Assessing the Internal Environment of the Firm


The purpose of this chapter is to help students understand the importance of the internal environment of the firm. Chapter 2 focused on assessing the external environment; we turn our attention in this chapter to managing value creating activities within the company. 


Introduce the chapter by reminding students of the limitations of SWOT analysis mentioned in Chapter 2. SWOT analysis was suggested as a starting point for analysis, but not an ending destination.  This chapter adds value chain analysis, the resource based view of the firm, and the balanced scorecard as methods for analyzing the firm's internal environment. The chapter is organized into three sections.


1.             Value Chain Analysis: The firm's activities are divided into a series of value-creating steps. Both individual activities as well as the interrelationships among activities within the firm—and between the firm and its suppliers, customers, and alliance partners--add value to the firm.


2.         Resource based view of the firm: We analyze the firm as a collection of tangible and intangible resources and organizational capabilities. The key to the sustainability of advantages is the creation of bundles of activities that satisfy four criteria: rare, valuable, difficult to imitate, and difficult to substitute. We also discuss how value can be appropriated by an organization's stakeholders, such as employees.


3.         Two approaches to evaluating firm performance: We emphasize both the inclusion of the analysis of financial resources as well as the interests of multiple stakeholders. Central to our discussion is Kaplan and Norton's concepts of the "balanced scorecard," and the "strategy map."





       The introductory case is Jaguar, a unit of Ford Motor Company that has been a significant drain on the corporation's earnings. Although Jaguar has improved its efficiency and overall product quality in recent years, its marketing, engineering, and styling have been flawed.


q                    What are the underlying causes of this problem (e.g., pressure to lower costs, increase unit sales volumes, leverage Jaguar brand)?


q                    What should be done?


The SUPPLEMENT below provides a brief update on Ford's recent financial performance. Although the firm is profitable overall, its automotive operations continue to be a drag on corporate performance. Further restructuring to reduce costs is in the near future.




         Although Ford is profitable overall (with pretax earnings of $2.7 billion through late 2005), these profits are coming from its financial services sector. Ford's automotive operations in North America are suffering losses — amid a vicious price war, high plant and labor costs, and falling market share. In the second quarter of 2005, Ford lost $907 million on North American automotive operations (General Motors's corresponding loss was $1.2 billion.)


         In early 2005, Chairman Bill Ford abandoned his goal of generating $7 billion in pretax income by 2006, and in July the company stopped providing quarterly earnings guidance to Wall Street. Ford's stock has slid 37% between the beginning of 2004 and late-2005. And, in May 2005, its bonds earned a junk rating from Standard and Poor's.


         Ford will need to make some drastic changes to make its factories profitable. The planned restructuring will include several plant closings and job cuts in the 10,000 range. (Current American employment in late-2005: 123,000)


Source:  Muller, J. 2005. Tough repair job. Forbes. September 5: 48-50.


Prior to moving on to value chain analysis, discuss STRATEGY SPOTLIGHT 3.1.  It highlights the advantages and limitations of SWOT analysis. We revisit the failed firm – ProCD (from Chapter 2) that entered the electronic telephone directory business with high hopes. This is a useful example to further reinforce the need to "go beyond" SWOT analysis and the need for value chain analysis in analyzing the internal environment of the firm.




Value chain analysis views the organization as a sequential process of value-creating activities.  Such an approach is very useful for understanding the building blocks of competitive advantage. In competitive terms, value is the amount that buyers are willing to pay for what a firm provides for them.  And, a firm is profitable to the extent that the value that it receives exceeds the total costs involved in creating the product or service.


Value chain analysis is described in Michael Porter's seminal book, Competitive Advantage.  EXHIBIT 3.1 illustrates Porter's value chain — which consists of both primary and support activities.


q          What changes in the value chain would be necessary if the CEO of a manufacturing firm decided to dramatically improve the delivery time of his or her products?


q          What are some examples of organizations that perform "very well" or "very poorly" with respect to the items in this exhibit?


Point out that when using value chain analysis one needs to view the concept in its broadest context, i.e., without regard to the boundaries of a given organization. That is, include suppliers, customers, and alliance partners. 


The balance of this section will address primary activities, support activities, and the importance of relationships among activities — both inside and outside the boundaries of a firm.




There are five categories of primary activities in an organization that is competing within any industry. These are included in EXHIBIT 3.2 — along with examples of each activity.


q          What are some examples of firms with which you are familiar that are successful (or unsuccessful) in each of the primary activities? Why?


Now, we will address each of the five primary activities.




Inbound logistics are associated with the receiving, storing, and distributing of inputs to the product. It includes material handling, warehousing, inventory control, vehicle scheduling, and returns to suppliers.


We provide the example of Toyota's exemplary use of JIT inventory systems — in which parts deliveries arrive at its assembly plants only hours before they are used.


q          How does this JIT system help Toyota to enhance its competitive advantages?


The SUPPLEMENT below illustrates how Weyerhaeuser was able to enhance its competitive advantages by improving its customers' inbound logistics.


