SYNOPSIS OF CHAPTERThis is an introductory chapter. Its purpose is to define critical concepts and introduce the main components of the strategic management process. The chapter serves to establish the context within which subsequent chapters fit.
This chapter begins with a discussion of the concept of strategy. The strategies an organization pursues have a major impact upon its performance relative to its peers. The firm’s top managers have direct responsibility for choosing strategies that will lead to superior performance and provide competitive advantage.
Next, the chapter equates superior performance with profitability, for profit-seeking enterprises. Sustained competitive advantage occurs when a firm is able to maintain above-average profitability over an extended period of time. Strategic management is just as crucial to nonprofits as it is to profit-seeking businesses.
A discussion of the roles of strategic managers and the function of strategic leadership in an organization follows. It examines the roles and responsibilities of strategic managers at three main levels within an organization: the corporate, business, and functional level. It also points out the attributes of sound strategic leadership.
The chapter gives an overview of the formal strategic management process. The process consists of two phases. The first phase, formulation, includes the establishment of corporate mission, values, and goals; analysis of the external environment; analysis of the internal environment; and selection of an appropriate functional-, business-, or corporate-level strategy. The second phase, implementation, consists of the actions taken to carry out the chosen strategy.
The traditional concept of the strategic planning process is one that is rational and deterministic, and orchestrated by senior managers. However, strategies may also emerge through other mechanisms.
Next, the chapter presents a discussion of strategic planning in practice. Formal planning helps companies make better strategic decisions, and the use of decision aids can help managers make better forecasts. However, formal strategic planning systems do not always produce the desired results.
The final section of the chapter stresses the importance of effective decision making by the firm’s top managers in achieving superior performance.
TEACHING OBJECTIVES1. Introduce students to the concept of strategy.
2. Specify the relationships between superior performance, profitability, competitive advantage and sustainable competitive advantage.
3. Identify the roles and responsibilities of strategic managers at different levels within the organization.
4. Outline the main components of the strategic management process covered in subsequent chapters and show how they fit together.
5. Contrast the rational, deterministic view of strategy with alternate views, which describe strategy as an emergent process.
6. Explain why formal strategic planning may not always lead to success, and identify ways of avoiding some of the common pitfalls associated with strategic planning.
7. Identify the attributes associated with superior strategic leadership.
8. Describe some of the barriers to effective strategic decision making and the techniques for improving decision making.
OPENING CASE: DELL COMPUTERThe Opening Case tells the story of Dell Computer, from its earliest days as a start-up in Michael Dell’s college dorm room, to an extremely successful giant corporation, with estimated sales of over $30 billion in 2002. Dell has the highest profitability in its industry, has maintained that leadership for several years, and even stayed profitable during the recent downturn in high technology industries.
Dell’s phenomenal success is directly attributable to its direct-sales business model, which allows the firm to cut costs and lower prices by eliminating the middlemen: wholesalers and retailers. Dell’s model also allows buyers to customize their computers quickly and easily, thus providing a high value-added product for a lower price than traditional PC makers. Another important aspect of Dell’s business model is a just-in-time supply chain, with purchases made in great quantities, allowing the firm to further reduce inventory, obsolescence, and cost of raw materials.
Teaching Note: This Opening Case provides an excellent opportunity to discuss many of the concepts that will be introduced in Chapter 1. For example, Dell developed a business model that was unique and revolutionary at the time. The model allowed the firm to add value for customers while keeping costs low, improving both effectiveness and efficiency. Because the model was unique and led to improved effectiveness and efficiency, the firm achieved a sustained competitive advantage. The business model was developed by Michael Dell, and thus provides an example of effective strategic leadership and vision. This case may be used to point out to students that every firm, no matter how successful, is vulnerable to competitive attack. Although Dell dominates its industry today, so too did IBM dominate at one time, as did Apple, Osborne, and Atari. To highlight Dell’s current advantages, one avenue of discussion would involve asking students to describe conditions under which Dell might lose its competitive advantage.
LECTURE OUTLINEI. Overview
A. Why do some organizations succeed and others fail? An answer can be found in the subject matter of this course. This course is about strategic management and the advantages that accrue to organizations that think strategically.
B. A strategy is a course of action that managers take in the effort to attain superior performance.C. Understanding the roots of success and failure is not an empty academic exercise. Through such
understanding comes a better appreciation for the strategies that must be pursued to increase the probability of success and reduce the probability of failure.
II. Superior Performance and Competitive AdvantageA. For businesses, superior performance is demonstrated through above-average profitability, as
compared to other firms in the same industry. Profitability is typically measured using after-tax return on invested capital.
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Figure 1.1: Return on Invested Capital in Selected Industries, 1997-2001
B. The strategies that an organization’s managers pursue have a major impact on its performance relative to its peers.
C. When a firm’s profitability is greater than the average profitability for all firms in its industry, it has a competitive advantage over its rivals. The greater the profitability, the greater is its competitive advantage. A sustained competitive advantage occurs when a firm maintains above-average profitability for a number of years.
D. A business model describes managers’ beliefs about how a firm’s strategies will lead to competitive advantage and superior profitability. An appropriate business model is one component of a successful strategy.
E. Another component of a successful strategy is a favorable competitive or industry environment.
F. Strategic management is relevant to many different kinds of organizations, from large multibusiness organizations to small one-person enterprises and from publicly held profit-seeking corporations to nonprofit organizations.
III. Strategic Managers and Strategic LeadershipA. General managers are responsible for the overall performance of the organization or for one of its
major self-contained divisions.B. Functional managers are responsible for specific business functions, such as human resources,
purchasing, production, sales, customer service, and accounts.C. The three main levels of management are the corporate level, the business level, and the functional
level. General managers are found at the first two of these levels but their strategic roles differ, depending on their sphere of responsibility. Functional managers too have a strategic role, though of a different kind.
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Figure 1.2: Levels of Strategic Management
D. The corporate level consists of the CEO, board of directors, and corporate staff. The CEO’s role is to define the mission and goals of the firm, determine what businesses the firm should be in, allocate resources to the different business areas of the firm, and formulate and implement strategies that span individual businesses.
E. The business level consists of the heads of the individual business units (divisions) and their support staff. Business unit (divisional) CEOs’ role is to translate general statements of intent at the corporate level into concrete strategies for individual businesses.
F. The functional level consists of the managers of specific business operations. They develop functional strategies that help fulfill the business- and corporate-level strategic goals. They provide most of the information that makes it possible for business and corporate-level general managers to formulate strategies. They are closer to the customer than the typical general manager, and therefore functional managers may generate important strategic ideas. They are responsible for the implementation of corporate- and business-level decisions.
IV. Strategic PlanningA. The formal strategic management planning process can be broken down into a number of
components. Each component forms a section of this course. Thus it is important to understand how the different components fit together.
B. Together, the components form a cycle, from strategy formulation to implementation. After implementation, the results that are obtained must be monitored, and the results become an input to the formulation process on the next cycle. Thus the strategic process is continuous.
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Figure 1.3: Main Components of the Strategic Planning Process
C. The components are organized into two phases. The first phase is strategy formulation, which includes selection of the corporate mission, values, and goals; analysis of the external and internal environments; and the selection of appropriate strategies.
D. The second phase is strategy implementation, which includes corporate governance and ethics issues, as well as the actions that managers take to translate the formulated strategy into reality.
STRATEGY IN ACTION 1.1: STRATEGIC PLANNING AT MICROSOFT
At first glance, formal strategic planning may seem to be incompatible with the unpredictable changes and the free-wheeling cultures of high-technology firms. But Microsoft, a dominant high-tech organization, has had a formal planning process in place since 1994, when CEO Bill Gates hired Bob Herbold to head the operations staff. Herbold’s planning system looked at strategies for extending and maintaining the company’s established products, such as MS Windows, as well as strategies for speeding, developing, and easing adoption of its newer
products, such as MSN and X-Box. The plan looks at goal and financial information from each of Microsoft’s divisions for three years into the future, and is updated annually. The planning process includes functional and top managers. The resulting strategic plans are used to determine resource allocation within the firm, as well as for strategic control and monitoring. Microsoft managers realize the need for flexibility as industry conditions change, but the formal plan provides a foundation for action that enables, rather than hinders, creativity and flexibility.
Teaching Note: This insert provides an example of how a large, diversified firm, with many products in many different stages of development, competing in a rapidly changing environment, has a powerful need for formal strategic planning. In fact, such firms’ need for formal planning is perhaps greater than smaller, less diversified firms or firms in industries that change slowly. One common, yet false, assumption made by students is that complexity or unpredictability can eliminate or reduce the need for planning. Through the example of this case, you can demonstrate that the opposite is true—that complex firms in difficult environments have a critical need for a consistent planning process, which allows comparison across divisions and across time.
E. Corporate Mission, Values and Goals1. A corporate mission or vision is a formal statement of what the company is trying to achieve
over a medium- to long-term time frame. The mission states why an organization exists and what it should be doing. Abell used a customer-oriented definition when he claimed that a mission statement should describe the customer, their needs, and the method the firm will use to satisfy those needs.
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Figure 1.4: Abell’s Framework for Defining the Business
2. The values of a company state how managers and employees should conduct themselves, how they should do business, and what kind of organization they should build to help a company achieve its mission. Values are the foundation of a company’s organizational culture. Values include respect for the organization’s diverse stakeholders.
3. A goal is a desired future state or an objective to be achieved. Corporate goals are a more specific statement of the ideas articulated in the corporate mission. Well-constructed goals are precise and measurable, address crucial issues, are challenging but realistic, and have a specified time horizon for completion.
4. A major goal of business is to provide high returns to shareholders, either through dividends or through an appreciation in the value of the shares. High profitability will enable the firm to pay high dividends as well as create an appreciation in share value. Thus, high profitability provides the best return to shareholders. However, managers must be aware that the profitability should be sustainable, and they should not sacrifice long-term profits for short-run profits.
F. External analysis identifies strategic opportunities and threats that exist in three components of the external environment: the specific industry environment within which the organization is based, the country or national environment and the macroenvironment.
G. Internal analysis identifies the strengths and weaknesses of the organization. This involves identifying the quantity and quality of an organization’s resources.
H. Together, the external and internal analyses result in a SWOT analysis, delineating a firm’s strengths, weaknesses, opportunities, and threats. The SWOT analysis is then used to create a business model to achieve competitive advantage, by identifying strategies that align, fit, or match a company’s resources to the demands of the environment. This model is called a fit model.
I. Strategic choice involves generating a series of strategic alternatives, based on the firm’s mission, values, goals, and SWOT analysis, and then choosing those strategies that achieve the best fit. Organizations identify the best strategies at the functional, business, global, and corporate levels.1. Functional-level strategy is directed at improving the effectiveness of functional operations
within a company, such as manufacturing, marketing, materials management, research and development, and human resources.
2. The business-level strategy of a company encompasses the overall competitive theme that a company chooses to stress, the way it positions itself in the marketplace to gain a competitive advantage, and the different positioning strategies that can be used in different industry settings.
3. More and more, to achieve a competitive advantage and maximize performance, a company has to expand its operations outside the home country. Global strategy addresses how to expand operations outside the home country.
4. Corporate-level strategy must answer this question: What businesses should we be in to maximize the long-run profitability of the organization? The answer may involve vertical integration, diversification, strategic alliances, acquisition, new ventures, or some combination thereof.
J. Strategy implementation consists of a consideration of corporate governance and business ethics, as well as actions that should be taken, for companies that compete in a single industry and companies that compete in more than one industry or country.
V. Strategy as an Emergent ProcessA. The formal planning process implies that all strategic decision making is rational, structured, and led
by top management. However, some criticisms of the formal planning process include the charge that the real world is often too unpredictable, that lower-level employees often play an important role in the formulation process, and that successful strategies are often the result of good luck rather than rational planning.
B. We live in an uncertain world, in which even thoughtful strategic plans may be rendered useless by rapid environmental changes. Therefore organizations must be able to respond quickly to changing circumstances. According to critics, such a flexible approach to strategy making is not possible within the framework of the traditional strategic planning process, with its implicit assumption that an organization’s strategies need to be reviewed only during the annual strategic planning exercise.
STRATEGY IN ACTION 1.2: A STRATEGIC SHIFT AT MICROSOFT
Microsoft is the dominant software company in the world. Nevertheless, Microsoft was caught off guard by the rapid rise of the Internet and the invention of the Java computer programming language. This led to the sudden emergence of companies such as Netscape and Sun Microsystems as potential competitors. Microsoft initially ignored these two developments, but later decided to respond. The firm’s goal was still to be the dominant software maker; however, its strategy to achieve this goal shifted to a reliance on industry standards, which made its products able to work in many different hardware and software environments. In addition, Microsoft decided to give away its own Web browser and Web server software for free; decided to incorporate “browser functions” in future software; and developed new versions of the software package Word that would enable users to convert their documents into HTML format that could be transmitted over the Web. The software giant surprised observers by announcing an alliance with rival America Online (AOL), the world’s largest on-line service, and Microsoft also cut a deal with Intel.
Teaching Note: The key point here is that strategy is not only a rational and deterministic planning process. Instead, strategy is constantly shaped by unforeseen events in an unpredictable environment. Ask students to consider the risks and benefits of following the strategic advice of just a few managers, in light of the material about biases in strategic decision making. Another discussion starter would be to ask students if they know of other actions that Microsoft took to increase the chances of success of this fairly risky shift in strategy. For example, at the same time as the case, Microsoft was entering into contractual relationships with PC makers to ensure that its products were bundled with every new PC purchased. (Some of these actions were found to be illegal; most were unethical; and they provide one of the bases for the antitrust lawsuits that were filed against Microsoft.)
STRATEGY IN ACTION 1.3: THE GENESIS OF AUTONOMOUS ACTION AT 3M
Serendipity, or luck, often plays a part in the development of successful strategies. 3M is renowned for its ability to capitalize on that luck, using events that seem to be random or accidental to inspire new products and strategies. The development of the waterproofing Scotch Guard products happened as the result of an accident in a lab experiment. In another example, an employee developed a product, terminal emulation software, purposefully for his own personal use, but was unaware at the time that the market demand for that product would be extraordinarily high. However, firms have to be prepared for happy accidents and recognize their potential contribution. In one sad example, Western Union turned down the opportunity to purchase Bell’s patent on the telephone, believing that their extremely successful telegraph business would continue to dominate the communications industry.
Teaching Note: An interesting discussion could be generated from this case by asking students to consider what kind of organization culture, policies, structure, leadership, and so on would be necessary to encourage employees’ creativity and autonomy, as opposed to the closed mindset displayed by Western Union. Tolerance of failure is perhaps the most important characteristic in encouraging creativity, because a firm that punishes failed experiments will find that employees are unwilling to experiment. Yet failure is abhorred and punished severely in most organizations. You can point out to students that 3M gives its R&D employees funds, space, and time to pursue experiments of personal interest, with the requirement that any promising developments be reported and pursued further. Post-It notes is another 3M product that grew from a failed experiment, when an experiment produced a very weak glue rather than the powerful glue that was intended. Classroom discussion can also be enlivened and humor introduced if you describe, or ask students to describe, other innovations that were not pursued, to disastrous results. For example, when a Harvard M.B.A. student wrote a paper proposing a profit-making delivery service, he hoped his professor would help him find venture financing, but instead, received a D on the assignment. The professor believed that no firm would ever be able to deliver packages more efficiently or cheaply than the government-subsidized U.S. Postal Service. The student went on to become the founder of Federal Express.
C. Mintzberg believed that strategies can emerge from deep within an organization, and therefore, he defined strategy as a pattern in a stream of decisions or actions. The pattern is a product of whatever aspects of an organization’s intended (planned) strategy are actually realized and of its emergent (unplanned) strategy. Strategies that are intended may be deliberately implemented, or realized. They may also be abandoned, or unrealized. Unintended strategies may spring from anywhere in the organization, or “emerge,” and are thus called emergent strategies.
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Figure 1.5: Emergent and Deliberate Strategies
D. Nevertheless, top management still has to evaluate the worth of emergent strategies and determine whether each one fits the organization’s needs and capabilities. This involves analyzing the organization’s external environment and internal operations. Moreover, an organization’s capability to produce emergent strategies is a function of the kind of culture fostered by its structure and control systems.
E. Thus the different components of the strategic management process are just as important from the perspective of emergent strategies as they are from the perspective of intended strategies. The formulation of intended strategies is a top-down process, whereas the formulation of emergent strategies is a bottom-up process.
F. In practice, the strategies of many firms are a mix of the intended and the emergent. The trick for managers is to recognize the process of emergence and to intervene selectively, killing off bad emergent strategies but nurturing good ones (strategic management process for intended and emergent strategies).
VI. Strategic Planning in PracticeA. Research indicates that formal planning does help companies make better strategic decisions.B. However, one mistake made by planners is to focus on the present, which is known, and neglect to
study the future, which is more unpredictable but also more essential for strategic decisions. Studying the future means making accurate estimates of future conditions. The text highlights the use of scenario planning, which was developed at Royal Dutch/Shell and is a helpful forecasting technique.
STRATEGY IN ACTION 1.4: SCENARIO PLANNING AT DUKE ENERGY
Duke Energy is one of the nation’s largest energy generators and marketers, and has been suffering increasingly intense competition as that industry becomes more uncertain and complex. Demand for energy is strongly dependent upon the economic cycle, which itself is highly unpredictable. In addition, energy generation capacity must be planned at least five years in advance, is very costly to develop, and can sit idle for some time if forecasts are inaccurate. To cope with this uncertainty, Duke managers developed three possible future industry scenarios. In the first, demand slips; in the second, energy trading becomes dominated by Internet firms, rather than
traditional marketers such as Duke; and in the third, demand grows, as does competition. For each scenario, managers identified about 20 signals that would indicate the scenario was developing in reality. Monitoring these signals pointed to the likelihood of the third scenario dominating the industry trends, and managers immediately began to make decisions that would maximize performance under that scenario, such as increasing capacity. Duke executives also realized that they could take some relatively simple and inexpensive actions that would enable them to hedge their bets, in case another scenario developed instead.
Teaching Note: Scenario planning can be a very useful technique but it depends upon having the information and ability to identify relevant signals, interpret trends, and so on. One way to help students understand scenario planning is to have a short classroom activity devoted to developing scenarios for some future time in the students’ lives, such as determining what they will be doing in five years’ time. Ask students to help develop two scenarios of their future, while you write their ideas down. They should identify relevant variables, which might include such items as the unemployment rate, their satisfaction or lack of satisfaction with their first professional job after graduation, and so on. For example, one scenario might be “Still Working at My First Job,” another might be “Returning to Graduate School,” whereas another might be “Switching Career Fields.” Help students think about what data they need to evaluate, what the relevant signposts might be, and what differing actions they might take in response to the scenario planning results. Yet another interesting concept is the extent to which the students could hedge their bets, taking actions that will help to achieve success no matter what the scenario. For example, savings could be used to support them while they take a short career break under one scenario, while they could be used to pay for graduate school in another scenario.
C. Another serious mistake that is often associated with the use of formal planning is ignoring the potential contributions of any employees that are not part of the top management team. This error is known as ivory-tower planning. This approach can result in strategic plans that are formulated by planning executives who have little understanding or appreciation of operating realities and are not the ones who must implement the plans. This separation between thinking and doing causes more harm than good.1. Correcting the ivory-tower approach to planning involves recognizing that, to succeed, planning
must embrace all levels of the corporation. Most of the planning can and should be done by functional managers. They are the ones closest to the facts. The role of corporate-level planners should be that of facilitators who help functional managers do the planning.
2. It is not enough just to involve lower-level managers in the strategic planning process. They also need to perceive that the decision-making process is just. Procedural justice is the extent to which the dynamics of a decision-making process are judged to be fair. Three criteria have been found to influence the extent to which strategic decisions are seen as just: engagement, explanation, and clarity of expectations.
D. Another serious error was pointed out by Hamel and Prahalad, who assert that adopting the fit model to strategy formulation leads to a mindset in which management focuses too much upon the existing resources of a company and current environmental opportunities—and not enough on building new resources and capabilities to create and exploit future opportunities. When companies have bold ambitions that outstrip their existing resources and capabilities and want to achieve global leadership, then they build the resources and capabilities that would enable them to attain this goal. The top management of these companies created an obsession with winning at all levels of the organization and then sustained that obsession over the long term. Hamel and Prahalad refer to this obsession as strategic intent.
VII. Strategic Leadership and Decision MakingA. One of the key strategic roles of any manager, whether general or functional, is to provide strategic
leadership for subordinates. Strategic leadership refers to the ability to articulate a strategic vision for the company and to motivate others to buy into that vision. Strong leaders meet six criteria.1. Strong leaders have a vision of where the organization should go, are eloquent enough to
communicate this vision to others within the organization in terms that energize people, and consistently articulate their vision until it becomes part of the culture of the organization.
2. Strong leaders demonstrate their commitment to their vision by actions and words, and they often lead by example.
3. Strong leaders are well informed, developing a network of formal and informal sources of information that keep them well apprised of what is going on within their company. They
develop “backchannel” ways of finding out what is going on within the organization so that they do not have to rely on formal information channels.
4. Strong leaders are skilled delegators. They recognize that, unless they delegate, they can quickly become overloaded with responsibilities. Besides, they recognize that empowering subordinates to make decisions is an effective motivational tool. Empowerment also makes sense when it results in shifting decisions to those who must implement them.
5. Strong leaders are politically astute. They play the power game with skill, preferring to build consensus for their ideas rather than use their authority to force ideas through. They act as members or leaders of a coalition rather than as dictators. Recognizing the uncertain nature of their forecasts, they commit to a vision rather than to specific projects or deadlines. They also realize that a big change may be more easily implemented in small, piecemeal steps.
6. Strong leaders exhibit emotional intelligence, which includes self-awareness, self-regulation, motivation, empathy, and social skills. Leaders who exhibit a high degree of emotional intelligence tend to be more effective.
B. The best-designed strategic planning systems will fail to produce the desired results if strategic decision makers fail to use the information at their disposal effectively. Our rationality as decision makers is bounded by our own cognitive capabilities. Experimental evidence shows that all humans suffer from innate flaws in their reasoning ability, which are called cognitive biases. We tend to fall back on certain rules of thumb, or heuristics, when making decisions, and sometimes they lead to severe and systematic errors in the decision-making process. However, to the extent that managers are aware of their own cognitive biases, they can attempt to compensate for the resulting weaknesses through some decision-making improvement techniques.1. The prior hypothesis bias refers to the fact that decision makers who have strong prior beliefs
about the relationship between two variables tend to make decisions on the basis of these beliefs, even when presented with evidence that their beliefs are wrong.
2. Escalating commitment occurs when, having already committed significant resources to a project, decision makers commit even more resources if they receive feedback that the project is failing. This may be an irrational response; a more logical response may be to abandon the project and move on, rather than escalate commitment.
3. Reasoning by analogy involves the use of simple analogies to make sense out of complex problems. However, because they oversimplify a complex problem, such analogies can be misleading.
4. Representativeness refers to the tendency on the part of many decision makers to generalize from a small sample or even a single vivid anecdote. Generalizing from small samples violates the statistical law of large numbers, which tells us that it is inappropriate to generalize from a small sample, to say nothing of a single case.
5. The illusion of control is the tendency on the part of decision makers to overestimate their ability to control events. Top-level managers seem to be particularly prone to this bias. Having risen to the top of an organization, they tend to be overconfident about their ability to succeed.
C. Another cause of poor strategic decision making appears to be a phenomenon referred to as groupthink. Groupthink occurs when a group of decision makers decides on a course of action without questioning underlying assumptions. Typically, a group coalesces around commitment to a person or policy. Information that could be used to question the policy is ignored or filtered out, while the group develops after-the-fact rationalizations for its decision. Thus commitment is based on an emotional rather than an objective assessment of what is the correct course of action.
D. The existence of cognitive biases and groupthink raises the problem of how to bring critical information to bear on the decision mechanism to ensure that strategic decisions made by the firm are realistic. Two techniques that have been proposed to guard against this problem are devil’s advocacy and dialectic inquiry.1. Devil’s advocacy involves the generation of a plan and a critical analysis of it. A member of
the group should act as the devil’s advocate, bringing out all the reasons why the proposal should not be adopted. Thus decision makers can be made aware of the possible perils of recommended courses of action.
2. Dialectic inquiry involves the generation of a plan and a counterplan reflecting plausible but conflicting courses of action. A debate between advocates of the plan and those of the counterplan should be considered by senior strategic managers. The debate is intended to reveal
problems with definitions, recommended courses of action, and assumptions. As a consequence, corporate decision makers and planners can form a new, more encompassing final plan (a synthesis).
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Figure 1.6: Processes for Improving Decision Making
CHAPTER 2
External Analysis: The Identification of Industry Opportunities and Threats
SYNOPSIS OF CHAPTERThe purpose of this chapter is to familiarize students with the forces that shape competition in a company’s external environment and to discuss techniques for identifying strategic opportunities and threats. The central theme is that, if a company is to survive and prosper, its management must understand the implications that environmental forces have for strategic opportunities and threats.
The chapter first defines industry, sector, and market segments. The next section offers a detailed look at the forces that shape competition in a company’s industry environment, using Porter’s Five Forces Model as an overall framework. In addition, a sixth force—complementors—is introduced and discussed.
The chapter moves on to explore the concepts of strategic groups and mobility barriers. The competitive changes that take place during the evolution of an industry are then examined.
Next the chapter considers some of the limitations inherent in the five forces, strategic group, and industry life cycle models. These limitations do not render the models useless, but managers need to be aware of them as they employ these models.
The next section provides a review of the significance that changes in the macroenvironment have for strategic opportunities and threats. Finally, the chapter deals with the trend toward globalization that has occurred in many industries in recent years. The central objective here is to demonstrate how the national context within which a company is based can impact that company’s competitive position and performance in the global marketplace.
TEACHING OBJECTIVES1. Stress the importance of understanding the forces that shape competition in a company’s external
environment.
2. Illustrate how change in the external environment gives rise to strategic opportunities and threats.
3. Discuss the strategic importance of each of Porter’s five forces, including potential new entrants, degree of rivalry, the power of buyers and suppliers, and the threat of substitutes.
4. Understand the emergence of a sixth competitive force—complementors.
5. Describe the concepts of strategic groups and mobility barriers, highlighting their competitive implications.
6. Discuss the industry life cycle, including the different stages of industry evolution and review the competitive implications of each stage, paying particular attention to how rivalry and barriers to entry change as an industry evolves.
7. Discuss the limitations of the five forces, strategic group, and industry life cycle models.
8. Discuss the different forces in the wider macroenvironment that give rise to strategic opportunities and threats.
9. Identify the forces that have resulted in the globalization of production and markets, and identify the competitive implications of globalization.
10. Highlight the link between national context and competitive advantage.
OPENING CASE: BOOM AND BUST IN TELECOMMUNCATIONSIn the mid-1990s, the telecommunications industry faced three significant changes. Increased use of the Internet increased demand for telecommunication services, deregulation intensified competition and eased access for new competitors, and wireless services became much more prominent. The anticipated increase in demand created a flood of new entrants into the industry, who then invested heavily in new equipment, increasing industry spending by 25 percent each year from 1996 to 2000. Equipment makers, such as Lucent, Cisco, and Corning increased production to meet surging demand and even began to make loans to buyers in order to increase sales. These loans seemed like a sure bet in the optimistic and growing industry. However, network capacity grew rapidly as the technology became more efficient and by 2001 the industry had ten times more capacity than needed. The newer entrants, including Global Crossing and Winstar, suffered drastic reverses and even bankruptcies. The problems occurred because telecommunications firms over-estimated demand, under-estimated the impact of technological improvements, and failed to consider the consequences of a dramatic increase in competitive intensity. As demand slowed, competitors began a price war, which, when combined with their heavy burden of debt, intensified the financial crisis. Overall, the industry and its suppliers experienced a drastic change of fortune, from boom to bust in just a few years.
Teaching Note: This case introduces many of the themes of Chapter 2, including the impact that competitive forces have on industry behavior and profitability, concepts about market segmentation and strategic groups, and the changing nature of competition over an industry’s life cycle. One of the most important lessons of this chapter and this case, and one that may be somewhat surprising to students, is the very strong influence that external environments can have on firm performance. Much of what is discussed in the popular business literature focuses on the achievements or shortcomings of individual managers and other forces internal to the firm. But it is worthwhile to remind students that external forces can have just as much impact and can even cause the demise of firms with competent managers.
LECTURE OUTLINEVIII. Overview
A. For a company to succeed, its strategy must either fit the industry environment in which it operates, or the company must be able to reshape the industry environment in which it operates to its advantage through its choice of strategy. Companies typically fail when their strategy no longer fits the environment in which they operate.
B. To achieve a good fit, managers must understand the forces that shape competition in their external environment. This understanding enables them to identify strategic opportunities and threats. Opportunities arise when a company can take advantage of conditions in its environment to formulate and implement strategies that enable it to become more profitable. Threats arise when conditions in the external environment endanger the integrity and profitability of the company’s business.
IX. Defining an IndustryA. An industry can be defined as a group of companies offering products or services that are close
substitutes for each other. Close substitutes are products or services that satisfy the same basic consumer need. Firms within the same industry are rivals, also called competitors.1. A correct industry definition can be the difference between success and failure.2. Managers must define industries based on the customer need (the demand side of the market)
and not the products the industry offers (the supply side of the market).B. Several industries combine to create a sector. For example, the PC industry, the handheld industry,
and the mainframe industry together create the computer sector.
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Figure 2.1: The Computer Sector: Industries and Segments
C. Within industries, customers with a common need group together to form a market segment. For example, the soft drink industry contains regular, diet, and caffeine-free market segments.
D. Industry boundaries are not fixed, but can change over time. Industries may fragment into a set of smaller industries, such as when the auto industry fragmented into the car and SUV industries. Industries may also consolidate, such as the blurring of the boundary between the handheld computer and cell phone industries.
X. Porter’s Five Forces ModelA. This model was devised by Michael Porter to describe forces that shape competition within an
industry and help to identify strategic opportunities and threats. The stronger each of these forces is, the more established companies are limited in their ability to raise prices and earn greater profits. A strong competitive force is a threat because it depresses profits. A weak competitive force is an opportunity because it allows the company to earn greater returns.
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Figure 2.2: Porter’s Five Forces Model
B. One of Porter’s Five Forces is the risk of entry by potential competitors. Potential competitors are companies that are currently not competing in the industry but have the capability to do so. New entry into an industry expands supply. This in turn depresses prices and profits. Thus a high risk of new entry constitutes a strategic threat. A low risk of new entry allows established companies to raise their prices, so it constitutes an opportunity. The risk of entry by potential competitors is a function of the height of barriers to entry. The height of barriers to entry is determined by several factors.1. The extent to which established companies have brand loyalty from their customers is one
factor. Loyal customers would discourage potential competitors.2. Potential competitors are also discouraged when established companies enjoy an absolute cost
advantage over potential entrants. Cost advantages might include factors such as patents, control of a specific raw material, or access to cheaper funds.
3. Potential competitors are also discouraged when established companies have economies of scale, that is, when established companies are able to produce at a lower cost than the new entrants due to their larger size and greater experience.
4. When customer switching costs, that is costs that accrue to a consumer that intends to switch from the product offering of an established company to the product offering of a new entrant, are high, potential new entrants are discouraged.
5. Government regulation, such as establishing a protected monopoly, tends to protect established firms, and thus to constitute a barrier to entry. When industries are deregulated, new entrants usually proliferate.
STRATEGY IN ACTION 2.1: ENTRY BARRIERS INTO THE JAPANESE BREWING INDUSTRY
The Japanese consume a lot of beer (as much as Australia, Germany, or Britain) and the market is dominated by just four players with a combined market share of 97 percent and one of the highest profit rates of any Japanese industry. It seems that new entrants would try to enter this desirable industry, but few have, therefore effective barriers to entry must exist. First, the competitors have built high brand loyalty through advertising and new product development. Second, for years the Japanese government limited brewing licenses to very large firms, which means that any potential entrant would have to start with a high capital outlay. Third, the large brewers have created high switching costs, by threatening to withhold products from any distributors who also sell lesser-known brands. However, entry barriers are declining as foreign beers become more popular, large discount store chains replace small distributors, and government policy becomes more liberal. Even with lower barriers to entry, there have been few new entrants, but the industry has been attacked by wine makers, whose products are increasing in popularity with Japan’s younger consumers.
Teaching Note: As this case illustrates, entry barriers can be effective in discouraging new entrants, and the effects of high entry barriers can be long-lasting. In this case, the effects lasted for decades, and did not lessen until other forces changed, leading to a weakening of the barriers. You can use this case in a classroom discussion to identify entry barriers in other industries. Another approach to classroom discussion is to ask students to
consider the lessons that other industries might learn from the Japanese brewers. What did the brewers do to raise entry barriers, and how could those tactics be used in another context?
