Strategic partnerships
 Which mode of market entry to choose depends on:
- Required resources and capabilities
- Entry barriers
- Entry speed
- Comparative costs
17
Diversification paths
Which Diversification
Path to Pursue?
Related Both Related

Unrelated Businesses
Businesses and Unrelated Businesses
18
Related diversification vs. Unrelated diversification
 Related businesses possess competitively valuable cross-business value chain and resource
matchups.
 Unrelated businesses have dissimilar value chains and resource requirements, with no
competitively important cross-business relationships at the value chain level.
 Generalized resources and capabilities:

 Can be deployed widely across a broad range of industry and business types
 Can be leveraged in both unrelated and related diversification situations
 Specialized resources and capabilities:

 Have very specific applications which restrict their use to a narrow range of industry and
business types
 Can typically be leveraged only in related diversification situations
19
Outline
20
Related diversification
Attractiveness of related diversification: Enhance shareholder value by capturing cross-

business strategic fit opportunities including:
 Transferring specialized expertise, technological know-how, or other resources and
capabilities from one business’s value chain to another’s
 Sharing costs by combining related value chain activities into a single operation
 Exploiting common use of a well-known brand name
 Sharing other resources (besides brands) that support corresponding value chain activities
across businesses
 Engaging in cross-business collaboration and knowledge sharing to create new
competitively valuable resources and capabilities
Drawbacks of related diversification:
 Underestimating new capabilities required and overestimating synergies
 Corporate level time and cost
 Business unit complexity
21
Strategic fit opportunities along the value chain

Economies of scope
Using Economies of Scope to Convert

Strategic Fit into Competitive Advantage
Leveraging
Transferring Combining related Using cross-business
brand names
specialized and value chain activities collaboration
and other
generalized skills or to achieve and knowledge
differentiation
knowledge lower costs sharing
resources
Benefits of strategic fit
Capturing the Cross-Business Strategic-Fit

Benefits of Related Diversification
Only possible Yields value in the Requires that

Builds more
via a strategy application management
shareholder value
of related of specialized take internal actions
than owning a stock
diversification resources and to
portfolio
capabilities realize them
Outline
25
Unrelated diversification
Can it meet corporate targets

for profitability and return on investment?
Evaluating the acquisition

of a new business or the Is it in an industry with attractive profit and growth
divestiture of an existing potentials?
business
Is it is big enough to contribute significantly to the

parent firm’s bottom line?
26
Benefits of unrelated diversification
Using an Unrelated Diversification

Strategy to Build Shareholder Value
Cross-business allocation of
Astute corporate Acquiring and restructuring
financial
parenting by management undervalued companies
resources
27
How to capture the benefits from unrelated diversification?
The attractiveness test Diversify into businesses that can produce

consistently good earnings and returns on
investment
Actions taken by upper

management to create value and The cost-of-entry test Negotiate favorable
gain a acquisition prices
parenting advantage
Provide managerial oversight and resource

The better-off test sharing, financial resource allocation and portfolio
management,
and restructure underperforming businesses
description
28
Drawbacks of unrelated diversification
Pursuing an
Demanding
Unrelated Limited Competitive
Managerial
Diversification Advantage Potential
Requirements
Strategy
Monitoring and Potential lack of

maintaining cross-business
the parenting strategic-fit
advantage benefits
29
Poor rationales for unrelated diversifications
Poor Rationales for

Unrelated Diversification
Seeking a reduction Pursuing rapid Seeking stabilization

Pursuing personal
of business or continuous growth to avoid cyclical
managerial motives
investment risk for its own sake swings in businesses
30
Outline
31
Evaluating a diversification strategy
1. Assess the attractiveness of the industries the firm has diversified into, both individually and as
a group
2. Assess the competitive strength of the firm’s business units within their respective industries
3. Evaluate the extent of cross-business strategic fit along the value chains of the firm’s various
business units
4. Check whether the firm’s resources fit the requirements of its present business lineup
5. Rank the performance prospects of the businesses from best to worst and determine resource
allocation priorities
6. Craft strategic moves to improve corporate performance

32
STEP 1: EVALUATING INDUSTRY ATTRACTIVENESS
How attractive are

the industries in which
the firm has business operations?
1. Does each industry represent a good market for the firm

to be in?
2. Which industries are most attractive, and which are least

attractive?
3. How appealing is the whole group of industries?