Enhancing your customers' inbound logistics activities


Weyerhaeuser employees at a sawmill in Cottage Grove, Oregon began spending a week at a time with their customers to decide how to improve their operations. They were there to look, listen, and learn — not to sell. They were able to bring back insights that enabled them to distinguish their mill. For example, they began to wrap their lumber in plastic and paint the ends in a distinctive color. They learned to load the lumber onto railway cars in a way that made it easier to unload. Buyers soon found that they were dealing with the field and telephone sales personnel who not only understood their problems but also frequently anticipated them. In the customers' minds, Weyerhaeuser's lumber became different from any other.  In essence, it became a branded item in an ocean of undifferentiated offerings.


Source:  Gouillart, F. J. & Sturdivant, F. D. 1994. Spend a day in the life of your customers. Harvard Business Review, 72(1): 125.


q          What other companies are you aware of that also interact this closely with their customers? 




Operations include all activities associated with transforming the final product form, such as machining, assembly, equipment, testing, printing, and facility operations.


We discuss how Shaw Industries, the world's largest carpet manufacturer, became known for its strong concern about the natural environment. They have received numerous awards for their recycling efforts.


STRATEGY SPOTLIGHT 3.2 discusses how Canon improved its operations by applying the principles of the Toyota Production System.  Ask:


q          Why do you think the cell production system worked at Canon? (e.g., production workers had responsibility for a finished product – not just a single function.) 



The SUPPLEMENT below addresses how Southwest Airlines is able to maintain superb productivity in an intensely competitive industry. This example may be particularly interesting because most of the attention at this firm is directed at its culture and colorful Chairman, Herb Kelleher.


Ensuring high productivity at Southwest Airlines


The key to our low costs is high productivity. We consistently demonstrate the highest asset utilization of any U.S. airline. Because we schedule point-to-point for local passengers, not connections, we minimize the amount of time the aircraft is at the gate, less than 25 minutes. This results in higher aircraft and airport utilization and, therefore, fewer aircraft and airport facilities than we would need otherwise. And, it allows our employees to be more productive.


One aircraft type, the Boeing 737, is operated by Southwest. This significantly simplifies our operation, in terms of scheduling, staffing, training, and maintenance. And it certainly contributes to lower costs.  As the launch customer for Boeing on its–300, -500, and, most recently, -700 models, we enjoy attractive acquisition costs. This, coupled with our young, well-maintained fleet, allows us to achieve low costs of ownership.


Source:  1999 Southwest Airlines Annual Report: 10.


q          What are some other ways that Southwest Airlines is able to lower costs? (It may be interesting to see how many students are aware of these: 70 percent of tickets are sold directly versus 10-15 percent average in the industry — lowering travel agent commissions; ticketless travel reduces significant paper and back office expenses; reusable boarding passes — and no assigned seating, etc.)


q          What are some of the advantages to being the low cost competitor in this industry? (e.g, higher margins, remaining profitable in downturns, reduce/eliminate the need for layoffs, etc.)




The activities of outbound logistics are associated with the collecting, storing, and distributing the product or service to buyers. They include finished goods warehousing, material handling, delivery vehicle operations, order processing, and scheduling.


       Our example is the use of electronic data interchange (EDI) for Campbell Soup, whereby Campbell has forged close links with their customers to both forecast future demand as well as determine what products require replenishment.


q          How does the use of EDI help Campbell Soup to enhance their competitive advantages in the marketplace? (Drawing on our discussion from Chapter 2, mention that it also increases their customers' switching costs.)




Marketing and sales activities are associated with purchases of products and services by end users and the inducements to get them to make purchases. They include advertising, promotion, sales force, quoting, channel selection, channel relations, and pricing.


We provide the example of Monsanto's effective efforts to convince channel partners to purchase their line of KeepSafe® (previously Saflex®) windows. It was critical to coordinate the product's value propositions.


       The SUPPLEMENT below addresses the importance of advertising for trade associations to get their members' message across to the public.




The low-carb Atkins Diet has become so popular in Britain that producers of starchy foods are worried. Although bread sales are down just 2 percent over the past three years, the food industry isn't taking it easy.


In September 2003, the British Potato Council, the Federation of Bakers, and the Flour Advisory Bureau held a "Carbo Summit" to unveil a study — funded by the industry — highlighting the health risks of low-carbohydrate diets. The Potato Council is spending $1.6 million on marketing, including a bus tour traveling the country passing out potatoes. In October, (also known as British Bread Month), the Federation of Bakers used retail promotions to try to boost bread's image as low-fat. "People think of bread and potatoes as fattening," say Tamara de Grassi, a nutritionist at the Flour Advisory Bureau.  "But carbohydrates provide important nutrients." Atkins officials say their diet allows "realistic" portions of starches.


While the carb crowd is hurting, the meat producers are living high on the hog. The U.K. Meat and Livestock Commission reports that consumption rose to a record 4.3 million tons in 2002 — up from 4.2 million the previous year.


Source:  Cohn, L. 2003. Starch is on the march. BusinessWeek, September 8: 10.



The SUPPLEMENT below discusses a very important aspect of marketing — marketing research. The example is Coach, a high-end producer of leather handbags and other leather products. (It should be of particular interests to marketing majors.)



