Firm Capabilities: Assessing Strengths and Weaknesses

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CASE 1: Pizza Hut CASE 2: General Motors Corporation Introduction The Value Chain Primary Activities Support Activities Pizza Industry Value Chain Primary Activities Support Activities Automobile Industry Value Chain Primary Activities Support Activities The Value Chain as Part of a Business System Pizza Hut General Motors Capability Drivers First-Mover Status Scale of Operation Experience Interrelationships Assessing Competitive Advantage First-Mover Advantages Scale and Experience Advantages The Growth of the Internet and Competitive Advantage Diagnosing Pizza Hut’s Capabilities First-Mover Advantages Scale Advantages Experience Benefits Interrelationships Achilles’ Heel of Established Firms Assessing the Financial Position of Competitors Ethical Issues Examining Competitors’ Products Questioning...

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Firm Capabilities: Assessing Strengths and Weaknesses CHAPTER OUTLINE Ethical Issues Examining Competitors’ Products CASE 1: Pizza Hut Questioning Competitors’ Employees CASE 2: General Motors Corporation Using Consultants Engaging in Industrial Espionage Introduction “Pirating” Employees The Value Chain Conclusion Primary Activities Support Activities Summary Pizza Industry Value Chain Exercises and Discussion Questions Primary Activities Support Activities Automobile Industry Value Chain Primary Activities Support Activities The Value Chain as Part WHAT YOU WILL LEARN of a Business System Pizza Hut • The strategic tool known as the value General Motors chain Capability Drivers First-Mover Status • The use of the value chain in Scale of Operation evaluating an organization’s internal Experience strengths and weaknesses Interrelationships Assessing Competitive Advantage • The differences between primary and First-Mover Advantages supporting value-adding activities Scale and Experience Advantages The Growth of the Internet and • The concept of competitive Competitive Advantage advantage Diagnosing Pizza Hut’s Capabilities First-Mover Advantages • The concept of distinctive Scale Advantages competence Experience Benefits Interrelationships • Some important economic sources Achilles’ Heel of Established Firms of competitive advantage Assessing the Financial Position of Competitors 55
56 PART 1 Building Competitive Advantage (Case 1) Pizza Hut1 Pizza Hut, a division of Tricon Global Restaurants, is the Chicken (KFC) and Taco Bell, enable Pizza Hut to gain largest seller of pizza in the world. As such, it enjoys unique significant negotiation leverage with advertising firms to advantages not available to smaller rivals. These advantages conduct jointly sponsored marketing campaigns. In have contributed significantly to its success in recent years, addition, all three restaurant chains were once part of enabling it to outperform the industry by a considerable mar- PepsiCo, the nation’s second largest provider of beverages and the leader in snack foods through Frito-Lay. Even gin in both revenue and growth. Among the most important though all three restaurants are now formally separated advantages Pizza Hut enjoys as a result of its leadership posi- from PepsiCo, they still closely work with Pepsi to secure tion are the following: lower cost beverages and other supplies from their former • Location: As the first competitor to establish a facility in parent. These advantages are not available to smaller rivals many high-traffic areas, it has been able to preempt some operating as single business firms. of the most desirable restaurant locations. Even with these many strengths, Pizza Hut has suffered its • Reputation: It is better known by consumers than are share of setbacks in the past. Perhaps the most serious resulted rivals. This distinction provides it an important from its refusal for many years to supply the growing demand marketing edge. for home delivery of cooked pizza. This policy left the home • Advertising clout: Because it can spread TV advertising costs over so many units, it can afford to advertise on delivery niche open to competitors. Pizza Hut has since nationwide TV; most rivals, having fewer units, are changed its stance and is now making a concerted effort to build effectively barred from this important advertising medium. market share in this area by opening up a series of pizza prepa- • Purchase discounts: Its large-scale purchase of advertising ration facilities that are solely dedicated to home delivery. How- time and food ingredients enables it to enjoy quantity ever, it faces a series of formidable competitors—Domino’s discounts not available to smaller competitors. Pizza, Pizza Inn, Little Caesar’s—all of whom have made seri- • Interrelationships: Its interrelationships with other units of ous inroads into this market. Tricon Global Restaurants, including Kentucky Fried (Case 2) General Motors Corporation2 Despite its status as the world’s largest auto manufacturer, U.S. market. The wage gap resulted in part from the historically General Motors has performed poorly in recent years, suffer- lower wages paid to Japanese workers. However, GM’s rela- ing a steady decline in market share (from 50 percent in 1979 tively high wage costs resulted mainly from its failure to to 35 percent in 1997), closing many factories, enduring improve productivity and to accurately assess the growing numerous strikes at its auto and parts plants, and laying off strengths of its foreign competitors. When compared with Ford thousands of workers. Why has GM performed so poorly over and Chrysler as recently as 1998, GM’s employee productivity the past two decades? The most likely factors are several weak- per car was still anywhere from 40 percent to 60 percent lower. nesses that continue to plague General Motors, despite numer- The comparatively low productivity of GM resulted from the ous attempts to revitalize and improve its operations. company’s inability to adjust to massive changes in the auto- mobile industry environment over the past two decades. High Wage Costs During the 1970s, GM, along with Ford and Chrysler, oper- Even with steep appreciation in the value of the Japanese yen ated in a relatively predictable environment that was insulated during the 1990s, GM’s wage costs per hour still remained from significant foreign competition. Within this safe cocoon, higher than those of its Japanese competitors until very U.S. firms were able to charge high prices and enjoy handsome recently. This differential was particularly wide during the profits. Workers soon demanded a share in this prosperity in the 1970s when Japanese companies first began their assault on the form of higher wages and benefits. Because foreign competition
