Evaluating a firm’s internal capabilities

Evaluating a firm’s internal capabilities
Ask students to describe the responsibilities of a CEO. • Students will usually respond with things like making decisions about: hiring and firing people, acquiring other companies, introducing new products, entering new markets, building new factories, etc. • Point out to students that all of these activities are really a matter of organizing and deploying the resources of the firm. • A CEO’s duties can be broadly described as doing just that: organizing and deploying the resources of the firm. • In order to carry out these responsibilities, a CEO needs to understand the resources of the firm and how those resources compare to other firms’ resources. • Internal analysis is a process for helping managers to understand a firm’s resource position.

What Does Internal Analysis Tell Us?
Internal analysis provides a comparative look at a firm’s capabilities • what are the firm’s strengths? • what are the firm’s weaknesses? Get the group to think about the strengths of their own companies. They can then discuss this in pairs what it is about this strength that others don’t have. Then ask a few of them to feedback to the group. Get them to think about whether this is enough. • how do these strengths & weaknesses compare to competitors?

Why Does Internal Analysis Matter?
Internal analysis helps a firm: • determine if its resources and capabilities are likely sources of competitive advantage Softsoap was the brainchild of Minnetonka’s CEO, Robert Taylor. The idea of putting liquid hand soap in a pump container for home use was novel at the time. Taylor knew that the most likely competitors would be large companies like Procter & Gamble who were good at developing and marketing new products for the home and personal care markets. Had Taylor forged ahead without any form of internal analysis he would have rightly developed a great product. He knew the liquid soap would be easy to manufacture and that he could buy the pumps from one or both of the two existing pump manufacturers. Procter & Gamble, and probably others, would have quickly imitated his product and most likely driven him out of business. These other manufacturers were many times larger than Minnetonka. However, Taylor engaged in a form of internal analysis by recognizing that even though these larger companies had a resource advantage when it came to manufacturing and marketing the liquid soap, they had no advantage when it came to the pump bottles. He recognized that if he bought all the pump bottle production of the two manufacturers he would have an advantage over firms much larger than Minnetonka. Taylor bought all the pumps the two manufacturers could produce in a year. He paid more for these orders of pumps than Minnetonka was worth at the time. The strategy worked. He had a month lead over his much larger competitors in which he was able to establish the Softsoap brand and capture market share. (Brandenburger & Nalebuff, 1995, The Right Game: Use Game Theory to Shape Strategy, Harvard Business Review.) In 1987 they were bought up by Colgate Palmolive. • establish strategies that will exploit any sources of competitive advantage

The Theory Behind Internal Analysis
The Resource-Based View • developed to answer the question: Why do some firms achieve better economic performance than others? • used to help firms achieve competitive advantage and superior economic performance The RBV is the theoretical lens through which internal analysis is conducted. A bit of history is in order here. The most popular strategic management theory and thinking before the mid-1980s was based on the Structure-Conduct-Performance Model from industrial organization economics. Recall from Chapter 2 that in this view of economic performance industry characteristics were assumed to be the primary drivers of a firm’s economic performance. In the mid-1980s scholars began to argue that the primary drivers of firm performance may be found at the firm level instead of the industry level. Differences in the resource endowments of firms were viewed as being the root causes of differences in firm performance. This very Ricardian view quickly became known as the Resource-Based View of the firm. This shift in level of analysis from the industry level to the firm level has important implications for management. Where the S-C-P message seemed to be “choose the right industry,” the RBV message seems to be “choose the right resources.” • assumes that a firm’s resources and capabilities are the primary drivers of competitive advantage and economic performance

The Resource-Based View
Resources and Capabilities Resources: • tangible and intangible assets of a firm » tangible: factories, products intangible: reputation • used to conceive of and implement strategies Emphasize the point that capabilities are simply a subset of resources.  Important Point: Sometimes students get confused as they try to separate these two concepts. Don’t get too hung up on this issue. Just remember that any asset or ability of a firm is a resource. Capabilities are simply those resources that firms use to combine and deploy other resources. Capabilities: • a subset of resources that enable a firm to take full advantage of other resources » marketing skill, cooperative relationships

Resources and Capabilities Are these resources or capabilities? Firm Assets: Machinery ? Collective Product Design Skill ? Ask students to categorize these firm assets as either resources or capabilities. Machinery is a resource. Collective Product Design skill is a capability. This refers to the ability of the firm, working together, to produce new product designs. Recruiting skill is a firm capability. Engineering skills of individuals are firm resources. Mineral deposits are firm resources. Recruiting Skill ? Engineering Skill of Individuals ? Mineral Deposits ?