Coach, with $1.4 billion in revenues, has put its leather in Lexus cars and Coach insignia on Canon Elph digital camera cases. However, the firm has turned down offers to lend its name to hotels or athletic drinks. It calls the strategy "focus" — and the Frankfort, Germany-based firm admits it had a rather stodgy image a decade ago. How things have changed! In its category, Coach ranks first for average annual total return (73.3%) since its October 2000 public offering, as well as first for average sales growth (21%), and earnings-per-share growth (60.1%) over the past five years.


         Coach clearly knows its customers' buying habits. It spends $4 million to $5 million a year on market research, including talking to 15,000 women on the phone, in-store or via the Internet or regular mail. From that, Coach knows the biggest spenders visit the stores every four to five weeks. With this information — Coach rolls out its new products and store designs to keep pace with this "rhythm." Last year, for example Coach introduced Madison, a satin and rhinestone line of evening bags that cost 20% or so more than its average $229 bag — it already makes up 5% of store sales.


Source:  Fass, A. 2005. Thank you for spending $300. Forbes, January 10: 150.



5.      SERVICE


This includes all activities associated with providing service to enhance the value of products such as installation, repair, training, parts supply, and product adjustment.


We discuss the importance of service for Internet-based retailers (e-tailers). In particular, we discuss the exemplar examples of Sephora.com and a more established, traditional retailer, Nordstrom's.


STRATEGY SPOTLIGHT 3.3 discusses one of Richard Branson's innovative approaches to exemplary customer service at Virgin Atlantic – the use of amphibious vehicles (Gibbs Aquada) to ferry first-class passengers down the Thames River to London's Heathrow International Airport.


q          What has your experience been with customer service when patronizing Internet firms? How can/should it be improved?





Support activities in the value chain are involved with competing in any industry and can be divided into four generic categories, as shown in EXHIBIT 3.3.


q          What firms are you familiar with that excel in some of the items included in Exhibit 3.3?  How does such excellence enhance their competitive position in their industry? How hard would it be for competitors to copy?


       We will now discuss each of the four support activities.




Procurement refers to the function of purchasing inputs used in a firm's value chain, not the purchased inputs themselves. Purchased inputs include raw materials, supplies, and other consumable items as well as such assets as machinery, laboratory equipment, office buildings, and buildings.


We discuss the example of how Microsoft improved their procurement operations by providing formal reviews of its suppliers. The example points out the value of constructive feedback and evaluation.


q          What are some of the benefits of such evaluation for both Microsoft and its suppliers?


The SUPPLEMENT below discusses how RoweCom, an electronic subscription agent on the Internet, has been successful by enhancing the procurement operations of its customers — libraries.


How RoweCom succeeds by helping libraries save money


Publishers traditionally have sold periodicals to libraries through subscription agents. Agents typically consolidate orders from many libraries and forward them to publishers, charging 3 % to 5 % of the list price for their services.  RoweCom permits libraries to order periodicals directly from publishers over the Internet and make payments electronically through Bank One. RoweCom also provides a new level of service. For instance, libraries can easily use the site to track their budgets. Most important, however, RoweCom charges $5 per transaction, not the 3 % to    5 % of the list price. As a result, libraries have been moving their expensive orders to RoweCom. In a recent 18-month period, more than 75 libraries—including some of the largest in the nation have subscribed to RoweCom's Internet service.


Source:  Ghosh, S. 1998. Making business sense of the Internet. Harvard Business Review, 76 (2): 131.




Every value activity embodies technology. The array of technologies employed in most firms is very broad, ranging from technologies used to prepare documents and transport goods to those embodied in processes and equipment or the product itself. Technology that is related to the product and its features supports the entire value chain, while other technology development is associated with particular primary or support activities.


We discuss some of the innovations in products and services that promise to emerge from the 2000 merger of Allied Signal and Honeywell. These include innovations in performance materials and control systems.


q          What are some of the most important technological innovations?  Are there possible "downsides"? Why? Why not?


STRATEGY SPOTLIGHT 3.4 discusses a rather innovative technology that should be of interest to students – a seaworthy foldable boat. The example provides an interesting instance of its use – a mountain rescue service – and how innovative technology eliminates leaks.


One of the major functions of universities is to generate research that is useful to society. The SUPPLEMENT below addresses some of the recent technological innovations and discoveries that have been developed at universities.




Below are three examples of recent innovations that have been recently developed at universities:


               Scientists have vastly underestimated the number of whales that inhabited the North Atlantic before the advent of whaling, say geneticists at Stanford University and Harvard University. By studying the DNA of whales, the researchers were able to estimate that there were some 2 million great whales in the 18th century — roughly 10 times than previously thought. Their findings are seen by conservationists as evidence that the ban on whaling should be extended for several more decades.


               For the 4 million Alzheimer's patients in the United States, new hope has just surfaced. Researchers at Harvard Medical School and Boston's Beth Israel Deaconess Medical Center report that an enzyme dubbed Pin1can prevent the brain's neurons from forming the deviant tangles characteristic of Alzheimer's.  Comparisons of Pin1 levels in healthy versus afflicted human brains, plus laboratory tests on mice show that the tangles are clearly associated with an absence of Pin1. Using gene therapy to restore the enzyme to normal levels — although extremely challenging to do — might therefore arrest the progress of the disease.