33
Key measures of industry attractiveness
 Market size and projected growth rate

 The intensity of competition among market rivals
 Emerging opportunities and threats
 The presence of cross-industry strategic fit
 Resource requirements
 Social, political, regulatory, environmental factors
 Industry profitability
34
Multi-business perspective
How well do the industry’s value chain and resource requirements

The question of cross-
match up with the value chain activities of other industries in which
industry strategic fit
the firm has operations?
The question of resource Do the resource requirements for an industry match those of the
requirements parent firm or are they otherwise within the company’s reach?
35
An illustration
Remember: The more intensely competitive an industry is, the lower the attractiveness rating for that industry!
36
STEP 2: EVALUATING BUSINESS-UNIT COMPETITIVE STRENGTH
• Relative market share

• Costs relative to competitors’ costs
• Ability to match or beat rivals on key product attributes
• Brand image and reputation
• Other competitively valuable resources and capabilities
• Benefits from strategic fit with firm’s other businesses
• Bargaining leverage with key suppliers or customers
• Profitability relative to competitors
37
An illustration
38
A Nine-Cell Industry Attractiveness–Competitive Strength Matrix
39
STEP 3: DETERMINING THE COMPETITIVE VALUE OF STRATEGIC FIT IN
DIVERSIFIED COMPANIES
• Assessing the degree of strategic fit across its businesses is central to evaluating a company’s
related diversification strategy.
• The real test of a diversification strategy is what degree of competitive value can be generated
from strategic fit.
• The greater the value of cross-business strategic fit in enhancing a firm’s performance in the
marketplace or on the bottom line, the more competitively powerful is its strategy of related
diversification.
40
Identifying the Competitive Advantage Potential of
Cross-Business Strategic Fit
41
STEP 4: CHECKING FOR RESOURCE FIT
• A company pursuing related diversification exhibits resource fit when its businesses have
matching specialized resource requirements along their value chains.
• A company pursuing unrelated diversification has resource fit when the parent company has
adequate corporate resources (parenting and general resources) to support its businesses’
needs and to add value.
42
STEP 4: CHECKING FOR RESOURCE FIT
 Financial resource fit

• A strong internal capital market allows a diversified firm to add value by shifting capital from
business units generating free cash flow to those needing additional capital to expand and
realize their growth potential.
• A portfolio approach ensures financial fit among a firm’s businesses is based on the fact that
different businesses have different cash flow and investment characteristics.
 Cash hogs need cash to develop.
 Cash cows generate excess cash.
 Star businesses are self-supporting.
 Nonfinancial resource fit

• Does the firm have (or can it develop) the specific resources and capabilities needed to be
successful in each of its businesses?
• Are the firm’s resources being stretched too thin by the resource requirements of one or more of
its businesses
43
STEP 5: RANKING BUSINESS UNITS AND ASSIGNING A PRIORITY
FOR RESOURCE ALLOCATION
 Ranking factors
 Industry attractiveness
 SBU’s competitive strength
 Strategic fit
 Resource fit
 Cash flow
 Steer resources to business units with the brightest profit and growth prospects and solid
strategic and resource fit
44
Options for Allocating Resources
 Strategic view
• Invest to strengthen or grow existing business
• Make acquisitions to establish positions in new industries or to complement existing
businesses
• Fund long-range R&D ventures aimed at opening market opportunities in new or existing
businesses
 Financial view
• Pay off existing long-term or short-term debt
• Increase dividend payments to shareholders
• Repurchase shares of the company’s common stock
• Build cash reserves; invest in short-term securities
45
STEP 6: CRAFTING NEW STRATEGIC MOVES TO IMPROVE OVERALL
CORPORATE PERFORMANCE
Strategy Options for a Firm