Four Categories of Resources • Financial (cash, retained earnings) • Physical (plant & equipment, geographic location) The purposes of categorizing resources are: 1) simply to demonstrate that anything and everything may be viewed as a resource, and 2) to show later on that different types of resources may be combined to form the capabilities of the firm. ► Example: Coca-Cola’s Resources and Capabilities Coca-Cola has a distinctive red can with a trademarked white wave image that goes around the can. These are physical resources. Coca-Cola has access to substantial working capital (cash). This is a financial resource. Coca-Cola has talented marketing professionals. These are individual human resources. Coca-Cola also has well established set of reporting structures, reward systems, communications systems, and IT systems. These are organizational resources. Coca-Cola has the ability to put these various resources together in an effective marketing campaign. This is a capability. Thus we would correctly refer to Coca-Cola’s marketing capability as one of its resources right along with its other physical, capital, human, and organizational resources.  Teaching Points • Ask students to name some firms that have resources that clearly make them different from the competition. • Ask students if those differences are due to financial, physical, human, or organizational resources. • Students will usually state that what makes the firm stand out from the rest is a combination of different types of resources. • Point out that the ability to put those resources together in a way that makes the firm different is a capability. • Human (skills & abilities of individuals) • Organizational (reporting structures, relationships)

Two Critical Assumptions of the RBV • Resource Heterogeneity » different firms may have different resources • Resource Immobility The RBV makes two critical assumptions that set it apart from the industrial organization economics that preceded it. In the IO economics view of the world any firm differences that may arise would be quickly dissipated through competition. If one firm had a good idea, others would quickly copy it. There would be no enduring differences between firms. The RBV makes two assumptions that directly oppose this idea. Explain to students that most of the time it is technically possible for a firm to acquire most any resource. However, resource immobility means that it is so costly to acquire the resource that it wouldn’t make economic sense. » it may be costly for firms without certain resources to acquire or develop them » some resources may not spread from firm to firm easily

What do these assumptions really mean? • if one firm has resources that are valuable and other firms don’t, and… • if other firms can’t imitate these resources without incurring high costs, then… These two assumptions make the notion of enduring firm differences plausible. The idea of enduring firm differences may not be all that novel to students—it seems like common sense. But, if we are to explain why one firm does better economically than another we need to have a logical explanation as to why there are causal differences between the firms.  Important Point: Students must understand these two assumptions before you move on to the VRIO model that follows. In the simplest of terms, these assumptions mean that one firm can be better at something than other firms and that the difference may be enduring. Slide 3-9 Emphasize that existence of differences between firms implies that some firms can be better at something than other firms, i.e., some firms can have a competitive advantage. • the firm possessing the valuable resources will likely gain a sustained competitive advantage

Resource Heterogeneity • heterogeneity of resources typically occurs as the result of ‘bundling’ the resources and capabilities of a firm • managers of a firm could take resources that seem homogeneous and ‘bundle’ them to create heterogeneous combinations  Important Point: A firm may possess resources that are similar to the resources of other firms (homogeneous). However, the managers of that firm may employ firm capabilities in such way as to create heterogeneous bundles of resources. In other words, managers can take common resources and create uncommon bundles of resources so that firm differences exist—even if the original basic building blocks (resources) are the same. Slide 3-10 Drive home the point that managers matter in this view because they have the ability to create firm differences even if they are working with resources that are rather common. Also, emphasize that competitive advantage usually comes from several resources bundled in a heterogeneous combination. • competitive advantage typically stems from several resources and capabilities ‘bundled’ together

The Internal Analysis Tool
The VRIO Framework Four Important Questions: • Value • Rarity • Imitability • Organization