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 57 appeared limited and current productivity levels appeared satis- factories, plants, and equipment than its competitors to build factory, GM management allowed personnel costs to rise to high these components. General Motors’ internal parts-making unit, levels. The net result was wage costs much higher than those of known as Delphi Automotive Systems, produces a whole range Japanese auto makers, putting GM at a serious disadvantage just of different components and parts, ranging from automotive at the time when it most needed competitive strength to ward off electronics to powertrains and engines. However, Delphi faces growing amounts of foreign competition. However, Chrysler and many of the same labor-related and productivity problems that Ford were pushed much closer to the brink of bankruptcy during plague GM’s automotive assembly operations. While a high several downturns in the 1980s and 1990s than GM; some ana- degree of self-contained manufacturing can sometimes be an lysts have noted that this “taste of death” has forced important advantage, it turned out to be a weakness for GM. High wages changes in the way that both Chrysler and Ford design and build and worker alienation also plague GM’s component facilities, their cars for a more demanding market. GM, on the other hand, so the components they supply are often more expensive, less was still large enough to avoid almost complete collapse. well designed, and less conveniently delivered than similar items available from outside suppliers. Oftentimes, outside sup- Disgruntled Work Force pliers can make components at far less cost and better quality Despite high wages, GM workers have remained generally than GM can. unsatisfied in recent years. Employees at GM felt alienated from management, resulting in high absenteeism, shoddy work, Bureaucratic Delays union rules limiting the tasks workers can perform, and general Because of its large size, GM experiences greater difficulty hostility towards management. These factors have led GM making and implementing decisions than its smaller competi- workers to be less diligent and less enthusiastic about seeking tors, often slowing its adaptation to changes in the industry improvements in production methods than their counterparts in environment. For example, it lagged behind Japanese rivals in other firms. As a result, GM’s productivity dropped signifi- seizing new opportunities for engine computerization and fuel cantly below that of competitors. efficient automobiles. Even routine changes such as new model introduction pose difficulties for GM. Its introduction of the Lack of Focus in Manufacturing Cadillac Seville in the early 1990s, for example, was delayed GM makes more (and buys less) of the components it uses to for almost a year because of difficulties with the design, paint assemble cars than its rivals. GM must therefore spend more on system, and quality control. INTRODUCTION To identify opportunities and to neutralize threats in the external environment, managers must thoroughly evaluate their firm’s potential capabilities to compete. A significant part of successful strategy formulation depends on a careful assessment of the firm’s strengths and weaknesses. This requires each firm to conduct an internal analysis to determine those activities it can perform better than its competitors. Finding those activities or resources that allow the firm to perform in ways that other competitors cannot do as well is one key to developing effective strategies. Even though numerous rivals may compete in the same industry environment, some firms are likely to perform some activities better than others. Thus, each firm has its own particular set of strengths and weaknesses that influences how it competes. This chapter examines the concept of firm capabilities and internal analysis of strengths and weaknesses. Developing effective strategies requires managers to under- stand how each firm’s strengths and weaknesses may differ from those of competitors. These differences lay the foundation on which each firm bases its own strategy in the competitive environment. We begin by examining the concept of the value chain. The value chain is an analytical tool that helps firms understand how their primary and sup- porting activities can be used to create value. It is the starting point for helping firms identify their strengths and weaknesses. We will then apply the value chain analysis tool to examine the types of activities that occur in two different industries: pizzas and
58 PART 1 Building Competitive Advantage value chain: an analytical automobiles. In a later section, we discuss other issues related to developing firm capa- tool that describes all bilities outside of the value chain, such as financial analysis and internal organization. activities that make up the economic performance and THE VALUE CHAIN capabilities of the firm; used to analyze and examine To understand how a firm builds its capabilities to compete, one must identify the specific activities that create value types of activities that make up the firm’s competitive posture. Every firm engages in for a given firm. numerous activities that, in sum, determine its competitiveness in serving customers in the primary activities: marketplace. These activities create economic value. A useful analytical tool for portray- economic activities that ing and analyzing these activities is the value chain shown in Exhibit 3-1.3 The value chain relate directly to the actual describes all of the activities that make up the economic performance and capabilities of creation, manufacture, the firm. It portrays activities required to create value for customers of a given product or distribution, and sale of a product or service to the service. As such, the value chain is an excellent means by which managers can determine firm’s customer (see the strengths and weaknesses of each activity vis-a-vis the firm’s competitors. support activities). The value chain classifies each firm’s activities into two broad categories: primary support activities: activities and support activities. Primary activities relate directly to the actual creation, economic activities that development, manufacture, distribution, sale, and servicing of the product or service assist the firm’s primary offered to the firm’s customer. These activities represent the key tasks a firm performs to activities (see primary produce and deliver a product or service to a customer. Support activities refer to those activities). tasks that contribute to or assist the firm’s primary activities. In other words, support activ- e x h i b i t (3-1) The Value Chain S U Infrastructure P P O R Human T Resource Management A C T Technology I Development V I T I Procurement E S PRIMARY ACTIVITIES Inbound Operations Outbound Marketing/ Service Logistics Logistics Sales Reprinted/Adapted with the permission of The Free Press, a division of Simon & Schuster, Inc. from COMPETITIVE ADVANTAGE: Creating and Sustaining Superior Performance, by Michael E. Porter. Copyright © 1985 by Michael E. Porter.