               Athletes like creatine for its brawn-building benefits. Now it turns out this compound, which occurs naturally in humans, may also enhance memory. In a study at Australia's University of Sydney, a group of young adult vegetarians who received a daily five-gram dose of the supplement had a boost in working memory. The researchers did not determine the duration of this improvement or the long-term consequences of using creatine.


Source:  Aston, A. 2003. Innovations. BusinessWeek, September 8: 105; and, Port, O. 2003. Innovations. BusinessWeek, August 11: 53.


q                    What do you think the role of research should be at universities (versus teaching and service)? (You will probably get some interesting discussion with some students claiming that universities should focus on teaching while others would stress the relationships between the teaching, research, and service missions.)




Human resource management consists of activities involved in the recruiting, hiring, training, development, and compensation of all types of personnel. It supports both individual primary and support activities (e.g., hiring of engineers and scientists) and the entire value chain (e.g., negotiations with labor unions).


In this section, we address JetBlue Airways' innovative "family friendly" initiative and AT & T's use of the internal labor market for talent.


q          What are the advantages of JetBlue Airways' and AT & T's innovative approaches to human resource management? Could these types of programs be used at companies with which you are familiar? Why? Why not?


STRATEGY SPOTLIGHT 3.5 provides an insightful discussion of how SAS justifies the broad array of benefits it provides to all employees. This should be interesting to students because often they may feel that such "expensive programs" do not have financial payoffs.


q          Could SAS Institute's approach be used at other organizations? Why? Why not?


Teaching Tip: While discussing the various support activities, ask those students who have some work experience whether or not the Human Resource Management function at their organization was well integrated with other value-creating activities such as operations, marketing, and procurement. Then you can address the issue of whether or not such relationships help to create value for the organization. (Interestingly, some students may point out that there were indeed interactions, but these actually were negative and bureaucratic in nature and eroded value.)




Firm infrastructure consists of a number of activities, including general management, planning, finance, accounting, legal, government affairs, quality management, and information systems.  Infrastructure (unlike other support activities) typically supports the entire value chain and not individual activities.


This section addresses how firm infrastructure can be used as a source of competitive advantages — not merely as "overhead expenses." We provide examples of the symbolic leadership of CEOs such as Hewlett-Packard's Carleton (Carly) Fiorina, Walgreen Drug's information systems, and how the legal services at Texas Instruments were able to generate significant cash flows for the firm via its patent portfolio.


STRATEGY SPOTLIGHT 3.6 discusses how Gary Kelly, Southwest Airlines' Chief Financial Officer, adds value for his firm. His approach is key to Southwest's liquidity and strong financial performance in an extremely competitive industry in the past few years.


The SUPPLEMENT below discusses an important general administration activity —legal — that can generate significant value for companies. We address how patenting of technological innovations has benefited IBM. (Clearly, patent attorneys have to work very closely with scientists and engineers to be successful in obtaining valuable patents.)














The number of patents granted is increasing and, apparently, becoming more valuable. In 2004, IBM was awarded 3,248 of them by America's patent office — 68 percent more than second place Matsushita. IBM has been top of the list for 12 years in a row, often beating its rivals by more than 50%.


         Such rankings shed light on both the past and the future of the technology industry.  Typically, it takes between three and five years to obtain a patent, so the 2004 crop reflects applications filed at the turn of the century. Patent protection lasts for 20 years from the filing date, giving successful applicants long-term exclusivity on their invention. Each of the leading patent winners has a backlog of over 1,000 applications at the U. S. patent office.


         IBM spends over $5 billion a year on R&D. It earns over $1.2 billion by licensing intellectual property (IP) protected by patents. According to Jim Stallings, IBM's vice-president of IP:  "We built a model that lets us invest and identify ways to differentiate our products, and also to give others access to our technology. That lets us ensure we leverage the investment we make in R&D."


Source:  Anonymous. 2005. Smart assets. The Economist. February 19: 60.




Up to now, we have addressed value chain activities separately. Here, we discuss: (1) interrelationships among activities within the firm, and, (2) relationships among activities with other organizations, such as suppliers and customers.


We first review the examples of AT & T's Resource Link Program and Campbell Soup's Electronic Data Interchange (EDI) to demonstrate interrelationships within the firm and relationships with other organizations, respectively.


Then, we present the example of Ciba Specialty Chemicals (now part of Novartis), a Swiss manufacturer of textile dyes. Their innovation of dyes that fix more readily to the fabric and require less salt provides significant advantages for their customers.


STRATEGY SPOTLIGHT 3.7 addresses how Cardinal Health works to create value for both its suppliers and customers. This example serves to illustrate the importance of viewing one's firm as part of a value chain system composed of a focal firm as well as its suppliers, customers, and alliance partners.





We added this section on how to apply the value chain concept to service organizations in order to help show how it can be applied to firms other than manufacturing firms (which is what Porter's generic value chain concept can be most directly applied). We provide Circuit City (retail) and Arthur D. Little (technology-based consulting company) as illustrations. EXHIBIT 3.4 includes a depiction of the primary activities for each of these firms.