C. Another of Porter’s Five Forces is rivalry among established companies. Strong rivalry tends to lower prices and raise costs, which constitutes a threat to established companies, whereas weak rivalry creates an opportunity to earn greater returns. The extent of rivalry among established firms depends on several factors.1. One factor is industry competitive structure, which refers to the number and size distribution of
companies within an industry. Structures vary from fragmented (made up of many small- and medium-sized companies) to consolidated (dominated by a small number of large companies). Different competitive structures have different implications for rivalry.a. Many fragmented industries are characterized by low entry barriers and commodity-type-
products that are hard to differentiate. These characteristics tend to result in boom-and-bust cycles, with a flood of new entrants, excess capacity, and price wars, leading to low industry profits and exit from the industry. The more commodity-like an industry’s product, the more vicious will be the price war. The “bust” part of the cycle will continue until overall industry capacity is brought into line with demand (through bankruptcies), at which point prices may stabilize again.
b. Consolidated industries are interdependent, so that the competitive actions of one company directly affect the profitability of competitors, forcing a response from them. The consequence can be price wars like those the airline industry has experienced. Thus interdependence is a major threat. This threat can be reduced when tacit price-leadership agreements exist within the industry and when companies are successful in emphasizing nonprice competition.
STRATEGY IN ACTION 2.2: PRICE WARS IN THE BREAKFAST CEREAL INDUSTRY
The breakfast cereal industry in the U.S. was one of the most profitable and desirable competitive environments, with steadily rising demand, brand loyalty, and close relationships with buyers (grocery retailers). Best of all, the industry was dominated by just three competitors, and one, Kellogg’s, controlled 40 percent of the market share. Kellogg’s was a price leader, raising prices a bit each year, and the smaller companies followed suit. Then the industry structure changed. Huge discounters began to promote cheaper private brands, just as bagels or muffins replaced cereal as the preferred breakfast food. Under pressure, the big manufacturers began a price war, ending the tacit price collusion that had kept the industry stable and profitable. Although profit margins were slashed in half, the big three continued to lose market share to private brands. What was once a desirable industry is now exactly like most others, competitive, unstable, and far less profitable.
Teaching Note: This case illustrates the sad outcomes that result when industry competitors react to increased pressure by breaking off tacit price collusion. You should be sure to emphasize to students the difference between tacit price collusion, which is indirect and therefore legal, and price fixing, which is overt and therefore illegal. Again, the message here is that well-run industry, with sustained high profitability and stability for all competitors, fell victim to powerful external forces. One interesting discussion question would be to ask students, “Is there any action the big three competitors can take now to undo the damage and recover their profitability?” If students suggest any action that they believe will restore the situation, ask them how the other competitors would be likely to react. For example, if students suggest a one-sided price increase, ask them if competitors would be likely to follow suit. Students may be surprised to realize how difficult it is to “put the genie back in the bottle”—once trust is destroyed; an industry may never be able to recreate stability and prosperity.
2. Demand conditions also determine the intensity of rivalry among established companies. Growing demand moderates competition by providing room for expansion. Declining demand results in more competition as companies fight to maintain revenues and market share.
3. Exit barriers are a serious competitive threat, especially when demand is declining. Economic, strategic, and emotional factors can keep companies competing in an industry even when returns are low. This in turn leads to excess capacity and price wars. Exit barriers include:a. investments in specialized assetsb. high fixed costs of exit such as severance pay
c. emotional attachments to an industryd. economic dependence on a single industrye. the need to maintain expensive assets in order to compete effectively in that industry.
D. A third factor in Porter’s Five Forces Model is the bargaining power of buyers. Buyers can be individual consumers, other businesses, wholesalers, or retailers. Buyers can be viewed as a competitive threat when they force down prices or when they raise expenses by demanding higher quality and better service. The ability of buyers to make demands on a company depends on their power relative to that of the company. Buyers tend to be powerful when:1. they are in industries that are more highly consolidated than the company’s industry2. they purchase in large quantities or constitute a significant buyer for that industry3. buyers can easily switch to substitute product or an alternate supplier4. buyers can readily produce the product themselves.
E. A fourth factor is the bargaining power of suppliers. Suppliers are any organization that supplies materials, services, or labor (such as labor unions) to the company. Suppliers are a threat when they are able to force up the price the company must pay for inputs or to reduce the quality of goods supplied. The ability of suppliers to make demands on a company depends on their power relative to that of the company. Suppliers tend to be powerful when:1. the supplier’s product has no substitutes or is vital to the company2. the company is not important to the supplier3. the company has a switching cost to change suppliers4. suppliers can readily enter the company’s industry5. the company cannot readily enter the supplier’s industry.
F. A fifth factor is the threat of substitute products. The existence of adequate substitute products limit the price that companies in an industry can charge without losing their customers to makers of substitutes. The threat of substitutes tends to be greater when:1. the substitute is a close one, equally adequate in filling customer’s needs2. the price of the substitute is equal to or less than the company’s products.
G. Recently, Intel CEO Andy Grove proposed a sixth force: complementors, or companies that sell products that are used in addition to and along with the enterprise’s own products. When there is a weak supply of complementary products, demand in the industry will be weak, and revenues and profits will be low. The threat from a lack of complementors tends to be greater when:1. few complementary products exist2. the existing complementary products are not attractive to customers, due to high prices,
inadequate features, and so on.
RUNNING CASE: DELL—CHANGING RIVALRY IN THE PERSONAL COMPUTER INDUSTRY
Throughout the 1990s, the personal computer industry was profitable, enjoying entry barriers in the form of brand loyalty, economies of scale, and expertise in the sophisticated technology. Rivalry was moderate, due to the industry growth; individual consumers, corporations, and small retailers were not strong buyers; there were no adequate substitutes for personal computers; and complementors, such as new PC software and accessories, were abundant and attractive. There were two strong suppliers: Intel controlled the supply of microprocessors, a vital component, and Microsoft provided the operating system that was necessary for virtually every PC. However, starting in 2000, the industry became more consolidated, creating more interdependence among the competitors. PCs became more “commodity-like” and were harder to differentiate. Then, computer sales began to slow as the market became saturated and the rate of development of new complementors stalled. Dell, the low cost provider, began a price war, and soon was the only profitable company in the industry. Dell’s strategy appears to be one of driving competitors out of business, and thus far, it has been a successful one. IBM has exited the industry, Gateway has lost most of its market share, and Hewlett Packard and Compaq merged, with an accompanying reduction in PC production capacity.
Teaching Note: This case details some of the recent changes in the PC industry and their competitive implications. You could point out to students the parallels between this situation and the situation of Microsoft’s operating system software in the early days of PC use. Dell has emerged as a dominant player, and its success has given it enormous resources, all of which seem to be focused on eliminating competition. With that in mind, ask students
what will be the likely end result for Dell, for other competitors, and for consumers. You can also ask students to analyze this case using Porter’s five forces and complementors, the sixth force. Describing the competitive forces in class would give you an idea about the students’ understanding of the concepts underlying the competitive industry analysis.
XI. Strategic Groups Within IndustriesA. A strategic group is a group of companies within an industry that are pursuing the same basic
strategy as the companies with the group, but different strategies from companies outside the group. The strategies may be based on a variety of factors, such as differences in quality, market segment served, or distribution channel utilized. Normally, a limited number of strategic groups capture the essence of strategic differences among companies within an industry.
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Figure 2.3: Strategic Groups in the Pharmaceutical Industry
B. Strategic groups have several implications for internal analysis.1. A company’s immediate competitors are those in its strategic group. Because all companies in a
strategic group are pursuing similar strategies, consumers tend to view the products of such enterprises as direct substitutes for each other.
2. Different strategic groups can have a different standing with respect to the threats and opportunities they face from each of Porter’s five competitive forces. Some strategic groups are more desirable than others, insofar as they are characterized by a lower level of threats and/or by greater opportunities.
3. Mobility barriers are factors that inhibit movement between groups. They are analogous to industry entry barriers and are based on the same factors: brand loyalty, absolute cost advantages, and economies of scale. Mobility barriers make it difficult for companies to move into another strategic group, and they also protect group members from entry by companies from other groups.
XII. Industry Life Cycle AnalysisA. Over time, industries pass through a series of well-defined stages with different implications for the
nature of competition. Porter’s five competitive forces and competitive dynamics change as an industry evolves. Managers must learn to anticipate the changes that will occur as the industry develops over time.
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Figure 2.4: Stages in the Industry Life Cycle
B. An embryonic industry is one that is just beginning to develop. Growth is slow because of buyer unfamiliarity with the industry’s products, poor distribution channels, and high prices stemming from the inability of companies to reap economies of scale.1. Barriers to entry at this stage tend to be based on access to key technological know-how, rather
than cost economies or brand loyalty. Rivalry in embryonic industries is based on educating customers, opening up distribution channels, and perfecting the design of the product.
2. Embryonic industries provide a good opportunity for firms to capture loyal customers, capitalizing on the lack of rivalry.
C. A growth industry is one where first-time demand is expanding rapidly as new consumers enter the marketplace. Typically, demand takes off when consumers become familiar with the product, prices fall with the attainment of economies of scale, and distribution channels develop.1. During an industry’s growth stage, there tends to be little rivalry. Rapid growth in demand
enables companies to expand their revenues and profits without taking market share away from competitors.
2. Growth industries provide opportunities for firms to expand their market share and revenues in a relatively low rivalry situation. Firms entering at this stage avoid the high expenses of initial product development.
D. An industry shakeout occurs when the rate of industry growth slows down as demand approaches saturation levels. A saturated market is one where there are few first-time buyers left. Most of the demand is limited to replacement demand.1. As an industry enters the shakeout stage, rivalry between companies becomes intense, with
excess productive capacity and severe price discounting. Many firms exit the industry at this point.
2. Industry shakeout provides an opportunity for those firms that are dedicated to success in this particular industry to consolidate their power, often by acquiring the assets of firms exiting the industry.
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Figure 2.5: Growth in Demand and Capacity
E. A mature industry is one where the market is totally saturated, growth is very low or near zero, and demand is limited to replacement demand. Most competitors have exited the industry, creating an oligopoly dominated by a few, large companies.1. As an industry enters maturity, barriers to entry increase and the threat of entry from potential
competitors decreases. Intense competition for market share can develop, driving down prices.2. In mature industries, companies tend to recognize their interdependence and try to avoid price
wars if possible. Stable demand gives them the opportunity to enter into price-leadership agreements, reducing the intensity of rivalry and allowing greater profitability. However, the stability of a mature industry is always threatened by further price wars, especially in an economic downturn.
F. In the decline stage, growth becomes negative. Virtually all companies exit the industry.1. Depending on the speed of the decline and the height of exit barriers, competitive pressures can
become as fierce as in the shakeout stage.2. Falling demand leads to excess capacity, causing companies to engage in price wars. The
greater the exit barriers, the harder it is for companies to reduce capacity and the greater is the threat of severe price competition.
XIII. Limitations of Models for Industry AnalysisA. The Five Forces, strategic groups, and industry life cycle models constitute very useful ways of
thinking about and analyzing the nature of competition within an industry. However, these models have limitations. It does not mean the models are useless. However, it does mean that managers must be aware of the limitations as they apply these models to their firms.
B. One important limitation of the life cycle model is that industry life cycles vary considerably, skipping or repeating stages, moving slowly or rapidly through the stages or remaining “stuck” at a particular stage.
C. Another limitation of all of these models is the lack of attention paid to the consequences of innovation. Over time, innovation in many industries competition leads to new products, processes, or strategies that can be very successful and transform the nature of competition within an industry. Innovation can fragment or consolidate an industry, create new strategic groups or market segments, speed or slow an industry’s life cycle, and otherwise disrupt the orderly predictions of all three of the models for industry analysis.1. Michael Porter, the originator of the Five Forces model, has recently shifted focus to
acknowledge the role of innovations as “unfreezing” and “reshaping” industry structure. Porter describes a model of punctuated equilibrium, in which an innovation triggers a period of turbulence, followed by a period of stability. The punctuated equilibrium theory allows Porter’s Five Forces Model to continue to be somewhat useful, in spite of limitation. This theory asserts that the Five Forces Model is not a good predictor of the changes that take place in the short time just after an important innovation, but it is useful in the longer periods of stability that follow the turbulence.
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Figure 2.6: Punctuated Equilibrium and Competitive Structure
2. However, there are those who question the validity of the punctuated equilibrium approach. Richard D’Aveni has argued that many industries are hypercompetitive, being characterized by permanent and ongoing innovation. In such industries, industry structure is constantly being revolutionized by innovation; there are no periods of equilibrium. Thus, the three models of internal analysis are not useful.
D. Another limitation of the models for internal analysis is the lack of attention paid to firm-specific factors. Studies point to enormous variance in the profit rates of individual companies within an industry, with industry effects accounting for only 10 to 20 percent of the variance. These studies suggest that the individual resources and capabilities of a company are far more important determinants of that company’s profitability than the industry or the strategic group of which the company is a member.
XIV. The Role of the MacroenvironmentA. The macroenvironment refers to the broader economic, technological, demographic, social, and
political environment within which an industry is embedded. It is apparent that changes in this macroenvironment can have a direct impact on any one of the five forces in Porter’s model, thereby altering the relative strength of these forces and with it, the attractiveness of an industry.
B. There are five important forces in the macroenvironment.
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Figure 2.7: The Role of the Macroenvironment
1. Macroeconomic forces include changes in the growth rate of the economy, interest rates, currency exchange rates, and inflation rates; these are all major determinants of the overall level of demand. Adverse changes in any of these can threaten profitability in an industry, whereas positive changes tend to increase profitability.
2. Technological forces are characterized by an accelerated pace of innovation and change. Technological change can make established products obsolescent overnight, but at the same time, it can create new products and processes. Thus technological change is both an opportunity and a threat; it is creative and destructive.
3. Demographic forces consist of any trends related to population, such as the aging of the U.S. population and the movement of people across national boundaries. Changing demographics create both opportunities and threats, spawning new industries and products while eliminating others.
4. Social forces consist of changes in societal preferences and values. New social movements also create opportunities and threats. For example, the impact of the trend toward greater health consciousness has been a boon to the fitness equipment and organic foods industries, while it has hurt the beef and cigarette industries.
5. Political and legal forces are shaped by changing laws and regulations. Factors such as deregulation, insurance reform, and even the political party makeup of the Congress can create opportunities and threats for companies in many industries.
XV. The Global and National EnvironmentsA. The Globalization of Production and Markets
1. International trade and foreign direct investment have grown rapidly in the last few years, driven by lower tariffs and non-tariff barriers. This has led to the globalization of production and markets.a. The globalization of production has occurred, as firms are increasingly able to disperse
parts of their production operations around the world, reducing costs.b. The globalization of markets has led to decreased emphasis on national markets, and
increased focus on one huge global marketplace. The tastes and preferences of consumers in different nations are beginning to converge at some global norm.
2. There are several implications of the globalization of products and markets that are important to managers.a. Implications of the globalization of production and markets include the need for
companies to recognize that industry boundaries do not stop at national borders, and competitors can be found in other national markets.
b. Another implication is that competitive rivalry will increase as relatively protected national markets are transformed into segments of fragmented global industries where a large number of companies battle one another for market share and profits in country after country around the globe.
c. A third implication is that the rate of innovation will continue to skyrocket, compressing product life cycles, and perhaps, reducing the importance of static models of external analysis, such as Porter’s Five Force Model or strategic groups.
d. A final implication is that, in spite of the increased threats due to globalization, it has also created enormous opportunities. The decline in trade barriers has opened up many once-protected markets to companies based outside those markets.
B. National Competitive Advantage1. The national context of a country influences the competitiveness of companies based within that
nation. Despite the globalization of production and markets, many of the most successful companies in certain industries are still clustered in a small number of countries. Individual companies need to understand the link between national context and competitive advantage in order to identify where their most significant competitors are likely to come from and to identify where they might want to locate certain productive activities.
2. In a study of national competitive advantage, Michael Porter identified four attributes of a national state that have an important impact upon the global competitiveness of companies located within that nation. Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where conditions with regard to the four attributes are favorable. He also argues that the diamond’s attributes form a mutually reinforcing system in which the effect of one attribute is dependent on the state of others.
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Figure 2.8: National Competitive Advantage
a. One attribute is factor endowments, which include the cost and quality of factors of production. Factors of production include basic factors, such as land, labor, capital, and raw materials, along with advanced factors, such as technological know-how, managerial sophistication, and physical infrastructure (for example, roads, railways, and ports). Companies gain competitive advantage when their home countries are rich in factor endowments.
b. Another attribute is local demand conditions. Companies are typically most sensitive to the needs of their closest customers. Thus the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Companies gain competitive advantage if their domestic consumers pressure them to meet high standards of product quality and to produce innovative products.
c. A third attribute is the presence of related and supporting industries that are internationally competitive. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Successful industries within a country tend to be grouped into “clusters” of related industries.
d. A fourth attribute is the strategy, structure, and rivalry of companies within the nation. Different nations are characterized by different “management ideologies,” which either help them or do not help them to build national competitive advantage. Also, companies that experience a vigorous domestic rivalry look for ways to improve efficiency, which in turn makes them better international competitors. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs, and to invest in upgrading advanced factors.
The cellular phone industry consists of two very large competitors. Nokia, which is headquartered in Finland, has a 35 percent market share, whereas the second-largest firm, American-based Motorola, has about 12 percent. How did a Finnish company come to be a world player in this sophisticated high-tech industry? In the 1980s, Nokia was a diversified conglomerate with businesses such as paper and tire manufacturing, in addition to consumer electronics and telecommunications equipment. With its inhospitable climate and many remote towns, Scandinavia was the perfect environment for early adoption of cellular phone technology. The region does have the highest rate of cell phone ownership—about 70 percent, as compared to the second most saturated market, the U.S., with about 33 percent. In addition, Finland has never had a national telephone monopoly, and so Nokia was forced to compete on price against many local, autonomous phone providers. This high competitive intensity created a firm that is strongly aware of the need for both low costs and cutting-edge technology. That advantage has continued to this day, when Nokia remains the most profitable of any firm in this industry.
Teaching Note: This case provides an excellent example of the advantages that international firms can obtain when their national context fosters strengths that lead to competitive advantage. In this case, Nokia benefits from favorable factor endowments such as infrastructure, including the cooperation of the Nordic countries in creating the first international telephone network. In addition, managerial sophistication in the cellular telephone industry could be developed early on because the Scandinavian states became the first nations in the world who took cellular telecommunications seriously. Also, sophisticated and demanding local customers in Scandinavia helped push Nokia to invest in cellular phone technology long before demand for cellular phones took off in other developed nations. Another favorable factor was the presence of suppliers and related industries that were internationally competitive. Finally, Nokia was exposed to the stimulating effects of strong domestic competition, competing with many local telephone companies, both on technology capability and price.
CHAPTER 3
Internal Analysis: Distinctive Competencies, Competitive Advantage, and Profitability
SYNOPSIS OF CHAPTERThe goal of this chapter is to explore the basis of competitive advantage at the level of the individual company. Put another way, the central question with which the chapter deals is why, within a given industry, some companies do better than others. This is a very important chapter because it introduces a framework for understanding competitive advantage that will be used throughout the rest of the book.
The chapter opens with a presentation of a basic model of competitive success. The text asserts that, to gain a competitive advantage, the firm must adopt an effective strategy, which will lead to the formation of distinctive competencies, or firm-specific strengths. The distinctive competencies arise from the firm’s resources and capabilities. Successful firms adopt strategies that build upon existing competencies or develop new competencies.
Next, the text explains that companies use their competencies to offer superior value to customers. The relationship between pricing, demand, costs, and differentiation is explored, as they relate to the creation of superior value.
The discussion of the value chain aims to show students how the different value-creation activities of a company fit together. A point strongly emphasized here is that each of the value chain activities is a potential source of value creation.
The chapter then examines the role of distinctive competencies in helping to achieve the four generic building blocks of competitive advantage: superior efficiency, quality, innovation, and customer responsiveness. Companies that have superior performance in one or more of these areas are able to differentiate their products
and/or reduce costs, which leads to value creation and higher profitability. The financial calculation of superior value (profitability) is explored in detail.
The durability of competitive advantage is the focus of the next section, which argues that the durability of a company’s competitive advantage is a function of three factors: the height of barriers to imitation, the capability of competitors, and the general dynamism of the industry environment.
Finally, the chapter addresses the reasons why formerly successful companies fail, focusing on organizational inertia, past strategic commitments, and the Icarus paradox. The concluding section of the text mentions ways that companies can avoid competitive failure and sustain a competitive advantage.
TEACHING OBJECTIVES1. Examine the internal causes of competitive success and failure.
2. Show how effective strategies create distinctive competencies, including resources and capabilities, which then aid a firm in achieving competitive advantage.
3. Describe the process of value creation, using the concepts of pricing, demand, costs, and differentiation.
4. Familiarize students with the concept of the value chain, and show how the different value-creation activities of a company fit together.
5. Explain how distinctive competencies lead to superior efficiency, quality, innovation, and responsiveness to customers, which in turn allow a company to differentiate its products and lower its costs.
6. Describe how competitive advantage leads to higher profitability, using financial measures.
7. Identify the factors that influence the durability of a company’s competitive advantage, including the height of barriers to imitation, the capability of competitors, and industry dynamism.
8. Explain the role played by organizational inertia, past strategic commitments, and the Icarus paradox in the failure of many formerly successful companies.
9. Discuss the steps that companies can take to avoid failure and sustain a competitive advantage.
OPENING CASE: BJ’S WHOLESALE—COMPETITIVE ADVANTAGEThe Opening Case describes the competitive advantages enjoyed by BJ’s Wholesale, a membership-based discount retailer that uses a business model similar to that of Costco or Sam’s Club. The firms in this industry provide a limited selection of products in a no-frills environment, keeping costs low, and allowing them to sell a high volume of low-priced products. BJ’s is the smallest of the big three competitors, but the most rapidly growing and the most profitable. BJ’s competitive advantages include a location clustering strategy for efficiency, a focus on markets with lower entry costs such as suburbs and small towns, a retail customer orientation that allows them to charge slightly higher prices, and an information system that lowers costs and further increases efficiency.
Teaching Note: This case provides an overview of many of the important concepts of this chapter, including resources and capabilities, distinctive competencies, competitive advantage, profitability and other performance measures, and the role of strategic choice in developing distinctive competencies. The Opening Case also provides several examples of value chain functional area, including location selection (infrastructure), high volume ordering (materials management), and acceptance of credit cards (customer service).
LECTURE OUTLINEXVI. Overview
A. The choice of industry affects firm performance but, within any given industry, some companies are more profitable than others. Why do some companies do better than their competitors? What is the basis of competitive advantage?
B. Internal analysis leads to the identification of a firm’s strengths and weakness, and especially its distinctive competencies, including its resources and capabilities.
C. Distinctive competencies enable firms to create superior value for customers, by helping them to achieve the four main building blocks of competitive advantage: efficiency, quality, innovation, and responsiveness to customers.
D. Superior value creation is driven by a firm’s ability to differentiate its products or reduce its expenses. When firms are able to create superior value, they experience higher profitability.
E. It’s also important for firms to sustain their competitive advantages over time, to maintain their competitive advantage, and to take steps to avoid competitive failure.
XVII.Distinctive Competencies and Competitive AdvantageA. A company has a competitive advantage when its profit rate is higher than the average for its
industry, and it has a sustained competitive advantage when it is able to maintain this high profit rate over a number of years.
B. Competitive advantage derives from a firm’s distinctive competencies, which are of two types: resources and capabilities.1. Resources refer to the financial, physical, human, technological, and organizational resources
of the company. They can be divided into tangible resources, such as land, buildings, plant, and equipment; and intangible resources, such as brand names, reputation, patents, and technological or marketing knowledge.a. Resources that are firm-specific and difficult to imitate are unique. Resources that create
a strong demand for the firm’s products are valuable.b. Unique and valuable resources lead to a distinctive competency.
2. Capabilities refer to a company’s skills at coordinating its resources and putting them to productive use.a. These skills reside in the way a company makes decisions and manages its internal
processes.b. Capabilities are, by definition, intangible. They reside not so much in individuals as in the
way individuals interact, cooperate, and make decisions within the context of an organization.
3. The distinction between resources and capabilities is of the utmost importance in understanding the source of a distinctive competency. A company may have unique and valuable resources, but unless it has the capability to use those resources effectively, it may not be able to create or sustain a distinctive competency. Thus, unique and valuable resources are helpful in creating distinctive competencies, but capabilities are essential.
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Figure 3.2: Strategy, Resources, Capabilities, and Competencies
C. A company’s profit rate and hence competitive advantage is determined by the value customers place on the company’s goods or services, the price the company charges for the products or service, and the company’s costs of production.1. Value is assigned by customers based on product attributes such as performance, design, and
quality. The more value a company creates, the more flexibility it has in assigning a price.2. The price a company charges is typically less than the value assigned by the consumer. The
customer captures that difference in value as a consumer surplus, which occurs because the company is competing with other companies and so must charge a lower price than it could as a monopoly supplier.
3. Another factor that causes the price to be lower than the value is the impossibility of segmenting the market so that the company can charge each customer a price that reflects that individual’s reservation price (their assessment of the value of a product).
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Figure 3.3: Value Creation per Unit
4. Looking at Figure 3.3, the company’s profit margin is equal to the difference between price and costs (P–C), whereas the consumer surplus is equal to the difference between value and price
(V–P). The company makes a profit so long as the price is greater than the cost. Its profit rate will be greater the lower costs are, relative to the price. The lower the competitive intensity, the greater the difference that can exist between price and value.
5. Looking at Figure 3.4, a company can create more value for its customers in two ways.a. Under Option 1, a company can make the product more attractive, raising costs (C) but
also raising value (V). Customers are then willing to pay a higher price (P increases).b. Under Option 2, a company can lower its price (P), creating a higher value (V), more
demand, and increased volume of sales. Economies of scale realized because of the increased volume allow the company to reduce its costs (C).
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Figure 3.4: Value Creation and Pricing Options
D. Low cost and differentiation are two basic strategies for creating value and attaining a competitive advantage in an industry. Competitive advantage (and higher profits) goes to those companies that can create superior value—and the way to create superior value is to drive down the cost structure of the business and/or differentiate the product in some way so that consumers value it more and are prepared to pay a premium price.
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Figure 3.6: The Roots of Competitive Advantage
XVIII. The Value ChainA. A company’s value chain is a sequence of interrelated activities for transforming inputs into outputs
that customers value. The process consists of a number of primary activities and support activities, each of which can add value to the product.
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Figure 3.7: The Value Chain
1. Primary activities have to do with the design, creation and delivery of the product, its marketing, and with its support and after-sales service. There are four primary activities: research and development, production, marketing and sales, and service.a. Research and development (R&D) is concerned with the design of products and
production processes. R&D occurs in manufacturing enterprises as well as service companies. By superior product design, R&D can develop superior product designs, which increase the functionality of products, making them more attractive to consumers. Alternatively, R&D may develop more efficient production processes, lowering costs.
b. Production is concerned with the creation of a good or service. For physical products, production means manufacturing. For services, production takes place when the service is actually delivered to the customer. The production function creates value by performing its activities efficiently so that lower costs result. Production can also create value by performing its activities in a way that is consistent with high product quality, which leads to differentiation and lower costs.
c. Marketing and sales functions create value through brand positioning and advertising, which increase the perceived product value. They also create value by discovering consumer needs and communicating them to the R&D function of the company, which can then design products that better match those needs.
STRATEGY IN ACTION 3.1: VALUE CREATION AT PFIZER
Prozac, introduced by Eli Lilly, was the market leader in antidepressant drugs. But in 1992, rival Pfizer introduced its own antidepressant, Zoloft, which is very similar to Prozac and has been gaining share from Lilly. Zoloft’s
success is due to an aggressive marketing and sales campaign designed to convince physicians that Zoloft is a safer drug. Pfizer salespeople also logged more “face time” with physicians than Lilly’s, and Pfizer focused on visits to primary care physicians, who increasingly prescribe antidepressants but are less familiar with them than are psychiatrists. Pfizer has enjoyed rapidly increasing revenues and market share and, therefore, a greater return on the company’s investment in developing Zoloft.
Teaching Note: This case describes Pfizer’s ability to create value for customers through the value chain function of marketing and sales. The case notes several specific actions taken by the firm to differentiate their products from those of their competitors. The actions included publishing the results of safety comparisons describing Zoloft as safer than Prozac, spending more time on physician’s visits, and focusing on the more malleable primary care physicians, rather than psychiatrists. One good discussion point would be to ask students whether these actions might be expensive or difficult for other firms to imitate. Students can then predict whether these actions would be likely to lead to a sustained competitive advantage for Pfizer.
d. The role of the customer service function is to provide after-sales service and support. This function can create a perception of superior value in the minds of consumers by solving customer problems and supporting customers after they have purchased the product.
2. The support activities of the value chain provide inputs that allow the primary activities to take place.a. The materials management function controls the transmission of physical materials
through the value chain, from procurement through production and into distribution. The efficiency with which this is carried out can significantly lower cost, thereby creating more value.
b. The human resource function helps to create value by ensuring that the company has the right mix of skilled people to perform its value creation activities effectively. It is also the job of the human resource function to ensure that people are adequately trained, motivated, and compensated to perform their value creation tasks.
c. Information systems refer to the (largely) electronic systems for managing inventory, tracking sales, pricing products, selling products, dealing with customer service inquiries, and so on. Information systems, when coupled with the communications features of the Internet, are holding out the promise of being able to alter the efficiency and effectiveness with which a company manages its other value chain activities.
d. The final support activity is the company infrastructure, or the company-wide context within which all the other value-creation activities take place. The infrastructure includes the organizational structure, control systems, and organizational culture. Because top management can exert considerable influence in shaping these aspects of a company, they should also be viewed as part of the infrastructure of a company.
XIX. The Generic Building Blocks of Competitive AdvantageA. Four generic factors build competitive advantage by allowing companies to better differentiate their
products or become more efficient in reducing costs: efficiency, quality, innovation, and responsiveness to customers. They are generic because they represent actions that any company can adopt, irrespective of industry. The factors are all highly interrelated.
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Figure 3.8: Generic Building Blocks of Competitive Advantage
B. Efficiency is measured by the cost of inputs required to produce a given output.1. The more efficient a company, the lower the cost of inputs required to produce a given output.
Thus efficiency helps a company attain a low-cost competitive advantage.2. One of the keys to achieving high efficiency is utilizing inputs in the most productive way
possible. Companies with high employee productivity and capital productivity will have low costs of production.
STRATEGY IN ACTION 3.2: SOUTHWEST AIRLINES’ LOW COST STRUCTURE
Southwest Airlines has consistently achieved the lowest costs in the industry, enabling it to grow market share by offering lower prices, and helping the firm to weather industry downturns. A major contributor to the low costs is the company’s high employee productivity, enabling them to serve more passengers with fewer personnel. High productivity is due to a number of factors, including care in hiring. The firm is known for hiring only those with positive attitudes and good teamwork skills. Incentives such as profit sharing also encourage hard work and cooperation. Another contributor is its no-frills operations, with only one type of aircraft, no meals, no assigned seats, and no paper tickets. Operations costs are further reduced because the firm only flies point-to-point, and doesn’t use a hub system, as most of the other major carriers do, reducing the need for a large number of gates and personnel.
Teaching Note: This case illustrates a number of ways in which Southwest Airlines has fostered high employee productivity and high capital productivity. Southwest has scrutinized each area of airline operations, from ticketing to baggage handling to food service to aircraft maintenance to route scheduling, for opportunities to drive down costs. Southwest’s efficiency creates a challenge for competitors. Classroom discussion of the case could center on the question of whether any firm could hope to imitate Southwest’s low-cost competitive advantage—the answer would probably be negative, at least in the short term. A follow-up question could address the possibility of a successful competitive attack by an airline pursuing a different strategy. What resources and capabilities would be required for such an attack, and how might it lead to changes in the airline industry?
C. Quality products are goods and services that have attributes that customers perceive as desirable. On important attribute is reliability, meaning that the product does the job it was designed for and does it well. Quality applies equally to goods and to services.1. Providing high-quality products creates a brand-name reputation for a company’s products. In
turn, this enhanced reputation allows the company to charge a higher price for its products.2. Higher product quality can also result in greater efficiency, with less employee time wasted
fixing defective products or services. This translates into higher employee productivity, which means lower unit costs.
STRATEGY IN ACTION 3.3: CONTINENTAL AIRLINES GOES FROM WORST TO FIRST
In 1994, Gordon Bethune became CEO of Continental Airlines, which had the lowest customer satisfaction and on-time ratings of any U.S. air carrier. Bethune felt that the firm had cut costs too low, and decided to spend more in order to improve quality. He set a goal for reliability improvement and gave bonuses when this goal was met. Within a year, the firm ranked in the top three in reliability, and it still does. In addition, Bethune empowered front-line employees to handle contingency situations as they saw fit. The increased flexibility and decentralization has had a tremendous impact on customers’ perception of the quality of service they receive at Continental.
Teaching Note: This case provides an excellent example of the ways in which higher quality can contribute to higher efficiency. Continental experienced a dramatic increase in employee productivity, and that higher level of effort by employees led to improved on-time performance and higher customer satisfaction. Through the changes described in this case, Continental was able to both reduce costs and increase differentiation. Ask students to consider the information in this case in conjunction with that presented in Strategy in Action 3.2, about Southwest Airlines. Which of the two firms has the greatest competitive advantage? Why? How long will that competitive advantage endure? What will it take for other firms to successfully imitate or bypass that advantage?