That Is Already Diversified
Restructure through
Stick with Broaden the Divest and retrench to
divestitures
the existing business diversification base a narrower
and
lineup with new acquisitions diversification base
acquisitions
46
When to stick with the existing business line-up?
This strategy makes sense when the current business lineup offers attractive growth
opportunities and can generate added economic value for shareholders.
47
When to broaden the diversification base?
 Factors motivating the addition of businesses
• The transfer of resources and capabilities to related or complementary businesses
• Rapidly changing technology, legislation, or new product innovations in core businesses
• Shoring up the market position and competitive capabilities of the firm’s present businesses
• Extension of the scope of the firm’s operations into additional country markets
48
When to divest some businesses?
 Factors motivating business divestitures

• Long-term performance can be improved by concentrating on stronger positions in fewer
core businesses and industries.
• Business is in a once-attractive industry where market conditions have badly deteriorated

• Business has either failed to perform as expected or is lacking in cultural, strategic, or
resource fit.
• Business has become more valuable if sold to another firm or as an independent spin-off
firm which is an independent company created when a corporate parent divests a business
either by selling shares to the public via an initial public offering or by distributing shares in
the new company to shareholders of the corporate parent.
49
When to restructure the diversification base?
 Factors leading to corporate restructuring

• A serious mismatch between the firm’s resources and capabilities and the type of
diversification that it has pursued
• Too many businesses in slow-growth, declining, low-margin, or otherwise unattractive

industries
• Too many competitively weak businesses

• Ongoing declines in the market shares of major business units that are falling prey to more
market-savvy competitors
• An excessive debt burden with interest costs that eat deeply into profitability
• Ill-chosen acquisitions that haven’t lived up to expectations
50
Outline
- Diversification strategy analysis Q&A

51
Signals for diversification
A firm should consider diversifying when:
1. Growth opportunities are limited as its principal markets reach their maturity and buyer
demand is either stagnating or set to decline.
2. Changing industry conditions—new technologies, inroads being made by substitute
products, fast-shifting buyer preferences, or intensifying competition—are undermining the
firm’s competitive position.

BMGT – Management
Lecture 14: Incentive compensation and Performance evaluation

Outline
• Basic incentive problem and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods
2
Outline

3
Incentive program at Du Pont
• In 1988 Du Pont`s fibers division introduced for each employee a so

called „risk pool“.
• Idea: Employees place 6% of annual pay to the pool. If the business

exceeded its profit goals for the year, the employees would receive a
multiple of the at-risk amount. If not, the employees would loose the
money.
• In 1990 the program was cancelled.

• Reason: Decreasing profits due to exogenous factors that could not be
influenced by employees (car market, oil price).
4
Incentive Compensation Program at Safelite
• Biggest wind shield installer in the US.

• In 1994 the CEO introduced a piece rate at Safelite (before, fixed
hourly wage): Employees receive a wage according to the amount
of installed wind shields ( $ 20 per piece).
• Workers are also guaranteed to receive a fixed wage of $ 11 per
hour.
• Result: Performance increases on average by 44%.
• Roughly half of the increased performance is explained by
stronger incentives within the company (overcoming moral
hazard).
• The other part: better employees are attracted by the company
(overcoming adverse selection).
• Detailed analysis by Edward Lazear: „Performance Pay and
Productivity,“ American Economic Review 90, 2000, 1346-1361.
5
Basic incentive problem
• You are the owner of a company with one employee (Erwin).

• The firm`s benefit from Erwin´s effort e is
B = 100e
• Erwin`s costs of effort are
C = e2
• Erwin`s utility function with respect to income I is
U = I – e2
• Erwin's reservation utility is 1000 dollars, then the wage the firm
should pay him is: $1000 + e2
6
Verifiable effort
• Assume you can observe Erwin`s effort and you can verify it in
court.
• Question:
- Which effort should you provide in the contract?
- How should you pay Erwin?
• Because of the outside option you have to pay Erwin at least

1000 + e2
• An incentive compensation is not necessary, because you can
compensate directly for the effort or effort is contractible. That
means Erwin receives a fixed payment of 1000 + e2
7
Optimal effort
costs/
benefits of effort
benefits
100e
5000
profit costs of effort
3500 1000 + e2
wage
1000
e*= 50 e
8
Unverifiable effort
• Assume that you can not verify the effort but you pay a fixed salary
(contractually binding) of 3500.
• Is Erwin motivated to choose e* = 50 ?
• …
Result
• The reason for the incentive problem is the conflict of interest
between principal and agent.
• There is no problem if effort were contractible (observable and
verifiable).
• The optimal effort is computed by equalizing the marginal benefits
and marginal costs of work.
9
The role of ownership
• You sell the company to Erwin for 1500 Euro.