Transparency XX (Ex. 3.4) Some Examples of…





q          What would be some of the important support activities for these two firms?


q          What are the key relationships among the primary and support activities to create value for these firms?





The resource-based view of the firm (RBV) combines two perspectives: (1) the internal analysis of phenomena within a company, and (2) an external analysis of the industry and its competitive environment. It extends SWOT analysis by combining internal and external perspectives and provides a useful framework for exploring why some firms are more successful than others.


EXHIBIT 3.5 addresses the types of resources that firms possess: tangible resources, intangible resources, and organizational capabilities.


q                    What are some examples of firms that are particularly strong (or weak) with regard to the items in Exhibit 3.5?


q                    Can you provide examples of firms that have effectively (or ineffectively) integrated their strengths regarding some of the items in Exhibit 3.5? 


Throughout this section we focus on the importance of integrating value-creating activities, i.e., that competitive advantages are created (and sustained) through the bundling of several resources in unique combinations.




This rather brief section discusses each of the three types of resources — tangible, intangible, and capabilities — and provides examples from business practice.


Tangible resources are assets that are relatively easy to identify and include financial, physical, organizational, and technological resources that an organization uses to create value for its customers.  We provide the example of FedEx's computer-based job competency tests.


Intangible resources are much more difficult for competitors to account for or imitate. These include human resources, innovation resources, and reputation resources. The example of Harley-Davidson's strong brand image is addressed.


Organizational capabilities are not specific tangible or intangible assets.  They are competencies or skills that a firm employs to transform inputs into outputs.  We present the example of Gillette's capabilities to combine several technologies in its wet-shaving products.


EXHIBIT 3.5 and the discussion on pages 93-94 address how Dell Computers' resources and organizational capabilities have enabled them to become dominant in the personal computer (PC) industry.




For a firm to earn a sustainable competitive advantage, it must have four attributes: valuable, rare, and difficult for competitors to imitate or substitute. We provide the example of Priceline.com and how this firm attained early success. However, its advantage was eroded due to imitation by competitors.  EXHIBIT 3.7 addresses these four criteria and their implications.


To encourage student discussion, ask the students: 


q          What are some examples of products (and services) that did not possess these four characteristics and subsequently did not provide sustainable advantages for the firm? 


The SUPPLEMENT below addresses the vast variety of consumer products on the market — giving additional credence to the argument that it is difficult to attain advantages that (typically) are not eroded over time.



The vast variety of consumer products


Imitation products have proliferated the consumer products market with 31,000 new consumer products in 2000 alone. The average grocery store stocks 40,000 items. There are 16 flavors of Kellogg Eggo waffles, nine kinds of Kleenex brand tissue, 19 varieties of Colgate toothpaste, and innumerable garbage can liners in scented, unscented with twist, drawstring, and handle ties. 


Procter & Gamble offers 19 varieties of Pert shampoo and 72 varieties of Pantene hair care products. Unilever has bucked the trend by decreasing its consumer products from 1,600 products to a mere 970 in the year 2000. The bottom line: It's not possible to attain sustainable advantages if your products don't satisfy the four RBV criteria.


Source:  Nelson, E. 2001. Too many choices.  The Wall Street Journal, April 23: B1, B4.


       We will now discuss each of the four criteria.




Resources are valuable when they enable a firm to formulate and implement strategies that improve its efficiency or effectiveness. The SWOT framework suggests that firms improve their performance only when they either exploit opportunities or neutralize (minimize) threats.




If competitors or potential competitors also possess the same valuable resource, it is not a source of competitive advantage because all of these firms have the capability to exploit the resource in the same way. Common strategies based on such a resource would give no one firm an advantage. For a resource to provide a competitive advantage, it must be uncommon, that is, rare relative to other competitors.




Inimitability is a key to value creation because it constrains competition. If a resource is inimitable, then any profits generated are more likely to be sustainable.


We discuss the example of Iowa Beef Processors (IBP). Although this firm was the first to modernize its facilities and capabilities, competitors easily duplicated its efforts. This drove down their profitability.


For imitation to be avoided, four conditions need to be satisfied:


Physical uniqueness. By definition it is inherently difficult to copy. Examples would include a beautiful resort location, mineral rights, or Merck & Co.'s pharmaceutical patents.


Path Dependency. This means that resources are unique and therefore scarce because of all that has happened along the path followed in their development and/or accumulation. We provide the examples of Gerber Products Co. and Southwest Airlines.


Causal Ambiguity. This means that would-be competitors may be thwarted because it is impossible to disentangle the causes (or possible explanations) of either what the valuable resource is or how it can be created. We discuss 3M's process of innovation as well as Continental Airlines' failure to imitate Southwest Airlines' successful low-cost strategy.


Social Complexity. These include "soft" issues such as culture, trust, and leadership.  Examples include interpersonal relations among the employees and managers of a firm, its culture, and its reputation among suppliers and customers. Although complex physical technology is not included in this category of imperfect inimitability, the exploitation of physical technology in a firm typically involves the use of socially complex resources.