The VRIO Framework If a firm has resources that are:
• valuable, • rare, and • costly to imitate, and… • the firm is organized to exploit these resources, Four Questions • Value – Does the resource enable the firm to exploit an opportunity or neutralize a threat? The evidence of a positive response to this question is usually that the resource somehow increases revenue or decreases cost. • Rarity – Is the resource rare? Is the resource rare enough that there is still scarcity in the marketplace for this resource? • Imitability – Is the resource costly to imitate? Specifically, is the resource so costly to imitate that no one would try to imitate it? • Organization – Is the firm organized in such a way that the resource can be exploited? If the answer to these four questions is affirmative, then the firm can reasonably expect to achieve a competitive advantage. Of course, there will be many resources that meet some but not all of the criteria. The competitive implication of these resources will be explained as we move along. then the firm can expect to enjoy a sustained competitive advantage.

The VRIO Framework Applying the Tool
• a resource or bundle of resources is subjected to each question to determine the competitive implication of the resource Important Point: Students must understand that the framework is applied on a resource-by-resource basis and not to the firm as a whole. For example, if a firm sought help in analyzing its proposed introduction of a new personal digital music device the VRIO Framework might be applied to the firm’s: design capability, marketing capability, distribution capability, proposed product per se, etc. This helps to highlight which of these resources, if any, might be sources of competitive advantage. Slide 3-13 Emphasize the point that these questions are asked in a comparative sense, meaning that the competitive context is taken into account. For example: Is the resource valuable in the market where it is being used or where it is planned to be used given the resources that other firms are deploying in that market? Is the resource rare in this market? • each question is considered in a comparative sense (competitive environment)

Applying the VRIO Framework
The Question of Value • in theory: Does the resource enable the firm to exploit an external opportunity or neutralize an external threat? iPod’s value is due to reputation of Apple. Also design features could also be something that adds value to the product. Can students think of other examples? Amazon gives value through choice, price, customer service. • in practice: Does the resource result in an increase in revenues, a decrease in costs, or some combination of the two? (Example: what makes the iPod so expensive?)

The Question of Rarity • if a resource is not rare, then perfect competition dynamics are likely to be observed (i.e., no competitive advantage, no above normal profits) • a resource must be rare enough that perfect competition has not set in Important Points: • Some firm resources that are valuable but not rare are still very important to the firm (e.g., telephone systems). • A resource can still be rare even if more than one firm possesses it—the real question is this: Is the resource rare enough that the firm derives some advantage from having the resource? • A resource is considered rare if so few firms possess the resource that nearly perfect competition is not observed. Slide 3-15 Remind students that one good way to tell if a resource is still rare is to see if the firm is able to charge a premium price for the output of that resource. For example, if we examine the reputation of Harley-Davidson Motorcycles we find that they are able to charge a premium for their motorcycles even though other manufacturers of large motorcycles offer similar machines. • thus, there may be other firms that possess the resource, but still few enough that there is scarcity (Example: medicines are expensive, even though there are several firms producing similar products)

Valuable and Rare If a firm’s resources are: The firm can expect: Not Valuable Competitive Disadvantage  Teaching Points • Explain to students that a rude concierge could be a resource that is not valuable. Such an employee could actually drive people away from a hotel. • Ask students for examples of resources that are valuable but not rare. They will probably list things like telephones, computers, some common HR practices, raw materials, steel, etc. • Ask students for examples of valuable and rare resources. • Ask students why they think these resources are rare. • Students will usually think of examples because they perceive that the resources have led a firm to have a competitive advantage (e.g., Nike’s marketing capability). • Now ask if the valuable and rare resources are likely to create enduring differences for the respective firms. This provides a segue into a discussion of the question of imitability. Valuable, but Not Rare Competitive Parity Competitive Advantage (at least temporarily) Valuable and Rare