• Does Erwin have an incentive to exert optimal effortl?
• Erwin`s utility
U = (100e – 1500) – e2
 Erwins optimal effort = 50.
Result
• Ownership is the solution for the incentive problem.
• The transfer of ownership is, however, only in part possible or
desirable (reason: wealth constraints, team production, risk
aversion).
10
Outline

11
Incentive compensation
• Assume the output of Erwin´s work is

Q = 100e + μ
where μ is a random variable with the expected value 0 and
variance σ2.
• The output is observable and verifiable but the effort and
uncertainty are not.
• You provide the following incentive contract to Erwin
W + βQ = W + β(100e + μ)
with the fixed wage W and a proportion β (0 ≤ β ≤ 1) of the output.
12
Graphical illustration:
W = 1000, β = 0.2
costs/
benefits
costs e2
expected compensation:
1000 + 20e
1200
1000
e*= 10 e
13
W = 2000, β = 0.2
costs/ expected compensation:

benefits 2000 + 20e
costs e2
2000
1000
e*= 10 e
14
W = 1000, β = 0.3
costs/
benefits expected compensation:
costs e2 1000 + 30e
1000
e*= 10 e*= 15 e
15
Result
• Fixed wages that are independent of the effort do not provide
incentives to exert effort.
• If the agent receives a proportion (β) of the output, he has an
incentive to exert effort because his wage (and thus his utility)
depends on his effort.
• The stronger the dependancy, the higher the incentives and the
higher the resulting effort.
• But with the proportion of the output the agent also has to bear
part of the risk (random effect μ). Risk-averse agents do not like it
and have to be compensated for bearing so much risk.
16
Result
• The optimal incentive contract (W*, β*) is balancing the advantages
(incentive effect) and the disadvantages (wage costs, risk bearing)
of the proportion of output.
• The effort level that is induced by incentive contracts is in general
lower than the effort level that would be optimal if effort is
observable and verifiable (« first best »).
• The statement, that the maximum incentives provide the best
result, is not correct.
17
Result
• Therefore: Incentives are effective, if…
1. the output of work depends strongly on the effort (productivity of

the employee).
2. the employee is not too risk-averse.
3. the risk, based on other factors, that can not be influenced by
employees, is not too high
4. the efforts of employees respond sufficiently to changes in
incentives (costs of effort ).
5. the output is well measurable.
18
– Example: Du Pont
Result

the employee).  low!
employees, is not too high  high!
4. the effort of employees respond sufficiently to changes in
5. the output is measurable.
19
– Example Safelite
Result

the employee).  high!
employees, is not too high  low!
4. the effort of employees respond sufficiently to changes in
5. the output is measurable.  good!
20
Forms of incentive compensation
• In the principal-agent model the incentives result from β.

• In reality a lot of forms of incentive compensation are possible:
- Piece rate
- Commissions
- Bonus, promotion, title, bigger office, etc. as a reward for good
performance
- Tournaments (e.g. incentive travel)
- Employee share scheme
- Punishment (wage cuts, dismissal, …) for bad performance
- Deferred compensation
21
Selection effect of incentive contracts
• Incentive contracts do not only solve the moral hazard problem but
they also influence the adverse selection problem.
• Starting point: Employees have diverse productivity
- Erwin‘s marginal productivity= 100
- Armin‘s marginal productivity= 90
- Both have effort costs of C = e2.
• Incentive contract W = 1000, β = 0.2
 marginal profit = 20 for Erwin and 18 for Armin
e* expected expected.
wage utility
Erwin 10 1200 1100
Armin 9 1162 1081
22
Selection effect of incentive contracts
• If both have an outside option of 1090, Erwin will take the contract
but Armin will not.
Result
• Incentive contracts attract more productive employees.
• Reason: They profit (ceteris paribus) more from the incentive
contract and therefore it is more attractive for them
23
Do incentive contracts work?
• Critics claim that incentive contracts are bad and do not work.
• Reason:
-Money is not important for all employees.
-Reality shows that incentives have negative consequences
because they induce undesirable actions
-In fact: Many studies show the positive effect of „right“ incentive
contracts (Lazear 2000, Bandiera et a. 2007).
• The question is not whether incentive contracts work but how they
have to be designed – also with respect to not monetary aspects
(intrinsic motivation, culture,…) – so that incentives cause what
they should.
24
Issues in Developing a Pay Structure
From Noe et al. (2011)