D. Process innovation occurs if there is anything new or novel about the way a company operates. Product innovation occurs if there is anything new or novel about the company’s products. Thus innovation includes advances in the kinds of products, production processes, management systems, organizational structures, and strategies developed by a company.1. Successful innovation gives a company something unique that its competitors lack (that is, until
imitation occurs). This uniqueness allows a company to differentiate and charge a premium price.
2. Successful innovation may also allow a company to reduce its unit costs.E. Achieving customer responsiveness requires that a company give its customers exactly what they
want when they want it. It involves doing everything possible to identify customer needs and to satisfy those needs.
1. One way to increase customer responsiveness is to improve the efficiency production processes and the quality of products.
2. Another way to increase responsiveness is to develop new products that have features currently not incorporated in existing products.
3. Another way to increase responsiveness is to customize goods and services to the unique demands of individual customers.
4. Another way to increase responsiveness is to reduce customer response time, or the amount of time it takes for a good to be delivered or a service to be performed.
F. In summary, superior efficiency enables a company to lower its costs; superior quality enables a company both to charge a higher price and to lower its costs; superior innovation can lead to higher prices or lower unit costs; and superior customer responsiveness enables a company to charge a higher price.
XX. Analyzing Competitive Advantage and ProfitabilityA. Managers must understand the financial impact of their strategies. They can compare their processes
and outcomes to competitors, using benchmarking.B. The most widely used measure of financial performance is profitability.
1. Profitability can be measured in different ways, but return on invested capital (ROIC) is one of the most widely used.
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Figure 3.10: Drivers of Profitability (ROIC)
2. ROIC is calculated as net profits divided by invested capital. ROIC represents the effectiveness with which a company is using the funds it has available for investment.
3. ROIC can be decomposed into two parts. Return on Sales is calculated as net profit divided by revenues, and represents how effectively the company converts sales revenues into profits. Capital turnover is calculated as revenues divided by invested capital, and represents how effectively the company uses its invested capital to generate revenues.
C. Managers can increase profitability by increasing return on sales, either by reducing expenses for a given level of sales, or by increasing sales revenues faster than expenses. They can also increase profitability by getting more sales revenue from their capital investment.
RUNNING CASE: DRIVERS OF PROFITABILITY FOR DELL COMPUTER AND COMPAQ
Dell enjoys a low-cost competitive advantage, leading to an ROIC of 38 percent, as compared to Compaq’s ROIC of 13 percent. Dell’s COGS is higher than Compaq’s, but its SG&A expenses are lower, due to Dell’s use of a direct sales model, with much lower sales, distribution, and retailing expenses. In addition, Dell’s focus on low cost PCs helps to keep its expenses low, while Compaq’s expenses are greater because it is trying to differentiate its products with proprietary technology. Also, Dell’s PPE expenses are just one-third of Compaq’s, as a result of Dell’s low inventory, efficient manufacturing processes, and web-based information system. [Compaq was acquired by Hewlett Packard in 2001.]
Teaching Note: Dell’s low-cost, direct sales business model has been remarkably successful, giving the firm an ROIC that is three times greater than its nearest competitor’s. Dell has reduced expenses in many areas of its operations, as evidenced by the figures quoted in the case. You can ask students to consider whether Compaq will ever be able to successfully imitate Dell’s low-cost strategy. They are likely to decide that Compaq cannot. Next, ask students whether that implies that Compaq will ultimately fail, or whether they could succeed by adopting a different strategy. Classroom discussion could include ideas for alternative strategies that might be useful to Compaq in competing against Dell. This case, like several in this chapter, has an important but veiled message about the impact of strategy on performance. You should make sure that students understand this point: Strategies can give firms a powerful, sustained advantage, however, there are always other strategies that could also lead to success. Managers must seek out alternate strategies if they want their firms to succeed against powerful rivals.
A. Durability refers to the length of time that a competitive advantage lasts, once it has been created. Successful companies earn above-average returns, which send a signal to competitors.
B. Three factors lead to durability: high barriers to imitation, poor capability of competitors, and low dynamism in the industry.1. Barriers to imitation are factors that make it difficult for a competitor to copy a company’s
distinctive competency. The longer it takes to imitate a company’s distinctive competency, the greater is the opportunity for the company to improve on that competency or build other competencies.a. The easiest distinctive competencies to imitate are those based on firm-specific tangible
resources such as buildings, plant, and equipment, which are visible to competitors and can be readily purchased.
b. Intangible resources are more difficult to imitate. Brand names symbolize a company’s reputation, and are protected by law.
c. Marketing and technological know-how are intangible resources that are relatively easy to imitate.(1) Marketing strategies are visible to competitors, and the movement of marketing
personnel between companies facilitates the diffusion of know-how.(2) Technological know-how should be protected by patents, but in practice, it is often
possible to “invent around” patents.d. Imitation of capabilities is more difficult than imitation of resources. Capabilities are
often invisible to outsiders, and are based on the way in which decisions are made and processes managed deep within a company. Also, a company’s capabilities are not dependent upon one individual, but are the product of how numerous individuals interact within a unique organizational setting. Thus, no one person can duplicate capabilities, and therefore personnel movement will not be as useful in imitating capabilities.
2. When a company is committed to a particular way of doing business based on a set of resources and capabilities, the company will find it difficult to respond to new competition if doing so requires a break with this commitment. This influence on the durability of competitive advantage is called “capability of competitors.”a. A related concept is absorptive capacity—that is, the ability of an enterprise to identify,
assimilate, and utilize new knowledge. Firms with a low absorptive capacity may experience an internal inertia that slows their ability to innovate and imitate.
b. Therefore, when innovations reshape the rules of competition in an industry, value often migrates away from established competitors and toward new enterprises that are operating with new business models.
3. Industry dynamism refers to the rate of product innovation. A high dynamism (rapid rate of innovation) means that product life cycles are shortening and that competitive advantage can be very transitory. Durability of competitive advantage is difficult for any company to sustain in a highly dynamic industry.
XXII.Avoiding Failure and Sustaining Competitive AdvantageA. Failing companies are not just below average; they earn very low or negative profits. Three related
reasons for failure are explored here: inertia, prior strategic commitments, and the Icarus paradox.1. The inertia argument is that companies find it difficult to change their strategies and structures
in order to adapt to changing competitive conditions.a. An organization’s capabilities contribute to inertia, because they are difficult to change.
Changing capabilities would require a redistribution of power and influence among the key decision makers, and therefore will be resisted. Turf battles may result.
b. Thus, capabilities can provide competitive advantage and also competitive disadvantage.2. Prior strategic commitments, such as investments in specialized resources, may also
contribute to competitive failure, because the resources are not well suited for other, evolving uses. Changing resources is difficult and expensive.
3. The Icarus paradox is based on the Greek myth of Icarus, who made himself a pair of wings from wax and feathers, then flew so well that he went too close to the sun, melting the wings and plunging to his death. The paradox is that his greatest asset, his ability to fly, gave rise to his demise.
a. Many successful companies become so dazzled by their own early success that they believe that pursuing the same course of action is the way to future success. They may pursue strategies such as “craftsmen,” “builders,” “pioneers,” and “salesmen.”
b. This attitude, however, leads a company to become so specialized and inner-directed that it loses sight of market realities and the fundamental requirements for achieving a competitive advantage. Sooner or later failure ensues.
STRATEGY IN ACTION 3.4: THE ROAD TO RUIN AT DEC
By 1990, DEC’s superiority in producing high quality VAX minicomputers made it one of the largest corporations in the world. However, the company’s success carried the seeds of its destruction. An increasingly narrow focus on engineering capability led to a neglect of other functions, and the firm became dangerously out of touch with changing customer needs and industry conditions. DEC went through a terrible change of fortune in the early 1990s, returning to profitability only with the ouster of CEO Ken Olsen and a drastic change in strategy. DEC was acquired by Compaq in 1998. [Compaq was acquired by Hewlett Packard in 2001.]
Teaching Note: This case provides a striking example of how successful firms can lose their competitive advantage, through strategic mis-steps. To facilitate classroom discussion, you can ask students to describe the causes of DEC’s failure, using the terms identified in section VII above. Students will see that DEC suffered from all three of the major causes of failure. The firm’s large size led to inertia, making it more difficult for DEC to adapt, and CEO Olsen was one of the worst offenders in terms of protecting his “turf” from changes proposed by others. DEC also had prior strategic commitments, in the form of specialized engineering know-how, which made change less likely. Finally, DEC suffered from the Icarus paradox. Dazzled by its early success, it became so specialized and inner-directed that it lost sight of customers and competitors, leading to strategic failure.
B. To avoid failure, companies can focus on the building blocks of competitive advantage, institute continuous improvement and learning, track best industrial practice and use benchmarking, and overcome inertia. Managers can also learn to exploit luck.1. Maintaining a competitive advantage requires a company to continue focusing on the four
generic building blocks of competitive advantage—efficiency, quality, innovation, and customer responsiveness—and to do whatever is necessary to develop distinctive competencies that contribute toward superior performance in these areas.
2. In today’s dynamic and fast-paced environments, the only way that a company can maintain a competitive advantage over time is to continually improve its efficiency, quality, innovation, and customer responsiveness. The most successful firms are those that continually learn, seeking out ways of improving their operations and constantly upgrading the value of their distinctive competencies or creating new competencies.
3. One of the best ways to develop distinctive competencies is to identify best industrial practice and to adopt it. Only by doing so will a company be able to build and maintain the resources and capabilities that underpin excellence in productivity, quality, innovation, and customer responsiveness.
4. The ability to overcome the inertial barriers to change within an organization is one of the key requirements for continuing to maintain a competitive advantage.
5. Luck can play a critical role in determining competitive success and failure, but it is an unconvincing explanation for the persistent success of a company. It is difficult to imagine how sustained excellence could be the product of anything other than conscious effort, that is, of strategy. However, companies can be flexible and prepared to exploit lucky breaks as they occur.
STRATEGY IN ACTION 3.5: BILL GATES’ LUCKY BREAK
Bill Gates, founder of Microsoft, benefited from luck in the company’s first product, the MS-DOS operating system. He knew that Seattle Computer had developed a PC operating system. Through his mother’s business contacts, he knew that IBM was looking to acquire such a system. His father, a prominent Seattle attorney, was able to loan Gates the $50,000 to acquire the system from Seattle Computer, which was then licensed to IBM for a tremendous profit. There were several elements of luck in this beginning, but Microsoft’s continued high
performance has been mainly due to Gates’ astute use of that initial profit to acquire resources and capabilities that would lead to enduring success.
Teaching Note: Many students will enter the classroom with the idea that success is largely a matter of luck: knowing the right people, being in the right place at the right time, or experiencing a sudden and undeserved windfall. They have heard this idea many times in our popular culture and media. However, it’s important to stress to students that a sustained success over determined rivals is unlikely to be result of mere luck; rather, it is the logical result of a series of thoughtful and deliberate plans and actions. This case acknowledges the relatively limited role that luck can play in organizational success, while focusing attention on the ways in which planning has contributed to Microsoft’s more recent successes. To spark a classroom discussion, you can ask students to describe other examples of organizations that benefited from luck, such as a helpful change in tax policy or the development of a new product just as demand grew. Describe the benefits that came to the organization as a result of luck. Then, ask students to consider how long those benefits endured. Students will see that luck is useful, but transitory.
CHAPTER 4
Building Competitive Advantage Through Functional-Level Strategy
SYNOPSIS OF CHAPTERThis chapter explains how functional-level strategies can help a company achieve superior efficiency, quality, innovation, and customer responsiveness, leading to competitive advantage.
Functional strategies consistent with attaining superior efficiency are considered first. This section reviews the contributions that each of the different functional areas of a company can make toward increasing efficiency. Among the topics discussed with regard to their impact on efficiency are economies of scale, learning effects, the experience curve, flexible manufacturing technologies, marketing strategy, and materials management. The contributions of the R&D function, the human resource function, the information systems function, and company infrastructure are then examined.
Next, the chapter addresses how functional strategies can improve quality of a company’s goods and services. One aspect of quality is reliability, and total quality management (TQM) is proposed as a methodology for improving reliability. Other aspects of quality, such as form, features, durability and styling are also discussed.
The third section focuses on the means of achieving superior innovation through functional strategies. A discussion of the reasons for the high failure rate of innovations is followed by a detailed examination of the ways in which a company can build a distinctive competency in innovation.
The final section of the chapter concentrates on the contribution of functional strategies to improved responsiveness to customers. Achieving superior customer responsiveness requires superior efficiency, quality, and innovation. Also, the chapter describes steps that companies can take to better understand the needs of their customers, better satisfy those needs, and satisfy those needs more quickly.
TEACHING OBJECTIVES1. Discuss how a company can build and maintain a competitive advantage through its choice of functional
strategies.
2. Identify the different steps that can be taken at the functional level to improve a company’s efficiency.
3. Identify the different steps that can be taken at the functional level to improve the quality of the company’s product.
4. Identify the different steps that can be taken at the functional level to improve a company’s ability to innovate.
5. Identify the different steps that can be taken at the functional level to improve a company’s responsiveness to its customers.
OPENING CASE: CSX—GETTING THE TRAINS TO RUN ON TIMECSX Corporation, a freight transporter, merged with Conrail in 1996, creating one of the largest railroad firms in the U.S. The expected costs savings due to economies of scale did not result, due to a host of problems in merging the two firms. Among the post-merger difficulties were poor quality, unsafe tracks, low employee morale, and poor customer service. In 2000, an efficiency campaign was launched, focused around the use of 14 critical operating efficiency metrics. CSX made tremendous improvement over the next year in those 14 areas, empowering local employees to make decisions, fixing defective tracks, and building a web-based customer interface for service. These actions led to better quality, higher customer satisfaction, greater efficiency, and ultimately, higher profits.
Teaching Note: This case provides a vivid demonstration of how a company suffering from poor performance and numerous internal problems could achieve successful outcomes, through the use of improvements at the functional level. The details of the case clearly relate to many of the topics introduced in this chapter, focusing on ways to improve efficiency, quality, and responsiveness to customers. This case provides an excellent introduction to an idea that may at first be difficult for students to grasp. That is, that the basis of competitive advantage is always found at the lowest levels of the organization (the functions). Students may erroneously assume that large, diversified companies should be turned around primarily by the actions of top managers. You can use this case as an opportunity to demonstrate that real, lasting, important changes are in fact, most often due to many small improvements at the functional level. Thus, functional level managers play a key role in organizational success.
LECTURE OUTLINEXXIII. Overview
A. This chapter addresses the role that functional-level strategies play in improving the effectiveness of functional operations within a company, such as manufacturing, marketing, materials management, research and development, and human resources. Functional strategies may also cut across two or more functions to attain a common goal.
B. Functional-level strategies can improve effectiveness by helping an organization to achieve efficiency, quality, innovation, and customer responsiveness.
C. Functional strategies are responsible for building the resources and capabilities that lead to distinctive competencies, allowing a firm to pursue a differentiation and/or low cost strategy.
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Figure 4.1: The Roots of Competitive Advantage
XXIV. Achieving Superior EfficiencyA. Efficiency is measured by the cost of inputs (labor, capital, equipment, know-how, and so on)
required to produce a given output (the good or service produced by the company). The more efficient a company, the lower the cost of inputs is required to produce a given output. An efficient company has higher productivity than its rivals, and, therefore, lower costs.
B. Economies of scale are unit-cost reductions associated with a large scale of output. Both manufacturing and service companies can benefit from economies of scale.1. One source of economies of scale is the ability to spread fixed costs over a large production
volume.2. Another source is the ability of companies producing in large volumes to achieve a greater
division of labor and specialization. Specialization improves employee productivity because it enables individuals to become very skilled at performing a particular task.
3. Economies of scale raise ROIC in two ways. They reduce spending on COGS, SG&A, and R&D as a percentage of sales, improving return on sales. They also make more intensive use of existing PPE, increasing capital turnover.
4. Economies of scale do not continue indefinitely. Typically, diseconomies of scale are reached at very high volumes, due to increased bureaucracy and the resulting inefficiencies.
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Figure 4.2: Economies and Diseconomies of Scale
C. Learning effects refer to cost savings that come from learning by doing. Labor productivity increases as individuals learn the most efficient way to perform a particular task and managers learn how best to run the operation.1. Learning effects are most important in a technologically complex task that is repeated, and are
really important only during the start-up period of a new process. The importance of learning effects tends to cease after two or three years.
2. Although economies of scale move a firm downward along the unit cost curve, learning effects shift the entire curve downwards.
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Figure 4.3: The Impact of Learning and Scale Economies on Unit Cost
D. The experience curve refers to systematic unit-cost reductions that have been observed to occur over the life of a product. According to the experience-curve concept, unit manufacturing costs for a product typically decline by some characteristic amount each time accumulated output of the product is doubled.
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Figure 4.4: The Experience Curve
1. Economies of scale and learning effects underlie the experience-curve phenomenon. As a company increases the accumulated volume of its output over time, it is able to realize both economies of scale (as volume increases) and learning effects. As a consequence, unit costs fall with increases in accumulated output.
2. The experience curve suggests that increasing a company’s product volume and market share will bring cost advantages over the competition. The concept is perhaps most important in those industries where the production process involves the mass production of a standardized output (for instance, the manufacture of semiconductor chips).
3. If a company wishes to attain a low-cost position, it must ride down the experience curve as quickly as possible. This involves building an efficient scale plant ahead of demand and aggressively pursuing learning effects. It also involves aggressive price cutting and marketing in order to expand sales and get down the experience curve ahead of competitors.
STRATEGY IN ACTION 4.1: TOO MUCH EXPERIENCE AT TEXAS INSTRUMENTS
Texas Instruments (TI) was one of the first companies to exploit the experience curve concept. When TI first produced a new product, it would slash the price to stimulate demand, driving up the accumulated volume of production and driving down costs. As a result, during the 1960s and 1970s TI hammered its competitors in transistors, semiconductors, hand-held calculators, and digital watches. Ultimately, however, TI’s single-minded focus on cost reductions left the company with a poor understanding of consumer needs and market trends. Competitors such as Casio, Hewlett-Packard, Motorola, and Intel made major inroads into TI’s markets by focusing on additional features that consumers demanded, rather than on cost and price. TI was slow to react to this trend and lost substantial market share as a result.
Teaching Note: The case shows students how increasing experience and expertise can be both an advantage and a disadvantage. The case demonstrates an example of a firm that rode down the experience curve, benefiting from the efficiency and know-how improvements, but then became over-reliant on further improvements in efficiency, ignoring changing conditions. Students can use this case to understand how organizations must balance their quest for efficiency with an equally important search for innovations. Some have called this need for balance, “learning vs. efficiency.” You can use this case for classroom discussion by asking students to suggest actions that TI could
have taken to avoid the loss of market share. Students will realize that TI needed to innovate, making changes and risking the possibility of error. That is not efficient, but it would have allowed TI to stay in touch with customers and improve their products’ functionality.
4. However, the company furthest down the experience curve must not become complacent about its position for three reasons.a. The experience curve bottoms out at some point, which implies that other companies can
catch up.b. Cost advantages gained from experience effects can be made obsolete by the
development of new technologies that require new methods of production.c. The experience curve suggests that high volume leads to a cost advantage, but this does
not always happen. In some industries, there are two or more different production technologies, one of which is cost-efficient at high volumes, and the other at low volumes. A company using low-volume technology may be able to operate with a cost structure similar to that of companies using a high-volume technology.
E. It seems then, that the best way to reduce costs is to produce high volumes of a standard product. However, this view has been challenged by the rise of flexible manufacturing technologies, also called lean production.1. Flexible manufacturing technologies allow firms to produce a wider variety of product while
still achieving the efficiencies of high volume production. Cost efficiencies are achieved by reducing setup times for complex equipment, increasing the utilization of individual machines through better scheduling, and improving quality control at all stages of the manufacturing process.
2. Mass customization refers to the use of flexible manufacturing technologies to achieve low cost and differentiation through product customization.
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Figure 4.6: Tradeoff Between Costs and Product Variety
STRATEGY IN ACTION 4.2: TOYOTA’S LEAN PRODUCTION SYSTEM
Toyota is the most efficient auto company in the global industry, thanks to its lean production system, developed in response to problems Toyota’s engineers saw with the long production runs of a mass production system. The problems included the creation of large and expensive inventories, the production of a large number of defective products if the initial machine settings were wrong, and the system’s inability to accommodate diverse consumer preferences. Toyota then developed a number of techniques designed to reduce equipment setup times—a major source of fixed costs. This made small production runs economical, which eliminated large inventories, fewer defective products, and better responsiveness to consumer demands for product diversity. Process innovations enabled Toyota to produce a more diverse product range at a lower unit cost than was possible with conventional mass production.
Teaching Note: This case describes Toyota’s disenchantment with mass production, and their subsequent development of a flexible manufacturing system, to overcome mass production’s disadvantages. The case also focuses attention on the interrelatedness of efficiency, quality, innovation, and responsiveness to customers, as Toyota’s new system improved all four at the same time. You can point out to students that virtually every manufacturing industry has adopted flexible manufacturing to some extent, and that the explosion in technologies such as CAD/CAM software, robotics, and artificial intelligence has enabled lean production techniques.
3. One type of flexible manufacturing technology is flexible machine cells, which are groupings of four to six various machines, a materials handler, and a central computer. The machines are computer controlled, allowing each cell to switch quickly between the production of different products.a. Flexible machine cells allow for improved capacity utilization due to a reduction in setup
times and better coordination of production flow between machines.b. Flexible machine cells reduce work in progress and waste because of the tight
coordination between machines and the ability of computer-controlled machinery to
identify how to transform inputs into outputs while producing a minimum of unusable waste material.
F. Marketing strategy refers to the position that a company takes with regard to pricing, promotion, advertising, product design, and distribution.1. Marketing strategy can increase efficiency by using aggressive pricing, promotions, and
advertising to improve sales and help the organization ride down the experience curve.2. Another aspect of marketing strategy that can improve efficiency is the creation of customer
loyalty, through high customer satisfaction. Loyalty reduces customer defection rates, or the percentage of a company’s customers that defect every year to competitors.a. There is a direct relationship between defection rates and costs. Acquiring a new
customer entails one-time fixed costs for advertising, promotions, and the like.b. The longer a company retains a customer, the greater is the volume of customer-
generated unit sales that can be set against these fixed costs and the lower is the average unit cost of each sale.
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Figure 4.7: The Relationship Between Customer Loyalty and Profit per Customer
G. Efficiency can also be improved through the use of materials management, which encompasses the activities necessary to get materials to a production facility, through the production process, and through a distribution system to the end user. Materials management is also called supply chain management.1. Materials management typically accounts for 50 to 70 percent of a manufacturer’s costs—thus,
even a small reduction can have a great impact.2. Improving the efficiency of the materials management function typically requires the adoption
of just-in-time (JIT) inventory systems. JIT reduces inventory-holding costs by having materials arrive at a manufacturing plant just in time to enter the production process, and not before.
3. The drawback of JIT systems is that they leave a firm without a buffer stock of inventory. Although buffer stocks of inventory are expensive to store, they can help tide a firm over shortages on inputs brought about by disruption among suppliers.
STRATEGY IN ACTION 4.3: SUPPLY CHAIN MANAGEMENT AT OFFICE SUPERSTORES
Three companies, Office Depot, Staples, and Office Max are the major competitors in the competitive office superstore industry, which retails office supplies, earning thin profit margins. All are examining their supply chain management, looking for ways to cut costs. Office Depot succeeds by having a high inventory turn rate, and the firm also has reduced the number of items it stocks, with a focus on carrying only items that turn over rapidly or earn a high profit margin. This allows Office Depot to use stores that are one-sixth smaller than its competitors’ stores, which further reduces costs. Staples is concentrating on developing closer, cooperative relationships with suppliers, which has led to lower inventory held at the stores. Staples has also eliminated in-store displays of computers, freeing up floor space, and now sells PCs through a web-based ordering system offering customized design to customers. Office Max too is reducing the number of items and scaling down the size of stores.
Teaching Note: This case provides students with examples of a number of possible improvements in materials management, including reduction in the number of items stocked, focus on high-margin items, cooperation with suppliers, JIT inventory, and use of the Internet for product display. The case also demonstrates the benefits that superior materials management can provide. This case could be used as the basis for class discussion, by asking students to describe how the materials management practices listed in the case could be used by other retailers. For example, ask students, “Which of the practices in the case could be successfully employed at a retail clothing store? At a bookstore? At a grocery store? Which could not, and why?”
H. The R&D function can boost efficiency by designing products that are easy to manufacture, cutting down on the number of parts and reducing assembly time. R&D can also pioneer process innovations to improve efficiency.
I. The human resource function can aid in improving efficiency by raising employee productivity.
1. Recruiting is one area where human resources can help. Carefully hiring individuals with the right attitudes and values can raise employee productivity. Skilled employees can also interact with customers in ways that improve customer loyalty.
2. Another way to raise employee productivity is through training. Skilled individuals perform tasks more quickly and accurately, and are better able to learn complex tasks. A company can upgrade the skill level of its employees through training.
3. Self-managing teams, where members are responsible for coordinating their own activities, are another source of efficiency gain. Team members learn all team tasks and rotate from job to job, creating a more flexible workforce in which members can fill in for absent coworkers. Teams also take over managerial duties, and the resulting empowerment is a motivator.
4. Another boost to productivity comes from linking pay to performance. Successful companies are careful to specify the quality, as well as the quantity, of production. Successful firms also tend to reward group, rather than individual, performance, in order to improve cooperation among employees.
J. With the rapid growth of computers, the Internet, corporate intranets, and high bandwidth communications, the information systems function contributes to operational efficiencies.1. Information systems can improve labor efficiency by automating tasks that were previously
performed manually.
RUNNING CASE: DELL’S UTILIZATION OF THE INTERNET
Dell began selling PCs by phone, and was one of the first companies to implement online selling of computers. Founder and CEO Michael Dell says that the Internet gives more information to customers, permits them to customize their computers, and provides timely and easy-to-use customer support, leading to differentiation. At the same time, Dell’s use of the Internet allows them to reduce their sales and customer support personnel, and eliminate physical stores, which reduces the company’s costs. In addition, Dell uses the Internet to manage its supply chain, using the web to communicate with suppliers and call for components on a just-in-time basis. This reduces inventory costs to very low levels, and also synchronizes demand and supply of components. Thus, customers get the latest-and-greatest products, and obsolete inventory write-offs are virtually eliminated.
Teaching Note: This case describes Dell’s success in utilizing the Internet to improve efficiency, and how the firm realized all three benefits: lower labor costs, easier coordination of the supply chain, and less reliance on physical facilities. To spark discussion, ask students why Dell’s competitors, such as Gateway, Apple, or Hewlett-Packard (owner of Compaq) have not imitated Dell’s strategy yet. Is it because they are unable to imitate the strategy, or is it because they have chosen a different strategy? Whichever answer students give, ask them to explain why—why the strategy cannot be imitated, or why they chose a different strategy, that is, what benefits did they expect to receive from a different strategy? You can also ask students whether Dell’s competitors could use some of the actions that Dell is using. In other words, ask students whether this strategy can be adopted a piece at a time. Why or why not?
1. Web-based information systems can reduce the costs of supply chain coordination, including the relationships between the company and its customers, and the company and its suppliers.
2. On-line sellers can replace their capital-intensive physical locations with a much less costly web site.
K. Infrastructure can also improve efficiency, as a companywide commitment to low costs can be built through top management leadership. Leaders can also facilitate cooperation among functions in the pursuit of efficiency goals.
XXV.Achieving Superior QualityA. Achieving superior quality gives a company two advantages. First, the enhanced reputation for quality
allows the company to differentiate and thus charge a premium price for its products. Second, by eliminating defects or errors from the production process, superior quality can result in greater efficiency and hence lower costs.
B. One aspect of quality is reliability. Total Quality Management (TQM) is a technique to improve reliability. TQM stresses that quality should be a main concern of the company, and that all of a company’s operations should be oriented toward this end.1. The TQM philosophy, as articulated by Deming and others, is based on a five-step chain
reaction. (1) Improved quality means that costs decrease because of less rework, fewer
mistakes, fewer delays, and better use of time and materials. (2) As a result, productivity improves. (3) Better quality leads to higher market share and allows the company to raise prices. (4) This increases the company’s profitability and enables it to stay in business. (5) Thus the company creates more jobs.
2. American firms are increasing their focus on quality, but still do not give it the same attention as overseas competitors. Many firms do not fully understand or have not yet fully embraced TQM, and therefore are not realizing the full benefits of it.
STRATEGY IN ACTION 4.4: GENERAL ELECTRIC’S SIX-SIGMA QUALITY IMPROVEMENT PROCESS
Six Sigma is a quality and efficiency program that aims to reduce defects, boost productivity, eliminate waste, and cut costs throughout a company. (The term comes from the Greek letter, sigma, which is used to represent a standard deviation. Thus, six-sigma quality is six standard deviations above the mean or average, which translates into about 3.4 defects per million units produced.) GE is perhaps the most fervent adopter of six-sigma programs, which are can be used as part of Total Quality Management. The company uses six-sigma analysis to improve the reliability of each component of their products, which translates to lower manufacturing costs. The attention to detail worked—GE’s products are known for their reliability. Although improvements led to a higher cost for customers, improved performance and decreased down time far outweigh the increased price.
Teaching Note: This case can be used to provide a specific example of a quality improvement process, as it was applied to the production of one product. The case also outlines the benefits that derived from the quality improvement, including better product performance, reliability, and durability; lower costs of rework; the ability to charge higher prices; and higher profits. The case also emphasizes two important points about quality improvement. First, the process is often timely, detailed, and painstaking—although it can also yield significant benefits. Second, customers are paying for value, and companies can charge more for a product that better serves customers’ needs.
3. Table 4.2 summarizes the contribution that each functional area can make to a TQM program.a. Infrastructure (firm leadership) can build an organizational commitment to quality. TQM
must be embraced by all, and top managers serve as role models. Also, the human resource function must take on responsibility for companywide training in TQM techniques.
b. A focus on the customer is the starting point of the whole quality philosophy. The marketing function, because it provides the primary point of contact with the customer, should play a major role here. The role of marketing is to identify customer needs, to identify how the company meets those needs, to identify the quality gap that exists between what customers want and what they actually get; and, in conjunction with other functional areas, to formulate a plan for closing the quality gap.
c. TQM requires objective measures of quality, including identification of the customer’s perspective on quality, and development of a metric to capture this. Top management, with input from other functional areas, should formulate various metrics to measure quality.
d. Top management and human resources should set goals and create performance incentives, to motivate workers to reach quality targets.
e. Employees can be an important source of information regarding the sources of poor quality. Therefore, some framework must be established for soliciting employee suggestions as to the improvements that can be made (for example, quality circles). Top managers should establish a communication mechanism.
f. A major source of product defects is the production process. TQM preaches the need to identify defects in the work process, trace them to the source, find out why they occurred, and make appropriate corrections. Manufacturing and materials management typically have primary responsibility for this task.
g. Poor-quality raw materials and components are a major source of poor-quality finished goods. Personnel in the materials management function can improve quality by reducing
the number of suppliers and then building cooperative relationships with those that remain.
h. R&D and manufacturing need to be involved in designing products that are easy to manufacture, in order to reduce mistakes and defects.
i. Top management must ensure that there is close cooperation among functions.
STRATEGY IN ACTION 4.5: IMPROVING QUALITY IN HEALTH CARE
Health care organizations are adopting the six-sigma approach to improve quality. Mount Carmel Health, an Ohio provider, discovered that profits were low, due to large write-offs of uncollectible Medicare reimbursements. A careful investigation showed that the problem began with incorrect coding of procedures on patients’ records. When coders were trained to ensure that correct codes were used, the firm’s net income increased dramatically. Another example is Intermountain Health Care, which operates 24 Western hospitals. Administrators there identified variations in practice across physicians, particularly with regard to the cost and success rate of treatments. These data were then shared among physicians, who used the data to eliminate poor practices and upgrade quality. The results have been a sharp drop in the rate of postoperative infections to 0.4 percent, compared with the current national average of 2 percent. Because the average postoperative infection adds $14,000 to a hospital bill, this constitutes a big cost saving.
Teaching Note: This case is interesting to consider as a comparison to the Strategy in Action 4.4 case about General Electric. Students often mistakenly believe that quality improvement applies primarily to manufacturing firms, and this case points out the importance of quality for service firms also. Ask students to compare the similarities and differences between this case and the preceding case about General Electric. Students will find many similarities, such as the painstaking nature of the process of uncovering the roots of poor quality. Also, this case, like the GE case, shows that the result of improved quality is not just higher profits; higher quality creates value for customers too.