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 59 ities work to enhance or to help the functioning of primary value-adding activities. The combination of both primary and support activities determines the firm’s basis for adding value. By breaking up the firm’s value chain into discrete, isolated centers of activity, man- agers can assess whether they are performing each activity in ways that are better than that of their competitors (for example, lower cost, better quality, faster delivery). In other words, it is not enough to say that one firm is better than another in some overall way; the value chain allows managers to compare their firm’s specific activities with the same activ- ities performed by competitors. Thus, comparing a firm’s chain with that of competitors can provide valuable insight on each firm’s individual strengths and weaknesses. Activities in the value chain can be characterized as being upstream or downstream. Upstream activities occur far away from the consumer, closer to the firm’s suppliers. In upstream activities: other words, upstream activities are performed in the early stages of the value-adding economic activities that process. Downstream activities occur closer to the firm’s buyers. Downstream activities occur close to the firm’s add value to those inputs that were processed through earlier upstream value-adding suppliers but far away from activities. the consumer. Examples include inbound logistics, procurement, manufacturing, and operations (see also Primary Activities downstream activities). The sequence of activities through which raw materials are transformed into benefits downstream activities: enjoyed by customers are called primary activities. These activities are shown along the economic activities that bottom row of Exhibit 3-1. Five major activities make up this sequence: inbound logistics, occur close to the customer operations, outbound logistics, marketing/sales, and service. Working together, these five but far away from the firm’s suppliers. Examples activities determine the key operational tasks surrounding the product or service. include outbound logistics, • Inbound logistics: In most industries, the transformation process begins with distribution, marketing, conveyance or delivery of raw materials to a firm’s manufacturing (or service) sales, and service (see also facilities. upstream activities). • Operations: Inputs are transformed into products. • Outbound logistics: Products are shipped to distributors or to final users. • Marketing/sales: Users are informed about products and encouraged to buy them. • Service: Once in the customers’ hands, products are installed, repaired, and maintained. Let us now examine more closely the specific tasks and operational procedures that make up these five primary activities. Inbound Logistics. As the words imply, inbound logistics deal with the handling of materials and inventory received from the firm’s suppliers. The typical operational proce- dures and tasks surrounding inbound logistics include warehousing, storage, and control of raw materials or managing component flows from different suppliers. Inbound logistics are considered a primary activity because they represent the beginning of the firm’s value- adding conversion of inputs. Inbound logistics represent a major source of direct costs to the firm; thus, new techniques and improvements in inventory control, storage, and mate- rials handling can dramatically improve a firm’s cost position in this activity. Differences in storage and inventory costs relative to one’s competitors can add up to a significant com- petitive strength or weakness. In many firms, inbound logistics require significant capital investment. The location and management of warehouses, and the inventory held in them are important areas in which to focus cost control and efficiency. Many manufacturers around the world have taken numerous steps in recent years to improve the efficiency and reduce costs involved with inbound logistics activities. At General Electric, for example, the huge dishwasher and refrigerator plant at Louisville, Kentucky, uses highly automated bar-coding, sorting,
60 PART 1 Building Competitive Advantage and inventory checking systems that enable GE to move components and parts quickly from the railhead to its factory. Parts and components do not sit idle in warehouses for long. Fast movement of components and inventory greatly reduces the operating costs for the entire Major Home Appliance Group business. Improvements in inbound logistics activities are not confined to manufacturing firms. For example, both United Parcel Service (UPS) and Federal Express (now FedEx) have built strong competitive positions by using techniques that promote super-efficient, time- responsive sorting of packages and overnight mail. Both firms expect their business to grow with the rise of on-line through the Internet and e-commerce. Banks and financial service firms depend on extremely automated, real-time, and efficient inbound logistics to manage, coordinate, and track the flow of payments and funds that enter their systems for different purposes such as credit card payments, investments, and cash management. Operations. Operations are the activities and procedures that transform raw materials, components, and other inputs into finished end products. In other words, operations con- cerns itself with the generation, manufacture, and/or production of products and services. Specific task activities in the operations realm include stamping, machining, testing, fab- rication, and assembly. In a broader sense, any type of processing activity that results in a product or service is the heart of the firm’s operations. Operations also represents the dom- inant upstream activity in many firms. Success in managing and improving upstream oper- ations over time represents a critical source of leverage in building or reinforcing a firm’s ability to compete in a sustained manner. Differences between firms conducting similar types of operations may result from relative age of equipment, type of technology used, size of plant, economies of scale, productivity levels and gains, wage rates, and possible improvements resulting from longer experience. In many ways, how a firm manages its production/transformation operations will strongly influence the entire firm’s competitive posture. For example, in the chemical, oil refining, and paper industries, the dominant production mode is that of continuous flow processes. Continuous flow processes are characterized by rigid and dedicated production systems geared to the standardized production of a single or limited range of products. These capital-intensive processes are costly to operate and hard to switch between prod- ucts; they represent very large fixed costs for the firm. Any disruption of a continuous flow process generates enormous down-time costs for the firm. As a result, firms in industries whose dominant production mode is that of continuous flow processes are likely to develop strategies that recognize the nature of the production process’s high fixed costs, rigidity, and lack of flexibility in switching to alternative products. The considerable focus and effort that firms have placed on implementing total qual- ity improvement (TQM) in manufacturing and service spawned new technologies and practices that allow firms to improve the efficiency and quality of their operations-based activities. Consider, for example, the illustration of Nucor in the steel industry. Unlike integrated steel mills such as Bethlehem Steel, USX, and National, Nucor built up a sig- nificant competitive position in the steel industry by focusing on mini-mills. These mills are super-efficient and can produce a ton of steel of significantly better quality for less cost than older integrated mills. Investment in highly responsive and efficient mini-mills has enabled Nucor to sustain its profitability for many years, even when the industry moved into downturns and recessions. The focus on improving operations has certainly not been limited to the heavy manufacturing sector. Motorola, a leading manufacturer of semiconductors, electronic components, and cellular telephones, has made enormous strides by simultaneously improving the responsiveness, cost efficiency, and quality of its manufacturing process. Motorola views sustained investment and improvement in