       The SUPPLEMENT below discusses the market for corporate real estate and the importance of personal relationships and insider knowledge. It serves to drive home the point that competitive advantages are difficult to attain or sustain for new entrants. This is because some intangible assets may be difficult to imitate.










Corporate real estate:
The importance of personal relationships and insider knowledge


The market for corporate real estate leases, including apartment buildings, office buildings, retail malls, and warehouses, is a largely fragmented market. There is no central source corporate clients can turn to when they are looking to lease these types of facilities. But a promising new venture, Zethus, Inc. backed by $15 million of venture capital form Goldman Sachs, hoped to change the way business was done in this industry. Zethus hoped to become a central source for locating corporate real estate by bringing together tenants and landlords. Jim Hime, founder of the new venture, intended to use the Internet to broker the relationship between interested parties. However, he found that "the industry thrives on intricate personal relationships and insider knowledge." This is a prime example of a service that is difficult to imitate.


Hime's company, founded in 1999, at first intended to replace brokers by bringing together landlords and tenants on Zethus's website. But when he found that this would not work due to personal relationships involved in the business, he began to target the brokers themselves. His sales pitch was that Zethus would act as a neutral party to the deal for a small portion of the commission. He was unable, however, to convince brokers that he was looking out for their best interests.


Source:  Rich, S. 2001. Why a plan to list office properties on the Web failed. The Wall Street Journal, April 21: B2, B3.




The fourth requirement for a firm to be a source of sustainable competitive advantage is that there must be no strategically equivalent valuable resources that are themselves not rare or inimitable.


Substitutability may take at least two forms. First, although it may be impossible for a firm to imitate another firm's resource exactly, it may be able to substitute a similar resource that enables it to develop and implement the same strategy. We provide the example of roughly equivalent top management teams. Second, very different firm resources can become strategic substitutes. We provide the example of Internet booksellers such as Amazon.com as substitutes to brick-and-mortar booksellers such as B. Dalton and Crown. The result is that premier real estate becomes less valuable. We also discuss the viability of roughly equivalent drug therapies that treat similar maladies.


EXHIBIT 3.8 illustrates the relationship among the four criteria of sustainability and shows the competitive implications.


q          What may be example(s) of companies that illustrate each of the four conditions?




The key point in this section is that even though a firm may have a source of competitive advantage that appears to satisfy the four criteria for sustainability, some (or a good deal) of its profits may be retained (or "appropriated") by its employees or managers—instead of going to the owners (i.e., shareholders).


We address four conditions that explain the extent to which managers and employees will be able to extract a proportionately high level of the profits they generate:


·                     Employee bargaining power

·                     Employee replacement cost

·                     Employee exit cost

·                     Manager bargaining power


Teaching tip: The discussion of the generation and distribution of a firm's profits between the firm and individual employees is a good opportunity to discuss some of the career implications for the students and enable them to realize the practical applicability of the concepts covered in this section. In this section, we address the four conditions that enable managers and employees to extract a disproportionate share of the profits that they generate. You may ask them to think back on people they have known in organizations who were either very successful or very unsuccessful and if their success (or lack thereof) could be explained by these four criteria. The career implications become rather self-evident.




Here, we address two major approaches to evaluating firm performance. The first is financial ratio analysis in which we assess how a firm is doing compared to its balance sheet, income statement, and market valuations. 


Second, we address performance from the perspective of a broader stakeholder perspective. Kaplan and Norton's concept of the balanced scorecard is central to our discussion.




We address five different types of financial ratios:


·                     Short-term solvency or liquidity

·                     Long-term solvency measures

·                     Asset management

·                     Profitability

·                     Market value


We also provide an APPENDIX to this chapter to provide detailed definitions and discussions of each of these types of ratios; including examples of how they are calculated.


(All of your students have been exposed to this information in their accounting and finance classes but it is worthwhile to spend some time in review.)


Next, we address some issues that must be taken into account in order to make financial analysis more meaningful: historical comparisons, comparisons with industry norms, and comparisons with key competitors.




Comparing a firm's performance over time helps to provide a means of evaluating trends. We provide the example of Nissan's improved performance between 1999 and 2000. EXHIBIT 3.9 illustrates a ten-year period of return on sales for a hypothetical company. As indicated by the dotted trend lines, the rate of growth (or decline) differs substantially over time periods.


At times, historical comparisons may need to be used with caution. For example, the SUPPLEMENT below provides some specific information on how percentage increases can, in effect, distort reality. Consider how some specific data on percentage in the export of U. S. automobiles to Japan many years ago could be misleading.


U.S. car sales to Japan — The importance of "relative" sales volume


Percentage increases may imply that U.S. automakers made inroads in the Japanese markets a decade ago.  However, such apparent optimism is eroded when absolute numbers are addressed. Though sales climbed 800 % between 1985 and the early 1990's, total sales of the Big Three in Japan were only about 17,000 in 1991. (This figure represents only about one month's production at a typical automobile plant!) Meanwhile, Japanese automakers sold approximately 3.3 million cars in the U. S. in 1991 — a factor of nearly 200!