C. In addition to reliability, superior quality depends upon the development of other attributes, such as form, features, performance, durability, and styling, which contribute to differentiation.1. Table 4.3 summarizes attributes of products, services, and personnel that may be valued by
customers.2. A company’s products and services must be superior to competitors’ offerings in order to be
regarded as high quality.a. To accomplish this, marketing intelligence is used to identify the attributes that customers
value.b. Then, products must be designed and personnel trained to deliver that attribute.c. Next, the company’s marketers must decide which attributes to promote and how to
position them for consumers. Usually, firms focus on just one or two critical attributes.d. Finally, a strong R&D function can help the firm continual improve its offerings to stay
ahead of competitors.XXVI. Achieving Superior Innovation
A. In many ways, innovation is the single most important building block of competitive advantage.1. Innovation is what gives a company something unique. Uniqueness allows a company to charge
a premium price or to lower its cost structure below that of its rivals.2. Studies in several industries have shown that innovation is a major driver of superior
profitability.B. However, the failure rate of innovations is high, due to a variety of causes. Only about 12 percent of
R&D projects result in a product for which the profits exceed the company’s cost of capital.1. Investment in R&D is a high-risk, high-return strategy. The high risk comes from the high
failure rate of most new-product innovations. The high return comes from the quasi-monopoly revenues that a successful innovation can earn for a company.
2. Uncertainty about the future is one reason for the high failure rate of innovation. New-product development requires asking a question whose answer is impossible to know prior to market
introduction; namely, is there sufficient market demand? Although good market research can minimize uncertainty about demand, the uncertainty cannot be eradicated altogether.a. Quantum innovations represent a radical departure from current technology, whereas
incremental innovations represent an extension of existing technology.b. Quantum innovations are accompanied by higher uncertainty, and thus are more likely to
fail than are incremental innovations.3. Another reason for the high failure rate of new-product introductions is poor
commercialization, which occurs when there is demand for a new product, but the company’s offering is not well adapted to consumer needs because of poor design or poor quality.
4. Another cause of innovation failure is the poor positioning strategy that arises when an attractive new product garners low sales because it is poorly positioned in the marketplace. Positioning strategy is the position a company adopts for a product on four main dimensions of marketing—price, distribution, promotion and advertising, and product features.
5. Another reason why many new product introductions fail is that companies often make the mistake of marketing product based on a technology for which there is not enough consumer demand. Technological myopia occurs when a company gets blinded by the wizardry of a new technology and fails to examine whether there is consumer demand for the product.
6. New products fail when companies are slow to get their products to market. The longer the time between initial development and final marketing, the more likely that someone will beat the firm to market. Also, slow innovators tend to update their products less frequently than fast innovators and therefore, can be perceived as technical laggards relative to the fast innovators.
C. There are a number of actions that firms can take to build competencies in innovation and reduce the chances of failure.1. Building skills in basic and applied research requires the employment of research scientists and
engineers and the establishment of a work environment that fosters creativity. A number of top companies try to achieve this by setting up university-style research facilities, where scientists and engineers are given time to work on their own research projects, in addition to projects that are linked directly to ongoing company research.
2. Project management is the overall management of the innovation process, and it requires three important skills: the ability to encourage idea generation, the ability to select the most promising projects at an early stage of development, and the ability to minimize time to market.
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Figure 4.8: The Development Funnel
a. Effective project management can be facilitated by using a three-phase development funnel. The objective in Phase I of the development funnel is to widen the mouth of the funnel to encourage as much idea generation as possible. To do so, a company should solicit input from all functions of the company, as well as from customers, competitors, and suppliers.
b. At Gate 1, the funnel is narrowed. Here ideas are reviewed by a cross-functional team of managers that were not involved in the original concept development. The concepts that are ready to proceed then move on to Phase II of the funnel, which is where the details of the project proposal are worked out.
c. Gate 2 is a go, no-go evaluation point. Senior managers are brought in to review the various projects and to select those that seem likely winners. Any project selected to go forward at this stage will be funded and staffed with the expectation that it will be carried through to market introduction.
d. In Phase III, the project development proposal is executed by a cross-functional team in order to ensure that time to market is minimized.
3. Tight cross-functional integration between R&D, production, and marketing can help a company to ensure that (1) product development projects are driven by customer needs, (2) new products are designed for ease of manufacture, (3) development costs are kept in check, and (4) time to market is minimized.
a. Close integration between R&D and marketing is required to ensure that product development projects are driven by the unmet needs of customers.
b. Integration between R&D and production can help a company to ensure that new products are designed with existing manufacturing capabilities in mind.
4. One of the best ways to achieve cross-functional integration is to establish cross-functional product-development teams. These are teams composed of representatives from R&D, marketing, and production. The objective of a team should be to take a product development project through from the initial concept development to market introduction.a. The team should be led by a “heavyweight” project manager who has high status within
the organization and who has the power and authority required to get the financial and human resources that the team needs to succeed.
b. The team should be composed of at least one member from each key function.c. The team members should be physically co-located to create a sense of camaraderie and
to facilitate communication.d. The team should have a clear plan and clear goals, particularly with regard to critical
development milestones and development budgets.e. Each team needs to develop its own processes for communication and conflict resolution.
5. One way in which a product development team can speed time to market is to use a partly parallel development process. Traditionally, product development processes are sequential. In a partly parallel development process, stages overlap so that work can be done in more than one stage simultaneously, shortening time to market.
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Figure 4.9: Sequential and Partly Parallel Development Processes
6. Table 4.4 summaries the roles that various functional areas play in achieving superior innovation.
XXVII. Achieving Superior Customer ResponsivenessA. Achieving superior customer responsiveness requires that a company give customers what they want
when they want it and at a price they are willing to pay—so long as the company’s long-term profitability is not compromised in the process.1. The more responsive a company is to the needs of its customers, the greater the brand loyalty
that the company can command. In turn, strong brand loyalty may enable a company to charge a premium price for its products or sell more goods and services to customers.
2. Achieving superior efficiency, quality, and innovation are all part of achieving superior customer responsiveness.
B. A company must know its customers’ needs in order to respond to them. Thus the first step in building superior customer responsiveness is to get the whole company to focus on the customer.1. Customer focus must start at the top of the organization with leadership. A commitment to
superior customer responsiveness involves attitudinal changes throughout a company that can only be affected through strong leadership.
2. Achieving a superior customer focus requires the right employee attitudes—leadership alone is not enough. Employees need to be trained to put themselves in the customers’ shoes, to identify ways of improving the quality of a customer’s experience with the company. To reinforce this mindset, incentive systems should reward employees for satisfying customers.
3. Another aspect of knowing the customer is listening to what customers say and bringing them into the company. This may mean soliciting feedback from customers and building information systems that communicate the feedback to the relevant people.
C. The next task is to satisfy customer needs, with efficiency, quality, and innovation all playing a part.1. In addition to efficiency, quality, and innovation, companies can satisfy customer needs through
customization. This involves varying the features of a good or service to tailor it to the unique needs of groups of customers, or in the extreme case, individual customers. Traditionally, customization raises costs, however, flexible manufacturing allows a company to produce a greater variety of products without raising costs.
2. Customization has fragmented many markets into ever-smaller niches, allowing firms to cater to the particular needs of a small segment of customers.
D. Giving customers what they want when they want it requires speed of response to customer demands. To gain a competitive advantage, a company often needs to be fast at responding to consumer demands. Increased speed allows a company to charge a significant premium.1. Reducing response time requires a marketing function that can quickly communicate customer
requests to manufacturing.2. The manufacturing and materials management functions that can quickly adjust production
schedules in response to unanticipated customer demands also enable the firm to respond more rapidly.
3. Rapid responses also relies on information systems that can help manufacturing and marketing in this process.
4. Table 4.5 summarizes the roles that various functional areas play in achieving superior responsiveness to customers.
CHAPTER 5
Building Competitive Advantage Through Business-Level Strategy
SYNOPSIS OF CHAPTERThe purpose of the chapter is to discuss the various business-level strategies that a company can use to compete effectively in a business and in industry. The chapter argues that the basis of all business-level strategy choice is a process of deciding what products to offer, what market segments to serve, and what distinctive competencies to pursue.
Next, the generic competitive strategies of cost leadership, differentiation, and focus are discussed; and it is argued that each represents a different set of choices concerning products, markets, and distinctive competencies. Pursuing a particular business-level strategy involves combining these choices successfully. These sections are very detailed and complete. There are also discussions of pursuing a simultaneous low-cost and differentiation strategy and to being “stuck in the middle.”
This chapter then discusses three tools that managers use to decide on competitive positioning of their firm. Strategic groups analysis helps managers understand the behavior of their closest competitors. In addition, companies can alter the competitive dynamics of their industry by raising mobility barriers to movement across strategic groups. Investment strategies at the business level aid managers in comparing the returns the competitive strategy is expected to generate with the costs of developing it. Two factors influence this decision: the relative strength of the company’s competitive position and the industry life cycle. Finally, the contribution of game theory to understanding competitive positioning is discussed.
TEACHING OBJECTIVES1. Familiarize students with the main ways to compete in a business or industry.
2. Discuss Porter’s generic strategies of cost leadership, differentiation, and focus; and the opposite, being stuck in the middle, as well as the combined cost leadership/differentiation strategy.
3. Familiarize students with the advantages and disadvantages of these strategies, and discuss the ways in which the company can achieve these strategies.
4. Discuss three tools of competitive positioning: strategic groups analysis, investment analysis, and game theory.
OPENING CASE: TOYOTA’S GOAL? A HIGH-VALUE VEHICLE TO MATCH EVERY CUSTOMER NEEDThe global auto industry is huge, with high sales and high competitive intensity. Increasingly, automakers are working to develop a wide range of vehicles to appeal to every customer. Toyota’s lean production methods and fast time to market have aided the firm in quickly developing car models focused on different market segments. Toyota’s first effort to win the important market segment of buyers in their twenties was unsuccessful; their fuel-efficient Echo subcompact was marred by unattractive styling. The firm quickly changed its approach, introducing Matrix, with sporty hatchback styling and electronic music capability, in 2002. Toyota is also known for its ability to segment markets, such as offering six different SUV models in varying price ranges. The Japanese automaker balances the number of products against cost constraints, and it also closely monitors the actions of its competitors, especially in emerging market segments.
Teaching Note: This case demonstrates how Toyota pursued both a low cost and a differentiation strategy, leading to an enduring competitive advantage. The case also demonstrates competitive dynamics, as Toyota was forced to adapt to changes in consumer tastes as well as the actions of competitors. In this case, students should recognize the way that firms must attempt to balance several factors, each of which may be pulling the firm in different directions—in this case, Toyota was pressured to keep costs low, create unique products that competitors did not yet have, and appeal to many customer segments with diverse needs.
LECTURE OUTLINEXXVIII. Introduction
A. This chapter examines the issue of how a company can use business-level strategy to compete effectively in an industry, maximizing its competitive advantage and profitability.
B. Business-level strategy refers to the plan of action that strategic managers adopt for using a company’s resources and distinctive competencies to gain a competitive advantage over its rivals in a market or industry.
XXIX. What Is Business-Level Strategy?A. To choose an appropriate business-level strategy, a firm must first describe its business model. One
critical component of a business model is the company’s definition of customer needs, which describes “what” is being satisfied. Customer needs are desires that can be satisfied by attributes of a product.1. Customer needs can be satisfied by the product’s price or by its differentiation from other,
similar products.2. All companies must differentiate their products to satisfy some customer needs, but some
companies do this to a much greater degree than others.3. Companies that use differentiation are seeking to create something unique about their products
to satisfy needs in ways in which other companies cannot. Even within relatively narrow market segments, customer needs differ widely.
4. Companies must balance their desire to differentiate their product against the accompanying increase in price. However, customers are often willing to pay a premium price for a product that closely meets their specific needs.
5. Uniqueness springs from product attributes.a. Uniqueness may spring from physical characteristics of the product, such as quality or
reliability.b. Uniqueness may be based on an appeal to a psychological need of customers, such as
status or prestige.B. A second component of a business model is the definition of customer groups and market
segmentation, or “who” is to be satisfied. Market segmentation depends on the way the company groups its customers according to important differences in needs or preferences.1. Market segmentation may be based upon the price the customer is willing to pay, or it may be
based on the particular need being satisfied by a product.2. Companies must develop a strategy for differentiating products for each market segment.
a. One strategy is to serve the average customer, ignoring market segmentation.
b. Another strategy consists of segmenting the market into different groups and developing a product to suit each group. As compared to the “average customer” strategy, this strategy allows the firm to better serve more customers’ needs, generating more revenue.
c. A third strategy has companies concentrating their efforts on serving only one or a few market segments.
3. Some products do not allow very much differentiation, such as cement. In this industry, price becomes the most important consideration.
C. The third component of a business model is the decision about what type of distinctive competency to pursue, or “how” a customer’s needs are to be satisfied. The four major types of distinctive competencies are superiority in efficiency, quality, innovation, and responsiveness to customers. (See Chapter 4 for a thorough discussion of these concepts.)
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Figure 5.1: The Dynamics of Business-Level Strategy
D. Differentiation and costs affect each other in a dynamic process.1. The decision to differentiate increases value for the customer, which increases demand, leading
to economies of scale and lower unit costs.2. Differentiation also requires higher costs, to provide the attributes that contribute to the
product’s uniqueness, and that contributes to higher unit costs.3. Pricing then must be carefully set, to compensate for the cost of differentiation, but not so high
as to stifle demand.4. Companies must seek to drive down costs, while maintaining the source of differentiation.5. In addition, each of these above decisions is made in a competitive environment, so companies
must carefully consider the actions of their competitors as they choose their level of differentiation, cost structure, pricing, and so on.
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Table 5.1: Product/Market/Distinctive-Competency Choices and Generic Competitive Strategies
XXX.Choosing a Generic Business-Level StrategyA. There are several generic business-level strategies. “Generic” refers to the fact that these strategies
could be pursued by any company, operating in any industry.B. A company’s goal in pursuing a cost leadership strategy is to outperform competitors by producing
goods and services at a lower cost.1. This strategy can lead to above-average profits.
a. First, when all companies charge the same price, the cost leader makes higher profits because its costs are lower.
b. Second, if price wars develop and competition increases, then high-cost companies will be driven out of the industry before the cost leader.
2. To become the cost leader a company must make choices about its product, market, and distinctive competencies.a. The cost leader chooses low product differentiation, aiming for a level of product
differentiation obtainable at low cost.b. The cost leader chooses to serve the needs of the average customer to avoid the high costs
of serving different market segments. Perhaps no one is wholly satisfied with the product, but because its price is lower, some customers choose it.
c. The cost leader chooses to develop competencies in manufacturing, because it must ride down the experience curve to lower costs. Materials management and information technology are other important sources of cost savings. Other functions tailor their distinctive competencies to meet the needs of these three areas.
3. The cost leadership strategy provides businesses with some advantages, as discussed in terms of Porter’s five forces model.
a. In the area of competitors, the cost leader is protected by its cost advantage.b. Lower costs mean that the cost leader will be less affected by powerful suppliers than
competitors. Also, the cost leader’s large volume purchases give the firm an advantage over suppliers.
c. The cost leader is less affected by buyers’ power to set prices, because its prices are already low.
d. The cost leader is better able than its competitors to reduce its price in order to compete against potential substitutes.
e. Potential entrants face high barriers to entry because of the cost leader’s low-price advantage.
4. A cost leader faces some dangers.a. Competitors may find ways of lowering their costs, perhaps because of technological
developments or because of cost savings, such as those foreign competitors can sometimes achieve.
STRATEGY IN ACTION 5.1: LEVI STRAUSS’S BIG CHALLENGE
Levi’s dominated the jeans market for decades, but in the early 1990s, competitors moved their production function offshore, dramatically reducing their expenses. Levi’s prices remained higher than its rivals, causing big retailers to focus selling efforts on lower-priced store brands. As competitors and buyers are now following a low-cost strategy, Levi’s has been forced to follow suit; it has closed almost all of its U.S. factories. The cost leadership strategy is necessary just to survive in the industry, but the firm is still struggling to catch up with its rivals in cost reduction.
Teaching Note: This case provides an excellent example of a firm that was risking getting stuck in the middle, when its traditional advantages were overcome by rival’s new business models. This case demonstrates how tough it is for a firm to change its strategy—in spite of the company’s continued long-term efforts, competitors still have a cost advantage. This case could be used as the basis for class discussion, by asking students to describe some of the actions in each functional area that Levi’s would have to undertake in order to change from a differentiation to a low-cost strategy. You can also ask students to consider other companies pursuing a cost leader or differentiator strategy, and then ask them to describe the changes required to switch strategies. This discussion would give students some idea of the magnitude of the decision to change a business-level strategy.
b. Competitors may imitate the cost leader’s methods, reducing their own costs.c. In a single-minded effort to reduce costs, the cost leader may lose sight of changes in
consumer tastes.5. The choice of a cost leadership strategy has some implications for managers.
a. Managers must diligently pursue cost advantages in every function, especially the key cost drivers of manufacturing, materials management, and information technology.
b. Managers must constantly monitor changing industry conditions, and be alert to the possibility of competitors mimicking their firm’s low-cost methods.
c. Managers must monitor the industry’s differentiators to ensure that their firm doesn’t fall too far behind in offering attributes that customer desire.
C. The objective of differentiation is to achieve a competitive advantage by creating a product or service that is perceived to be unique in some way.1. This strategy can lead to above-average profits.
a. A differentiator can charge a premium price for its products—that is, a price higher than its competitors’ prices—because customers perceive the product’s differentiated qualities to be worth it.
b. For a differentiator, product pricing is done on the basis of what the market will bear.2. To become a differentiator a company must make choices about its product, market, and
distinctive competencies.a. The differentiator aims for a very high level of differentiation and frequently produces a
wide range of products. Differentiation can be achieved through quality, innovation, and responsiveness to customers.
b. A differentiator segments its market into many niches, offering products for many market niches.
c. For a differentiator, the importance of each function depends on the source of the differentiation. For example, if it seeks a competitive advantage based on innovation, the key function is R&D. This does not imply that manufacturing is unimportant. Instead, the differentiator wants to control costs enough so that the price charged is not higher than what customers are willing to pay.
3. The differentiation strategy provides businesses with some advantages, as discussed in terms of Porter’s Five Forces Model.a. Competitors are less of a threat for differentiators, due to the company’s brand loyalty.b. Powerful suppliers are rarely a problem because the differentiator’s strategy is not as
focused on driving down costs as is a cost leader’s strategy. Increased costs can often be passed on to customers.
c. Powerful buyers are rarely a problem because only the company can supply the differentiated product.
d. The threat of substitute products is low, due to the low probability of finding another product that can meet the same customer needs and break brand loyalty.
e. Potential entrants are discouraged by the high cost of developing a unique product to compete against the differentiator, who enjoys strong brand loyalty.
4. A differentiator faces some risks.a. The differentiator must maintain its perceived uniqueness in customers’ eyes and defend
itself against agile imitators. This is especially critical when the source of the differentiation is a physical feature of the product, which is often relatively easy to imitate.
STRATEGY IN ACTION 5.2: WHY SO MANY AMERICAN EXPRESS CARDS?
American Express dominated high-end credit cards, with high annual fees, no-balance charging, and celebrity endorsements. But in the 1990s AmEx’s traditional differentiation strategy came under increasing attack from other credit cards, which offered monthly balances, no or low fees, and wider acceptance than the more expensive AmEx cards. Other cards also developed affiliation programs with companies like GM, GE, AT&T, and airlines to offer benefits to customers that used the branded cards. Managers at AmEx did not see the new cards as threats, and continued with their old business model. The result is that the American Express card has lost its differentiated appeal. To regain it differentiation status, the firm has begun to offer increased value to customers, including smart cards, rebates, and affiliated cards of its own.
Teaching Note: Unfortunately for AmEx, the firm’s earlier myopia, as they ignored changes in consumer preferences for credit cards, has created a significant disadvantage for the firm, and it now must play “catch up” with its rivals. The firm’s efforts now may be an example of too little, too late. You can spark a classroom discussion by asking the students if they think that AmEx’s new strategy is likely to lead to a sustainable competitive advantage. The students will quickly realize that the answer is “no,” and in fact, that AmEx may never regain market leadership. This demonstrates very clearly for your class the disastrous impact that a serious strategic misstep can have on a firm’s future performance, perhaps even threatening its continued survival.
b. Another threat is that a source of uniqueness may be overridden by changes in consumer tastes and demands. A company must constantly look for ways to match its unique strengths to changing product/market opportunities.
c. A differentiator must be cautious in setting prices. If prices are perceived as too high, customers may switch in spite of the differentiated product’s uniqueness.
D. Due primarily to the impact of flexible manufacturing technologies, it is possible to follow both generic strategies simultaneously.1. Flexible manufacturing systems enable companies to manufacture many different models of a
product at little extra cost than if they produced large batches of standardized products.2. Flexible manufacturing allows companies to build many different models of a product cost-
effectively, because of the use of standardized components.3. Some companies provide efficient customization by allowing customers to choose from a
4. Many firms are using the Internet to have customers perform some of their own service, paying bills, gathering information, and so on. This reduces costs allowing the company to differentiate itself through higher service.
5. Direct sales businesses use the Internet for marketing and logistics, reducing costs and increasing responsiveness to customers.
6. Overseas manufacturing reduces labor expenses so much that companies are able to produce differentiated products at very low cost.
7. Firms that pursue both strategies have a competitive advantage compared with the differentiator because they have lower production costs; they also have an advantage compared with the cost leader because they can charge a premium price. Consequently, more and more firms are pursuing both strategies simultaneously.
E. The focus strategy positions a company to compete for customers in particular market segment, based on geography, customer type, or market segment.
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Figure 5.2: Why Focus Strategies Are Different
1. A focus strategy can be pursued using either a differentiation or a low-cost approach.a. If a company adopts a focused low-cost strategy, it competes against the market cost
leader only in those segments where it has no cost disadvantage, such as small niches or complex products that do not lend themselves to economies of scale.
b. If a company adopts a focused differentiation strategy, it competes against the differentiator by exploiting their knowledge of a small customer set or of a particular specialization within the broader range of products.
c. Focused differentiators may also be more innovative than larger firms, because the focuser is concentrating on the needs of just one type of customer.
STRATEGY IN ACTION 5.3: FINDING A NICHE IN THE OUTSOURCING MARKET
Companies often turn to outsourcing to satisfy their needs for complex, specialized, and rapidly changing technology. Large companies, such as EDS and IBM, are the leading companies in the outsourcing market for data processing and systems management. Yet smaller, focused companies survive and prosper because they concentrate on products for specific kinds of companies. These focused differentiators dominate in some market segments because they are closer to their customers than the giant national firms.
Teaching Note: Students are often perplexed about the advantages of a focus strategy. They often may reason, “If the firm is so good, why doesn’t it expand its product line further and become a differentiator?” This example shows students how a focus strategy can bring a lasting advantage, through allowing a smaller firm to concentrate on a niche that may be too small to appeal to large-scale differentiators. Classroom discussion of this case can then lead into a more creative exercise, by asking students to consider the opportunities for a successful focus strategy in industries dominated by a few large firms (for example, auto manufacturing, discount retailing, or broadcasting).
2. To become a focuser a company must make choices about its product, market, and distinctive competencies.a. Product differentiation is low for a focused cost leader and high for a focused
differentiator.b. Market segmentation is low, with the focuser filling just one or a few niches.c. The choice of distinctive competency depends on the company’s source of competitive
advantage. If it is differentiation, the competency could be R&D or service; if it is low cost, the competency could be local manufacturing.
3. The focused strategy provides businesses with some advantages. Focusers can find a niche that is unfilled by the large firms, and then develop a specialized product to fill that need. Focused companies can also grow by taking over other focusers. Other advantages exist, as discussed in terms of Porter’s Five Forces Model.
a. Focusers are protected against rivals because it can provide a product or service at a price or quality others cannot offer.
b. Powerful suppliers are a threat because the focuser buys in such small volumes that it has less bargaining power. However, if the company is pursuing a focused differentiation strategy and can pass on price increases, this is less of a problem.
c. A focuser’s ability to satisfy unique customer needs gives the company power over its buyers; they cannot get the same thing from other companies.
d. Potential entrants have to overcome the hurdle of consumer loyalty, so the focuser is somewhat protected.
e. Substitute products must overcome consumer brand loyalty, so again, the focuser is somewhat protected.
4. A focuser faces some risks.a. Because the focuser produces at smaller volumes, its costs will be higher than those of the
low-cost company.b. If the focuser’s niche suddenly disappears because of changes in technology or consumer
tastes, it is hard to switch to a new niche quickly.c. Large differentiators may compete for the focuser’s niche if it becomes very profitable, as
occurred in IBM’s fight with Apple.F. When a company chooses a generic strategy that is inconsistent with its capabilities and resources, or
when a company simply fails to choose and implement a coherent strategy, that firm is said to be stuck in the middle.1. Such firms are unable to obtain a competitive advantage, and they will earn below-average
profits.
STRATEGY IN ACTION 5.4: HOLIDAY INNS ON SIX CONTINENTS
Holiday Inns founded the market for average price, average quality motel rooms. But in the 1970s the chain ran into trouble because it failed to see that the market was fragmenting, creating the need for different kinds of products, ranging from luxurious resort features to basic, no-frills accommodation. Holiday Inns was left stuck in the middle, with its undifferentiated product and average costs. In the 1980s the company fought back by differentiating to offer a range of products, from the inexpensive Hampton Inns chain to the luxury Crowne Plazas. These moves were successful, and led to a temporary advantage, but by the late 1990s, Holiday Inns was again in decline. The firm needs to find a new strategy to ensure that it prospers in the highly competitive hotel industry.
Teaching Note: The case of Holiday Inns shows how easily a market leader may become stuck in the middle through strategic inattention. The firm’s reliance on their original business model made them great, yet it led them into difficulty when it became over-reliance. The case also demonstrates the difficulties in trying to move from being stuck in the middle to once again successfully pursuing a generic strategy. You can ask students to discuss what it would take for Holiday Inns to regain market leadership in differentiation, and whether they think the company will be able to implement that strategy successfully. You can then use that as a springboard for thinking about the risk of becoming stuck in the middle for other leading companies (e.g., Dell, Exxon, Wal-Mart).
2. There are many paths that lead to a company becoming stuck in the middle.a. A company may start out by pursuing a generic strategy but loses that strategy because it
makes the wrong choices or because the environment changes.b. A successful focuser may unsuccessfully try to become a broad differentiator.c. Differentiators may find competitors entering their market and chipping away at their
competitive advantage.XXXI. Competitive Positioning and Business-Level Strategy
A. One of the tools that managers can use to position themselves with regard to competitors is strategic group analysis.1. Companies in an industry that are pursuing the same business-level strategy make up a strategic
group.2. A careful analysis of strategic groups can help managers understand the past actions and likely
3. A company is most threatened by members of its own strategic group, because those firms are pursuing the same strategy, and consumers tend to view their products as being substitutes.
4. Different strategic groups can have a different standing with respect to each of Porter’s five forces because the five forces affect companies in different ways.
5. Mobility barriers inhibit the movement of companies between strategic groups, and the height of mobility barriers determines how successfully companies in one group can compete with companies in another.
6. If companies in one strategic group can either lower their costs or increase differentiation, they can compete successfully with companies in another strategic group. In effect, they have created yet another strategic group—a combined low-cost and differentiation strategic group, which has the strongest competitive advantage and the greatest ability to earn above-average profits.
B. Another tool that managers can use to position themselves with regards to competitors is investment analysis.1. An investment analysis refers to decisions about the amount and type of resources that must be
invested to gain a competitive advantage.2. Different strategies require different amounts and types of resources. Differentiation is the most
expensive strategy because of the need to provide uniqueness. Cost leadership is less expensive, once the initial investment in plant and equipment has been made. Focus is the least expensive because fewer resources are needed to serve just one market segment rather than the whole market.
3. In deciding on an investment strategy, the company must evaluate the returns from a strategy against the cost of developing that strategy. Two factors are important in determining the potential returns from an investment strategy: the strength of a company’s competitive position and the stage of the industry life cycle.a. One required factor in choosing an investment strategy is knowledge about the strength of
a company’s competitive position.(1) Competitive position is a function of a firm’s market share. Large market share
provides the company with experience-curve effects or suggests that the company has brand loyalty. Also, a large market share creates a large cash flow, providing resources for investment in developing competencies.
(2) Competitive position is also a function of a firm’s strength in its distinctive competencies. For example, the more difficult its R&D or service expertise is to imitate, the stronger is its position.
(3) These factors reinforce one another, so a company with both is in a very strong position and is probably a good investment.
b. The second factor influencing investment strategy is the stage of the industry life cycle.(1) The nature of the opportunities and threats from the environment is different at
each stage, affecting the potential returns from a competitive strategy.
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Table 5.2: Choosing an Investment Strategy at the Business Level
(2) At the embryonic stage, companies are developing a distinctive competency, so investment needs are very great, leading to a strategy for building market share. Companies require large amounts of capital to develop a competitive advantage and much of this must come from outside investors.
(3) At the growth stage, a company should try to grow in pace with the growth of the market, in order to consolidate its position and survive the coming shakeout. Growing requires large amounts of capital, as does the development of distinctive competencies. Companies in strong positions segment their markets to increase market share, whereas companies in a weak position become a focuser, to lower expenses. Very weak companies exit the industry.
(4) By the shakeout stage, companies in strong competitive positions are increasing their market share by attracting customers from exiting companies. Cost leaders
invest in cost control. Differentiators enter more market segments and offer more products. Weak companies choose a focus strategy, or if very weak, a harvest or liquidation strategy.
(5) By the maturity stage, companies want to reap profits from their past investment in the business. All companies tend to pursue both cost leadership and differentiation. Strong companies stop aggressively pursuing new customers and invest less. This works well if the environment is constant and the number of competitors stable. All too often, however, large companies rest on their laurels and allow competitors to catch them unawares. Weak companies use the decline strategies (see below).
(6) The decline stage starts when demand for the industry’s products begins to fall. Companies in strong positions that are cost leaders choose a market concentration strategy, consolidating products and markets, or an asset-reduction (or harvest) strategy, decreasing investment and milking profits. Strong companies that are differentiators use a turnaround strategy. If these strategies are not possible, the company may liquidate assets, or it may sell the entire business, called “divestiture.”
C. Another tool that managers can use to position themselves with regards to competitors is game theory.1. Game theory is a branch of social sciences theory that describes the actions and reactions of
rivals in a competitive game.2. Business competition can be modeled using game theory. In this game, companies make
decisions that can affect outcomes (profitability) without knowing each other’s moves.a. Games may be sequential, with moves following one after another, such as occurs in
chess.b. Games may also be simultaneous when players choose at the same time, as occurs in
rock-paper-scissors.c. Business competition entails use of both sequential and simultaneous games.
3. Game theory works well in describing situations where the number of rivals is stable and limited, and the interdependence between the players is high. This situation occurs in mature, competitive industries.
4. Game theory consists of a number of related principles.a. The principle of “look forward and reason back” says that managers should try to predict
and anticipate the future and then use that information to reason backward to determine the strategic moves they need to make today.(1) Strategies that appear at first glance to be effective may not be when the likely
reactions of competitors is included in the model.(2) Decision trees are one tool that can be used to look forward and reason back.
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Figure 5.3: A Decision Tree for UPS’s Pricing Strategy
b. A second principle of game theory is “know thy rival,” because a company’s ability to make accurate predictions about a competitor’s likely future actions is based upon knowledge about the competitor’s cost structure, pricing, and so on.
c. A third principle is “find the most profitable dominant strategy.” This principle asks managers to try to find a strategy that gives their company an advantage, no matter what strategies competitors follow. (1) A payoff matrix can be used to determine likely outcomes under different
combinations of strategies selected by a company and its competitors.
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Figure 5.4: A Payoff Matrix for GM and Ford
(2) A common outcome is that, when each company picks its “best” strategy, the resulting combination offers the lowest profits to the competitors. This sets up a
prisoner’s dilemma situation, in which competition leads to low outcomes while cooperation results in higher outcomes.
d. A fourth principle is “strategy shapes the payoff structure of the game.”
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Figure 5.5: Altered Payoff Matrix for GM and Ford
(1) This principle, taken together with the first three principles, for example, says that the way out of a destructive price war is for competitors to change their business models and increase their product differentiation, reducing customers’ sensitivity to price.
(2) Another implication of this principle is that companies need to think about more than just the effectiveness of a particular strategy, they also need to consider how their strategic choices can affect the payoff structure of competition in their industry.
STRATEGY IN ACTION 5.5: COCA-COLA AND PEPSICO GO HEAD TO HEAD
From the 1940s to the 1970s, the cola industry was dominated by just two players, Coca-Cola and PepsiCo. These giants competed on advertising, but never on price, leading to high industry profitability. In the 1970s, number-two ranked PepsiCo introduced the Pepsi challenge, a blind taste test, in which Pepsi was overwhelmingly preferred by consumers. Pepsi thus was able to differentiate its product on a real attribute: taste. Coke could not compete on taste, and so it responded with sharp price discounts, a strategy that was quickly matched by Pepsi. Today, price discounting is expected by consumers, and the entire industry is less profitable.