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 61 advanced manufacturing technologies as central to its ability to compete. This highly admired U.S. firm has built up substantial manufacturing capabilities that allow the firm to produce winning new products every year against Japanese competitors in the semi- conductor, communications equipment, and electronics business. Outbound Logistics. Outbound logistics refer to the transfer of finished end product to the distribution channels. The focus in outbound logistics is on managing the flow and dis- tribution of products to the firm’s immediate buyers, such as wholesalers and retailers. Activities and procedures associated with outbound logistics include inventory control, warehousing, storage, and transport of finished products. As is the case with inbound logis- tics and operations, improvements in efficiency and responsiveness of outbound logistics can greatly aid the firm’s competitive posture. Firms can build competitive strengths based on their ability to lower the costs of outbound distribution and to enhance responsiveness. Procter and Gamble over the past several years has made major efforts to improve the efficiency and turnaround of its outbound logistics activities. By linking up more closely with key wholesalers and retailers (Wal-Mart Stores, for example), P&G has accelerated the timely delivery of goods that retailers have trouble stocking. By making extensive use of bar-coding technology, P&G and its key buyers balance the flow of inventory and goods between P&G’s warehouses and the retailers’ store shelves. This responsive distribution system becomes an overwhelming competitive strength for P&G and helps the company track which products are in particularly high demand. Conversely, a close understanding of how its products are distributed gives P&G a better understanding of how to work with its buyers to improve everyone’s margin over time. Marketing and Sales. Marketing and sales activities include advertising, promotion, product mix, pricing, specific distribution channels, working with wholesalers, and sales force issues. Marketing is vital in helping the firm determine the competitive scope of its value-adding activities. For example, some firms may decide to concentrate their efforts on a specific market segment or niche, while other firms may want to pursue a more broad- line product strategy. Thus, marketing becomes a vehicle by which the firm can develop specific competitive postures and strategies to serve a variety of segments or niches within the industry. Marketing activities deal extensively with pricing issues as well. The price of a firm’s product can be an important signal or indicator of the firm’s value-creating capa- bilities; a product’s price becomes a surrogate measure of what value the firm is deliver- ing to the market. Marketing activities also represent a central part of the firm’s down- stream value-adding activities; planning in these activities is oriented toward meeting the needs of immediate buyers and the final consumer. Clearly, numerous companies have built extensive competitive positions and strengths based on their superior approaches to managing marketing activities. Companies such as Coca-Cola, McDonald’s, Burger King, PepsiCo, American Home Products, Bristol- Myers Squibb, Schering-Plough, and American Express come to mind as leading corpo- rate examples of firms that have built effective competitive strengths based on excellence in marketing activities. Service. Customer service is a central value-adding activity that a firm can seek to improve over time. During the 1990s, an increasing number of companies are redefining the way they manage their customer service activities. Value is more often defined in the eyes of the customer rather than by what the firm thinks it has created. Thus, customer service has become a vital means to compete in any industry environment. Customer service includes such activities and procedures as warranty, repair, installation, customer support,
62 PART 1 Building Competitive Advantage product adjustment and modification, and immediate response to customer needs. Customer service is so important as a competitive weapon because it enables a firm to create value immediately before the customer’s eyes. How well the firm conducts these tasks will strongly impact the customer’s preference for buying from the firm again in the future. Both FedEx and UPS thrive in the overnight delivery business because of their superior approaches to customer service. Conversely, the U.S. Postal Service, which offers a similar overnight delivery service, has comparatively fewer customers in this segment than both FedEx and UPS, despite the enormous size and reach of the postal system. Lingering con- cerns (albeit declining) over the Postal Service’s reputation for service quality have limited its ability to seize a big portion of this profitable market. Companies in every industry ranging from telecommunications to hotels, industrial equipment to aerospace, are rethinking and reinventing the ways they perform customer service activities. For example, many current reengineering efforts are devoted to reengineering: the improving how firms meet their customers’ needs. Reengineering means redefining the complete rethinking, way firms organize their operations to improve responsiveness to customer needs. For reinventing, and redesign of example, at GTE, customers can now call one number and get all of the information they how a business or set of need about their account from one customer service representative. In the past, cus- activities operates. tomers had to dial separate numbers for different requests, such as telephone installation, equipment repair, leasing, purchase, and account adjustments. Now, one phone call to GTE enables a customer to have all of his/her questions and concerns addressed by a customer service representative who can provide assistance and service on almost any aspect of telecommunications that GTE provides. Other telecommunications companies, such as SBC Communications, AT&T, Sprint, MCI Worldcom, and U.S. West, are mov- ing in the same direction to improve the speed, accuracy, and delivery of their customer service operations. Perhaps the most important source of technological change that has transformed the very notion of fast and responsive customer service is the Internet. Barnes & Noble, L. L. Bean, Xerox, IBM, General Electric, Dell Computer, Fidelity Investments, Charles Schwab, and Wells Fargo are among the firms that have begun to lead the way in using the Internet as a competitive weapon to dramatically improve their customer service operations. By creating sophisticated home pages on the World Wide Web, many com- panies are encouraging their current and potential customers to use the Internet as a means to gather information, select their desired products, and order products through on-line, instantaneous transactions. In the financial services industry, for example, many securities brokerage operations (e.g., Fidelity, Schwab, Merrill Lynch, Morgan Stanley Dean Witter) are building state-of-the-art, secure Internet sites that enable customers to set up accounts, transfer funds, and invest in stocks and other investment vehicles from their computer screens. In fact, entirely new companies with names such as Ameritrade and E*Trade have become thriving, vibrant competitors to existing financial service firms by offering customers low-cost commissions and transactions fees through the Internet to trade stocks. In the most advanced form of Internet-driven customer service, companies such as IBM, Intel, Dell, General Electric, and Amazon.com link up their customers’ orders directly to their distribution facilities for immediate transaction processing. These compa- nies are using the Internet to link up directly and transfer a customer’s order to their dis- tribution centers, factories, and even suppliers for immediate processing, billing, and deliv- ery. Dell Computer, for example, can receive and process a customer’s order for a highly customized personal computer over the Internet and have it shipped and delivered in less than four days. Amazon.com, a company that did not exist as recently as 1996, has become a major retailer of books, compact discs (CDs), videos, toys, and other items through the
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 63 Internet. By allowing customers to order any book or music CD in print, Amazon.com offers customers a fast, secure, and easy way to purchase these items (often at prices lower than those of existing “brick-and-mortar” competitors) without leaving the comforts of their home. The Internet is becoming a powerful tool that companies and organizations in every industry are using to make themselves more responsive to the needs of their cus- tomers. The Internet has become an important economic driver of distribution, marketing, and service for all types of firms, even those in less technologically intensive industries. For example, grocery store chains are beginning to harness the power of the Internet to enable customers to order food and other items for fast delivery. Some analysts are pre- dicting that by the middle of the next decade, on-line transactions on the Internet may become anywhere from 25 to 33 percent of total revenues. Support Activities The remaining activities of the value chain are undertaken to support primary activities. They are therefore referred to as support activities. Support activities help the firm support activities: improve coordination across and achieve efficiency within the firm’s primary value-adding economic activities that activities. Support activities are located across the first four rows in Exhibit 3-1 and assist the firm's primary include procurement, technology