Source:  Miller, K. L. 1991. What's this?  American cars gaining in Japan. Business Week: July 22: 82-83.




When evaluating a firm's financial performance, it is important to compare it with industry norms. That is, a firm's current ratio or profitability may be impressive at first glance. However, it may pale when compared to industry averages.


EXHIBIT 3.10 compares financial ratios for three different industries — semiconductors, grocery stores, and skilled nursing facilities. Although the text provides a brief discussion of why there is such variation among these industries, it may still be useful to pose this question — to reinforce learning and obtain additional insights.




Referring back to Chapter 2, firms with similar strategies are considered members of strategic groups in a given industry. Furthermore, competition tends to be more intense among competitors within groups than across groups. Thus, one can gain valuable insights into a firm's financial and competitive position if comparisons are made between a firm and its most direct competitors.


EXHIBIT 3.11 points out the importance of comparing financial figures to key competitors.  Although Procter & Gamble's R&D budget for drugs may be quite large in an absolute sense--$380 million, it pales in comparison to the major competitors in this industry such as Bristol-Myers Squibb, Pfizer, and Merck.




            1.      THE BALANCED SCORECARD


The balanced scorecard helps to provide a meaningful integration of many issues that come into play when evaluating a firm's performance. It is a set of measures that provide top managers with a fast but comprehensive view of the business. In a nutshell, it includes financial indicators, operational measures of customer satisfaction, internal processes, and the organization's innovation and improvement activities.


The balanced scorecard enables managers to consider their business from four key perspectives:


·               How do customers see us? (customer perspective)

·               What must we excel at? (internal perspective)

·               Can we continue to improve and create value? (innovation and learning perspective)

·               How do we look to our shareholders?  (financial perspective)




Managers must translate their general mission statements on customer service into specific measures that reflect the factors that really matter to customers. There are four primary categories of customer concerns: time; quality; performance and service; and cost. 




Customer-based measures are important. However, they must be translated into indicators of what the firm must do internally to meet customers' expectations. The internal measures should reflect business processes that have the greatest impact on customer satisfaction. This includes factors such as cycle time, quality, employee skills, and productivity.




Given the rapid rate of change in markets, technologies, and global competition, the criteria for success are constantly changing. Accordingly, a firm's ability to improve, innovate, and learn ties directly to its value. That is, only by developing new products and services, creating greater value for customers, and increasing operating efficiencies, can a company penetrate new markets, increase revenues, and grow shareholder value.


q          Should other companies use Tivoli's approach? If so, how should it be organized?




Such measures indicate whether the company's strategy, implementation, and execution are, in fact, contributing to bottom-line improvement. Typical financial goals include profitability, growth, and shareholder value. Periodic financial statements remind managers that improved quality, response time, productivity, and innovative products benefit the firm only when they result in improved service, increased market share, reduced operating expenses, or higher asset turnover.


We Discuss the example of Sears, the giant U. S. retailer to illustrate the strong causal relationships among employee attitudes, customer attitudes, and financial outcomes. This should come across as an interesting example in that many "hard to quantify" concepts are, in fact, accurately measured.


The SUPPLEMENT below serves as a "caveat" to the use of the balanced scorecard. That is, it emphasizes that the alleged linkage between improved operating performance and financial success can be quite tenuous and uncertain. 


The tenuous linkage between financial success and operating performance


Over a three-year period between 1987 and 1990, a NYSE electronics company made a significant improvement in quality and on-time delivery performance. Outgoing defect rates dropped from 500 parts per million to only 50, on-time delivery improved from 70 % to 96%, and yield soared from 26 % to 51 %. Unfortunately, these breakthrough improvements in quality, productivity, and customer service did not provide substantial financial benefits to the company.


During the same period of time, the firm's financial results showed little improvements and the stock price eroded to one-third of its July 1987 value. Why? The considerable improvements in manufacturing capabilities had not been translated into increased profitability. Slow releases of new products and a failure to expand marketing to new and perhaps more demanding customers prevented the company from realizing the benefits of its manufacturing achievements. The operational achievements were real, but the company failed to capitalize on them.


Source:  Kaplan, R. S. & Norton, D. P. 1992. The balanced scorecard—Measures that drive performance.  Harvard Business Review, 70 (1): 77.


Teaching Tip:  During the discussion of the Balanced Scorecard, it is important to bring to the class' attention that there are inevitable tradeoffs between the elements in the balanced scorecard. What are the challenges involved in balancing these tradeoffs? You may point out that at a given time a firm may focus on a goal that is more pressing at that point in time. You may also point out that a firm can focus on different elements at different points in time, building on the success in one area to improve in another.


In addition to the tradeoffs that we discussed in the above SUPPLEMENT, there have been other critical commentaries on the use of the Balanced Scorecard concept. We include this discussion not to discount its potential value, but rather to add an additional perspective on this widely used strategy tool. 


In the SUPPLEMENT below, we summarize some of the problems/challenges that users have discovered in using the Balanced Scorecard:





Although Canada has embraced the use of balanced scorecards, there has hardly been universal positive response. An estimated 65% to 70% of organizations have used them and their use is increasing.