Teaching Note: The decades-long competition between Coke and Pepsi provides a wonderful illustration of game theory principles, and especially of the prisoner’s dilemma game. As long as the two competitors did not use price competition, both firms could be highly profitable, although Coke took the lead position. When Pepsi tired of its number-two status, it changed the nature of competition in ways that damaged both firms, although Pepsi gained market share. A thought-provoking question for students is “Which is most important to corporate managers, market share or profitability?” Another is “Which should be most important?” Examples of prisoner’s dilemma abound in other industries, and you can ask students to identify some of them (for example, Nike versus Reebok; the cereal price wars; the airline industry; the Big Eight, then Big Five; then Big Four in the audit and accounting services industry).
CHAPTER 6
Competitive Strategy and the Industry Environment
SYNOPSIS OF CHAPTERThis chapter extends the analysis of business-level strategy by considering the different competitive strategies that firms can and should adopt as they enter different industry environments. The formulation of business-level strategy does not take place in a vacuum; companies have to consider the reaction of other firms to their competitive moves. The chapter is therefore a necessary addition to Chapter 5 and provides a building block to the chapters on corporate-level strategy.
The chapter begins with an examination of the problems of managing a generic business-level competitive strategy in different kinds of industry environments: fragmented industries, embryonic and growth industries, mature industries, and finally in declining industries. In each type of industry, there is a discussion of the competitive problems associated with that particular environment and the appropriate strategies that firms can use to tackle those problems.
TEACHING OBJECTIVES1. Familiarize students with the different kinds of competitive problems that exist in different industry
environments.
2. Discuss the problems of developing a competitive advantage in a fragmented industry and the solutions to such problems.
3. Discuss the problems of maintaining a first-mover advantage in embryonic and growth industries.
4. Examine the main kinds of competitive strategies that firms use to manage competitive industry relations in mature industries.
5. Familiarize students with the main strategies for handling a declining industry environment.
OPENING CASE: INFORMATION TECHNOLOGY, THE INTERNET, AND CHANGING STRATEGIES IN THE FASHION WORLDFashion houses, such as Armani and Gucci, produce highly differentiated, expensive clothes that are affordable only to the very rich. They supplement their sales by producing a line of upscale ready-to-wear fashion for sale in luxury department stores. However, in recent years, fashion houses’ position as the industries differentiators has been challenged by new firms that use information technology (IT) to lower costs and speed time to market with new designs. These new designers sell their clothes through mid-price retailers such as Dillard’s or Macy’s, or through their own retail outlets, as new start-up Zara does. Zara, headquartered in Spain, has designers that closely watch fashion houses’ offerings each season. Then, the designers link with low cost suppliers, manufacturers, and shippers from overseas, to produce a new product line and have it in the stores in about six weeks. The firm also uses IT to monitor each product line’s sales, constantly change its product mix, and minimize inventory. Zara is thus able to charge low prices, increasing demand, and leading to high ROIC. Zara’s profitability led to a very successful IPO in 2001, and rivals are now copying the firm’s techniques, hoping to improve their own performance.
Teaching Note: The clothing design industry is relatively fragmented, with a few large design houses, both upscale and mass market, and thousands of smaller designers. The success of Zara shows the firm’s understanding of the factors leading to high performance, including the use of IT to reduce costs, the ability to offer high-quality products at relatively low prices, and the flexibility to continually innovate and introduce new products quickly. Zara’s recent actions, including the IPO and opening of more retail outlets, demonstrates the firm’s eagerness to make the industry more consolidated.
LECTURE OUTLINEXXXII. Overview
A. This chapter examines the development of a firm’s strategy to manage its industry environment.B. Firms have to manage competitive relations with other firms, and these relationships differ depending
on the nature of the competitive industry environment. First, strategies to compete in fragmented industries are described. Next, strategies that are appropriate for embryonic, growth, mature, and declining industry environments are discussed.
XXXIII. Strategies in Fragmented IndustriesA. A fragmented industry comprises a large number of small- and medium-sized companies, such as the
dry cleaning or restaurant industries.B. An industry may be fragmented for several reasons.
1. It may be fragmented because of lack of economies of scale leading to low barriers to entry. For example, customers prefer to deal with local real estate agents.
2. Some industries are fragmented due to diseconomies of scale, such as occurs when customers prefer the taste of local restaurant food to the standardized offerings of chain restaurants.
3. Low barriers to entry allow a constant influx of entrepreneurs in some specialized industries.4. High transportation costs, such that local production is the only efficient method, can contribute
to fragmentation.5. Specialized customer needs mean that companies cannot take advantage of mass production and
encourage fragmentation.C. A focused strategy is an appropriate competitive choice in a fragmented industry. Examples are small
specialty or “custom-made” companies and service organizations.D. However, if a way can be found to overcome the factors that cause industry fragmentation and to let
the industry consolidate, the potential returns are high. This is what firms like Wal-Mart and McDonald’s and chains of health clubs, lawyers, and accountants have done.1. Chaining involves establishing a network of linked merchandise outlets to obtain the
advantages of a cost-leadership or differentiation strategy. It allows bulk purchasing, economies of scale in advertising, increased ability to serve customers, and so on. Examples include restaurant chains, discount store chains, and supermarket chains.
2. In franchising, the local outlets of a chain are owned and managed by the same person. Thus there is a strong motivation for the owner-manager to control costs and maintain quality. The personal service they offer is especially helpful for differentiators. Franchising also permits quick expansion and thus growth. The franchisers’ operations can be small and local, while still taking advantage of the same opportunities that larger firms enjoy.
3. When one firm in an industry takes over and merges with another firm, a horizontal merger has occurred. The result of horizontal mergers is less competition and greater ability to influence price and output decisions, which increases industry profitability. Chapter 9 contains a more expanded discussion of horizontal mergers.
4. The Internet is the latest means by which companies have been able to consolidate a fragmented industry. Good examples of this approach are eBay in the auction industry and amazon.com in the bookstore industry.
STRATEGY IN ACTION 6.1: CLEAR CHANNEL CREATES A NATIONAL CHAIN OF LOCAL RADIO STATIONS
In just seven years, Clear Channel has gone from owning a single radio station to ownership of over 1,200 compared to the second-largest radio broadcaster, Citadel with 205 stations. Before 1996, U.S. regulators allowed one firm to own no more than 40 stations, but Clear Channel acted quickly when the law was repealed. The firm sought to grow as a way to increase quality, listeners, and advertising revenues, while reducing expenses. Radio listeners enjoy a station’s local ties, and the firm had to find a way to keep that link, while still gaining the advantages of standardization. To obtain economies of scale, Clear Channel used IT to develop a new method called voice tracking. This allows the company to employ just a few popular DJs to produce standard output for all markets, and also to contribute some customized product for each local market. The firm also developed KISS as its brand name across all its radio stations. These measures created a differentiated product that appealed to many customer segments, while also lowering costs.
Teaching Note: Before Clear Channel’s phenomenal growth, the radio industry was highly fragmented, with hundreds of local broadcasters. Clear Channel found a way to pursue both cost leadership and differentiation simultaneously, giving the firm higher profitability. When combined with a change in legislation, this strategy allowed the firm to consolidate the once-fragmented industry. Ask students to describe which of the four strategies for consolidation Clear Channel has adopted. Then, ask if they know of any other firms that are using one or more of those methods to consolidate industries that were previously consolidated. (Examples might include Dell in the PC industry or Yum! Brands—which owns Kentucky Fried Chicken, Long John Silver’s, Pizza Hut, Taco Bell, and A&W Root Beer—in restaurants.)
XXXIV.Strategies in Embryonic and Growth IndustriesA. Embryonic and growth industries pose special challenges for strategists because customer attributes
change as markets develop. Also, the rate of market growth exercises a significant influence over the success of the chosen strategy.
B. Embryonic industries typically arise through innovations by pioneering companies.
C. Customer demand in embryonic industries is typically limited, due to the limited performance and poor quality of the first products, customer unfamiliarity with what the new product can do for them, poorly developed distribution channels to get the product to customers, a lack of complementary products to increase the value of the product for customer, and high production costs because of small volumes of production.
D. Embryonic industries become growth industries as a mass market develops for the firm’s products. This occurs when technological progress increases the value of the product to the customer, key complementary products are developed, and companies reduce production costs and set a low price, stimulating demand.
E. Understanding changes in market demand is critical for firms in the embryonic and growth stages.1. Growth follows an S-curve, with demand first accelerating and then decelerating.
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Figure 6.1: Market Development and Customer Groups
a. The first customers to enter a market are innovators, who enjoy tinkering with new products and are willing to pay high prices.
b. Early adopters follow the innovators. They are visionaries, and see the possibility of using the new product in diverse and ingenious ways.
c. These are followed by the early majority, who constitute the leading edge and signal of the arrival of the mass market. They are practical, weighing product benefits against costs. They arrive in large numbers.
d. After about 30 percent of potential customers have entered the market, the late majority enters. This is a more cautious group of customers, but it is as large as the early majority.
e. Finally, the laggards, who tend to be very conservative and perhaps even techno-phobic, arrive.
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Figure 6.2: Market Share of Different Customer Groups
2. Pioneering companies that fail often attract innovators and early adopters, but fail to attract the majority, leading to few sales and ultimately, the firm’s failure. Companies that attract the majority, on the other hand, are likely to experience very high sales and high profits.
3. Geoffrey Moore argues that innovators and early adopters have very different needs than the early majority, and thus firms need a different set of competencies to serve them effectively.a. Innovators tolerate technical problems, but the early majority favors ease of use and
reliability.b. Innovators can be reached through specialty retailers, but the early majority uses mass
distribution channels.c. Innovators are few and are not price sensitive, so skills in mass production are not
required. When the early majority arrives, mass production is necessary to insure quality at a lower cost.
d. Moving from an embryonic market to a mass market is not easy and smooth; instead, it represents a competitive chasm. Thus, embryonic markets consist of many small firms, but most fall into the chasm and disappear, leaving only a few firms in a mass market.
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Figure 6.3: The Chasm: AOL and Prodigy
STRATEGY IN ACTION 6.2: HOW PRODIGY FELL INTO THE CHASM
Prodigy, founded in 1984 and nurtured by major investors Sears and IBM, was once the leader in online networks. The match of retailing and technological expertise seemed to be made in heaven. Prodigy was very successful and had little competition, except from CompuServe, which was focused on financial services (it was founded by
H&R Block). Ten years later, AOL was the dominant online network and Prodigy was gone, after Sears and IBM together lost $1.2 billion. Prodigy had a very accurate vision of the future of the Internet—driven by the mass market for online retailing—but its business model was not as good. It charged customers for e-mail and censored chat rooms, fearful of lawsuits. Prodigy was also slow to adopt a new Windows interface, due to the competition between IBM and Microsoft. In contrast, AOL offered free e-mail, uncensored chat rooms, and easy-to-use Microsoft interfaces. By 1996, the competition was over and Prodigy was through.
Teaching Note: Prodigy did a wonderful job of attracting innovators and early adopters, but stumbled when making the transition to a mass market. They failed to consider how the needs of mass-market customers differed from those that they had served so well in the past. In addition, they were cautious in making changes and let their rivals get ahead in innovation. Finally, they failed to update their business model, even when other models were demonstrably superior. This is a cautionary tale for students about how a successful firm can go horribly wrong, and quickly. Ask students if they know of other examples of companies that did not successfully cross the chasm.
4. Managers in embryonic and growth industries must learn how to compete for the mass market.a. One important focus for these managers is to correctly identify the needs of the first
members of the early majority very early on, while the growth is still primarily being driven by innovators and early adopters.
b. Managers must then alter their business model and their value chain activities so as to effectively reach the early majority.
c. Managers must also not become too focused on meeting the needs of innovators and early adopters, who don’t contribute significant sales.
d. Managers must be aware of and respond effectively to their competitors’ actions. Game theory is useful here.
e. Managers must understand the S-curve of growth, and realize that industries develop at different rates. By their strategic choices and actions, managers can change their industry’s growth rate, and thus, its profitability.
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Figure 6.4: Differences in Diffusion Rates
(3) A factor that accelerates customer demand is a new product’s relative advantage, that is, the degree to which a new product is perceived as better at satisfying customer needs than the product it supersedes.
(4) Another factor is compatibility, which refers to the degree to which a new product is perceived as being consistent with the current needs or values of potential adopters.
(5) Complexity, the degree to which a new product is perceived as difficult to understand and use, is another factor.
(6) A fourth factor is trialability, which is the degree to which a new product can be experimented with on a hands-on trial basis.
(7) A fifth factor is observability, which refers to the degree to which the results of adopting a new product can be clearly seen and appreciated by other people.
(8) A final factor that is very important in the growth of many new products is the availability of complementary products.
f. Therefore, one way for managers to help their industries grow rapidly is to use these six factors to their advantage. For example, increase the product’s compatibility, reduce its complexity, and so on.
g. Another concept that can be helpful to managers is to think of the spread of demand for a new product as analogous to a viral infection. Thus, companies can identify and court community opinion leaders.
XXXV. Strategy in Mature IndustriesA. A mature industry becomes consolidated so that it comprises a small number of large companies that
are interdependent; they recognize that their actions affect one another.
B. Thus, the main issue facing a company in a mature industry is to adopt a competitive strategy that simultaneously enables it to maximize its profitability given the strategies that all other companies in the industry are likely to pursue.
C. Firms in a mature industry can pursue strategies based on game theory principles to increase the profitability of all competitors in the industry.1. One important goal of firms in mature industries is to deter potential entrants.
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Figure 6.5: Strategies for Deterring Entry of Rivals
a. One method for deterring potential entrants is product proliferation, which occurs when a company tries to broaden its product line and provide products for all market segments in order to make it very hard for a potential competitor to enter the market. Such an effort is also called “filling the niches.” When the niches are filled, it is hard to enter except at a disadvantage.
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Figure 6.6: Product Proliferation in the Restaurant Industry
b. Another way to deter potential entrants is through the use of pricing games. (1) Companies can deter entry by cutting prices every time a potential entrant
contemplates entering, sending a strong signal. However, firms must be careful to avoid illegal predatory pricing, in which a large company uses revenue generated in one market to support pricing below the cost of production in another market.
(2) Another pricing game is the use of limit pricing, in which existing companies with scale economies can set prices above their cost of production, but under the new entrant’s cost of production, which will be higher due to their smaller size and lack of experience. However, firms that plan to enter and use a new, lower-cost technology will not be deterred by limit pricing.
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Figure 6.7: Limit Pricing Strategy
(3) Both of these strategies will be unsuccessful against a powerful new entrant, for example, a firm that is already successful in another industry and now wishes to enter other industries.
STRATEGY IN ACTION 6.3: TOYS “R” US’S NEW COMPETITORS
Toys “R” Us rapidly opened a nationwide chain of retail stores and pursued a cost-leadership strategy to outperform its rivals and consolidate a previously fragmented industry. Originally, its low cost strategy relied on efficient materials management techniques and low levels of customer service. As the company grew in size, it also decided to add more products, which raised inventory expenses. However, new rivals like Wal-Mart and Target saw the profitability of the toy market and began to focus more attention on toys. Toy “R” Us had lost its cost advantage and couldn’t drop prices to the levels that the big discounters could. In response, Toys “R” Us concentrated on lowering costs further through the use of IT and a reduction in the number of items sold. They also created other types of stores, which focus on different customer segments and try to differentiate in addition to following cost leadership. It also went online, partnering with amazon.com in offering toys online.
Teaching Note: Toys “R” Us used pricing games to attack its competitors in the toy industry, driving several of its major rivals out of business. Successful pursuit of that strategy was enabled by the firm’s very low expenses—it could cut prices and still be profitable. However, the firm became complacent, and soon found that other, stronger firms were using its own strategy. This case demonstrates the difficulty of competing on a price basis, namely, that there will always be someone who can find a way to drive down costs further. Cost advantages are often based on factors, such as economies of scale, which can be duplicated by powerful rivals. Point out to students
that this is a continual strategic threat—the possibility that a rival will adopt one’s own strategy and do it better. With that in mind, ask students if they think that market leaders in other industries will ever lose their leadership. What does it take to unseat a leader?
c. A third way to deter potential entrants is by maintaining excess capacity. Existing firms threaten potential entrants on notice with the possibility that they will increase production and drive down prices to a level at which new entry would be unprofitable.
2. Another important goal of firms in mature industries is to reduce industry rivalry.a. Price signaling is the process by which firms convey their intentions to rivals concerning
pricing strategy and how they will compete in the future or how they will react to the competitive moves of their rivals.(1) For example, firms can announce that they will follow along with other firms’ price
cuts or increases. This is called a tit-for-tat strategy.b. Price leadership, in which one company takes the responsibility of setting industry
prices, is another way of using price signaling to enhance industry profitability. By setting prices, the leader creates a model that other firms can follow. (1) The price leader is generally the strongest firm in the industry, so it can best
threaten other companies that might cut prices.(2) Such price setting is illegal, so the process is often very subtle. For example,
frequently, the weakest firms—those with the highest cost structures, are used as a price model for the other competitors.
(3) Price leadership stabilizes industry relationships, giving weaker firms more time to strengthen. However, it can lead to complacency and makes existing firms vulnerable to competitors with new, lower-cost technologies.
c. A third way that companies try to reduce industry rivalry is by the use of nonprice competition, such as product differentiation. Nonprice competition reduces rivalry because it keeps a competitor from gaining access to its customers and from attacking its market share. Product differentiation also reduces rivalry because it minimizes the risk that companies will compete by price, which hurts everybody.
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Figure 6.8: Four Nonprice Competitive Strategies
(1) Market penetration is one type of nonprice competition. It occurs when a company expands into more segments of its existing market. This strategy uses heavy advertising to promote and build product differentiation.
(2) Product development involves consistently creating new or improved products to replace existing ones. This strategy relies on extensive R&D and can be expensive. In some industries, preemptive signaling, or announcing a product development that is not yet ready for sale, is widely used.
(3) Market development involves finding new market segments to exploit a company’s products. The firm is seeking to capitalize on its brand name in new markets, as the Japanese did in entering the luxury segment of the car market.
(4) Product proliferation can also be used to reduce rivalry. Here each firm in the industry makes sure that it is in every niche to prevent any firm from gaining a competitive advantage, and if a new niche develops, it rushes to provide a product to fill the niche and reestablish industry stability.
STRATEGY IN ACTION 6.4: FAST FOOD IS A RUTHLESS BUSINESS
Prices are very important in the fast food industry, where customers often make decisions based purely on price. Taco Bell introduced 99¢ tacos, shocking competitors who then scrambled to find a way to meet that price with their products. When all competitors had prices in the very low range, they then looked to nonprice competition for advantages, trying tactics such as offering a bigger burger. The firms also began to aggressively open outlets in previously untapped segments of the market, for example in airports, gas stations, and Wal-Marts. The fast food rivals are also busily developing new products and allowing stores to customize products for local tastes. They are
also trying to become a one-stop food shop, offering fare such as pizza and salads. The quest for next “must-have” fast food product continues.
Teaching Note: The mature, saturated, highly competitive fast food industry has every type of competition: price, market penetration, product development, market development, and product proliferation. Ask students to look through the case and find examples of each of the above. Then, choose another industry that is also highly competitive and ask students to give examples from that industry.
d. Although firms prefer nonprice competition, price competition is likely to break out when industry overcapacity exists, due to overbuilding, falling demand, technological advancements, or entry into the industry.
e. Firms control industry capacity preemptively, when one first-mover rapidly increases capacity and deters others from doing so.(1) This strategy is risky because it involves committing to investment before the
market demand is clear.(2) It is also risky because it may fail to deter competitors.
f. Firms may instead choose to control capacity through a coordination strategy in which firms signal to one another their intentions concerning their future capacity. By indirectly informing one another of their plans, they seek to ensure jointly that capacity does not become so large that it promotes a price war. However, they must avoid overt signaling, which is considered to be illegal tacit collusion under antitrust law.
3. Another important goal of firms in mature industries is to effectively manage its relationships with buyers and suppliers.a. Companies in mature industries tend to have high power over buyers and suppliers. Both
buyers and suppliers tend to become dependent on the firm in a consolidate industry.b. One common strategy is for companies to own their supply or distribution operations,
which is called “vertical integration.” Vertical integration is covered more extensively in Chapter 9.
c. Another common strategy is for the firm to outsource some of its functions in order to lower costs.
d. There are important reasons to control supplier-distributor relationships. The firm can safeguard its ability to dispose of its outputs or acquire inputs in a timely, reliable manner, thereby reducing costs and improving product quality.(1) One type of relationship between a firm and its buyers or suppliers is the
anonymous approach, in which the two parties have an arms-length, short-term relationship. This type of relationship has been the norm in American business for years.
(2) Another type of relationship is the relational approach, in which the two parties develop a long-term, mutually supportive relationship built on trust. This type of relationship offers benefits to both parties and is becoming more common in the U.S.
e. There are several ways to distribute products. The company can sell to an independent distributor that sells to retailers, or the firm may sell directly to retailers or even directly to the customer.
RUNNING CASE: COMPAQ AND DELL GO HEAD-TO-HEAD IN CUSTOMER SERVICE
In the competitive PC industry, Compaq first followed a differentiation strategy based on technological expertise and extensive customer support, and it became the premier provider of business machines. Dell was the first company to directly market personal computers to consumers, bypassing the middleman to keep costs low and undercut its rivals. Dell saw itself as a distribution company, not an engineering one. In 1993, Compaq announced that it would also pursue this strategy, and the two are now in direct competition. However, Compaq was not as successful as Dell in its on-line distribution strategy, both because Dell was first to engage in such distribution and established a first-mover advantage, and because Dell has established a more customer-friendly web site and enjoys the record for fewest customer complaints. With Compaq’s merger with Hewlett Packard, however, all that may change. Compaq now has the resources to upgrade its customer service.
Teaching Note: Dell’s direct sales model is built upon an advantage in the efficient use of IT resources. The company can use its web site to sell direct to customers, which also reduces the labor expenses associated with maintaining a large, skilled sales force. Whether Compaq can leverage the advantages it has gained by the merger with HP remains to be seen. For class discussion, ask students to make suggestions as to how Compaq should use its new resources to help it better compete with Dell.
(1) The complexity of the product and the amount of information it requires will determine which method a company will use to distribute its products. The more complex the product, the more likely a company is to try to control the way its products are sold and serviced.
(2) However, large firms that sell nationwide usually sell directly to the retailer because they save the profit that would otherwise have gone to the wholesaler or distributor.
XXXVI.Strategy in Declining IndustriesA. Once demand starts to fall, an industry is in decline, and competitive pressures become even more
intense. Industries usually decline due to changes in technology, social trends, or demographics.B. Four critical factors determine the intensity of competition in a declining industry. Rapid decline, high
exit barriers, high fixed costs, and commodity products generate more competition. Also, segments within an industry may decline at different rates.
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Figure 6.9: Factors that Determine the Intensity of Competition in Declining Industries
C. Companies have different strategies available to deal with decline.
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Figure 6.10: Strategy Selection in a Declining Industry
1. One strategy for dealing with decline is the leadership strategy, which is an attempt to pick up the market share of companies leaving an industry. This makes most sense when a company has distinctive strengths that give it a competitive advantage and the rate of decline is moderate.a. The tactical steps companies might use to achieve a leadership position include
aggressive pricing and marketing to build market share, acquiring established competitors to consolidate the industry, and raising the stakes for other competitors.
b. The leadership strategy signals to competitors that a firm is willing to stay and compete, and may speed up exit of competitors from the industry.
STRATEGY IN ACTION 6.5: HOW TO MAKE MONEY IN THE VACUUM TUBE BUSINESS
In the declining vacuum tube industry, Richardson bought the stocks and business of large companies like Westinghouse. Richardson then became the dominant (in fact, the only) company in the industry. As such, it is able to charge customers high prices and reap profits of 35 to 40 percent. Although vacuum tubes have been replaced by transistors in most consumer electronics, they are still in demand from customers who are maintaining older equipment. They also are preferred in some limited applications, such as radar and welding equipment. Richardson has focused on efficient and speedy delivery—when a customer like GE is facing a loss of thousands of dollars due to a broken welding machine, cost isn’t the most important consideration. Thus, Richardson is able to earn enviable results even in a declining industry.
Teaching Note: Declining industries are often perceived of as “dead ends,” and this case can be used to demonstrate for students that declining industries may still contain opportunities. Richardson’s leadership strategy is one approach to decline; you can spark a classroom discussion by asking students to consider other declining industries and the strategies that firms in those industries might use. One good example is the baking soda industry, which was declining as consumers baked less, until Arm & Hammer thought up new uses for baking soda, such as for a deodorant or a carpet cleaner, which revitalized that industry.
2. Another strategy for decline is the niche strategy, which focuses on pockets of demand where demand is stable or declining less slowly than in the industry as a whole. This strategy makes sense when the company has distinctive competencies in that particular segment of the market.
3. A third decline strategy is the harvest strategy, which involves a company optimizing its cash flow as it exits an industry. This strategy makes sense when the firm anticipates a very steep decline or when it lacks distinctive competencies.a. Tactical steps for achieving a harvest strategy include cutting all investment in the
business, then continuing to produce until sales decline, after which divestiture follows.b. In practice, this strategy may be difficult to implement because employee morale suffers,
and if customers realize what is happening, they may defect rapidly and hasten the decline.
4. A fourth strategy is the divestment strategy. Once a company has recognized that an industry is in decline, it moves early to sell the business to maximize the value that it can get for it. Often it might sell to the leadership company, which is best positioned to weather the storms ahead.
CHAPTER 7
Strategy in High-Technology Industries
SYNOPSIS OF CHAPTERThe goal of this chapter is to describe the strategies and concepts that are unique to high-technology industries. High-tech industries are growing in number and many formerly low-technology industries are become more high-tech. In addition, high technology industries face similar industry conditions, and thus tend to employ a similar range of strategies.
One of the most important concepts in understanding high-technology industries is the idea of technical standards. These standards emerge as a new technology evolves rapidly in its early days. Typically, many alternate technologies are tried before a new standard is chosen. The existing technology is usually completely replaced by the new technology in time. The contest to decide which firm will own the technical standard is called a “format war.”
Standards may emerge as a result of government policy, through an agreement made by firms within an industry, or gradually emerge based on consumer buying patterns. A critical part of a new technology’s success is often the support of complementary products. A network of interrelated buyer and supplier firms creates a support system for new technology.
First movers typically have an economic benefit, due to the early monopoly and the opportunity to gain technology-specific knowledge, driving down costs and increasing sales. Sometimes, however, firms that follow first movers can benefit from the first mover’s experience without the steep up-front investment.
In addition, high-tech products are increasingly digitized, which makes it easier to steal the product, through piracy. Therefore, intellectual property rights are an important concern of high-tech firms. Also, high-technology industries tend to have high fixed costs and low marginal costs.
Therefore, strategies for success in high-tech industries include being a first mover, owning the technical standard, building demand early by dropping price, riding down the experience curve, and being open to strategic alliances with firms that possess complementary assets.
TEACHING OBJECTIVES1. Recognize the important role of technical standards in creating success in high-tech industries.
2. Know the ways in which technical standards can emerge.
3. Examine the concepts of network effects, positive feedback loops, and customer switching costs.
4. Know a variety of strategies for winning a format war.
5. Be aware of the cost structure of high-technology industries and its impact on strategy.
6. Recognize the importance of intellectual property rights for high-tech firms, and understand the methods by which firms protect those rights.
7. Examine the advantages and disadvantages of being a first mover or a follower in a high-tech industry.
8. Understand the cycle of development of new technologies that underlies technological paradigm shifts.
9. Examine strategies that can be used by first movers and existing firms to manage during a time of technological paradigm shift.
OPENING CASE: EXTENDING THE WINTEL MONOPOLY TO WIRELESSIn the PC software industry, Microsoft and Intel have established the industry standard, based on Intel’s microprocessors and Microsoft’s Windows operating system. This highly successful duo is now attempting to create a standard for the next generation of cellular phones, which will be able to compute, send e-mail, and browse the Internet, in addition to traditional telecommunications functions. The two giant firms are creating a reference design based on current technologies, that they plan to license to manufacturers. The makers can reduce their R&D costs substantially, offer the phones at lower prices, increase the number of users, and cause more applications to be developed for the phones. Increased sales will boost Intel’s and Microsoft’s royalties. It’s not yet clear if the Wintel design can prevail against industry heavyweights such as Ericsson, Motorola, and Nokia. Whoever establishes the industry standard will be the dominant firm in the developing industry for years to come.
Teaching Note: This case sets the stage for many of the conclusions that are presented in this chapter. Among them are the importance of establishing a technical standard and the importance of first-mover advantages. Most students are familiar with the downside to the dominance of Microsoft and Intel in the PC industry, including the monopoly pricing power, lack of choices for consumers, and stifling of innovation. You can use this case for classroom discussion by asking students to consider whether those disadvantages are likely to develop in the cell phone industry, if the two firms create the industry standard. Are the disadvantages likely to occur if another firm, for example Nokia, were to win the format war? Why or why not?
LECTURE OUTLINEXXXVII. Overview
D. Technology refers to “the body of scientific knowledge used in the production of goods or services.” High-technology industries (also called high-tech industries) are ones in which the scientific knowledge used by companies in the industry is advancing rapidly, leading to rapid changes in the attributes of goods and services.
E. Examples of high-tech industries include the computer industry, telecommunications, consumer electronics, pharmaceuticals, power generation, and aerospace, among others.
F. High-technology industries deserve special consideration because they are an ever-increasing part of our economy, many traditionally low-technology industries and products are becoming more high-tech, and high-tech firms a similar competitive situation.
XXXVIII. Technical Standards and Format WarsA. Technical standards are “a set of technical specifications that producers adhere to when making the
product or component,” and they can be a source of differentiation, leading to competitive advantage.1. Competitive struggles over control of technical standards are called “format wars.”2. Examples of technical standards include the layout of a computer keyboard, the dimensions of
shipping containers such as trucks and railcars, and the components included in a personal computer.
3. When an industry relies upon a common set of features or design characteristics, such as the Wintel design for personal computers, this is called a “dominant design.” Each dominant design may be made up of a set of related technical standards.
Figure 7.1: Technical Standards for Personal Computers
B. Standards provide economic benefits to those companies that adhere to them.1. Standards guarantee compatibility, such as the ability to use the same software programs on
different brands of PCs.2. Standards help reduce consumer confusion. When consumers sense that the technology is still
evolving, they may delay purchase, which can cause the technology itself to fail to gain initial acceptance in the market.
STRATEGY IN ACTION 7.1: WHERE IS THE STANDARD FOR DVD RECORDERS?
DVD industry members were able to agree on a standard format for DVD players. But in spite of the existence of at least three viable technologies, the industry is unable to agree on a standard for DVD recorders. Consumers and retailers are hesitant to invest in DVD recorders based on a system that might or might not be the standard ultimately chosen by the industry. On the supply side, manufacturers such as Sony, Matsushita, Philips, and Hewlett Packard are unwilling to accept their competitors’ standards, which would require them to pay royalties to their rivals. DVD recorders are also currently expensive compared to VHS or CD recorders, because they are produced in small volume. In order to drive the price down, sales must be higher, and that requires the establishment of a standard.
Teaching Note: This case illustrates the types of problems that occur when an industry is unable to agree upon a format. In this case, the big electronics manufacturers are unwilling to accept each other’s technology as the standard, although establishing a standard would certainly increase sales and profits for the entire industry in the long run. You can ask students to name examples of other standards that are beneficial to the industry and consumers alike. (Examples include gasoline octane ratings, parental advisory ratings on movies and music, and banks’ reporting of interest as a standardized APR, or Annual Percentage Rate.)
3. Standards serve to reduce production costs, by facilitating mass production, along with its consequent economies of scale and lower costs. Both manufacturers and components suppliers are able to benefit from standards, reducing the cost of components too.
4. Standards reduce the risk associated with supplying complementary products. Makers of complementary products, such as software providers for the PC industry, will hesitate to invest in producing complementary products until standards are reached. A low supply of complementary products can reduce sales of the product.
C. Standards emerge in an industry in several ways. When standards are set by the government or industry group, they are part of the public domain, meaning that any company can use that standard in their products.1. Companies may lobby the government to mandate an industry standard. An example would be
the digital TV broadcast standards put forth by the FCC.2. Companies may band together to cooperatively establish standards, without government
intervention, as DVD manufacturers did.3. Standards may also be selectively chosen by consumers, who use market demand as a selection
mechanism. Microsoft and Intel both use proprietary standards, which are protected through patents.
D. Network effects arise in industries where the number of complementary products is a primary determinant of standards. For example, the success of VCRs is driven by the standard VHS format for tapes, creating a positive feedback loop, in which demand for VCRs led to demand for tapes, and the increased availability of tapes led to further demand for VCRs.
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Figure 7.2: Positive Feedback in the Market for VCRs
1. In a format war, the winner will be the company that best exploits positive feedback loops. Microsoft beat Apple by creating “open” computer code for its operating system; Matsushita beat Sony in VHS tapes by licensing its technology to competitors.