development, human resource management, and firm- activities (see primary level infrastructure. activities). • Procurement: Inputs are secured for primary activities. • Technology development: Methods of performing primary activities are improved. • Human resource management: Employees who will carry out primary activities are recruited, trained, motivated, and supervised. • Infrastructure: Activities such as accounting, finance, legal affairs, and regulatory compliance are carried out to provide ancillary support for primary activities. Since each primary activity generally requires assistance in each of these four areas, the value chain includes four cells above each primary activity, one for each category of sup- port activity. Let us examine how each of these four support activities contributes to build- ing the capabilities of the firm. Procurement. Procurement refers to purchasing the necessary inputs, resources, or com- ponents for the firm’s primary value-adding activity. The purchasing function involves spe- cific procedures such as billing systems, methods for dealing with suppliers and vendors, and information systems about different components and parts. Even though it is a support activity, the purchasing function can significantly enhance the firm’s cost position relative to its competitors. Improved procurement practices enable the firm to gain significant economies of scale and higher bargaining power over suppliers if the firm coordinates its procurement across different functions and even businesses. Technology Development. Technology is found in every value-adding activity within the firm. Given the rapid technological changes that are present in almost every indus- try (e.g., new forms of communications, software, Internet), this support activity has assumed enormous importance in every firm. Technology in firms today transcends the conventional wisdom that it is primarily focused on research and development (R&D). Although most firms still have engineering and R&D staffs devoted to exploring and using new sources of technology, in practice, technology is developed and used in count- less ways throughout the firm. It can be the software found in computers, the standard operating procedures used to manage a factory, the human know-how employed in
64 PART 1 Building Competitive Advantage developing, manufacturing, and selling products, the layout of the factory, the sophisti- cated nature of the firm’s Internet capabilities, and the laboratory equipment involved in the firm’s value-adding activities. Technology is pervasive in both upstream and down- stream activities of the firm. Technology is concerned with both product development and process development. product development: the Product development refers to the conception, design, and commercialization of new conception, design, and products. For example, the design of new aircraft, more sophisticated microchips, better- commercialization of new tasting potato chips, and faster-heating, microwave-oriented convenience foods all repre- products. sent different types of product development. Even though the end products are completely different, they all come from the firm’s ability to conceive and design new product ideas. process development: the Process development, on the other hand, refers to the development and use of new pro- design and use of new cedures, practices, or equipment to improve the value-adding activity itself. For example, procedures, technologies, the development of new assembly and packaging techniques, the use of new factory lay- techniques, and other steps outs to reduce work-in-process (WIP), the creation of a new medium to deliver advertis- to improve value-adding ing, and the improvement of inventory tracking systems represent different ways to con- activities. duct process development. The aim of process development is to adapt new techniques or to improve existing methods of conducting value-adding activities. Many companies have refocused efforts on technology development to improve their value-adding activities. For example, Allen-Bradley (a unit of Rockwell International), a leading U.S. producer of motor controls, has developed new techniques to use factory automation that have dramatically reduced the unit costs of new motor components. Frito- Lay is currently investigating the potential of developing a new microwave-oriented potato chip. These chips could be heated in the customer’s home microwave oven to provide a fresher taste that is different from conventionally bagged potato chips. General Electric has invested large sums to introduce new forms of flexible automation and materials handling that lower the production costs and improve the quality of its dishwashers and refrigera- tors. These firms are investing steadily in technology—product and process—to find new sources of competitive strength. Human Resource Management. Human resource management refers to working with people throughout the firm. These activities focus on recruiting, hiring, compensating, and training people to perform their jobs within the firm. As with technology development, human resource development receives considerable attention from top management because of its strategic role in helping the firm learn and build new types of competitive skills. Human resource management activities thus affect every aspect of the firm’s value-adding activities. When conducted properly, human resource management enables the firm to cultivate the skills necessary for competitive success. Although managers typically tend to think of investments in terms of capital budgets and physical, durable assets, continuous investment in the firm’s people represents a more enduring way to build the firm’s capabilities. Man- agers and employees are the most flexible and capable assets firms have. By providing the right levels of training, firms can assign people to perform different tasks, thus enhancing job satisfaction, efficiency, and quality. However, assessing the direct costs of investing in human resource activities is often difficult, since factors such as employee turnover and morale are hard to measure. Successful human resource management is often a key factor in determining a firm’s com- petitive strengths. As a result, hotels and restaurants need to ensure that their employees are well trained and know the correct procedures for treating guests. Direct customer service activities, in particular, require extensive training. Professional service firms, such as account- ing, architecture, management consulting, and legal firms, depend heavily upon the human resource function to recruit, select, and hire the right people that make up the workforce.
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 65 Firm Infrastructure. Infrastructure include such activities as finance, accounting, legal affairs, information systems, and payroll. These activities assist all of a firm’s value-adding functions, so it is difficult to put an accurate dollar figure on their worth to the firm. Since infrastructure costs are hard to isolate, they are often called overhead expenses. Although many firms seek to cut infrastructure expenses during business downturns, such activities can be important sources of competitive strength. For example, in highly regulated envi- ronments, such as electric utilities, telecommunications, financial services, and pharma- ceuticals, the firm’s legal department can be as critical to success as operations, outbound logistics, marketing, or technology development activities. Understanding legislation and government regulations may be just as important as designing new types of drugs or pric- ing long-distance telephone calls. Thus, infrastructure activities cannot be ignored when formulating competitive strategies. PIZZA INDUSTRY VALUE CHAIN Let us now apply the value chain concept to a service setting, using the pizza restaurant industry as our reference point (see Exhibit 3-2). Pizza Restaurant Industry Value Chain e x h i b i t (3-2) S U Obtain funds, carry out accounting and payroll functions, and P Infrastructure perform other administrative tasks for each activity. P O R Supervise truck Human Supervise Supervise T drivers and Supervise Resource kitchen advertising warehouse waiters Management personnel personnel A personnel C Improve truck Develop new T Discover new Improve Technology routing and menu items; I promotional restaurant Development warehouse improve oven V materials layout methods design I T Buy trucks; Buy dough, Buy tables, I lease cheese, ovens, chairs, Procurement Buy TV time E warehouse and other silverware to S space supplies equip restaurant Transport dough, Cook pizzas; PRIMARY Develop Serve food to cheese, etc., make salads; ACTIVITIES advertising restaurant to restaurants prepare other copy customers menu items Inbound Operations Outbound Marketing/ Service Logistics Logistics Sales Reprinted/Adapted with the permission of The Free Press, a division of Simon & Schuster, Inc. from COMPETITIVE ADVANTAGE: Creating and Sustaining Superior Performance, by Michael E. Porter. Copyright © 1985 by Michael E. Porter.