25
Outline

26
An example from Lincoln Electric
• Founded in 1895.
• One of the premier supplier of electric arc welding machines,
welding disposables (electrodes) and cutting products.
• The long history of success is based on high quality products and
low production costs (leader of productivity gains and cost
savings).
• „Secret of success“: Individuals are paid for performance.
1. Piecework (X $ per unit produced)

2. Annual variable bonus based on the performance evaluation
assessed by the supervisor (dependability, quality,
cooperation)
• Combination of objective and subjective performance measures.
27
Performance evaluation methods
- Objective performance evaluation
- Relative performance evaluation
- Subjective performance evaluation
28
Objective performance evaluation
• Remember: Principal - Agent model

• Output depends on the agent`s effort and a random component.
Q = αe + μ
μ random component, α agent`s marginal productivity.
• Output is observable and verifiable while effort and random
component are not.
• Compensation contract
W + βQ = W + β(αe + μ)
fixed wage W and sensitivity of pay to performance β (0 ≤ β ≤ 1).
29
Objective performance evaluation
• Productivity is difficult to observe and therefore the principal has to

estimate it. (Problem: Output depends on e as well as on μ.)
• Two options:
- Time and motion studies
- Historical data on past performance
• Problems:
- Time and motion studies are complex. Employees have an
incentive to underperform.
- Past performance  « Ratchet effect »
30
Ratchet effect
• If future standard of performance depends on the actual

performance an incentive is provided that leads to a low actual
performance.
• Example:
-In an unexpected good year, sales are deferred into the next
fiscal year.
-The difficulty of an exam in the end of the semester is based on
the results of a mock exam.
• Possible solution: Job rotation
• There is also a risk of the ratchet effect at Lincoln Electric: If high

productive employees earn a lot, the piece rate should not be
adjusted until production methods or processes are changed.
 Commitment important!
31
Measurement costs
• Basically: The stronger the incentive component, the more

important to measure output and effort as exactly as possible.
 Compensation and evaluation are two legs of the same stool!
• Sometimes output is not directly measurable

• Costs are incurred when generating performance measures
• Measured output needs to be highly correlated with firm value.
Otherwise agents have an incentive to game the system
(«gaming »)! Only because something is measureable it is not
necessarily useful! (Example: Students whose Bachelor thesis is
graded by the amount of pages)
32
Relative performance evaluation
• A possibilty to increase the exactness of a performance evaluation

is to consider the information about the other colleagues` output.
 Relative performance evaluation
• Advantage:
-Exogenous, random influences are filtered out.
-Therefore, the risk that is transferred through incentive
compensation is reduced.
33
Relative performance evaluation
• Concrete: Q is the average output of the benchmark group.

• Compensation contract
W + β(Q – λQ)
• The optimal level of λ is determined as follows.
Cov(Q, Q)
 λ* =
Var(Q)
• Example: λ* = 1, Q = 43, Q = 40  variable compensation = 3β.
34
Cov(Q, Q)
Interpretation of λ* =
Var(Q)
Cov(Q, Q)
• The output of the benchmark group Q should be considered only if
this is correlated with Q.
• The stronger the correlation, the stronger the weight of relative
performance.
Var(Q)
• If the output of the benchmark Q is noisy, it should not be
considered that strongly.
• The higher the variance Q, the weaker the weight of relative
performance.
35
Problems of relative performance evaluation
• There is not always a (useful) benchmark group.