STRATEGY IN ACTION 7.2: HOW DOLBY BECAME THE STANDARD IN SOUND TECHNOLOGY
Dolby technology is the industry standard for sound recording and playback, in industries ranging from consumer electronics to movie production. Founder Ray Dolby, holder of a Ph.D. in physics, invented a technology in 1965 for reducing the background hiss in professional tape recording. Sales were slow, until Dolby licensed his technology to KLH, an American producer of audio equipment. Dolby decided to charge a modest licensing fee,
to discourage manufacturers from developing their own, competing technology. He also made licensees agree to quality inspections from Dolby employees, to protect his firm’s reputation. Dolby chose to give away his technology for free to prerecorded tape makers, to increase sales of tape players with Dolby capability. The company today is relatively small but its technology is used in virtually every film, CD, DVD, PC, and video game.
Teaching Note: Ray Dolby made a number of intelligent decisions that enabled his firm to win the format war for audio standards. His firm is exemplary in its use of strategies for establishing an industry standard. A class discussion of this case should center on listing every effective choice, and then describing the benefits that resulted from those choices.
2. Companies that fail to adopt the dominant design as it emerges may find themselves locked out of the market. Customers may be unwilling to bear the switching costs of changing to an alternate technology, unless the benefits of doing so outweigh the costs.
3. As a new technology becomes more widely adopted, there comes a point at which the prior technology becomes outmoded. For example, CDs replaced the long-playing record.
XXXIX.Strategies for Winning a Format WarA. It’s clear that firms benefit when they exploit network effects and when positive feedback loops are in
operation, so companies must find a way to make the effects work in their favor and against their competitors. Therefore, they must build an installed base as rapidly as possible, leveraging the positive feedback loop, forcing customers to bear switching costs, and locking the market into their technology.
B. One important step for firms to take in winning a format war is to ensure a supply of complementary products.1. One way for companies to ensure a supply of complements is to diversify into the production of
complements themselves.2. Another way is to create incentives for others to produce complements, such as reducing
licensing fees or providing technical assistance.C. Another important step is to leverage killer applications, those uses of a product that are so
compelling to consumers that they kill demand for competing formats. The killer applications can either be developed by the company itself or by other firms.
D. A third strategy for winning a format war is for the companies to price and market their products aggressively.1. One common pricing strategy is to price the product low and the complements high, such as the
way Hewlett-Packard prices printers at cost, and then charges substantial markup on ink cartridges.
2. Aggressive marketing strategies include substantial up-front marketing and point-of-sale promotion to encourage first-time buyers.
E. Yet another strategy involves cooperation with competitors, in order to ensure compatibility and lock out alternative technologies.
F. Another strategy requires licensing the format, so that the licensing firm may profit from licensing fees while also boosting demand and speeding adoption of the format. A relatively low licensing fee reduces the financial incentive for competitors to develop their own, alternative formats.
G. These five strategies may be used in combination, depending upon the unique demands of the situation. Care is needed to select the optimal mix of strategies, as well as to ensure that strategies are working together, and not counteracting against each other.
XL. Costs in High-Technology IndustriesA. In most high-tech industries, the fixed costs of product development are very high, whereas the
marginal costs—the costs of producing one extra unit of the product—are very low. The initial costs of R&D and building manufacturing capacity contribute to the high fixed costs, whereas the marginal costs might be just a small amount, especially in a mass production environment where the product might be a DVD or a piece of software.
B. The high fixed costs and low marginal costs of high-tech industries stands in contrast to many traditional industries, where the marginal costs tend to increase as production rises. Figure 7.3 graphically illustrates how the differing relationships between fixed and marginal costs lead to different levels of profitability.
Figure 7.3: Cost Structures in High-Technology Industries
C. The implication for strategy is that companies should try to switch from an industry with increasing marginal costs to one where marginal costs are lower, in order to increase profitability.
STRATEGY IN ACTION 7.3: LOWERING COSTS THROUGH DIGITALIZATION
Ultrasound is an important diagnostic tool, producing images of organs. The technology is very valuable, but the equipment is bulky, heavy, and expensive, so it is used primarily in dedicated hospital facilities. ATL, a leading maker of ultrasound technology, decided to reduce the size of an ultrasound set-up to about the size and weight of a lap top computer. This would be accomplished by replacing many of the machine’s solid circuits with software (in a process called “digitalizing”), reducing size and costs. Smaller size and lower cost would allow the units to be placed on ambulances or into physician’s offices-market niches that are impossible with today’s technology. Late in 1999, the first unit was produced, and by 2001, sales reached $46 million (mostly to buyers for ambulatory care and foreign markets).
Teaching Note: This case shows how a company reached a previously untapped market niche by digitalizing a product, which also allows the firm to reduce expenses. Thus, digitalizing can support a firm that is pursuing a simultaneous advantage in differentiation and cost leadership.
D. Another strategic implication is that companies should deliberately drive prices down to drive volume up, leading to increased profitability.
XLI. Managing Intellectual Property RightsA. Intellectual property refers to the product of any intellectual and creative effort, which would
include products such as music, film, books, graphic arts, manufacturing and other processes, and new technology of any type.
B. Intellectual property is a very important driver of economic progress and social wealth. That is, nations where many individuals or firms are creating valuable intellectual property will prosper, as will the individuals or firms. However, the creation of intellectual property is often expensive, risky, and time-consuming. The costs of a new technology may be in the hundreds of millions of dollars, and the failure rate may be close to 90 percent in some industries.
C. Because of the expense and risk, few would undertake the creation of intellectual property unless they expected some economic return. Therefore, patents, copyrights, and trademarks are used to give incentives for its creation.1. Protection of intellectual property rights is an important strategy for high-tech firms, and they
may use lawsuits against competitors, both to stop actual violations and as a deterrent against future violations.
2. The protection of intellectual property rights has been complicated in recent years due to digitalization, or the rendering of creative output in digital form, which is common today for artistic works and computer software.
3. Digitalization lowers the cost of copying and distributing intellectual property, aided by the Internet, making the marginal costs almost zero.
4. The low cost of copying and distributing creates an opportunity for piracy, the theft of intellectual property. Piracy is quite common in the computer software and music recording industries, costing each of those industries billions of dollars in lost sales annually.
5. Companies in the software and music industries don’t rely solely on legal protection—they also protect their works with encryption software. However, sophisticated pirates know how to defeat the encryption.
D. Digital rights can be effectively managed through the use of several tactics.1. One strategy relies on giving something away for free to boost sales of complementary
products, just as companies do to win format wars.2. Another strategy is to keep prices so low that customers have little incentive to steal.
XLII. Capturing First-Mover AdvantagesA. Companies in high-tech industries strive to be a first mover, that is, the first to develop a new
1. First movers initially have a monopoly position, which can be very profitable if consumers adopt the new technology.
2. Once a first-mover has been profitable with a new product, imitators rush into the market, lowering returns for all competitors.
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Figure 7.4: The Impact of Imitation on Profits of a First Mover
3. In spite of imitators, some first movers have been able to turn that initial advantage into an enduring advantage. For example, Cisco was the first to create an Internet router and still dominates that market. They do this by slowing the rate of imitation.
4. However, there are also first mover disadvantages, which occur when a first mover pursues an inappropriate strategy.
B. First movers have five key advantages.1. They can exploit network effects and positive feedback loops.2. They can establish brand loyalty.3. They can increase production earlier than rivals, and thus benefit from cost savings due to scale
economies and learning effects.4. They can create customer switching costs.5. They can accumulate valuable knowledge about customers, distribution, technology, and so on.
C. First movers also have four potential disadvantages.1. They have to bear the costs of initial development and marketing, called pioneering costs. Later
entrants can free-ride on the pioneer’s investment.2. They make more mistakes than do later entrants.3. They risk building the wrong resources and capabilities, because they are focusing on an
atypical customer segment, the innovators and early adopters.4. They may invest in inferior technology. Later entrants may be able to leapfrog the first mover
and introduce products based on a more sophisticated technology, due to the rapidly changing nature of the technology.
D. First movers can exploit their advantages in a number of ways.1. In order to choose an appropriate strategy, the first mover must answer three key questions.
Table 7.1 of the text summarizes the concepts presented in this section.a. Does the company possess the complementary assets needs to exploit the new
innovation? Complementary assets might include competitive, expandable manufacturing facilities, the ability to ride quickly down the experience curve, marketing know-how, access to distribution networks, a customer support network, and sufficient capital.
b. What is the height of barriers to imitation? Barriers to imitation might include patents and a secret development process.
c. Are there capable competitors that could rapidly imitate the innovation? Competitors are capable if they have excellent R&D skills and access to complementary assets.
2. The first mover can choose to develop and market the innovation itself, if the firm has complementary assets, barriers to imitation are high, and capable competitors are few. If this strategy can be sustained, it will lead to the highest level of profits—but it may not be possible.
3. The first mover can use a joint venture or strategic alliance to develop and market the innovation with other companies, if the firm lacks complementary assets, barriers to imitation are high, and there are several capable competitors. The joint venture partner should be a firm that possesses the required complementary assets.
4. The first mover can license the innovation to others and let them develop the market, if the firm lacks complementary assets, barriers to imitation are low, and there are many capable competitors. A modest licensing fee will discourage development of competing innovations.
XLIII. Technological Paradigm ShiftsA. Technological paradigm shifts occur when new technology revolutionizes the structure of an
industry. This alters the nature of competition and requires the use of new strategies. An example is the current trend toward digital photography in replacing chemical photography.
B. Paradigm shifts occur when an industry is mature, with technology approaching its “natural limit” and when a new technology has begun to be adopted by customers who are poorly served by the existing technology.1. The technology S-curve (shown in Figure 7.5) describes the relationship between performance
of a technology and time. Early on, new technologies improve rapidly in performance, but the effect diminishes over time, and ultimately approaches a natural limit beyond which only smaller, incremental improvements can be made.
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Figure 7.5: The Technology S-Curve
2. When a technology approaches its natural limit, researchers begin to investigate possible alternative technologies, increasing the chances that a paradigm shift will occur.
3. This means that a technology that has just been developed will not be as useful as the existing technology, until after a period of refinement and improvement. Therefore, new technologies are sometimes mistakenly dismissed by competitors.
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Figure 7.6: Established and Successor Technologies
4. In many situations, the old technology is dying out just as a host of new technologies are being developed. It’s often very difficult for established companies to decide which of the possible alternatives will ultimately be successful.
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Figure 7.7: Swarm of Successor Technologies
C. Clayton Christensen has developed a theory about disruptive technologies, or a new technology that gets its start away from the mainstream of the industry, and then invades the main market, causing a paradigm shift.1. Christensen claims that established companies are often aware of the new alternatives, but they
listen to their customers, and their customers don’t want the new technology, because it’s not yet efficient.
2. As the performance of the new technology improves, customers do want it, but it’s too late for the established firms to accumulate the technical knowledge in time to meet rising market demand.
STRATEGY IN ACTION 7.4: DISRUPTIVE TECHNOLOGY IN MECHANICAL EXCAVATORS
Excavators are used to dig foundations and trenches, and for years the dominant technology was a system of cables and pulleys that lifted a large bucket of earth. In the 1940s, however, hydraulic technology presented a more efficient and convenient design, but it could not lift as large a load. Excavator manufacturers surveyed customers and found that most did not want to use the new technology, because of the limits on load size. This created an opportunity for new entrants into the industry. Manufacturers such as Case, Deere, and Caterpillar initially focused on small hydraulic excavators, but as their expertise grew, they solved the engineering limitations of the hydraulic design. They were able to make hydraulic excavators with larger buckets, and ultimately they rose to dominate the industry.
Teaching Note: This case describes an example of a disruptive technology revolutionizing an industry. You can describe other examples of paradigm shifts to reinforce this concept. Examples might include PCs and word processing software replacing typewriters (along with correction fluid and ink erasers), calculators replacing slide rules, automobiles replacing horse-drawn buggies (and horseshoes and harnesses), and many more. A book that discusses one case in extended detail is The Victorian Internet: The Remarkable Story of the Telegraph and the
Nineteenth Century’s On-Line Pioneers (by Tom Standage, published by Berkley Publishing Group, October 1999). This book tells a wonderfully modern story of industrial espionage, wildly ambitious entrepreneurs, and the development of complementary products—such as the development and placement of a 1,600- mile-long cable at the bottom of the Atlantic.
3. Christensen identifies other factors that make it difficult for established firms to adopt a new technology, including the assumption that new technologies only serve a small market niche, the necessity of adopting a new business model, and the lack of a new network of suppliers and distributors.
D. What can established companies do to remain competitive when disruptive technologies emerge?1. Companies should understand the process of technological disruption, and particularly the
rapidity with which a new technology can replace an older one. Awareness of the process could lead to better strategic decisions.
2. Established companies should invest in newly emerging technologies, hedging their bets by investing in several alternatives. They might also enter into joint ventures with new-technology companies, or acquire them.
3. Established companies should separate the new technology into its own autonomous division. This allows the new technology to develop in spite of what is often significant internal opposition. Autonomy also helps the division develop a new business model, with a radically different value chain.
E. What should new entrants do to gain an advantage of established enterprises?1. New entrants must deal with problems such as the raising of capital, the management of rapid
growth, and moving their technology from a small niche to a mass market.2. Another concern of new entrants is the choice of whether to partner with an established
company or go it alone.
CHAPTER 8
Strategy in the Global Environment
SYNOPSIS OF CHAPTERThis chapter looks at the strategies companies adopt when they expand outside their domestic marketplace and start to compete on a global basis. The chapter opens by discussing how global expansion creates value for a company. The focus is on the ability of global companies to transfer distinctive competencies across national markets, to realize location economies from basing individual value-creation activities in the optimal location for that activity, and to ride down the experience curve more rapidly than competitors that are focused on just their domestic market.
Next the chapter examines two types of competitive pressures that firms competing in the global marketplace typically face: pressures for cost reductions and pressures to be responsive to local conditions. These pressures place conflicting demands on a company.
The discussion then turns to the different strategies that companies can pursue in the global arena. Four different strategies are reviewed in some detail, and a link is made between the appropriateness of different strategies and the pressures for cost reductions and local responsiveness.
We then discuss the basic entry decisions a company faces when going international. In particular, we look at decisions about which markets to enter, when to enter, and on what scale to enter.
In the next section, which reviews various options that a company has for entering a foreign market, the five basic options—exporting, licensing, franchising, joint ventures, and the establishment of a wholly owned subsidiary—are compared and contrasted.
A discussion of global strategic alliances closes the chapter. It assesses the advantages and disadvantages of entering into strategic alliances with global competitors and highlights ways of improving the probability of a successful alliance.
TEACHING OBJECTIVES1. Familiarize students with the importance of global competition and global competitors.
2. Describe the benefits that global firms enjoy and also the costs they must bear.
3. Discuss the pressures for cost reductions and local responsiveness that face global companies.
4. Discuss the pros and cons of four different strategies for competing in the global marketplace: an international strategy, a multidomestic strategy, a global strategy, and a transnational strategy.
5. Understand how global companies make decisions about which markets to enter, when to enter, and on what scale to enter.
6. Discuss the advantages and disadvantages of various modes of entry into foreign markets.
7. Identify the factors that determine which way of entering a foreign market is best for a particular company.
8. Review the benefits and potential pitfalls of building global strategic alliances with competitors, and discuss ways of improving the probability of success for global strategic alliances.
OPENING CASE: MTV HAS TO SING A NEW SONG AS IT EXPANDS GLOBALLYMTV Networks is one of the most successful businesses at globalization, with 29 distinct channels reaching 330 million subscribers, generating a profit of over $1 billion annually. In 1987, its first year of overseas operations, MTV managers naively assumed that Europeans would be interested in American pop stars and commentary. Soon, copycats began to offer local programming, spurring MTV to create separate, regional channels, including eight in Europe and six in Asia. Forty percent of the programming and 70 percent of the music videos feature local performers, and all of it is delivered by local VJs (video jockeys). Ratings are growing and the threat from copycats is much less. Even more importantly, advertising revenues are up, especially revenues from local advertisers.
Teaching Note: This case illustrates the way in which a firm that experienced success in its home country began the process of globalization. MTV’s experience with globalization was hesitant and error-prone at first, but they learned from those experiences. To discuss this case in class, ask students to consider the benefits that MTV has received from its globalization efforts. Then ask them to describe MTV’s current global strategy, and point out any potential weaknesses that must be addressed.
LECTURE OUTLINEXLIV. Overview
A. This chapter considers the contribution of global strategy to the process of building and maintaining a competitive advantage, outlining and discussing global strategies.
B. Also covered are the decisions managers make about when and how to enter a foreign market.C. Multinational companies, companies that do business in two or more countries, are also discussed,
as are global strategic alliances.XLV. Increasing Profitability Through Global Expansion
A. Expanding globally lets both large and small companies increase their profitability in a number of ways not available to purely domestic enterprises.
B. One way for firms to increase their profitability through internationalization is the realization of location economies, those benefits that arise from performing a value-creation activity in the optimal location for that activity, wherever in the world that might be.1. One benefit of location economies is the lowering of costs for raw materials, power, labor, and
so on. This is consistent with the business-level strategy of cost leadership.
2. Another benefit of location economies is the firm’s improved ability to differentiate its product, consistent with a differentiation business-level strategy.
3. However, a negative consequence of pursing location economies is the potential for increased transportation costs and unfavorable trade barriers.
4. Another possible negative consequence is the increased political and economic risk in regions where governments are unstable or implementing unfavorable business policies.
C. Another way that firms can benefit from global expansion is through the increased ability to ride down the experience curve, reducing the costs of production over the life of a product. Moving down the experience curve is consistent with the business-level strategy of cost leadership.1. Global markets are larger than domestic markets, and therefore companies that serve a global
market from a single location are likely to build up accumulated volume quickly.2. The cost advantages of serving the world market from a single location will be all the more
significant if that location is also the optimal one for realizing location economies.D. Yet another benefit of global expansion is the ability to further exploit distinctive competencies.
Companies with valuable distinctive competencies can often realize enormous returns by applying those competencies to foreign markets, where indigenous competitors lack similar competencies.
STRATEGY IN ACTION 8.1: MCDONALD’S IS HERE, THERE, AND EVERYWHERE
As the U.S. fast food market became saturated, McDonald’s began to open global franchises. Today, 90 percent of their new restaurant openings are overseas. And the firm is planning further expansion to increase penetration, especially in developing countries. However, McDonald’s has had to adjust its business model. In the U.S. tight relationships with suppliers and standardization help to drive down costs. Overseas stores prepare American staples, but they also have the flexibility to offer foods suited for local tastes.
McDonald’s biggest problem has been to replicate its U.S. supply chain in foreign countries. The firm maintains rigorous specifications for all raw materials, but local suppliers are less willing to make the investments required to meet them. McDonald’s approach in Russia was to vertically integrate through the entire supply chain, managing dairy and vegetable farms and building a $40 million food-processing plant. Increasingly, the firm is finding that its foreign franchisees are a source of valuable new ideas.
Teaching Note: McDonald’s is using the distinctive competencies they developed in their home country, such as cost cutting and input standardization, to gain advantage in foreign markets, where competing restaurants do not have those skills. Their business model is so successful and so strongly ingrained in the company’s operations that when a piece of the puzzle is missing, as it was in Russia, then McDonald’s takes on the heroic task of providing that piece themselves, rather than change the model. To generate discussion, have students think critically about McDonald’s attachment to its business model. Does it always make sense, for example, as in Russia? What are the benefits of their approach? What are the negative consequences?
E. Another benefit of global expansion is the ability of multinational firms to leverage the skills of global subsidiaries. Multinational firms with foreign subsidiaries can have valuable competencies arise in any of their locations, and then share that knowledge with other subsidiaries. This creates important new challenges for managers.1. Managers must recognize that competencies can develop anywhere, and be on the lookout for
those new competencies.2. The firm must have an incentive system for local subsidiaries to develop new competencies.3. Managers must be able to identify new competencies and help to transfer them within the
company.
STRATEGY IN ACTION 8.2: HEWLETT PACKARD IN SINGAPORE
Hewlett Packard needed a low-cost overseas location for manufacturing facilities, and Singapore was ideal, with low labor costs, an educated, English-speaking workforce, a stable government, and good national infrastructure. Singapore officials also negotiated a favorable tariff agreement with HP. The factory began manufacturing basic components, but as they demonstrated their capability, HP managers began to trust them with more sophisticated manufacturing tasks. Then, in the early 1980s, HP gave the Singapore workers responsibility for a complete
redesign of a handheld calculator. Singapore took over the redesign of ink jets and keyboards, typically reducing manufacturing expenses by 30 percent. Today, the Singapore facility is responsible not just for manufacturing, but also for the redesign of many HP products for Asian markets.
Teaching Note: This case shows how HP benefited far more than it expected in its relationship with its Singapore managers. The relationship was so successful as a result of actions taken on both sides. The workers at the Singapore facility were talented, motivated, and persevering in their tasks. HP officials saw the talent at Singapore, gave the workers the resources and training to expand their abilities, and rewarded them for high performance by giving them more autonomy. Students may be inclined to think of the relationship between a large U.S. company and its overseas facilities as exploitative, an opinion based perhaps on media coverage of problems uncovered at Nike and other manufacturers. You can use this case to show by counterexample that the relationship can be mutually beneficial and still be cost-effective for the U.S. firm.
XLVI. Pressures for Cost Reductions and Local ResponsivenessA. Companies that compete in the global marketplace face competitive pressures for cost reductions and
pressures to be locally responsive. These competitive pressures place conflicting demands on a company.1. Responding to pressures for cost reductions demands that a company try to minimize its unit
costs. To accomplish this, a company must base its activities at the most favorable low-cost location, wherever in the world that might be. It must also offer a standardized product to the global marketplace in order to ride down the experience curve as quickly as possible.
2. Reacting to pressures to be locally responsive requires a company to differentiate its product offering and marketing strategy from country to country. It must try to accommodate the diverse demands arising from national differences, which can lead to significant duplication and a lack of standardization, raising costs.
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Figure 8.1: Pressures for Cost Reductions and Local Responsiveness
B. Pressures for cost reductions arise from several sources.1. Pressures for cost reductions are intense in industries producing commodity-type products that
serve universal needs. For these products, differentiation on nonprice factors is difficult and price is the main competitive weapon.
2. Pressures for cost reductions are also strong in industries where major competitors are based in low-cost locations, where there is persistent excess capacity, and where consumers are powerful and face low switching costs.
3. Liberalization of the world trade and investment environment in recent decades has generally increased cost pressures by facilitating greater international competition.
C. Pressures for local responsiveness arise from several sources.1. One source of strong pressures for local responsiveness emerge when consumer tastes and
preferences differ significantly between countries, for historic or cultural reasons. Products and marketing messages have to be customized for local tastes and preferences, leading to the delegation of production and marketing functions to national subsidiaries.a. However, some observers claim that consumer demands for local customization are on
the decline worldwide, because modern communications and transportation technologies have led to a convergence of tastes and preferences. The result is the emergence of enormous global markets for standardized consumer products.
b. However, other commentators have observed that in some industries, consumers have reacted to an overdose of standardized global products by showing a renewed preference for products that are differentiated to local conditions.
2. Another source of pressures for local responsiveness emerge when there are differences in infrastructure and traditional practices between countries, creating a need to customize the product. This may necessitate the delegation of manufacturing and production functions to foreign subsidiaries.
3. Pressures for local responsiveness may arise when a company’s marketing strategies have to be responsive to differences in distribution channels between countries. This may necessitate the delegation of marketing functions to national subsidiaries.
4. Economic and political demands imposed by host country governments may require a degree of local responsiveness. Examples of threats from host governments include protectionism, economic nationalism, and regulations to ensure local content.
XLVII. Choosing a Global StrategyA. Companies use four basic strategies to enter and compete in the international environment: (1)
international strategy; (2) multidomestic strategy; (3) global strategy; and (4) transnational strategy. Each of these strategies has advantages and disadvantages. The appropriateness of each strategy varies with the extent of pressures for cost reductions and local responsiveness.
B. A firm must balance the pressures for costs reductions with the pressures for local responsiveness. In order to customize products to respond to local demands, the firm may have to give up some of the potential cost savings. Also, the firm may not be able to fully leverage its distinctive competencies.
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Figure 8.2: Four Basic Strategies
1. One global strategy is the international strategy, in which a firm tries to create value by transferring valuable skills and products to foreign markets where indigenous competitors lack those skills and products.a. International companies create value by transferring differentiated product offerings
developed at home to new markets overseas. They centralize product development functions at home.
b. However, international companies also establish manufacturing and marketing functions in each major country. They undertake limited local customization of products and marketing strategy, but the head office retains tight control over these.
STRATEGY IN ACTION 8.3: IKEA’S SWEDISH WAYS
Since its founding in the 1940s, IKEA has grown to be one of the world’s largest furniture retailers, selling a “typically Swedish” mix of products in every country in which it does business. IKEA’s international expansion began in 1974, and today the firm generates only eight percent of its sales in Sweden. IKEA products are known for their European stylishness and their good value for money. Their sales volume gives the firm high economies of scale and volume discounts from suppliers. However, when the firm entered the North American market in 1985, the stores were not immediately profitable. It turns out that American tastes differed significantly from Swedish preferences, for example, in the size of beds, drinking glasses, dresser drawers, and windows. After six years of struggling, IKEA managers began to tailor products to American needs, and sales have taken off.
Teaching Note: IKEA began its globalization efforts with a pure international strategy, in which products that were designed for Swedish customers were sold to buyers around the world. One reason this strategy worked so well is that Swedish furniture design is admired by many. However, the designs did not suit the tastes of American consumers, and the firm had to change to somewhat of a transnational strategy, in which the firm centralizes some tasks, but also learns from its regional offices. Some American firms make the same assumption when selling products overseas—that consumers worldwide will have the same taste as Americans do. For a lively classroom discussion, ask students who have lived or visited overseas to describe how American products are perceived in different parts of the world. The class can also debate the extent to which a firm should tailor its products to local preferences. For example, Mattel’s Barbie dolls, with their unrealistic bosoms and long legs, aren’t popular children’s toys in many European countries, so the firm’s European dolls have more life-like proportions.
c. An international strategy can be very profitable if a company has a valuable distinctive competency that indigenous competitors lack and if the pressures for local responsiveness and cost reductions are relatively weak.
d. However, when pressures for local responsiveness are strong, companies pursuing this strategy lose out to companies that customize products for local conditions. Moreover,
because they must duplicate manufacturing facilities, international companies suffer from high operating costs.
2. Another global strategy is the multidomestic strategy, in which a firm orients itself toward achieving maximum local responsiveness.a. Multidomestic companies transfer skills and products developed at home to foreign
markets, however, unlike international companies, they extensively customize both their product offering and their marketing strategy.
b. Multidomestic firms also establish a complete set of value-creation activities in each major national market in which they do business. Multidomestic companies are unable to realize value from experience-curve effects and location economies, and therefore have a high cost structure and are unable to leverage distinctive competencies.
c. A multidomestic strategy makes sense when there are strong pressures for local responsiveness and weak pressures for cost reductions.
d. Another drawback of this strategy is that many multidomestic companies develop into decentralized federations in which each national subsidiary functions in a largely autonomous manner. They typically lack the ability to transfer local distinctive competencies to their worldwide subsidiaries.
3. A third global strategy is the global strategy, which focuses on increasing profitability by reaping the cost reductions that come from experience-curve effects and location economies. Firms pursuing a global strategy are attempting to be cost leaders.a. The production, marketing, and R&D activities of companies pursuing a global strategy
are concentrated in a few favorable locations.b. Global companies do not customize their products and marketing strategy to local
conditions because customization raises costs. Instead, global companies market a standardized product worldwide so that they can reap the maximum benefits from the economies of scale that underlie the experience curve.
c. Global companies use their cost advantage to support aggressive pricing.d. A global strategy makes most sense when there are strong pressures for cost reductions,
but minimal demands for local responsiveness. These conditions prevail in many industrial goods industries, but are not as common in consumer goods.
4. Every one of the preceding strategies has some serious drawbacks. Increasingly, companies must be both low cost and differentiated in order to compete, especially in the intense rivalry found in industries with many multinational competitors. A transnational strategy allows companies to pursue both goals simultaneously.a. A transnational strategy allows skills and products to flow in both directions between the
home country and the foreign subsidiaries in a process referred to as global learning.b. The transnational strategy makes sense when a company faces high pressures for cost
reductions and high pressures for local responsiveness. However, this strategy is not an easy one to pursue, because pressures for local responsiveness and cost reductions place conflicting demands on a company.
c. To deal with cost pressures, companies can redesign their products to use identical components. Another tactic is to invest in a few large-scale manufacturing facilities sited at favorable locations and then augment those with assembly plants in each of its major markets, which allows for tailoring the finished product to local needs.
5. Table 8.1 summarizes the advantages and disadvantages of the four strategies just discussed. Although a transnational strategy appears to offer the most advantages, it should not be forgotten that implementing it raises difficult organizational issues. The appropriateness of each strategy depends on the relative strength of pressures for cost reductions and pressures for local responsiveness.
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Table 8.1: The Advantages and Disadvantages of Different Strategies for Competing Globally
C. A firm contemplating expansion into foreign markets must confront decisions about which markets to enter, when to enter, and on what scale to enter.
1. The choice among different foreign markets must be made on the basis of an assessment of their long-run profit potential, balancing the benefits, costs, and risks associated with doing business in that country.a. The long-run economic benefits of doing business in a country are a function of factors
such as the number of buyers in a market, the purchasing power of buyers, and their likely future purchasing power.
b. The benefit-cost risk-calculation is complicated by the fact that the potential long-run benefits bear little relationship to a nation’s current stage of economic development or political stability. Rather, they depend on likely future economic growth rates, which are a function of a free market system and a country’s capacity for growth, which may be greater in less-developed nations.
STRATEGY IN ACTION 8.4: MERRILL LYNCH IN JAPAN
Merrill Lynch tried to enter Japan’s private client business in the 1980s but met with limited success. It was the first foreign firm to offer these types of services in Japan, and regulations limited the scope of its products. The government began to relax regulations, and so Merrill tried entry again in 1997, attracted by the huge financial assets owned by Japanese households. The firm considered a joint venture with Japan’s Sawa bank, but managers decided that Merrill needed to establish its own brand name, to give the bank an advantage over later arrivals in the market. When a large Japanese securities firm declared bankruptcy, Merrill acquired some of their facilities and hired some of their former employees. Japan’s economy continues to be weak, but Merrill is on target to break even in 2003.
Teaching Note: Merrill has clearly signaled its commitment to the Japanese market, which will make it easier to attract clients and will tend to discourage competitors. On the negative side, the move may elicit a vigorous competitive response from Japan’s banks, and it limits the resources available to support expansion in other desirable markets, reducing the firm’s flexibility. To begin a class discussion, ask students to describe the problems presented by the profit (or lack of profit) potential in other countries. (For example, China has many potential buyers, but with a low disposable income.) Ask them to tell how the characteristics of each market create opportunities or problems for foreign new entrants.
c. One other factor is the value that international business can create in a foreign market, through offering a product that has been unavailable and that satisfies an unmet need.
2. With regard to the timing of entry, we say that entry is early when an international business enters a foreign market before other foreign firms, and late when it enters after other international businesses have already established themselves.a. Several first-mover advantages are frequently associated with entering a market early.
(1) One advantage is the ability to preempt rivals and capture demand by establishing a strong brand name.
(2) A second advantage is the ability to build up sales volume, revenue, and market share in that country and ride down the experience curve ahead of rivals.
(3) A third advantage is the ability of early entrants to create switching costs that tie customers into their products or services.
b. There can also be disadvantages associated with entering a foreign market before other international businesses.(1) One disadvantage is pioneering costs, or costs that an early entrant has to bear but
a later entrant can avoid.(2) Pioneering costs arise when the business system in a foreign country is very
different than in a firm’s home market.(3) Pioneering costs also arise when the company makes strategic mistakes through
ignorance.(4) Another source of pioneering costs is the cost of educating customers about
products with which they may be unfamiliar.(5) Research shows evidence that the early mover advantages are outweighed by the
disadvantages, in most cases. Therefore, it pays for companies to be late entrants into new foreign markets.
3. An international business also needs to decide on the scale of its entry into foreign market.
a. Entering a market on a large scale involves the commitment of significant resources to that venture. Smaller companies may not have the resources necessary to enter on a large scale. Even some large enterprises prefer to enter foreign markets on a small scale and then build their presence slowly over time as they become familiar with the foreign market in order to reduce risk.
b. A strategic commitment is a decision that has a long-term impact and is difficult to reverse. Deciding to enter a foreign market on a significant scale is a major strategic commitment.(1) Strategic commitments, such as large-scale market entry, can have an important
influence on the nature of competition in a market through signaling to competitors.(2) Large companies are more likely to have the resources necessary to successfully
implement a strategic commitment to early entry than are small companies.(3) Small-scale entry is a way of gathering more information about a foreign market
before making a large-scale strategic commitment, and therefore can reduce risk and increase the chances of entry success, although delay will also cause the company to lose any first-mover advantages.
