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SYNOPSIS OF CHAPTER
The goal of this chapter is to explore the basis of competitive advantage at the level of the individual company. Put another way, the central question with which the chapter deals is why, within a given industry, some companies do better than others. This is a very important chapter because it introduces a framework for understanding competitive advantage that will be used throughout the rest of the book. The chapter opens with a presentation of a basic model of competitive success. The text asserts that, to gain a competitive advantage, the firm must adopt an effective strategy, which will lead to the formation of distinctive competencies, or firm-specific strengths. The distinctive competencies arise from the firms resources and capabilities. Successful firms adopt strategies that build upon existing competencies or develop new competencies. Next, the text explains that companies use their competencies to offer superior value to customers. The relationship between pricing, demand, costs, and differentiation is explored, as they relate to the creation of superior value. The discussion of the value chain aims to show students how the different value-creation activities of a company fit together. A point strongly emphasized here is that each of the value chain activities is a potential source of value creation. The chapter then examines the role of distinctive competencies in helping to achieve the four generic building blocks of competitive advantage: superior efficiency, quality, innovation, and customer responsiveness. Companies that have superior performance in one or more of these areas are able to differentiate their products and/or reduce costs, which leads to value creation and higher profitability. The financial calculation of superior value (profitability) is explored in detail. The durability of competitive advantage is the focus of the next section, which argues that the durability of a companys competitive advantage is a function of three factors: the height of barriers to imitation, the capability of competitors, and the general dynamism of the industry environment. Finally, the chapter addresses the reasons why formerly successful companies fail, focusing on organizational inertia, past strategic commitments, and the Icarus paradox. The concluding section of the text mentions ways that companies can avoid competitive failure and sustain a competitive advantage.
TEACHING OBJECTIVES
1. 2. 3. 4. 5. 6. Examine the internal causes of competitive success and failure. Show how effective strategies create distinctive competencies, including resources and capabilities, which then aid a firm in achieving competitive advantage. Describe the process of value creation, using the concepts of pricing, demand, costs, and differentiation. Familiarize students with the concept of the value chain, and show how the different value-creation activities of a company fit together. Explain how distinctive competencies lead to superior efficiency, quality, innovation, and responsiveness to customers, which in turn allow a company to differentiate its products and lower its costs. Describe how competitive advantage leads to higher profitability, using financial measures.
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7. 8. 9.
Chapter 3: Internal Analysis: Distinctive Competencies, Competitive Advantage, and Profitability Identify the factors that influence the durability of a companys competitive advantage, including the height of barriers to imitation, the capability of competitors, and industry dynamism. Explain the role played by organizational inertia, past strategic commitments, and the Icarus paradox in the failure of many formerly successful companies. Discuss the steps that companies can take to avoid failure and sustain a competitive advantage.
LECTURE OUTLINE
I. Overview A. The choice of industry affects firm performance but, within any given industry, some companies are more profitable than others. Why do some companies do better than their competitors? What is the basis of competitive advantage? B. Internal analysis leads to the identification of a firms strengths and weakness, and especially its distinctive competencies, including its resources and capabilities. C. Distinctive competencies enable firms to create superior value for customers, by helping them to achieve the four main building blocks of competitive advantage: efficiency, quality, innovation, and responsiveness to customers. D. Superior value creation is driven by a firms ability to differentiate its products or reduce its expenses. When firms are able to create superior value, they experience higher profitability. E. Its also important for firms to sustain their competitive advantages over time, to maintain their competitive advantage, and to take steps to avoid competitive failure. Distinctive Competencies and Competitive Advantage A. A company has a competitive advantage when its profit rate is higher than the average for its industry, and it has a sustained competitive advantage when it is able to maintain this high profit rate over a number of years. B. Competitive advantage derives from a firms distinctive competencies, which are of two types: resources and capabilities. 1. Resources refer to the financial, physical, human, technological, and organizational resources of the company. They can be divided into tangible resources, such as land, buildings, plant, and equipment; and intangible resources, such as brand names, reputation, patents, and technological or marketing knowledge. a. Resources that are firm-specific and difficult to imitate are unique. Resources that create a strong demand for the firms products are valuable. b. Unique and valuable resources lead to a distinctive competency. 2. Capabilities refer to a companys skills at coordinating its resources and putting them to productive use. a. These skills reside in the way a company makes decisions and manages its internal processes.
II.
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Capabilities are, by definition, intangible. They reside not so much in individuals as in the way individuals interact, cooperate, and make decisions within the context of an organization. The distinction between resources and capabilities is of the utmost importance in understanding the source of a distinctive competency. A company may have unique and valuable resources, but unless it has the capability to use those resources effectively, it may not be able to create or sustain a distinctive competency. Thus, unique and valuable resources are helpful in creating distinctive competencies, but capabilities are essential. Show Transparency 15 Figure 3.2: Strategy, Resources, Capabilities, and Competencies
C.