A few users — about 10% — insist that their scorecards are attaining positive results and meet with spirited rebuttal suggestions that balanced scores do not work. In contrast, a much larger group doubts that scorecards achieve sustained financial performance.


The overwhelming view seems to be that balanced scorecards can be worthwhile in clarifying an organization's strategy and that if this can be accomplished, better results should follow. A few companies stated categorically that scorecards have made a positive difference in their firm's financial results. A typical statement was, "We did not meet our financial goals previously, but since implementing our balanced scorecard, we have now met our goals three years running."  In contrast, a larger number agreed with the statement, "Balanced scorecards don't really work." Comments included: "It became just a number-crunching exercise by accountants after the first year;" "It is just the latest management fad and is already dropping lower on management's list of priorities as all dads eventually do;" "We found it very complex to implement;" and, "If scorecards are supposed to be a measurement tool, why is it so hard to measure their results?"


A summary of some of the key problems that can be associated with Balanced Scorecards include:


·                      Emphasis on financial measures rather than nonfinancial, leading to measures that do not connect to the drivers of the business and are not relevant to performance improvement

·                      Too many objectives defined and too many performance metrics being measured to enable the organization to prioritize improvements steps adequately

·                      Poor data on actual performance, negating most of the effort invested in defining performance measures by not being able to monitor actual changes in results from changes in behavior

·                      Managers not communicating the cultural change clearly and continuously, supported by management deeds that confirms that management is serious.

·                      An implementation plan that is not grounded in reality and unable to respond quickly to unforeseen events.


Source:  Angel, R. & Rampersad, H. 2005. Do scorecards add up? Camagazine.com, May: np.



Teaching Tip:    You might consider asking the following question prior to discussing the material in the supplement above: What do you think are some of the problems that can potentially be expected with the use of the Balanced Scorecard. Or, if your students, as a group, have a relatively large amount of business experience, you may ask them: What has been your experience with the use of the Balanced Scorecard in your organization? Has it worked well? Why? or, Why not?




       We close the chapter with a discussion of the concept of the "strategy map," which is a further refinement of Kaplan and Norton's "balanced scorecard." Strategy maps endeavor to indicate the case and effect links by which specific improvements in different areas lead to a desired outcome. Strategy maps also help employees see how their jobs are related to the overall objectives of the organization. They also serve to clarifying how an organization can convert its assets, both tangible and intangible, into tangible outcomes.


              EXHIBIT 3.12 illustrates how to develop a strategy map using ExxonMobil as an example.


Transparency XX (Ex. 3.12)  ExxonMobil's Strategy Map





In traditional approaches to assessing a firm's internal environment, a manager's primary goal would be to determine her firm's relative strengths and weaknesses. Such is the role of SWOT analysis, wherein a manager analyzes her firm's Strengths and Weaknesses as well as the Opportunities and Threats in the external environment. In this chapter, we discussed why this may be a good starting point but hardly the best approach to performing a sound analysis. There are many limitations of SWOT analysis, including its static perspective, its potential to overemphasize a single dimension of a firm's strategy, and the likelihood that a firm' strengths do not necessarily help the firm create value or competitive advantages.


We identified two frameworks that serve to complement SWOT analysis in assessing a firm's internal environment: value chain analysis and the resource-based view of the firm. In conducting a value chain analysis, you first divide the firm into a set of value creating activities. These include primary activities such as inbound logistics, operations, and service as well as support activities such as procurement and human resources management. Then you analyze how each activity adds value as well as how interrelationships among value activities in the firm and among the firm and its customers and suppliers add value. Thus, instead of merely determining a firm's strengths and weaknesses per se, we analyze them in the overall context of the firm and its relationships with customers and suppliers, the value system.


The resource-based view of the firm considers the firm as a bundle of resources:  tangible resources, intangible resources, and organizational capabilities. Competitive advantages that are sustainable over time generally arise from the creation of bundles of resources and capabilities. For advantages to be sustainable, four criteria must be satisfied: rareness, valuable, difficulty in imitation, and difficulty in substitution. Such an evaluation requires a sound knowledge of the competitive context in which the firm exists. The owners of a business may not capture all of the value created by the firm. The appropriation of value created by a firm between the owners and employees is determined by four factors: employee bargaining power, employee replacement cost, employee exit costs, and manager bargaining power.


An internal analysis of the firm would not be complete unless you evaluated its performance and made the appropriate comparisons. Determining a firm's performance requires an analysis of its financial situation as well as a review of how well it is satisfying a broad range of stakeholders, including customers, employees, and stockholders. We discuss the concepts of the balanced scorecard and strategy map, in which four perspectives must be addressed: customer, internal business, innovation and learning, and financial.  Central to the balanced scorecard is the idea that the interests of various stakeholders can be interrelated.  We provide examples of how indicators of employee satisfaction lead to higher levels of customer satisfaction, which in turn lead to higher levels of financial performance. Thus, improving a firm's performance does not need to involve making tradeoffs among different stakeholders.  Assessing the firm's performance is also useful if it is evaluated in terms of how it changes over time, compares with industry norms, and compares it with key competitors.


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