XLVIII. The Choice of Entry ModeA. Most manufacturing companies begin their global expansion as exporters, making their products in
the home country and then transporting them to foreign markets for sale.1. Exporting avoids the costs of having to establish manufacturing operations in the host country,
and it is consistent with a pure global strategy.2. However, exporting from the company’s home base may not be appropriate if there are lower-
cost locations for manufacturing the product abroad. High transport costs or tariff barriers can make exporting uneconomical.
3. Also, many exporters rely on local sales agents, and it is difficult for the company to ensure that the agents act in the company’s best interests. Some exporters establish wholly owned market subsidiaries in the host country to eliminate this concern.
B. Companies that lack capital to develop operations overseas or that are unwilling to make a significant investment in a risky country, choose licensing as their entry mode. Like exporting, licensing is a fairly low-risk strategy. Licensing involves a company selling the rights to certain intangibles, such as product design or brand name, to foreign licensees in return for royalty payments.1. The advantage of licensing is that the company does not have to bear the development costs and
risks associated with opening up a foreign market.2. A drawback of licensing is the lack of tight control over manufacturing, marketing, and
strategic functions, which can hinder the firm’s ability to realize experience curve and location economies.
3. Competing in a global marketplace may require a company to coordinate strategic moves across countries so that the profits earned in one country can be used to support competitive attacks in another. Licensing severely limits a company’s ability to do so.
4. By licensing its technology, a company often gives away valuable know-how to future competitors. To limit this risk, some companies use a cross-licensing agreement. This agreement asks the foreign licensee to license some of its valuable technology to the licensor in addition to royalty payments.
C. Franchising occurs when a company sells limited rights to franchisees to use its brand name in return for a lump sum payment and a share of the franchisee’s profits. Franchising involves the sale of intangible assets, but also typically imposes strict rules on the franchisee. Franchising is often for a longer period of time than is licensing. Licensing is common among manufacturing companies, whereas franchising is used primarily by service companies.1. The advantages of franchising as an entry mode are the same as those of licensing. The
franchiser doesn’t bear the development costs and risks. Therefore, a global presence can be built quickly and inexpensively.
2. The disadvantages of franchising are somewhat less than those of licensing. One disadvantage is that franchising may inhibit global strategic coordination.
3. Another disadvantage is that foreign franchisees may not be as concerned about quality as the franchiser is, and poor quality may mean not only lost sales, but also a decline in the company’s
worldwide reputation. To alleviate this concern, some companies set up subsidiaries in each country, which then oversee the franchisees to ensure that quality is maintained.
D. Joint ventures require a sharing of ownership, along with the sharing of all attendant costs and benefits, between a company in the home country and one in the host country. To maintain control, some multinational firms maintain a majority share of ownership.1. Joint ventures have the advantage that a multinational can benefit from a local partner’s
knowledge of a host country’s competitive conditions, culture, language, political systems, and business systems.
2. Another advantage is the sharing of costs and risk of setting up business with a local partner.3. A third advantage is that, in many countries, political considerations make joint ventures the
only feasible entry mode.4. One drawback of joint ventures is the risk of losing control over technology. Some companies
cope with this threat by not allowing foreign partners to own a majority stake in the venture. However, some foreign partners may not be willing to accept minority ownership.
5. Another drawback exists because a joint venture does not give a company tight control over different subsidiaries that it needs to realize economies or engage in coordinated global attacks against global rivals.
E. A wholly owned subsidiary is created when the parent company owns 100 percent of its subsidiary’s stock. A company can establish a wholly owned subsidiary either by acquisition or by setting up a completely new operation.1. One advantage to a wholly owned subsidiary is the tight control the company maintains over its
distinctive competencies, which can be especially important when the competitive advantage is based on control over a technological competency.
2. Another advantage is that a wholly owned subsidiary gives a company the kind of tight control over operations in different countries that is necessary for pursuing a global strategy—supporting competitive attacks in one country with profits from another.
3. A wholly owned subsidiary allows the company to realize location and experience curve economies.
RUNNING CASE: DELL’S GLOBAL BUSINESS
Dell generates about one-quarter of its revenues from overseas sales, using its direct sales model wherever it competes. It has wholly owned subsidiaries in Brazil, Malaysia, China, and Ireland, in addition to its facilities in Tennessee and Texas. Each of these plants is large enough to serve a regional market and enjoys economies of scale. Each plant uses the same supply chain management techniques that led to Dell’s domestic success. Each location also supports a customer service center.
Teaching Note: Dell uses wholly owned subsidiaries because the firm wants to ensure that its methods are followed exactly, and also to reduce the risk of losing know-how to a partner that may then use the knowledge to compete against Dell. To encourage student participation, suggest other companies that the students are familiar with, and ask them to predict which mode of entry that company uses. This will help make the relationship between strategy and mode of entry more clear.
1. However, a wholly owned subsidiary is the most costly method of serving a foreign market, and companies taking this approach bear the full costs and risks associated with setting up overseas operations.
2. These costs and risks can be diminished somewhat by using acquisition, rather than setting up a new operation. However, acquisitions raise a host of additional problems, such as trying to integrate two disparate operations and cultures. Acquisitions and the problems associated with them are discussed in more detail in Chapter 10.
F. Inevitably, choosing an entry mode involves trade-offs. Therefore, it is difficult to make specific recommendations as to what a company should do. A number of rough generalizations can be made, however.
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Table 8.2: The Advantages and Disadvantages of Different Entry Modes
1. One area that companies must consider when choosing a mode of entry into international markets is the source of their competitive advantage.a. If a company’s competitive advantage is based on control of proprietary technological
know-how, wholly owned subsidiary is the best strategy to minimize the risk of losing control over that technology. Other entry modes might work also, if measures are taken to reduce the risks.
b. If the company is using technological know-how, but the technological advantage is expected to be short-lived anyway, then a licensing strategy might be more appropriate, because it allows rapid diffusion of the technology. Rapid diffusion raises royalty payments, and makes it more likely that the company’s technology will be accepted as the dominant design.
c. The competitive advantage of many service companies is based on management know-how, where the risk of losing control is not high. The valuable asset of such companies is their brand name, which is protected by international trademark laws. Such companies should use franchising and wholly owned or joint venture subsidiaries to control the franchisees. Some companies prefer a joint venture because it is more politically acceptable and brings a degree of local knowledge.
2. A second area for consideration in choosing an entry mode is the level of pressures for cost reduction.a. The greater the pressures for cost reductions, the more a company should pursue some
combination of exporting and wholly owned subsidiaries. By manufacturing in those locations where factor conditions are optimal and then exporting to the rest of the world, a company may be able to realize substantial location economies and experience-curve effects.
b. Wholly owned subsidiaries are preferable to joint ventures, because they give the company tighter control over marketing, increasing coordination and allowing the profits generated in one market to be used to improve competitive position in another.
XLIX. Global Strategic AlliancesA. Global strategic alliances are cooperative agreements between companies from different countries
that are actual or potential competitors. Strategic alliances vary considerably in the length of time and degree of interrelatedness they offer.
B. Companies enter into strategic alliances with actual or potential competitors in order to achieve certain strategic objectives.1. Strategic alliances may facilitate entry into a foreign market.2. Strategic alliances allow companies to share the fixed costs and associated risks that arise from
the development of new products or processes.3. Alliances bring together complementary skills and assets that neither company could easily
develop on its own.4. Alliances help companies set technological standards for their industry, which can benefit the
allied firms.C. One problem with global strategic alliances is that they can give a firm’s competitors a low-cost route
to gaining new technology and market access. Unless it is careful, a company can give away more than it gets in return.
L. Making Strategic Alliances WorkA. The failure rate of global strategic alliances is quite high—two-thirds have some initial problems, and
one-third are eventually rated as failures.B. The benefits a company derives from a strategic alliance seem to be a function of several factors.
1. One of the keys to making a strategic alliance work is to select the right kind of partner.a. The partner must be able to help the company achieve its strategic goals through the
possession of capabilities that the company lacks but values.b. The partner must share the company’s vision for the purpose of the alliance.c. The partner must be unlikely to try to opportunistically exploit the alliance for its own
ends, expropriating the company’s technological know-how, while giving little in return.d. Therefore, companies must thoroughly research potential alliance partners.
2. Another critical factor in alliance success is a structure that reduces the risks of a company giving too much away to its alliance partner without getting anything in return.
Table 8.4: Structuring Alliances to Reduce Opportunism
a. Alliances can be designed to make it difficult to transfer technology that is not meant to be transferred. Specifically, the product or process may be structured so as to “wall off” the most sensitive technologies and prevent their leakage to others.
b. Contractual safeguards can be written into an alliance agreement to diminish the risk of opportunism by a partner.
c. Both parties can agree in advance to exchange skills and technologies that the other wants, thereby ensuring an equitable gain. Cross-licensing agreements are one way of achieving this goal.
d. The risk of opportunism can be decreased if the company extracts a significant credible commitment in advance, requiring each partner to make such a substantial and long-term investment that the chances of opportunism are sharply reduced.
3. The last critical factor for success is to manage the alliance in a way that maximizes benefits.a. One important management tactic is to develop sensitivity to cultural differences.
Managers must take differences into account when dealing with their partner.b. Another contributor to managing an alliance successfully is building interpersonal
relationships between managers from the different companies, which means building trust as well as an informal network to resolve issues.
c. Learning from the partner is a major factor in determining how much a company gains from an alliance. Firms that view the alliance as merely a cost- or risk-sharing device receive fewer benefits.
d. Therefore, an effective strategy would be to educate all employees about the partner’s strengths and weaknesses, as well as informing them about the particular skills that the company hopes to learn from the partner. Then, the resultant learning must be spread in a coordinated fashion throughout the company.
CHAPTER 9
Corporate Strategy: Horizontal Integration, Vertical Integration, and Strategic Outsourcing
SYNOPSIS OF CHAPTERThis chapter and Chapter 10 concern corporate-level strategy. This chapter focuses on the different strategic choices that companies make with regard to horizontal and vertical integration. In particular, we consider the arguments for and against horizontal and vertical integration and examine strategic alliances and strategic outsourcing as alternatives. In the next chapter, the focus is on the strategies that companies use to enter and exit businesses.
Successful corporate strategy adds value by enabling the company to perform one or more of the value-creation functions at a lower cost or in a way that allows differentiation and brings a premium price. For a company to be successful, its corporate strategy must assist in the process of establishing a distinctive competency at the business level.
To a certain extent, this view conflicts with the received wisdom of the strategic management literature. It is often claimed that a company’s corporate-level strategy sets the context for its business-level strategy. Our position is that if a corporate-level strategy is to succeed, the reverse should be the case. That is, the process of establishing a sustainable competitive advantage at the business level defines the set of appropriate corporate-level strategies.
Another theme stressed in the chapter is that the existence of bureaucratic diseconomies implies a fundamental limit to the profitable pursuit of horizontal and vertical integration. As companies become more diversified or vertically integrated, top management begins to lose control, leading to the dissipation rather than the creation of value.
A final theme of this chapter is that strategic alliances and strategic outsourcing are often viable alternatives to horizontal and vertical integration. That is, these strategies can achieve many of the same benefits without encountering the same bureaucratic costs.
TEACHING OBJECTIVES1. Familiarize students with the range of corporate-level strategies open to a company.
2. Illustrate how horizontal integration can create value for a company and show the bureaucratic limits to the profitable pursuit of horizontal integration.
3. Illustrate how vertical integration can create value for a company and show the bureaucratic limits to the profitable pursuit of vertical integration.
4. Show how strategic alliances can be used instead of horizontal and vertical integration, and describe the limitations of alliances.
5. Show how strategic outsourcing can be used instead of horizontal and vertical integration, and describe the limitations of outsourcing.
OPENING CASE: THE RISE OF WORLDCOMThrough the 1980s and 90s, WorldCom grew to be the second-largest telecommunications provider, behind number-one AT&T. To speed growth, the company acquired many smaller providers, including MCI, financing the deals with stock and debt. WorldCom CEO Bernie Ebbers knew that growing would help the firm to realize economies of scale and also increase its ability to offer a bundle of related telecom services. However, when WorldCom made a bid for Sprint, U.S. and European antitrust regulators opposed the deal because of the high industry concentration. The firm abandoned the acquisition, and began a long plunge toward failure. Along the way, the stock price fell, a long-distance services price war erupted, and the debt burden crushed profits. The final blow was a 2002 audit that showed the company had overstated earnings and understated expenses by billions of dollars. In July 2002, the firm declared bankruptcy.
Teaching Note: This case shows the inherent dangers in an acquisition strategy—high costs of debt, failure to realize potential savings, and overcapacity. Although it is still unclear at this time whether there was deliberate fraud at WorldCom, its clear that their acquisition strategy was out of control, moving too fast, and focused too little on integration and realization of cost savings. Ask students to discuss the extent to which, in hindsight, there were warning signs of trouble at WorldCom. Ask the students what they should look for in other companies to avoid making the same mistakes again?
LECTURE OUTLINELI. Overview
A. The principal concern of corporate strategy is identifying the business areas in which a company should participate, the value creation activities it should perform, and the best means for expanding or contracting businesses, in order to maximize its long-run profitability.
B. To add value, a corporate strategy should enable one or more of a company’s business units to perform one or more of the value-creation functions at a lower cost or perform them in a way that allows differentiation and brings a premium price.
LII. Horizontal IntegrationA. Horizontal integration is the process of acquiring or merging with industry competitors to achieve
the competitive advantages that come with large scale and scope.B. Horizontal integration may be achieved by acquisition, as when a company purchases another
company, or by a merger, meaning an agreement by which equals pool their operations and create a new entity.
1. Horizontal integration has been a popular strategy since the early 1990s. The trend toward horizontal integration peaked in 2000 and has fallen off somewhat since then.
2. The net result of all the horizontal integration has been to increase the consolidation in many industries.
3. The popularity of this strategy is due to the benefits that horizontally integrated firms realize.a. Horizontal integration allows companies to grow, and therefore to realize economies of
scale. This is especially important in industries with high fixed costs.b. Another benefit of horizontal integration is the cost savings due to reducing duplication
between the two companies, for example, eliminating duplicate headquarter offices.c. In addition, horizontal integration can allow the company to offer a wider range of
products that can be sold together for a single price, a strategy called product bundling. Customers value the convenience of bundled products, leading to differentiation.
d. Horizontal integration facilitates another strategy, similar to bundling, called a “total solution.” This is an important strategy, for example, in the computer industry, where corporate customers prefer the ease and coordination of purchasing all their hardware and service from a single source.
e. Horizontal integration also aids in value creation by supporting cross selling, as occurs when a company tries to leverage its relationship with customers by acquiring additional product categories that can be sold to them. Again, customers’ preference for convenience leads to differentiation.
f. Horizontal integration helps companies manage industry rivalry by reducing excess capacity in the industry.
g. Horizontal integration also reduces the number of players in an industry, thus making it easier to implement tacit price coordination.
RUNNING CASE: BEATING DELL: WHY HEWLETT-PACKARD WANTED TO ACQUIRE COMPAQ
Dell’s dominance of the PC industry has had terrible consequences for rival Compaq, and Dell announced its plans to then go after the lucrative printer market, currently dominated by Hewlett Packard. HP and Compaq decided to merge, in order to better combat this threat. HP CEO Carly Fiorina believed the merger would bring cost savings by eliminating duplication and by increasing economies of scale. Fiorina also claimed the merger gives the combined company a broader expertise in both hardware and services. This should enable the firm to differentiate and reduce the threat from cost-leader Dell, as well as to better compete with other service providers, such as IBM and EDS. Critics of the merger pointed out that the merged firms still can’t compete with Dell’s efficient supply chain management, and that Dell’s success with a no-services strategy demonstrates that providing services is not necessary for profitability. The proposed merger ran into opposition, and while Fiorina and the two firms were distracted, Dell continued to gain market share.
Teaching Note: The HP-Compaq merger was made for a number of sound reasons, such as to increase market size and power, to expand the firm’s product lines, to support cross-selling, to bundle products, to realize economies of scale, to reduce duplication and to reduce excess capacity. But will that be enough to defeat powerful rival Dell? Ask students to debate this issue in class.
h. Companies gain bargaining power over buyers and suppliers through horizontal integration, because industry consolidation increases the remaining firms’ power. This is called market power, or monopoly power.
STRATEGY IN ACTION 9.1: HORIZONTAL INTEGRATION IN HEALTH CARE
Health maintenance organizations (HMOs) are health insurance companies that act as middlemen between patients and providers, and they profit when they are able to enroll many patients and negotiate low prices from providers. In trying to maximize profits, HMOs have caused health care providers to try horizontal integration. For example, in Massachusetts there are few HMOs but many hospitals, giving power to the HMOs. They used that power to demand discounted prices and threatened to remove hospitals from approved providers lists if discounts weren’t granted. In response, hospitals began to merge. As their power grew, hospitals refused to offer
discounts. When HMOs retaliated by removing those hospitals, patients protested and eventually forced the HMO to accept the higher prices. Bargaining power is now shifting to the providers.
Teaching Note: This case can be used for class discussion, by asking students to consider the shifting balance of power between HMOs and providers, from the patient’s point of view. Many of the students will be aware of this issue, and perhaps have personal experiences. Starter questions might include: “Is it better for patients when HMOs are in power or when hospitals are in power?” and “Is it possible to both increase patients’ choices and reduce costs simultaneously?” Students may be inclined to side with the providers, but you can point out that the providers’ historically high fees led to this situation in the first place. Also ask students to consider the costs of any of the solutions they proffer.
1. However, horizontal integration also has some drawbacks and limitations.a. Mergers and acquisitions are difficult to implement successfully, and therefore may
destroy value rather than creating it. Problems include disparate cultures, high management turnover, an underestimation of integration expenses, and a tendency to overestimate the expected benefits and to overpay. This topic is discussed in more detail in Chapter 10.
b. Antitrust law is designed to provide protection against the abuse of market power and tends to favor industries with numerous, smaller companies rather than consolidated industries. The U.S. Justice Department sometimes blocks proposed mergers and acquisitions because of these concerns about reducing competition and raising prices for consumers.
LIII. Vertical IntegrationA. Vertical integration means that a company is producing its own inputs (backward or upstream
integration) or is disposing of its own outputs (forward or downstream integration).B. There are four main stages in a typical raw-material-to-consumer production chain: raw materials;
component part manufacturing; final assembly; and retail. For a company based in the assembly stage, backward integration involves moving into intermediate manufacturing and raw-material production. Forward integration involves movement into distribution. See Figure 9.1 for details.
Figure 9.1: Stages in the Raw Material to Consumer Value Chain
1. At each stage in the chain value is added to the product. The difference between the price paid for inputs and the price at which the product is sold is a measure of the value added at that stage. Thus, vertical integration involves a choice about which value-added stages of the raw-material-to-consumer chain to compete in.
2. Another important distinction is the difference between full integration, which occurs when a company produces all of its own inputs or disposes of all of its own output, and taper integration, in which a company buys from independent suppliers in addition to company-owned suppliers or when it disposes of its output through independent outlets in addition to company-owned outlets.
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Figure 9.3: Full and Taper Integration
3. Firms pursuing a strategy of vertical integration realize some benefits.a. By vertically integrating backward or forward, a company can build barriers to new entry,
limiting competition and enabling the company to charge a higher price and make greater profits.
b. Vertical integration facilitates investment in specialized assets. A specialized asset is an asset that is designed to perform a specific task and whose value is significantly reduced in its next best use. It may be a tangible or an intangible asset.(1) Specialized assets lower the costs of value creation and provide better
differentiation, and thus provide the basis for achieving a competitive advantage.(2) It may be difficult to persuade companies in an adjacent stage of the production
chain to invest in specialized assets, because there is a risk that one will take advantage of the other, demanding more favorable terms after the companies commit to the relationship. This is referred to as holdup.
(3) Instead, the company may vertically integrate and invest in specialized assets for itself.
STRATEGY IN ACTION 9.2: SPECIALIZED ASSETS AND VERTICAL INTEGRATION IN THE ALUMINUM INDUSTRY
Aluminum refineries are designed to refine bauxite ore and produce aluminum. Refinery designs are very specialized—each factory must be designed for a particular type of ore, which is produced only at one or a few bauxite mines. Using a different type of ore would raise production costs by 50 percent. Therefore, the value of the aluminum company’s investment is dependent on the price it must pay the bauxite company. Recognizing this, once the aluminum company has made the investment in a new refinery, the bauxite company can raise prices to holdup the refiner. The aluminum company can reduce this risk by purchasing the bauxite company. Vertical integration, by eliminating the risk of holdup, makes the specialized investment worthwhile.
Teaching Note: The case reports that over 90 percent of aluminum refiners own the bauxite mine. Ask students to consider whether there are any other effective methods of reducing holdup. If so, what are they? If not, why not?
c. By protecting product quality, vertical integration enables a company to become a differentiated player in its core business, leading to more pricing options.
d. Strategic advantages arise from the easier planning, coordination, and scheduling of adjacent processes made possible in vertically integrated organizations. This can be particularly important in companies trying to realize the benefits of just-in-time inventory systems. The assumption underlying this argument is that scheduling is somehow more problematic between freestanding enterprises—an argument that seems rather dubious.
4. However, vertical integration has some disadvantages. Because of these disadvantages, the benefits of vertical integration are not always as substantial as they might seem initially.
a. Although often undertaken to gain a production cost advantage, vertical integration can raise costs if a company becomes committed to purchasing inputs from company-owned suppliers when low-cost external sources of supply exist.(1) Company-owned suppliers might have high operating costs relative to independent
suppliers because they know that they can always sell their output to other parts of the company. The fact that they do not have to compete for orders with other suppliers reduces their incentive to minimize operating costs.
(2) The problem may be less serious, however, when the company pursues taper, rather than full, integration, because the need to compete with independent suppliers can produce a downward pressure on the cost structure of company-owned suppliers.
b. When technology is changing rapidly, vertical integration poses the hazard of tying a company to an obsolescent technology. Vertical integration can inhibit a company’s ability to change its suppliers or its distribution systems to match the requirements of changing technology.
c. Vertical integration can be risky in unstable or unpredictable demand conditions, because it may be difficult to achieve close coordination among vertically integrated activities. The resulting inefficiencies can give rise to significant bureaucratic costs.(1) The problem involves balancing capacity among different stages of a process. For
example, if demand falls, the company may be locked into a business that is running below capacity. Clearly, this would not be economical.
(2) If demand conditions are unpredictable, taper integration might be somewhat less risky than full integration. When the company provides only part of its total input requirements from company-owned suppliers, in times of low demand it can keep its in-house suppliers running at full capacity by ordering exclusively from them.
d. Bureaucratic costs are the costs of running an organization. They include the costs arising from the lack of incentive on the part of company-owned suppliers to reduce their operating costs and from a possible lack of strategic flexibility in the face of changing technology or uncertain demand conditions.(1) Bureaucratic costs place a limit on the amount of vertical integration that can be
profitably pursued. The farther a company moves from its core business, the more marginal the economic value and the higher the bureaucratic costs.
(2) Given their existence, it makes sense for a company to integrate vertically only when the value created by such a strategy exceeds the bureaucratic costs associated with expanding the boundaries of the organization to incorporate additional upstream or downstream activities.
LIV. Alternatives to Vertical Integration: Cooperative RelationshipsA. Under certain conditions, companies can realize the gains associated with vertical integration without
having to bear the associated bureaucratic costs, if they enter into long-term cooperative relationships, called strategic alliances, with their trading partners.
B. However, companies will not realize gains from short-term (less than one year) contracts with their trading partners.1. Because it signals a lack of long-term commitment to its suppliers by a company, the strategy of
short-term contracting and competitive bidding makes it very difficult for that company to realize the gains associated with vertical integration.
2. This is not a problem when there is minimal need for close cooperation between the company and its suppliers to facilitate investments in specialized assets, improve scheduling, or improve product quality. Indeed, in such cases competitive bidding may be optimal. However, a competitive bidding strategy can be a serious drawback when these considerations do arise.
C. In contrast to short-term contracts, long-term contracts are cooperative arrangements by which one company agrees to supply the other, and the other agrees to continue purchasing from that supplier.1. In a long-term contract, both parties make a commitment to work together and seek ways of
lowering the costs or raising the quality of inputs.2. This stable long-term relationship lets the participating companies share the value that might be
created by vertical integration while avoiding many of its bureaucratic costs. Thus long-term contracts can be a substitute for vertical integration.
STRATEGY IN ACTION 9.3: DAIMLERCHRYSLER’S U.S. KEIRETSU
At one time, Chrysler used lowest-cost competitive bidding to buy components. The quality of the components wasn’t important, and the relationships were short-term and characterized by mutual distrust. But over the last decade, Chrysler has built a network of stable long-term relationships with suppliers (which the Japanese call keiretsu). Suppliers make investments that are specific to Chrysler’s needs, in exchange for long-term contracts and a share of any benefits that result from process improvements that the suppliers suggest. This aligns incentives between Chrysler and its suppliers. Chrysler is able, due to these long-term relationships, to gain the advantages of vertical integration without bureaucratic cost. Benefits include quicker new product development and a dramatic increase in suggestions from suppliers. Implementation of these suggestions reduces Chrysler’s costs by millions, or even billions, of dollars annually.
Teaching Note: This case demonstrates how a strategy (lowest-cost competitive bidding) that seems to offer the most benefits, can in fact lead to few benefits in the long-term. Remind students that this case shows the importance of asking “And then what happens?” in strategy. Too often, managers (and students) will recommend solutions without adequate consideration of long-term consequences. You can mention other examples of this in class, or ask students to think of examples.
D. Companies can take some specific steps to ensure that a long-term relationship can succeed and to lessen the chances of one party taking advantage of the other.1. One way of designing long-term cooperative relationships to build trust and reduce the
possibility of a company reneging on an agreement is for the company making investments in specialized assets to demand a hostage from its partner. This occurs when companies both invest in specialized assets in order to serve each other, and it makes them mutually dependent and therefore less likely to renege.
2. A credible commitment is a believable commitment to support the development of a long-term relationship between companies. Credible commitments involve long-term and substantial investments, and therefore are believable guarantees of trust.
3. Building a cooperative long-term relationship is more readily relied upon when a company can maintain some kind of market discipline on its partner, to ensure that the partner doesn’t lack incentives to maintain efficiency.a. One way of maintaining market discipline is to periodically renegotiate the agreement.
Thus a partner knows that if it fails to live up to its side of the agreement the company may refuse to renew.
b. Another way to maintain market discipline is to enter into long-term relationships with suppliers use a parallel sourcing policy. Under this arrangement, a company enters into a long-term contract with two suppliers for the same part. The idea is that when a company has two suppliers for a single part, each supplier knows that it must fulfill its side of the bargain, lest the company terminate the contract and switch business to the other supplier.
LV. Strategic OutsourcingA. The opposite of integration (a firm’s growth, in number of businesses) is outsourcing value-creation
activities to subcontractors. In recent years there has been a clear move among many enterprises to outsource noncore or nonstrategic activities.
STRATEGY IN ACTION 9.4: CISCO’S $2 BILLION BLUNDER
Cisco, the largest supplier of Internet hardware such as routers and switches, performs R&D, marketing, and supply chain management within the organization, and outsources all other functions, including manufacturing. Cisco claimed that the firm benefited by not investing in capital-intensive manufacturing facilities and by not maintaining any inventory. The supply chain was a four-level pyramid, with Cisco at the peak and hundreds of suppliers of commodity inputs at the base. But when demand started to fall in 2001, Cisco found that its system couldn’t adapt quickly enough, and the company had to write off $2.2 billion in unusable inventory. This occurred because customers overbooked in the high-demand periods, and then at each level of the pyramid, buyers overbooked, magnifying the extent of the problem. Cisco’s outsourcing system distanced the company from its suppliers, with a disastrous loss of communication capability. Since the write down, Cisco has implemented a web
site for industry-wide supply chain management that allows firms at all stages of the supply chain to stay in touch with the true level of demand.
Teaching Note: This cautionary tale shows the pitfalls of outsourcing very clearly. To start a discussion, ask students to name functions that could be outsourced at their school and describe the benefits that the school would reap. Then, ask them to describe any potential pitfalls that the school might experience, and describe actions that would lessen the dangers from those pitfalls.
B. Any function can be outsourced, if it is not critical to a firm’s success (is not one of its distinctive competencies).
C. Outsourcing begins with a identification of a firm’s distinctive competencies—these will continue to be performed within the company. All other activities are then reviewed to see whether they can be performed more effectively and efficiently by independent suppliers. If they can, these activities are outsourced to those suppliers. The relationships between the company and those suppliers are then often structured as long-term contractual relationships.
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Figure 9.4: Strategic Outsourcing of Primary Value Creation Functions
D. The term virtual corporation has been coined to describe companies that have pursued extensive strategic outsourcing.
E. There are several advantages of strategic outsourcing.1. First, by outsourcing a noncore activity to a supplier who is more efficient at performing that
particular activity, the company may reduce its own cost structure, enhancing its cost leadership strategy.a. Suppliers may be more efficient due to economies of scale or learning effects.b. Suppliers may also be more efficient because of a low-cost location.
2. By outsourcing a noncore value-creation activity to a supplier that has a distinctive competency in that particular activity, the company may be able to better differentiate its final product.
3. A third advantage of strategic outsourcing is that it allows the company to remove distractions, focusing more resources on strengthening its distinctive competencies.
F. There are also some risks associated with strategic outsourcing.1. There is a risk of holdup, or becoming too dependent on an outsourced activity.
a. This risk can be reduced by outsourcing from several companies at once, using a parallel sourcing policy.
b. Another way to manage this risk is simply to signal to the subcontractors the company’s willingness to choose a different provider when the contract is up for renewal.
2. A further drawback of outsourcing is the potential for loss of control of scheduling. This problem is intensified by a long supply chain, unpredictable demand, and outsourcing to a number of competing companies, rather than just one.
3. Another concern is the potential for a loss of important competitive information. This risk can be managed by ensuring good communication between the subcontractor and the company.
CHAPTER 10
Corporate Strategy: Diversification, Acquisitions, and Internal New Ventures
SYNOPSIS OF CHAPTERThis chapter continues the discussion of corporate strategy that was begun in Chapter 9. Diversification into more than one business is the corporate-level strategy for growth. The corporation is treated as a portfolio of
investments, and diversification is seen as a way of further leveraging the firm’s distinctive competencies. The role of diversification in increasing firm profitability, through transferring or leveraging competencies, sharing resources, managing multipoint competition, or leveraging general organizational competencies, is also discussed.
Next, the chapter deals with related and unrelated diversification, the advantages and disadvantages of each strategy. The limits of diversification are also described, including an extensive treatment of bureaucratic costs. The chapter continues with a discussion of diversification efforts that lead to value dissipation, rather than value creation.
The remainder of the chapter describes three entry strategies for diversification: internal new ventures, acquisitions, and joint ventures. In each section, the benefits and challenges of that entry strategy are listed, along with suggestions about how to increase the chances of a successful implementation of that strategy. Finally, diversification’s opposite, restructuring, is introduced and several exit strategies are described.
TEACHING OBJECTIVES1. Introduce students to concepts related to diversification, including the reasons why firms pursue
diversification.
2. Describe related and unrelated diversification and the benefits and problems associated with each.
3. Summarize the limits of diversification with a focus on bureaucratic costs, and show how diversification can lead to value dissipation, rather than value creation.
4. Describe benefits, challenges, and implementation guidelines for the corporate-level strategy of internal new ventures.
5. Describe benefits, challenges, and implementation guidelines for the corporate-level strategy of acquisitions.
6. Describe benefits, challenges, and implementation guidelines for the corporate-level strategy of joint ventures.
7. Discuss the reasons why firms restructure, and illustrate several exit strategies.
OPENING CASE: TYCO INTERNATIONALFrom 1996 to 2001, the conglomerate Tyco International expanded rapidly, acquiring over 100 diverse businesses. Tyco’s business model is to seek to consolidate a previously fragmented industry in each of the industries in which it competes. Also, Tyco refuses to enter into risky hostile takeovers, instead looking for companies that make basic products and have a strong market presence, but are less profitable than their peers. The firm thoroughly investigates each potential target and replaces top managers with its own team. After acquisition, cost cutting becomes the focus, with incentives for executives whose units reach earnings objectives.
Tyco’s stock underperforms, because investors are put off by the complexity of its financial reporting and its heavy debt burden. Rumors that Tyco was conspiring with managers of the acquired firms to inflate Tyco’s performance persist. CEO Kozlowski resigned after being charged with tax evasion. John Fort, the new CEO, spun off Tyco’s finance division, and used the cash to pay down debts. Whether he can find a source of continuing profitability remains to be seen.
Teaching Note: This case tells how Tyco’s acquisition strategy both brings benefits to the firm, as well as introduces some potential weaknesses. For example, the very success of its acquisition strategy led to the high debt that brought the stock price down. An interesting discussion for your class could be started, based on questions about Tyco’s ethics. Persistent rumors of financial misdeeds, a CEO charged with tax evasion, and obscure financial reporting all seem to point to ethical problems at Tyco. Do your students think that Tyco does in fact have an unethical organization culture? If no, how do they explain the rumors? If yes, can outside observers (for example, potential investors) determine the nature of the ethical issues, and how?