The Question of Imitability • the temporary competitive advantage of valuable and rare resources can be sustained only if competitors face a cost disadvantage in imitating the resource Describe the Kinds of Resources and Capabilities that Are Likely to Be Costly to Imitate Maintaining the rareness of a resource is the key to having a sustained competitive advantage. If competing firms can acquire a valuable and rare resource, then the advantage of possessing that resource will quickly dissipate. The big issue here is the cost of imitation. A firm can expect to sustain its competitive advantage if other firms face a cost disadvantage in acquiring the valuable and rare resource.  Important Point: A cost disadvantage means that a competing firm would face a cost so high that acquiring the resource would not be worth that cost. Assume a firm faces a cost of $100 to acquire a particular resource and that the firm can expect to sell the output of that resource for only $85. It would be irrational for the firm to attempt to acquire the resource. Slide 3-17 Emphasize the point that intangible resources are usually more difficult to imitate and therefore are more likely to be sources of sustained competitive advantage. Also mention that bundles of resources are more difficult to imitate than a single resource. A sustained competitive advantage does not mean that the firm will have the advantage indefinitely. It means the firm will have the advantage only until the resource is imitated by enough other firms that nearly perfectly competitive comp » intangible resources are usually more costly to imitate than tangible resources (Harley-Davidson’s styles may be easily imitated, but its reputation cannot)

The Question of Imitability • if there are high costs of imitation, then the firm may enjoy a period of sustained competitive advantage » a sustained competitive advantage will last only until a duplicate or substitute emerges if a firm has a competitive advantage, others will attempt to imitate it (Example: Intel and AMD)

The Question of Imitability Costs of Imitation Unique Historical Conditions (Coca Cola) • first mover advantages Costs of Imitation. There are several categories of cost that firms may face as they attempt to imitate valuable and rare resources. These sources of cost are examined with the aim of helping students understand and exploit these costs. If a firm is protected by the high costs of imitation that competitors face, then the firm can expect the competitive advantage to be sustained. Unique Historical Conditions Firms attempting to imitate resources that came about because of unique historical conditions may face substantial cost disadvantages. Two types of cost disadvantages faced by would be imitators are: • First mover advantages – brand loyalty and market share are difficult to overcome. • Path dependency – refers to the fact that the development of a resource may depend heavily on other resources being in place before the desired resource. Could use the Samsung example here to explain how to get around first mover advantages. • path dependence

The Question of Imitability Costs of Imitation Causal Ambiguity (Pixar) • causal links between resources and competitive advantage may not be understood Pixar is leading in 3D animation. Disney faced problems with competing with them so finally bought them. What is it that Pixar does that it difficult to imitate? • bundles of resources fog these causal links

The Question of Imitability Costs of Imitation Social Complexity (Steve Jobs/Steve Wozniak) • the social relationships entailed in resources may be so complex that managers cannot really manage them or replicate them Jobs and Wozniak were so successful together. Ronald Gerald Wayne, one of the founders was overwhelmed by their work ethic. ► Example: WordPerfect – The Early Days The WordPerfect word processing software was developed by college professor, Alan Ashton, and Bruce Bastian, a student. Originally these two came together to use a computer to map out and coordinate the movements of the university’s marching band. They continued to work together in creating a word processor for an office on campus. One thing led to another and within a short time, they had developed a software package that was better than anything available on the market at the time. This unique social relationship between Ashton and Bastian led to the early development of the software. It would be virtually impossible to imitate this relationship. However, WordPerfect benefited even more from another form of social complexity. Early on, Ashton and Bastian realized that the programmers were their bread and butter. They allowed the programmers to have the best of everything—offices, bonuses, extremely flexible hours, etc. Soon a set of relationships developed among these programmers such that development efforts aimed at improving the product were naturally well-coordinated. These programmers were able to develop new features in the product that were astonishing for their time, especially for the legal profession. The immense amount of typing done by attorney’s office staffs was greatly reduced and simplified by WordPerfect’s technology. For several years, no other software company was able to match the innovation of WordPerfect. Much of this innovation was the result of the social relationships among the programmers.  Important Point: Some resources and capabilities are generated, in part, from the interaction of two or more individuals. These resources and capabilities are also influenced by organizational surroundings within the firm. Attempting to recreate such a set of social interactions is costly at best, if not strictly impossible. Slide 3-21 Emphasize that even hiring the creators of a resource (like a technology) away from a firm might not be enough to effectively imitate the resource. Furthermore, a would-be imitator might have to pay so much to lure the creators away that the benefits of having the resource would be outweighed by the costs.