A companys profit rate and hence competitive advantage is determined by the value customers place on the companys goods or services, the price the company charges for the products or service, and the companys costs of production. 1. Value is assigned by customers based on product attributes such as performance, design, and quality. The more value a company creates, the more flexibility it has in assigning a price. 2. The price a company charges is typically less than the value assigned by the consumer. The customer captures that difference in value as a consumer surplus, which occurs because the company is competing with other companies and so must charge a lower price than it could as a monopoly supplier. 3. Another factor that causes the price to be lower than the value is the impossibility of segmenting the market so that the company can charge each customer a price that reflects that individuals reservation price (their assessment of the value of a product). Show Transparency 16 Figure 3.3: Value Creation per Unit 4. Looking at Figure 3.3, the companys profit margin is equal to the difference between price and costs (PC), whereas the consumer surplus is equal to the difference between value and price (VP). The company makes a profit so long as the price is greater than the cost. Its profit rate will be greater the lower costs are, relative to the price. The lower the competitive intensity, the greater the difference that can exist between price and value. Looking at Figure 3.4, a company can create more value for its customers in two ways. a. Under Option 1, a company can make the product more attractive, raising costs (C) but also raising value (V). Customers are then willing to pay a higher price (P increases). b. Under Option 2, a company can lower its price (P), creating a higher value (V), more demand, and increased volume of sales. Economies of scale realized because of the increased volume allow the company to reduce its costs (C). Show Transparency 17 Figure 3.4: Value Creation and Pricing Options
5.
D.
Low cost and differentiation are two basic strategies for creating value and attaining a competitive advantage in an industry. Competitive advantage (and higher profits) goes to those companies that can create superior valueand the way to create superior value is to drive down the cost structure of the business and/or differentiate the product in some way so that consumers value it more and are prepared to pay a premium price. Show Transparency 18 Figure 3.6: The Roots of Competitive Advantage
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III.
Chapter 3: Internal Analysis: Distinctive Competencies, Competitive Advantage, and Profitability The Value Chain A. A companys value chain is a sequence of interrelated activities for transforming inputs into outputs that customers value. The process consists of a number of primary activities and support activities, each of which can add value to the product. Show Transparency 19 Figure 3.7: The Value Chain 1. Primary activities have to do with the design, creation and delivery of the product, its marketing, and with its support and after-sales service. There are four primary activities: research and development, production, marketing and sales, and service. a. Research and development (R&D) is concerned with the design of products and production processes. R&D occurs in manufacturing enterprises as well as service companies. By superior product design, R&D can develop superior product designs, which increase the functionality of products, making them more attractive to consumers. Alternatively, R&D may develop more efficient production processes, lowering costs. b. Production is concerned with the creation of a good or service. For physical products, production means manufacturing. For services, production takes place when the service is actually delivered to the customer. The production function creates value by performing its activities efficiently so that lower costs result. Production can also create value by performing its activities in a way that is consistent with high product quality, which leads to differentiation and lower costs. c. Marketing and sales functions create value through brand positioning and advertising, which increase the perceived product value. They also create value by discovering consumer needs and communicating them to the R&D function of the company, which can then design products that better match those needs.
2.
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IV.
The human resource function helps to create value by ensuring that the company has the right mix of skilled people to perform its value creation activities effectively. It is also the job of the human resource function to ensure that people are adequately trained, motivated, and compensated to perform their value creation tasks. c. Information systems refer to the (largely) electronic systems for managing inventory, tracking sales, pricing products, selling products, dealing with customer service inquiries, and so on. Information systems, when coupled with the communications features of the Internet, are holding out the promise of being able to alter the efficiency and effectiveness with which a company manages its other value chain activities. d. The final support activity is the company infrastructure, or the company-wide context within which all the other value-creation activities take place. The infrastructure includes the organizational structure, control systems, and organizational culture. Because top management can exert considerable influence in shaping these aspects of a company, they should also be viewed as part of the infrastructure of a company. The Generic Building Blocks of Competitive Advantage A. Four generic factors build competitive advantage by allowing companies to better differentiate their products or become more efficient in reducing costs: efficiency, quality, innovation, and responsiveness to customers. They are generic because they represent actions that any company can adopt, irrespective of industry. The factors are all highly interrelated. Show Transparency 20 Figure 3.8: Generic Building Blocks of Competitive Advantage B. Efficiency is measured by the cost of inputs required to produce a given output. 1. The more efficient a company, the lower the cost of inputs required to produce a given output. Thus efficiency helps a company attain a low-cost competitive advantage. 2. One of the keys to achieving high efficiency is utilizing inputs in the most productive way possible. Companies with high employee productivity and capital productivity will have low costs of production.