66 PART 1 Building Competitive Advantage Primary Activities The value chain in this industry begins with transport of foodstuffs, such as dough, cheese, and pasta, from suppliers to restaurants (inbound logistics). Materials are then converted in each restaurant’s kitchen into items such as pizza and salads (operations), which are then served to customers (service). In addition, customers must be persuaded to seek restaurant service (marketing/sales). Note that outbound logistics is not a part of this industry’s value chain since customers come to a pizza restaurant to be served. Indeed, outbound logistics is, to a large degree, significantly absent from the value chain in many service industries, including hospital services, tax preparation assistance, and higher education. Support Activities Let us now examine the support these activities require. Procurement. Trucks and warehouse space must be procured to perform inbound logistics activity; ovens and foodstuffs to perform operations; TV advertising to perform marketing/sales; and tables, chairs, and silverware to provide restaurant service. Since restaurant firms do not generally produce these inputs themselves, they must procure them from outside vendors. Identification of suppliers for these inputs, evaluation of sup- plier offerings, and negotiation of purchase terms are major procurement activities in this industry. Technology Development. Movement of materials to restaurant sites can be improved by streamlining warehousing methods, kitchen operation by designing better ovens, marketing/sales by devising more effective advertising copy, and restaurant service by improving restaurant design. Opportunities for technology development thus exist in each primary activity of the industry. Human Resource Management. Personnel responsible for inbound logistics, for oper- ations and service, and for marketing must be hired, trained, and supervised. Infrastructure. Finally, those involved in primary activities need financing and budget- ing assistance, accounting activities, and legal affairs. These are infrastructure activities. AUTOMOBILE INDUSTRY VALUE CHAIN To illustrate the value chain in a manufacturing context, consider the automobile industry (see Exhibit 3-3). Primary Activities The value chain in this industry begins with transport of components from suppliers to auto assembly facilities (inbound logistics). Components are then assembled into finished autos (operations), and the finished cars are shipped to dealers (outbound logistics). Finally, dealers sell cars to customers (marketing/sales) and maintain the products owned by cus- tomers (service). Support Activities These primary activities require assistance in each of the support areas noted previously.
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 67 Automobile Industry Value Chain e x h i b i t (3-3) S U Obtain funds, carry out accounting and payroll functions, and Infrastructure P perform other administrative tasks for each activity. P O R Supervise truck Human Supervise (Same as Supervise Supervise T drivers and Resource assembly inbound advertising and maintenance warehouse Management workers logistics) sales personnel personnel A personnel C Improve truck Improve product (Same as Improve Improve T Technology loading proce- design and inbound selling maintenance I Development dures and ware- assembly logistics) methods procedures V house methods process I T Buy trucks; Buy components (Same as Hire advertising Buy tools for I lease Procurement and assembly inbound agency; buy maintenance E warehouse equipment logistics) media time personnel S space Transport Make and PRIMARY Transport Advertise, components to assemble Maintain and ACTIVITIES autos to promote, and assembly components repair autos dealers sell autos facility into autos Inbound Operations Outbound Marketing/ Service Logistics Logistics Sales Reprinted/Adapted with the permission of The Free Press, a division of Simon & Schuster, Inc. from COMPETITIVE ADVANTAGE: Creating and Sustaining Superior Performance, by Michael E. Porter. Copyright © 1985 by Michael E. Porter. Procurement. Trucks and warehouse space must be procured to perform inbound and out- bound logistics; machinery, raw materials, and components to operate factories; media adver- tising space to conduct marketing/sales; and specialized tools, lubricants, parts, and diagnos- tic machines to provide auto service. Identification of suppliers for these inputs, evaluation of supplier offerings, and negotiation of prices are procurement activities. Note that procurement does not deal with the physical movement of goods or “logistics.” Rather, it focuses on iden- tification of suppliers, evaluation of supplier offerings, and negotiation of purchase terms. Technology Development. Inbound and outbound logistics activities in the auto industry can be improved by redesigning the flow of component and finished product inventories in warehouses and transportation facilities. Auto firms can improve their operations by simpli- fying product design, introducing automated manufacturing techniques, and redesigning fac- tories to make work easier and more satisfying for employees. Marketing and sales can be improved through designing better advertising copy, while service activity can be improved by instituting more efficient repair procedures, training service personnel to be more respon- sive to customer needs, and installing more sophisticated diagnostic equipment. Activities undertaken to achieve such improvement are designated technology development. Human Resource Management. Personnel performing primary activities must be recruited, trained, developed, and supervised. Human resource management, through its activities, helps improve product quality, innovation, and productivity.
68 PART 1 Building Competitive Advantage Infrastructure. Primary activities require capital budgeting, financing, accounting, legal affairs, governmental affairs, and other administrative assistance. These infrastructure activ- ities help automakers finance expansion, communicate with shareholders, and work with the government in implementing new types of environmental and fuel efficiency regulations. THE VALUE CHAIN AS PART OF A BUSINESS SYSTEM So far, we have seen how different activities make up the value chain. A firm need not always perform every single activity of the value chain. Indeed, most firms do not. The subset of value chain activities that a firm actually performs is referred to as its business system.4 To illustrate, let us return to Pizza Hut and General Motors. Pizza Hut Pizza Hut’s business system includes only a portion of the activities contained in its indus- try’s value chain (see Exhibit 3-4). Primary Activities. Suppliers deliver raw materials to Pizza Hut’s restaurants. Conse- quently, Pizza Hut performs little inbound logistics activity. Pizza Hut’s restaurant business e x h i b i t (3-4) Pizza Hut’s Business System S U P Infrastructure P O R Human T Resource Management A C T Technology I Development V I T I Procurement E S PRIMARY ACTIVITIES Inbound Operations Outbound Marketing/ Service Logistics Logistics Sales Key: = Extensive activity = Modest activity = No activity Reprinted/Adapted with the permission of The Free Press, a division of Simon & Schuster, Inc. from COMPETITIVE ADVANTAGE: Creating and Sustaining Superior Performance, by Michael E. Porter. Copyright © 1985 by Michael E. Porter.