The Question of Imitability Costs of Imitation Patents • patents may be a two-edged sword Patents help to create cost disadvantages for imitators, but they are not an ironclad protection for patent holders. One problem for those seeking a patent is that potentially sensitive information has to be disclosed to get the patent in the first place. This information could prove useful to others attempting to develop a similar product or solution. Another problem for patent holders is that the patent must be enforced if others choose to infringe on the patent. For these reasons, some firms opt for a trade secret instead of a patent. Trade secrets offer a different level of protection, but there is little, if any, a priori disclosure requirement. • offer a period of protection if the firm is able to defend its patent rights • required disclosure may actually decrease the cost of imitation, and the timing

Value, Rarity, & Imitability If a firm’s resources are: The firm can expect: Valuable, Rare, but not Costly to Imitate Temporary Competitive Advantage The main point with this slide is that unless competitors face a cost disadvantage in acquiring a valuable and rare resource the focal firm should expect the resource to be imitated. Once the imitation occurs, any competitive advantage is quickly dissipated. Only those resources that are costly to imitate can be sources of sustained competitive advantage. Sustained Competitive Advantage (if Organized appropriately) Valuable, Rare, and Costly to Imitate

The Question of Organization • a firm’s structure and control mechanisms must be aligned so as to give people ability and incentive to exploit the firm’s resources • examples: formal and informal reporting structures, management controls, compensation policies, relationships, etc. Dell is a good example of a company that is organised to exploit their resources. Organisation: different type of staff depending on the customer type. I.e. if you have centralised buying, the account teams is also centralised. If you have regional buying, you have an account manager combined with the global account manager. Dell hires people who have a constructive attitude, are flexible, can grow with the company, and can adapt in a rapidly changing environment. For sales personnel, it is important to select people who like to be rewarded for performance. Dell’s flat structure is organised functionally, but each customer segment has its own product engineering, marketing, sales and service group to design and support products for its unique needs. Both successes and failures are shared freely within the organisation, and functional areas communicate across customer lines instead of acting as silos hoarding information. Employee bonus and profit sharing incentives are tied to quality metrics such as on-time delivery and after-sales service. In addition, each employee has financial measurements tailored to his/her specific responsibilities including asset velocity, “cost per box,” sales/product mix, days inventory in the field, and days receivable and payable. Employees monitor their impact on these metrics on an ongoing basis. For example, the marketing department calculates the ROI for each advertisement and mailing, and purchasing managers figure out the cost of unsold inventory. We spent 15 months educating people about return on invested capital, convincing them they could impact our future. • these structure and control mechanisms complement other firm resources—taken together, they can help a firm achieve sustained competitive advantage (Dell)

Costly to Imitate? Exploited by Organization? Competitive Implications Economic Implications Valuable? Rare? Below Normal No No Disadvantage Yes No Parity Normal Temporary Advantage Above Normal Yes Yes No Sustained Advantage Above Normal Yes Yes Yes Yes

Resources & Capabilities Competitive Advantage • Valuable CA will be sustained if: • Rare • other firms’ costs of imitation are greater than benefit of imitation Remind students that the RBV was developed in an effort to answer the question: Why do some firms do better economically than other firms? • The RBV assumes that firm-level phenomena are the primary determinants of economic performance. • The RBV makes two assumptions that distinguished it from previous economic theory: • resource heterogeneity: firms may have different resource endowments • resource immobility: some resources may not be easily transferred or acquired • These assumptions allow for the possibility of enduring firm differences. • Without firm differences, there would be no advantage for any one firm over any other firm. • Costly to Imitate • Organized to Exploit • the firm is organized to exploit advantages

Internal Analysis List the main resources and capabilities of Baosteel
How do these resources and capabilities add value? Are these resources rare? Can they be easily imitated? Is Baosteel organised to exploit these resources and capabilities? It is important to identify weaknesses in the organisation. Only by identifying these weaknesses is it possible to develop a sustainable competitive strategy.