• Differences between stores are potentially too big.
• Even if there is a statistical relation, it does not mean that a
comparison makes sense from an economic perspective.
• Resistance of employees is to be expected.
• Employees have an incentive to collude and to sanction the so
called « rate busters » who raised the average (social
pressure, sabotage, …).
• Incentive to recruit only « low performers » to have a benchmark
group that is as favorable as possible.
36
Subjective performance evaluation
• Subjective performance evaluation typically refers to „soft“ and

difficult to measure aspects of effort that are nevertheless
important.
• Standard-Rating Scale
1 2 3 4 5
„Cooperates with colleagues“
„Shows self initiative“
„Works problem oriented“
• Goal-Based System, MBO

- A set of goals for the year.
- At the end of the year the extent to which each goal has been
met is checked.
37
Problems of subjective performance evaluation
• Main problem: It is subjective.

• Frequent bias:
- Every employee is more or less evaluated equally.
 Distribution is „too compressed“
- Supervisor is too mild.
 Evaluations are „too good“
- Direct favoritism
• Solution (?): Grade to a fixed distribution
• Further (resulting from above) problems:
 Incentive for exerting influence activities.
 Uncertain career perspectives. Can employees be confident that
supervisors evaluate good performance appropriately?
38
Outline

Q&A
39

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BMGT | Winter semester 2017/18

Lecture 3&4: Evaluating a Company’s External Environment

Dr. Le Minh Hanh

1. An overview of environment analysis

1. An overview of environment analysis

1. Every strategy is based on certain planning premises. Thus, premise

2. Strategic control refers to management efforts to track a strategy as it

3. Premise control is the management process of systematically and

• Identify potentially important external and internal developments

• Assess their impacts and influences

• Adapt a company’s direction and strategy as needed

1. An overview of environment analysis

Focuses on principal components of strategic significance in the

Political Economic Social T

1. An overview of environment analysis

1. How strong are the industry’s competitive forces?

3. What market positions do industry rivals occupy—who is strongly

4. What strategic moves are rivals likely to make next?

5. What are the industry’s key success factors?

6. Is the industry outlook conducive to good profitability?

1. An overview of environment analysis

 The five competitive forces

For each of the five forces, identify the different parties

Evaluate how strong the pressures stemming from

Determine whether the five forces, overall, are

Competitive rivals are organizations with similar products and services

1.Concentration rate and relative size of the competitors

 Entry threat considerations

 Incumbent cost advantages related to learning and experience,

• Whether an industry’s entry barriers ought to be considered high or

Substitutes are products or services that offer a similar function to an

 Substitute products considerations

 Indicators of substitutes’ competitive strength

 Supplier bargaining power depends on:

 Buyer bargaining power considerations

 Can industry firms expect to earn decent profits given prevailing

 Are some of the competitive forces sufficiently powerful to undermine

• Even one powerful force may be enough to make the industry

• Complementors are the opposite of substitutes in that they increase the

• Example: Cars and roads; software applications and microprocessor;…

• Complementors belong to a new category of industry participant.

 Effectively matching a firm’s business strategy to prevailing

 Pursuing avenues that shield the firm from as many competitive

 Initiating actions calculated to shift competitive forces in the firm’s

A company’s strategy is increasingly effective the more it provides some

1. An overview of environment analysis

 Driving forces analysis has three steps

• Assessing whether the drivers of change are, on the whole, acting

to make the industry more or less attractive

• Determining what strategy changes are needed to prepare for the

impact of the driving forces

• Changes in the long-term industry growth rate

The most important part of driving forces analysis is to determine whether

• Is the collective impact of the driving forces making competition more

The real payoff of driving-forces analysis is to help managers understand

 What strategy adjustments will be needed to deal with the

• What can we do now to prepare for adjustments we anticipate

1. An overview of environment analysis

 A strategic group is a cluster of industry rivals that have similar

 Constructing a strategic group map

• Price and quality range (high, medium, low)

• Geographic coverage (local, regional, national, global)

• Degree of service offered (no frills, limited, full)

• Degree of vertical integration (none, partial, full)