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 69 performs no outbound logistics at all since customers come to its facilities to be served. However, Pizza Hut is extensively involved in operations (food preparation), marketing/sales (mainly advertising), and service (serving restaurant customers). These three activities are therefore integral parts of its business system. Support Activities. Pizza Hut conducts procurement activity for each of its primary activities. For example, it procures dough, cheese, ingredients, and ovens for operations; TV advertising time for marketing/sales; and tables, chairs, and silverware for service. It also conducts technology development activity for each primary activity. For example, Pizza Hut devotes considerable effort to improve pizza-making procedures, to enhance advertising copy, and to streamline restaurant design. It also conducts extensive human resource management and infrastructure activities for each primary activity. These support activities are therefore integral parts of its business system. General Motors General Motors’s business system is shown in Exhibit 3-5. As indicated, it includes many but not all activities of the automobile industry value chain. General Motors’ Business System e x h i b i t (3-5) S U P Infrastructure P O R Human T Resource Management A C T Technology I Development V I T I Procurement E S PRIMARY ACTIVITIES Inbound Operations Outbound Marketing/ Service Logistics Logistics Sales Key: = Extensive activity = Modest activity = No activity Reprinted/Adapted with the permission of The Free Press, a division of Simon & Schuster, Inc. from COMPETITIVE ADVANTAGE: Creating and Sustaining Superior Performance, by Michael E. Porter. Copyright © 1985 by Michael E. Porter.
70 PART 1 Building Competitive Advantage Primary Activities. GM makes many of its own components, warehouses them, and transports them to its assembly sites. However, it also purchases an increasing number of components from outside suppliers. These purchased components are generally delivered to GM’s facilities by other firms, such as trucking and railroad companies. Consequently, GM performs some, but not all, inbound logistics activity associated with its business. GM builds and assembles components into automobiles and delivers finished autos to dealers; thus it is extensively involved in both operations and outbound logistics. GM advertises its products, but leaves the actual selling up to its dealers; thus it performs only a portion of the marketing/sales activity associated with its industry. Independently owned dealers maintain and repair GM vehicles, so GM is not significantly involved in auto service. Support Activities. Procurement activities for GM include purchase of components for cars, factory equipment from machine tool companies, and lubricants and supplies from oil companies. General Motors devotes considerable effort to technology development for its key value-adding activities. For example, it is attempting to improve internal ware- housing and factory inventory control through just-in-time (JIT) techniques. GM has invested heavily in new forms of factory automation and software to improve both prod- uct quality and the responsiveness of its factories. GM also commits substantial resources and effort to managing the human resource function. For example, it must work closely with the union leadership to create new labor contracts. Within individual plants, GM attempts to cooperate with workers to find new ways and insights to build better cars. Finally, GM has an extensive group of people working in legal affairs and government rela- tions. In recent years, the company has spent considerable time working with consumer groups and government safety boards. CAPABILITY DRIVERS Once a firm’s various activities have been identified using the value chain, an analyst inter- ested in strategy must then assess the firm’s capability in performing each activity. Any activity that the firm can perform more efficiently than its rivals (because fewer resources are required) or more effectively than rivals (because greater customer benefits are produced with the same resources) constitutes a strength. Similarly, activities that the firm performs less efficiently and effectively than rivals constitute weakness. The specific attributes and practices that determine efficiency and effectiveness differ markedly across industries. For example, the practices that enable the Walt Disney Company to excel in theme park opera- capability drivers: the tions are very different from those underpinning Intel’s success in microprocessors. As a basic economic and strategic result of these differences, it is difficult to provide general guidance to a strategy analyst on means by which a firm what to look for when trying to assess a firm’s strengths and weaknesses. However, guid- builds an underlying source ance is possible at a more general level. In most industries, enduring competitive strength— of competitive advantage in i.e., strength that cannot be easily duplicated or imitated by rivals—derives from a few fun- its market or industry. damental capability drivers. Capability drivers represent broad routes to achieving Examples of basic capability competitive strength regardless of the particular industry setting in which a firm operates. drivers include first-mover By assessing capability drivers underlying an activity, an analyst can often gain valuable advantages, economies of scale, experience effects, insight into whether a firm possesses strength in performing the activity. In this section, we and interrelationships examine four common capability drivers—first-mover status, scale, experience, and inter- among business units. relationships—and consider the kinds of competitive strength provided by each. first-mover advantages: the benefits that firms enjoy First-Mover Status from being the first or earliest to compete in an Early entrants to an industry sometimes enjoy benefits that are not available to firms arriv- industry. ing later. These benefits are referred to as first-mover advantages.5 Common benefits in
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 71 Common First-Mover Advantages e x h i b i t (3-6) • Patents • License • Location • Channel access • Supply access • Reputation this category are patent protection, a government license, superior location, channel access, supply access, and reputation (see Exhibit 3-6). Because established firms have operated in the competitive environment for longer periods of time, they often possess commanding, but not impenetrable, advantages over new entrants in these areas. Patent Protection. Established firms sometimes own patents on important technology. They enjoy a strong competitive advantage over new entrants that must either circumvent the patented technology or develop a new one on their own. Xerox Corporation, for example, held early patent rights to the xerographic duplicating process. These rights gave it a strong advantage over other entrants during the long period over which the patents applied. In the pharmaceutical industry, patents are an important source of advan- tage, since they legally protect the chemical composition of a drug from unauthorized duplication by other firms. For example, Smith Kline introduced a new type of ulcer med- ication known as Tagamet during the 1970s. Having received patent protection from the government, Smith Kline enjoyed considerable profits from Tagamet until the patent expired in the mid-1980s. Other firms were prohibited from copying Smith Kline’s patented formulas for making Tagamet. The same patent protection capability gives Eli Lilly and Pfizer significant competitive advantages in depression and blood pressure med- ications respectively in the 1990s. Patents thus represent a very strong source of compet- itive advantage. Licenses. A government license is needed to operate some businesses. Licenses are nec- essary, for example, to operate an airline, a radio or TV station, an electric generation facil- ity, and a gas distribution company. Governments often limit the number of licenses they make available. Once all available licenses have been issued, new entrants may be blocked from entering an industry or, if allowed to enter, may be forced to operate at a disadvan- tage. Thus, early holders of licenses have a significant competitive advantage over later entrants. Location Sites In some industries, a suitable location is an important source of compet- itive advantage. A waterfront site, for example, may be useful to a boat dealer; a site near a busy intersection is often useful for a fast-food operator. By entering an industry early, leaders can sometimes preempt the best locations. Later entrants must often make do with less attractive sites. Channel Access. Large, established firms sometimes lock up the most desirable channels of distribution. New entrants or smaller existing firms then have difficulty finding outlets for their products, and must often engage in extensive promotions and negotiations with