Internal Analysis Tells us: Managers’ Job:
• what the firm should do, given the relative strengths and weaknesses of resources and capabilities Managers’ Job: Remind students that the VRIO Framework is to be applied to a specific resource (or bundle of resources) or capability—not to the resources and capabilities of the firm as a whole. • Remind students that the framework can be used to assess what a firm is currently doing, or, it can be used to help a firm craft a strategy using the resources and capabilities of the firm. It can be used to answer the question: Is this resource likely to be a source of competitive advantage? • Remind students that each of the four questions (VRIO) should be asked in the context of the market in which the firm operates. • Point out that the most desirable position for a firm is to have a sustained competitive advantage. • A competitive advantage depends on a cost disadvantage for others who would imitate a valuable and rare resource. • A competitive advantage also depends on the focal firm’s organization. It must be able to exploit its resource advantages in order to achieve competitive advantage. Slide 3-34 This slide should be used to put the whole subject of internal analysis in context. Emphasize that internal analysis matters because it offers managers a way to use economic reasoning to formulate an informed opinion about whether a firm’s resources are likely to generate competitive advantage. CONCLUSION Finally, it has proven useful to conclude the class session with a return to the big picture and a final explanation about why internal analysis matters. In a nutshell, the RBV and the VRIO Framework offer us a way to think about the probable results of our strategic decisions.  Important Points: • External analysis only tells half the story. A firm would be hard pressed to formulate an effective strategy using only external analysis. • Internal analysis and external analysis, taken together, allow us to think about positioning firm resources in a way that is likely to lead to competitive advantage and above normal returns. • Internal analysis helps to sharply focus attention on the role of managers. If we accept that managers are responsible for the economic performance of a firm, then the role of managers must be to ‘bundle’ the resources of the firm. • The VRIO Framework is a very effective tool for managers to use as they attempt to position or ‘bundle’ the resources of the firm in the pursuit of competitive advantage. As a final note, we suggest that you point out to students that the principles covered in this session may have very real and relevant application in their personal and professional lives. Encourage students to think about the contributions they can make within their families, communities, and professional circles given their personal ‘resources’ such as talents, abilities, personalities, and interests. In a utilitarian sense, a little VRIO analysis of one’s personal and professional ‘resources’ may go a long way toward helping the individual achieve a measure of competitive advantage on a personal level. • bundle resources and capabilities to achieve competitive advantage VRIO Framework Helps Managers Recognize Sources of Competitive Advantage

Cirque du Soleil Traditional Circus Cirque du Soleil
What are the characteristics of a traditional circus? What resources and capabilities does it have? Are these resources rare? Can they be imitated? What things don’t you like about the traditional circus? Cirque du Soleil How has Cirque du Soleil changed the circus? Think in terms of target group, resources and capabilities. What is Cirque du Soleil’s biggest challenge?

Cirque du Soleil Traditional Circus Socio-cultural changes:
Animals Danger Fun Multiple arenas Star performers Popcorn Socio-cultural changes: Circus old fashioned Attitudes towards performing animals Traditional circus was easy to copy and trends meant that it was less popular, seen as old fashioned and use of animals was negatively seen by parents. So the market is in decline so you must do one of 4 things: market leader: focus and become the best, so that there are no other rivals. Might mean cutting back on activities. Niche: identify a new market niche to operate in. Harvest: cut back on the offering and run the business down. Divest: sell off your assets. The problem is that the assets are mainly in people’s skills, so cannot be sold. Five Forces are affected by: Fall in demand increases rivalry Substitutes become more popular

Cirques solution Go for a niche market Unique Venue Value Fun Comfort
Danger Theme Dance and Music Rare Concept was new, but resources and capabilities not Immitable Health care Yes, can be copied Strong HR policy Well paid Organisation

The Strategy Canvas of Cirque du Soleil
Smaller Regional Circus Large Scale Traditional Circus hi offering level lo Price Fun & Humor Unique Venue Aisle Concessions Multiple Show Arenas Thrills & Danger Animal Shows Star Performers Theme Refined Viewing Environment Multiple Productions Artistic Music & Dance Cirque du Soleil © Kim & Mauborgne2006

Evaluating a firm’s internal capabilities

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