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Chapter 3: Internal Analysis: Distinctive Competencies, Competitive Advantage, and Profitability 2. Higher product quality can also result in greater efficiency, with less employee time wasted fixing defective products or services. This translates into higher employee productivity, which means lower unit costs.
V.
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C.
ROIC is calculated as net profits divided by invested capital. ROIC represents the effectiveness with which a company is using the funds it has available for investment. 3. ROIC can be decomposed into two parts. Return on Sales is calculated as net profit divided by revenues, and represents how effectively the company converts sales revenues into profits. Capital turnover is calculated as revenues divided by invested capital, and represents how effectively the company uses its invested capital to generate revenues. Managers can increase profitability by increasing return on sales, either by reducing expenses for a given level of sales, or by increasing sales revenues faster than expenses. They can also increase profitability by getting more sales revenue from their capital investment.
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within a unique organizational setting. Thus, no one person can duplicate capabilities, and therefore personnel movement will not be as useful in imitating capabilities. 2. When a company is committed to a particular way of doing business based on a set of resources and capabilities, the company will find it difficult to respond to new competition if doing so requires a break with this commitment. This influence on the durability of competitive advantage is called capability of competitors. a. A related concept is absorptive capacitythat is, the ability of an enterprise to identify, assimilate, and utilize new knowledge. Firms with a low absorptive capacity may experience an internal inertia that slows their ability to innovate and imitate. b. Therefore, when innovations reshape the rules of competition in an industry, value often migrates away from established competitors and toward new enterprises that are operating with new business models. 3. Industry dynamism refers to the rate of product innovation. A high dynamism (rapid rate of innovation) means that product life cycles are shortening and that competitive advantage can be very transitory. Durability of competitive advantage is difficult for any company to sustain in a highly dynamic industry. VII. Avoiding Failure and Sustaining Competitive Advantage A. Failing companies are not just below average; they earn very low or negative profits. Three related reasons for failure are explored here: inertia, prior strategic commitments, and the Icarus paradox. 1. The inertia argument is that companies find it difficult to change their strategies and structures in order to adapt to changing competitive conditions. a. An organizations capabilities contribute to inertia, because they are difficult to change. Changing capabilities would require a redistribution of power and influence among the key decision makers, and therefore will be resisted. Turf battles may result. b. Thus, capabilities can provide competitive advantage and also competitive disadvantage. 2. Prior strategic commitments, such as investments in specialized resources, may also contribute to competitive failure, because the resources are not well suited for other, evolving uses. Changing resources is difficult and expensive. 3. The Icarus paradox is based on the Greek myth of Icarus, who made himself a pair of wings from wax and feathers, then flew so well that he went too close to the sun, melting the wings and plunging to his death. The paradox is that his greatest asset, his ability to fly, gave rise to his demise. a. Many successful companies become so dazzled by their own early success that they believe that pursuing the same course of action is the way to future success. They may pursue strategies such as craftsmen, builders, pioneers, and salesmen. b. This attitude, however, leads a company to become so specialized and inner-directed that it loses sight of market realities and the fundamental requirements for achieving a competitive advantage. Sooner or later failure ensues.
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To avoid failure, companies can focus on the building blocks of competitive advantage, institute continuous improvement and learning, track best industrial practice and use benchmarking, and overcome inertia. Managers can also learn to exploit luck. 1. Maintaining a competitive advantage requires a company to continue focusing on the four generic building blocks of competitive advantageefficiency, quality, innovation, and customer responsivenessand to do whatever is necessary to develop distinctive competencies that contribute toward superior performance in these areas. 2. In todays dynamic and fast-paced environments, the only way that a company can maintain a competitive advantage over time is to continually improve its efficiency, quality, innovation, and customer responsiveness. The most successful firms are those that continually learn, seeking out ways of improving their operations and constantly upgrading the value of their distinctive competencies or creating new competencies. 3. One of the best ways to develop distinctive competencies is to identify best industrial practice and to adopt it. Only by doing so will a company be able to build and maintain the resources and capabilities that underpin excellence in productivity, quality, innovation, and customer responsiveness. 4. The ability to overcome the inertial barriers to change within an organization is one of the key requirements for continuing to maintain a competitive advantage. 5. Luck can play a critical role in determining competitive success and failure, but it is an unconvincing explanation for the persistent success of a company. It is difficult to imagine how sustained excellence could be the product of anything other than conscious effort, that is, of strategy. However, companies can be flexible and prepared to exploit lucky breaks as they occur.