72 PART 1 Building Competitive Advantage wholesalers and retailers to obtain suitable shelf space. For example, new entrants in the packaged goods field—canned goods, breakfast cereal, diapers, personal care products— often face this challenge. The chief distribution channels for such products are supermar- kets. Because of limited capacity, supermarkets often restrict the amount of shelf space they devote to each product category to just two or three brands, giving preference to well-known brands that can generate the most volume. Because of this policy, smaller firms and new entrants often experience difficulty getting their products on the shelf. Supply Access. Established firms can sometimes monopolize critical supplies. Later entrants then experience difficulty securing inputs for their own operations. US Steel (now USX), for example, once controlled the world’s richest iron ore deposits. Exclusive access to this valuable resource gave it a formidable advantage over newcomers forced to rely on more costly supplies that often required high transportation costs. Established firms do not necessarily have to own a resource to enjoy exclusive access. A long-term supply contract can sometimes produce the same benefit. Large food processors, for example, sometimes dominate supply by entering into long-term contracts with groups or cooperatives of farm- ers in a region. In the Midwest, companies such as Pillsbury, General Mills, Kellogg, Car- nation, Archers-Daniel-Midland (ADM), and Cargill are large purchasers of wheat and corn. They often buy huge amounts of wheat and corn through long-term contracts with farmers for use in making processed foods. This practice can make it difficult for a small processor to secure low-cost supplies. Reputation. Many customers have already used products made by established firms. If satisfied, they will often seek out the same brand when making subsequent purchases. Even customers who have not yet tried an industry’s product will often be familiar with a well-known brand and therefore may give it higher preference when making their first pur- chase. Established firms thus often enjoy a significant reputation advantage over later entrants. Scale of Operation Large, established firms produce, sell, and advertise in greater volume than smaller firms and later entrants. Their greater volume allows them to take advantage of economies of scale within many primary and supporting value-adding activities. Research has shown that as the scale of many business activities increases, the cost of carrying them out per unit of output declines.6 This phenomenon is shown in Exhibit 3-7. Among the most important contributors to economies of scale, shown in Exhibit 3-8, are specialization, fixed-cost spreading, purchase discounts, and vertical integration. Specialization. As the scale of an activity increases, more employees are needed to carry it out. The more employees who are involved in performing an activity, the greater are the opportunities for individuals to specialize. Since specialization fosters expertise, increas- ing scale often enhances productivity. Fixed-Cost Spreading. Many fixed costs (for example, technology development and automated production equipment) do not increase proportionally as an activity expands in size. These costs can therefore be spread over a larger number of units as an activity increases, resulting in declining per unit cost. Because large firms can operate activities on a big scale, they often have greater opportunity to spread and amortize fixed costs than smaller rivals or later entrants.
CHAPTER 3 Firm Capabilities: Assessing Strengths and Weaknesses 73 Economies of Scale e x h i b i t (3-7) Cost per unit of output A Scale of activity (plant size, sales volume) Major Contributors to Economies of Scale e x h i b i t (3-8) • Specialization • Fixed-cost spreading • Purchase discounts • Vertical integration Purchase Discounts. Since large purchasers frequently enjoy high bargaining power, suppliers frequently extend them quantity discounts. Greater volume—and therefore greater profit—allows suppliers to offer large, established firms in the industry major dis- counts on components, inputs, and other raw materials, which may not be available to smaller rivals. Vertical Integration. Vertical integration refers to the expansion of the firm’s value chain to include activities once performed by its suppliers and buyers. By manufacturing inputs itself, a firm can eliminate the potentially high costs associated with locating sup- pliers, evaluating the quality of their products, negotiating purchase contracts, and litigat- ing disputes. A large firm is usually in a better position than a smaller one to make its own inputs, since it consumes inputs in greater volume and can therefore operate larger, more efficient facilities to produce them. Similarly, large firms are often in a superior position than smaller firms or new entrants to undertake activities that its buyers once performed. Thus, large established firms are in a better position than smaller rivals to reduce a variety of different costs by pursuing vertical integration. (Vertical integration is discussed more fully in Chapter 6.)
74 PART 1 Building Competitive Advantage Experience As an organization’s experience in carrying out an activity increases, the cost of perform- ing the activity often declines on a per unit basis. Cost reductions of this sort are called economies of experience: economies of experience.7 Continuous repetition of activities that allow for improvements cost reductions that occur with each successive repetition is the basis of economies of experience. Established firms from continuous repetition have more opportunity than later entrants to make such improvements since they typically of activities that allow for have greater experience conducting and improving their activities. improvement with each A typical experience curve, also known as a learning curve, is shown in Exhibit 3-9. Its successive act (also known vertical axis is the same as an economies of scale curve, cost per unit of output. Its hori- as experience curve effects or learning curve effects). zontal axis is different, however; it depicts the number of units processed (that is, pro- duced, sold, or serviced) since a firm began performing that activity. This variable is cus- cumulative volume: the tomarily referred to as cumulative volume. The most important processes that facilitate quantity that a firm has declining costs with growing cumulative volume are employee learning, product redesign, produced since the and process improvement (see Exhibit 3-10). beginning of that activity, up to this point in time. Employee Learning. As employees repeat activities, they learn how to carry them out more quickly and accurately. The net result is continuing improvement in both pro- ductivity and quality as employees’ experience base expands. For example, workers in e x h i b i t (3-9) Economies of Experience Cost per unit of output Cumulative volume* *Number of units produced (or sold, serviced, developed, etc.) since commencing an activity. e x h i b i t (3-10) Major Contributors to Experience Benefits • Employee learning • Product redesign • Process improvement