A. This chapter is the second chapter that deals with corporate strategy, and focuses on diversification, the process of adding new businesses to the company that are distinct from its established operations. Thus, a diversified company is involved in two or more distinct businesses.
B. Another focus is on the execution of a diversification strategy. This might take place through internal new venturing, which is starting a business from scratch; acquisition, or buying an existing business; and joint ventures established with the help of a partner.
C. A third topic is restructuring, the opposite of diversification, in which a company reduces the scope of its operations by exiting industries.
LVII. Expanding Beyond a Single IndustryA. Corporate-level managers identify which industries a company should compete in to maximize long-
run profitability.1. Often, it is better to compete within a single industry.
a. One advantage of a single business corporation is the ability to focus more resources and attention on that one area.
b. Another advantage is that a firm sticks with what it knows and does best, and does not risk making the mistake of moving into areas in which it has no distinctive competencies.
2. There are also disadvantages to a single-business strategy.a. One disadvantage is the increased risk that comes from tying corporate profitability to
just one industry.b. Another disadvantage is that a firm may miss out on opportunities to further leverage its
distinctive competencies.B. One model of a corporation looks at the firm as a portfolio of distinctive competencies, rather than a
portfolio of products. Managers can then consider how to leverage those competencies.C. Hamel and Prahalad claim that, once a firm has identified its current competencies, it should use a
matrix, such as the one presented in Figure 10.1, to establish an agenda for building and leveraging competencies to create new businesses.
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Figure 10.1: Establishing a Competency Agenda
1. The lower left corner of the matrix represents the company’s current portfolio of competencies. This quadrant is called “fill-in-the-blanks” because the recommended strategy here is to transfer existing competencies in order to improve its position in existing industries.
2. The upper left matrix quadrant is called “premier plus 10,” to suggest that managers must be building new competencies today to ensure that the firm is a premier provider ten years from now.
3. The lower left quadrant is “white spaces,” and it indicates the firm’s search for new industries where its existing distinctive competencies could be deployed through diversification.
4. The upper left quadrant is referred to as “mega-opportunities,” and it represents opportunities for entry into new industries where the company currently has none of the required competencies.
5. Use of this matrix helps managers think strategically about competencies and industries as they change over time. Managers who use this matrix will be unlikely to enter new markets where they do not have a competitive advantage.
D. Companies that wish to expand beyond a single industry must develop their business model at two levels.1. First, they must develop a business model for each industry in which they plan to compete.2. Then, the company must develop a higher-level multibusiness model that justifies entry into
different industries in terms of profitability. This model should describe how the firm plans to leverage its distinctive competencies across industries. The model must also describe how the business and corporate strategies boost profitability.
LVIII. Increasing Profitability Through DiversificationA. Diversification is the process of adding new businesses to the company that are distinct from its
established operations. Thus, a diversified company is involved in two or more distinct businesses.
B. To increase profitability, diversification should allow the company to lower costs, differentiate its products, or better manage industry rivalry.
C. When the firm is generating free cash flow, that is, profits about the level necessary to meet current expenses and obligations, the firm’s managers may choose to return dividends to shareholders or to invest the cash in diversification.
D. For diversification to make economic sense, the expected return on invested capital (ROIC) from the diversification must exceed the returns shareholders could realize through investing that capital in a diversified investment portfolio.1. One way that firms use diversification to boost profitability is through their ability to transfer
their existing distinctive competencies to an existing business in another industry. The transfer must involve competencies that are important for competitive advantage in that business.
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Figure 10.2: Transfer of Competencies at Philip Morris
2. Another way of boosting profitability requires that the company leverage its existing distinctive competencies by using them to create a new business in a different industry.a. Leveraging competencies involves creation of a new business, whereas transferring
competencies involves an existing business. This distinction is important because the two different situations require the use of different managerial skills.
b. Companies that leverage competencies tend to use R&D skills to build a new venture in a technology-related industry, whereas companies that transfer competencies tend to acquire established businesses.
STRATEGY IN ACTION 10.1: DIVERSIFICATION AT 3M: LEVERAGING TECHNOLOGY
3M is known for its ability to generate new products and new businesses—30 percent of its sales come from products developed during the last five years. The company is consistently able to extend an existing technological competency to making a similar yet innovative product. Their success is due to a variety of factors, including a culture that encourages risk taking, a focus on solving customer problems, the use of stretch goals, and employee autonomy to pursue their own ideas. Also important are the firm’s system for sharing technologies and expertise and a reward structure that recognizes innovators.
Teaching Note: This case provides an example of a firm that is skilled at leveraging existing competencies into the creation of new businesses, but it’s especially useful that the specific mechanisms for encouraging innovation are described in detail. Ask students to consider how another company with which they are familiar might use some or all of 3M’s strategies for improving innovation. What would be some likely results?
3. Another way to use diversification to increase profitability is through sharing resources across multiple businesses in order to obtain cost reductions. This sharing is called economies of scope.a. Economies of scope occur because each business can invest less in the shared resource
than in resources that are not shared.
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Figure 10.3: Sharing Resources at Procter & Gamble
b. Economies of scale generate economies of scope, because resource sharing allows the company to use the resource more intensively.
c. Economies of scope are obtained only when there is significant commonality between one or more value creation functions in the two businesses.
d. Also, managers must weigh the benefits obtained by resource sharing against the increased bureaucratic costs of doing so.
4. Diversification can also boost profitability by enabling the company to better manage rivalry through the use of multipoint competition.
a. Multipoint competition occurs when two companies rival each other in more than one industry.
b. The threat of increasing competitive rivalry in one industry can keep a competitor from entering another industry or can cause the competitor to lessen the intensity of competitive pressure.
5. A final way that profitability can increase due to diversification is through the improved use of general organizational competencies, that is, corporate-level competencies that transcend individual functions or businesses.a. General organizational competencies require the use of rare managerial skills and are
difficult to develop and implement.b. One general organizational competency is an entrepreneurial capability, which allows
managers to recognize and develop new businesses internally. Companies with this competency are skilled at encouraging risk taking while also limiting the amount of risk undertaken.
c. Another general organizational competency is the ability to develop effective organization structure and controls.(1) Effective structure and controls encourage business-level managers to maximize
efficiency and effectiveness, increasing profitability.(2) Companies with effective structure and controls tend to use self-contained business
divisions.(3) Companies with effective structure and controls tend to be decentralized.(4) Companies with effective structure and controls tend to link pay to performance.
d. Another general organizational competency is a superior strategic capability, such that top managers have good governance skills and can effectively manage the firm’s business-level managers. (1) One aspect of superior strategic capability is a flair for entrepreneurship.(2) Superior strategic capability also expresses itself in an ability to recognize ways to
improve the performance of individuals, functions, and businesses.(3) Another aspect of effective governance is the ability to diagnose the real source of
problems and then to know the appropriate steps to take to fix those problems.(4) Superior strategic capability is at work when a diversified company acquires a new
business and then restructures it to improve performance.LIX. Types of Diversification
A. Related diversification moves the company into a new activity that is linked to its existing activity by a commonality between value chain activities.1. Typically, the commonality lies in the manufacturing, marketing, and technology functions.2. Typically, firms pursing a strategy of related diversification expect to benefit from transferring
and leveraging competencies and from sharing resources.3. Also, companies pursing a strategy of related diversification are likely to encounter their rivals
in several related industries and thus are likely to benefit from managing that rivalry through multipoint competition.
STRATEGY IN ACTION 10.2: RELATED DIVERSIFICATION AT INTEL
Intel’s operations have been focused on microprocessors for personal computers, but when executives realized that PC sales were reaching saturation and that communications would likely be the next high-growth industry, they turned the company’s attention to developing semiconductors for the communications industry. This switch would allow the company to leverage their technological know-how more fully. From 1997 to 2001, Intel acquired 18 chipmakers and moved into fourth place in the industry, spending a total of $18 billion. Unfortunately, the communications industry slumped and the business became a money-loser. In contrast, its PC chips are still highly profitable and its competition position in that industry seems assured.
Teaching Note: This case gives an example of a not very successful foray into related diversification. Although Intel executives expected to be able to leverage their competencies, the firm is still in a weak position in the communications industry. You can use this case to illustrate the difficulties in identifying businesses that have enough commonality to allow for successful leveraging of competencies. Also, now is a good time to ask students
for creative suggestions for related diversification in other firms. You can ask them, “What businesses are good candidates for related diversification by Exxon?” “by Disney?” “by Wal-Mart?” and so on. As students debate the merits of different potential targets, they will come to realize how difficult identifying a good target can be.
B. Unrelated diversification moves the company into a new activity that has no obvious commonalities with any of the company’s existing activities.1. Typically, firms expect to benefit from unrelated diversification through the exploitation of
general organizational competencies.2. Typically, firms pursuing unrelated diversification are unlikely to meet their rivals in more than
one industry, and thus are unlikely to benefit from managing rivalry through multipoint competition.
LX. The Limits of DiversificationA. Diversification, in many cases, can dissipate value instead of creating it.
1. Although related diversification has more ways to increase profitability and seems to involve fewer risks, research has shown that related firms achieve profits that are only slightly higher than unrelated firms.
2. Firms that are extensively diversified, with many businesses, tend to be less profitable.3. A study by Michel Porter found that over time, companies divested many more of their
acquisitions than they kept.B. One reason for the failure of diversification to achieve its goals is that the bureaucratic costs of
diversification exceed the value created by it.1. The level of bureaucratic costs is a function of the number of businesses in a company’s
portfolio.a. The greater the number of businesses, the more difficult it is for managers to remain
informed about the complexities of each business. They simply do not have the time to process all the information.(1) Therefore, corporate-level managers end up making important decisions based on a
superficial analysis of each business.(2) Corporate managers’ lack of familiarity with operations increases the probability
that business-level managers will be able to distort information provided to those at the corporate level.
b. Thus, information overload can result in substantial inefficiencies within extensively diversified companies.
c. In order to overcome information overload, some corporate managers limit the extent of diversification at their firms.
2. Another source of bureaucratic costs is the coordination required to realize value from transferring competencies and resource sharing.
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Figure 10.4: Coordination Among Related Business Units
a. Bureaucratic costs arise from an inability to identify the unique profit contribution of a business unit that is sharing resources and functions with another unit.
b. This problem can be resolved if corporate management directly audits both divisions, however, doing so requires both time and effort from corporate managers.
c. The accountability problem is far more serious at companies that are extensively diversified. Information overload occurs and corporate management effectively loses control of the company.
3. Thus, bureaucratic costs, which increase as a function of the number of businesses and the extent of resource sharing, place a limit on the value created by diversification. If a company continues to diversify after the point at which costs exceed benefits, profitability will decline. Then, divestment is the best solution.
C. Another reason that companies fail to realize the expected benefits of a diversification is that companies make an inappropriate choice between related and unrelated diversification.
1. Although the ways that related diversified companies can create value are more numerous, the bureaucratic costs of a related strategy are higher than those of an unrelated strategy. Thus, related firms may be no more profitable than unrelated firms.
2. Related diversification should be chosen when the firm’s distinctive competencies in its core business have commonalities with the competencies required to compete in other businesses, and when the bureaucratic costs of implementation do not exceed the value created through resource sharing.
3. A company should pursue unrelated diversification when its distinctive competencies are highly specialized and have few applications outside the core business, when top management possesses super strategic capabilities, and when the bureaucratic costs of implementation do not exceed the value created through restructuring.
D. Another reason for the failure of a diversification strategy to meet its objectives is that many companies diversify for the wrong reasons, and end up dissipating value rather than creating it.1. One inappropriate reason for diversification is to pool risk.
a. Risk pooling is said to create a more stable income stream, reducing the risk of bankruptcy, which is in the best interests of stockholders.
b. However, this argument ignores two facts.(1) Stockholders can easily eliminate the risks inherent in holding an individual stock
by diversifying their own portfolios, and they can do so at a much lower cost than the company can.
(2) Research shows that corporate diversification is not a very effective way to pool risks. The business cycles of different industries are not easy to predict and in any case tend to be a less important influence on share price than a general economic downturn, which hits all industries simultaneously.
2. A second inappropriate reason to diversify is to achieve greater growth. Such diversification is not a coherent strategy because growth on its own does not create value, despite the fact that empire-building top executives sometimes pursue growth for its own sake.
LXI. Entry Strategy: Internal New VenturesA. Internal new venturing is one method that companies can use to execute a corporate-level
diversification strategy.B. Internal new venturing is an appropriate strategy to use for several reasons.
1. Internal new venturing is used when a company possesses a set of valuable competencies in its existing businesses that can be leveraged or recombined to enter the new business area.
2. Science-based companies that use their technology to create market opportunities in related areas tend to favor internal new internal venturing.
3. Even if it lacks the competencies required to compete in a new business area, a company may use internal new venturing to enter a newly emerging or embryonic industry where there are no established players that possess the competencies required to compete in that industry. Thus, internal new venturing is the only option.
C. There are some drawbacks to the use of internal new ventures, which have a very high failure rate.1. Large-scale entry into a new business is more likely to be successful than is small-scale entry,
because it entails greater short-term costs, but gives greater returns in the long run. This is due to the greater economies of scale, brand loyalty, and access to distribution channels that large firms enjoy. The effect is especially noticeable when a firm is entering an established industry with powerful incumbents.
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Figure 10.5: Scale of Entry, Profitability, and Cash Flow
2. Another concern with internal new ventures is that a company can become blinded by the technological possibilities of a new product and fail to analyze market opportunities properly, leading to poor commercialization. Successful commercialization requires that there be a market demand for the technology.
3. Internal new ventures can also fail due to a poor implementation. Common mistakes here include pursuit of too many ventures at once leading to strained resources, failure to ensure the strategic value of the venture beforehand, and failure to anticipate the tie-and-cost demands—leading to an unrealistic profit expectation.
D. To avoid the above pitfalls, managers can follow a number of guidelines to reduce the risk of new venture failure.1. A company should use a structured approach to new venture development, including both
exploratory (basic) research and development research.a. Good basic research comes from strong ties to university research communities and from
giving researchers enough resources to pursue “blue-sky” projects of their own choosing.b. However, basic research alone will not lead a successful commercial venture.c. Good development research also requires resources to be given to business-level
managers, who are ideally situated to recognize commercially viable technologies.d. Good development research also requires communicating company strategies and goals to
researchers, so that their research will be relevant to those goals.2. Another way to increase the probability of new venture success is to foster close links between
R&D and marketing and R&D and manufacturing.a. Project teams with members from the various functional areas are an effective way to
foster close links.b. These teams can also significantly reduce product development time.
3. Another strategy is to devise a selection process for choosing only the ventures that demonstrate the greatest probability of commercial success.
4. To ensure success, managers must also monitor the new venture closely, focusing on market share rather than on profit goals for the first few years. Large market share facilitates economies of scale and learning effects, which will ultimately lead to superior profitability.
5. Finally, companies can help to ensure new venture success by thinking big. They should look for products that have high potential demand, construct efficient-scale manufacturing plants ahead of need, and spend generously on marketing. These steps will help to lead to high market share and profitability.
LXII. Entry Strategy: AcquisitionsA. Acquisitions are the main strategy for implementing horizontal integration, and they are also used in
vertical integration and diversification strategies.B. Acquisition is an appropriate strategy to use for several reasons.
1. A company can use acquisition to enter a new business area when they lack important competencies required in that area, and they can purchase an incumbent company that has those competencies at a reasonable price.
2. Acquisition is a quick way to establish a significant market presence and generate profitability.3. Acquisitions are perceived to be somewhat less risky than internal new ventures, because they
involve less uncertainty. When a company makes an acquisition, it is acquiring known profitability, revenues, and market share; thus it reduces uncertainty.
4. Acquisition is a good entry mode when the industry to be entered is well established with high barriers to entry. The greater the barriers to entry, the more likely it is that acquisitions will be the favored entry mode.
C. There are some drawbacks to the use of acquisition, which have a high failure rate and often dissipate value instead of creating it.1. A challenge for acquiring firms is to smooth postacquisition integration of the two companies.
Unanticipated problems often occur when an attempt is made to marry two divergent corporate cultures. This can lead to high management turnover and can depress profitability.
STRATEGY IN ACTION 10.3: POSTACQUISITION PROBLEMS AT MELLON BANK
In 1993 Mellon Bank acquired Boston Co., a money management firm for major institutional clients, for $1.45 billion. Problems at Boston Co. began to surface soon after the acquisition. From the start there was a clash of cultures—Mellon’s culture is based on frugality and top-down control, whereas Boston Co. employees expected autonomy and high pay. Mellon cut Boston’s expenses and increased rules and restrictions. When a Boston Co. portfolio experienced low returns, Mellon managers liquidated it, taking a $130-million charge against earnings and firing the portfolio manager, for “unauthorized trades.” Infuriated by what they saw as Mellon’s interference, seven Boston Co. managers proposed a management buyout. When Mellon rejected the proposal, some high-profile Boston Co. managers left, taking valuable employees and clients with them.
Teaching Note: The problems at Mellon and Boston are yet another example of how difficult it can be to merge two divergent corporate cultures, and how the management turnover that results from such attempts can deal a serious blow to any attempt to create value out of an acquisition. Ask students to suggest how Mellon might have avoided or mitigated some of these problems.
2. Another challenge is that companies often overestimate the potential for creating value by joining together different businesses. They overestimate the strategic advantages of the acquisition and thus overpay for the target company. Richard Roll attributes this to top management hubris.
3. Another drawback relates to the price of acquisitions, which tend to be very expensive. Stockholders of the target company do not want to sell unless they are offered a premium price. In addition, several bidders are sometimes pursuing the same target company, bidding up the price to result in a typical increase in market value of 40 to 80 percent.
STRATEGY IN ACTION 10.4: JDS UNIPHASE’S $40 BILLION ERROR
JDS Uniphase was doing a booming business in optical gear, but couldn’t increase capacity fast enough to handle the growing demand. So from November 1999 to July 2000, the firm made three acquisitions, financing them with issuance of JDS stock. When demand collapsed in early 2001, it became clear that the firm paid too much for the acquisitions and the company had to write down the value of intangible assets, reducing earnings by $44.8 billion. No “real” money was lost and the write down left the company in a sound financial position. However, shareholders saw the stock price decline from a high of over $150 in March 2000 to under $2 in September 2002.
Teaching Note: This case illustrates yet another drawback to acquisitions, which is that an accurate valuation can be very difficult to achieve, especially when the reasons for the acquisition are not wholly rational, as in this case.
4. Another drawback is that, when firms overpay for the acquisition, the resulting debt can depress company profits.
5. Yet another drawback is that many companies make acquisition decisions without thoroughly analyzing the potential benefits and costs. As a consequence, after the acquisition is complete, many acquiring companies find that they have purchased a troubled organization instead of a well-run business.
D. To avoid the above pitfalls, managers can follow a number of guidelines to reduce the risk of acquisition failure.1. Thorough screening of acquisition targets leads to a more realistic assessment of the costs and
benefits of an acquisition.a. The company should begin with an assessment of the strategic rationale for the
acquisition and identify the types of companies that would make good candidates.b. Next, the company should scan the target population, assessing such items as finances,
management capabilities, and corporate culture.c. Then, favorable targets should be identified and evaluated more thoroughly. This may
involve talking to third parties, as well as performing a detailed audit, if the acquisition is a friendly one.
2. Good bidding strategy help to reduce risk because it can reduce the price of an acquisition.a. Friendly takeovers are more likely to have a favorable price.b. The timing of the acquisition is also important. Essentially sound businesses that are
suffering from short-term or localized problems are usually undervalued.3. Taking positive steps to quickly integrate the acquired business into the company’s
organizational structure is also key to an acquisition’s success.a. Integration should focus on the source of the expected competitive advantages.b. Integration should be accompanied by elimination of any duplication of assets or
functions.4. Acquirers should also take steps to learn from previous experience with acquisitions.
LXIII. Entry Strategy: Joint VenturesA. Joint ventures are used as a diversification mode less frequently than are internal new ventures and
acquisitions.B. Joint venture is an appropriate strategy to use for several reasons.
1. Joint ventures are particularly appealing when a firm wishes to enter an embryonic or emerging market, but hesitates to commit the resources. Joint ventures allow two or more companies to share the risks of a new business.
2. Companies use joint ventures when they possess some of the skills and assets needed by the new business, but not all. They can team up with a firm with complementary skills to increase the probability of success.
C. There are some drawbacks to the use of joint ventures.1. Although a joint venture allows a company to share the risks and costs of developing a new
business, it also means that it must share the profits if the new business is successful.2. By definition, in the case of a joint venture, control must be shared with the venture partner.
This can lead to substantial problems if the two companies have different business philosophies, time horizons, or investment preferences. Conflicts over how to run the joint venture can tear it apart and result in business failure.
3. When a company enters into a joint venture, it always runs the risk of giving away critical know-how to its joint-venture partner.
LXIV. RestructuringA. Restructuring, or strategies for reducing the scope of the company by exiting from business areas, is
the opposite of diversification, which increases scope.B. Restructuring is becoming increasingly popular among firms that diversified in the 1980s and 1990s.C. Restructuring occurs in response to several factors.
1. In recent years, investors have assigned a diversification discount to highly diversified companies, meaning that their stock was undervalued as compared to the stock of less diversified firms.a. Investors are deterred by the complexity and lack of transparency in the financial
statements of highly diversified firms, leading to an increased risk for the investment.b. Investors have learned from experience that many companies overdiversify, or diversify
for the wrong reasons, leading to lower profitability.c. Therefore, companies have restructured in order to split the company and increase returns
to shareholders.2. Restructuring can be a response to failed acquisitions.3. Due to innovations in management processes and strategies, the advantages of being vertically
integrated or diversified have diminished, and so companies are restructuring.D. Companies use a variety of strategies to implement restructuring, that is, to exit a business.
1. Divestment is the best way for a company to recoup as much of its initial investment in a business as possible. The idea is to sell the business unit to the highest bidder. There are three types of buyers.a. Selling a business to independent investors is referred to as a spinoff. A spinoff makes
good sense when the unit to be sold is profitable and the stock market is looking for new stock issues.
b. Selling off a unit to another company is another strategy. The buyer is often a competitor in the same line of business. In such cases, the purchaser may pay a considerable amount of money for the opportunity to substantially increase the size of its business immediately.
c. Selling off a unit to its management is normally referred to as a management buyout (MBO). In an MBO, management finances the purchase through the sale of high-yield bonds to investors. In recent years, the lack of investors interested in high-yield, high-risk bonds (also called junk bonds), has made it difficult to carry out any MBOs.
2. A harvest strategy is implemented when a company ceases investment in a business, but continues to “harvest” profits from it for as long as possible.a. Although this strategy sounds nice in theory, it is often a poor one to pursue in practice
because the morale of the unit’s employees, as well as the confidence of the business’s customers and suppliers in its continuing operation, can all decline rapidly once it becomes apparent that the business is pursuing a harvest strategy.
b. Therefore, the rapid decline in the business’s revenues can make the strategy untenable. This strategy is thus much less desirable than a divestment strategy.
3. A liquidation strategy requires a company to cease operations in that business and sell its assets.
a. A liquidation strategy is the least attractive of all to pursue because the company has to write off its investment in a business unit—often at a considerable cost.
b. Liquidation is much less desirable than either a divestment or a harvest strategy.c. More information about harvest and liquidation strategies is available in Chapter 6, in the
final section that discusses strategies for declining industries.
CHAPTER 11
Corporate Performance, Governance, and Business Ethics
SYNOPSIS OF CHAPTERChapter 11 introduces concepts related to strategy implementation. The first section addresses the causes of poor performance, which occurs in some firms in every industry. Causes of poor performance include poor management, high costs, inadequate differentiation, overexpansion, shifts in demand, and organizational inertia. The chapter then suggests ways that firms can improve poor performance, such as changing leadership, changing strategy, or changing the organization.
The chapter then describes the ways in which various stakeholder groups make contributions to, and receive benefits from, the organization, and how stakeholder support leads to high organizational performance. Managers don’t always act in the best interests of stakeholders, and this chapter uses agency theory to explain this difficulty and to suggest ways to overcome it.
Next, corporate governance is presented, including boards of directors, compensation for principals, independently audited financial statements, the threat of corporate takeover, strategic control systems, and incentive systems. Each of these governance mechanisms is described in detail, and the costs and benefits of each are provided.
The final topic of the chapter is ethics. Business ethics are defined and described. Then, suggestions are given to help improve an organization’s ethical performance.
TEACHING OBJECTIVES1. Introduce concepts about strategy implementation.
2. Describe reasons for poor performance and suggest ways to improve poor performance.
3. Identify important stakeholder groups, show how they contribute to and benefit from the firm, and describe how stakeholders affect corporate profitability.
4. Familiarize students with agency theory, and use it to explain why a misalignment of interests exists at every level of the organization.
5. Present information about various corporate governance mechanisms.
6. Define and describe business ethics, and show how managers can improve a firm’s ethical performance.
OPENING CASE: THE FALL OF ENRONEnron was one of the world’s largest energy traders in 2000; by 2001, it was bankrupt. Enron fell so rapidly because it held $27 billion in hidden debt, with most investors and regulators completely unaware of the firm’s true financial position. The partnerships were set up in compliance with regulations, but they were a way of boosting Enron’s apparent profitability for the enrichment of a few corrupt executives. These top managers reaped millions from the sale of their Enron stock, then abruptly left the firm. It seems clear that a few managers were deliberately misleading investors. And the company’s independent auditor, Arthur Andersen came under
suspicion for its role in the debacle and has also declared bankruptcy. More than one employee attempted to “blow the whistle” on the suspect transactions, but Enron management took no action. The outcome? Thousands of lost jobs, billions of dollars in lost shareholder wealth.
Teaching Note: The Enron case highlights the importance of good strategic control and other corporate governance mechanisms. Enron’s board, its auditors, and its bankers have all been held partially responsible for the mess. However, poor ethics seems to be at the heart of it all. Management was apparently committing deliberate fraud, although a legal outcome for the case may be years away. This is a tale of governance and ethics gone horribly wrong and provides a sobering note for students as they approach the topics in this chapter.
LECTURE OUTLINELXV. Overview
E. This chapter examines the issues and factors that can prevent a company’s strategies from being implemented in a way that will lead to superior profitability, along with strategies for raising performance.
F. Corporate governance and business ethics are two tools that can be used to ensure that managers act in the best interests of stakeholders.
LXVI. The Causes of Poor PerformanceA. Virtually every industry contains some firms, and in some industries, many firms, that are not
profitable—that is, whose returns do not exceed their cost of capital.B. There are six causes of persistent poor performance that are found in many organizations. When
organizations are declining, typically they are experiencing several of these factors simultaneously.1. Poor management is a cause of persistent poor performance, and it covers a variety of problems,
from neglect to outright incompetence.a. Poor managers are too dominant, autocratic, or overly-ambitious.b. Another characteristic of poor managers is trying to do too much by themselves, rather
than delegating appropriately.c. Other characteristics include the lack of a succession plan, failure by the board of
directors, or a lack of strong middle managers.d. Poor managers sometimes execute strategies that are designed to enrich themselves,
rather than the firm’s shareholders.2. Another hallmark of poorly-performing organizations is a high cost structure, which is often
due to low labor or capital productivity.a. Low labor productivity stems from union work restrictions, lack of investments in labor-
saving technology, or lack of employee incentives.b. Low capital productivity is caused by failure to fully use the company’s fixed assets, such
as occurs when a firm has low economies of scale or holds too much inventory.c. Low productivity is usually tied to deeper problems, such as lack of accountability for
financial returns.3. Companies whose products lack adequate differentiation will suffer from low performance.
a. Poor product quality or lack of attractive product attributes contributes to lack of differentiation.
b. Lack of differentiation can usually be traced to deeper problems, such as a failure to implement cross-functional product development teams or failure to implement quality improvement processes.
4. Another contributor to poor performance is overexpansion, which occurs when a company tries to move into too many diversified industries too quickly.a. Overexpansion often results when an autocratic CEO tries an empire-building strategy,
with poorly conceived diversification leading to disappointing results.b. Overexpansion also tends to raise a company’s debt burden rapidly, and that may be
untenable, particularly if economic conditions decline.5. Poor performance arises when industries experience a structural shift, that is, a shift in
demand that is permanent, often brought on by technological, economic, or social changes.a. These shifts revolutionize industry dynamics and threaten existing firms (although they
b. Structural shifts are difficult to predict and the entrance of new competitors creates significant upheaval for existing firms.
6. Organizational inertia also plays a role in poor performance, because it slows the firm’s response to changes and problems.a. The existing distribution of power within a firm causes individual managers to resist
change, leading to organizational inertia.b. Deeply-held values and norms can provide benefits to the firm, but they can also be very
hard to change, contributing to inertia.c. Managers’ preconceptions about their firm’s business model may go unchallenged,
creating an inability to see the need for change, and thus leading to inertia.LXVII. Strategic Change: Improving Performance
A. Most companies that are attempting to improve performance change leadership.1. The old leaders are seen as contributing to the problems, whereas new leaders from outside the
company will bring in fresh perspectives and ideas, overcoming preconceptions.2. The new leaders must be able to make difficult decisions, motivate and listen to others, and
delegate when appropriate.B. Changing strategy is another common tactic to improve performance.
1. Strategy must first be evaluated and redefined, if necessary. For a single-business firm, redefining the strategy means changes in the generic business-level strategy. For diversified firms, it means re-evaluating and balancing the firm’s portfolio of businesses.
2. Next, a firm must divest or liquidate any assets that do not contribute to the new strategy. The resulting cash can be used to improve the remaining operations.
3. Then a firm should focus attention on improving efficiency, quality, innovation, and responsiveness to customers. (This was described in detail in Chapter 4.) This will involve activities such as laying off excess employees, reengineering processes, and introducing total quality management programs.
4. Acquisitions can also be used to improve performance, if the acquired company strengthens the firm’s competitive position in its core operations.
C. Firms can also improve performance through a change in the organization.1. The first step in organizational change is to “unfreeze” the company, that is, to shock the
employees in such a way that they understand and agree with the necessity for change.a. Reorganizations or plant closings are often used as a way to signal the need for change to
employees.b. The commitment of senior managers—as evidenced by both their words and their actions
—facilitates lower-level employees making the change.2. After the organization is shocked into unfreezing, it can be moved into its desired state.
a. Moving the organization requires actions, such as redesigning processes, reorganizing the structure, reassigning responsibilities, new control and reward systems, firing people who refuse to change, and so on.
b. The changes must be substantial, in order to have an important impact on performance, and they must be rapid, to ensure success.
3. Refreezing, or making the new way of doing business the firm’s established practice, follows movement.a. Management education programs, hiring individuals whose values support the new state
of the organization, and implementing consistent control and reward systems are all part of refreezing.
b. Senior leaders must be consistent in their words and actions throughout the entire change and refreezing period. Also, they must be patient because changing an organization’s values and culture takes time.
LXVIII. Stakeholders and Corporate PerformanceA. Stakeholders are individuals or groups with an interest, or stake, in a firm. Internal stakeholders
include stockholders and employees at all levels. External stakeholders are all other groups, and typically include customers, suppliers, creditors, governments at all levels, unions, local communities, and the general public.
B. Stakeholders are in a reciprocal relationship with the firm, providing the organization with resources and expecting some benefit in return.1. Each stakeholder group has a unique relationship with the firm.
a. Stockholders provide funds and expect returns.b. Creditors provide funds and expect repayment and interest.c. Employees provide labor, skills, and ideas, and expect income, job satisfaction and
security, and good working conditions.d. Customers provide sales revenues and expect products that provide value for money.e. Suppliers provide inputs and expect revenues and dependable buyers.f. Governments provide regulation and expect companies to adhere to the rules.g. Unions provide productive employees and expect income and other benefits for their
members.h. Local communities provide local infrastructure and expect companies to behave as
responsible citizens.i. The general public provides national infrastructure and expects the company to improve
their quality of life.2. Companies that neglect to satisfy the needs of one or more important stakeholder groups will
find that the stakeholders withdraw their support, damaging the firm.
STRATEGY IN ACTION 11.1: BILL AGEE AT MORRISON KNUDSEN
Bill Agee was a manager with a troubled history—accounting overstatements made while he was chief financial officer at papermaker Boise Cascade, promoting a female colleague with whom he was having an affair while CEO of defense contractor Bendix. Agee became CEO of construction contractor Morrison Knudson (MK) in 1988, with a plan to update the firm’s assets and to pursue new contracts aggressively. The plan seemed to be working, but trouble signs soon appeared. Aggressive bidding led to low profits on large construction jobs, and most of the firm’s earnings came from risky securities trading. Employees became disgruntled over Agee’s self-promoting style, firing of long-time top managers, and high compensation and perquisites. Finally, an anonymous letter to MK’s board of directors led to a full investigation. When financial mismanagement was revealed, Agee was ousted. Shareholder lawsuits caused MK to make a $63 million settlement, and Agee was required to return some of his severance pay and pension benefits.
Teaching Note: Agee’s tenure at MK was a study in how to offend stakeholders. He was unable to effectively lead employees, and stockholders were displeased with MK’s poor performance, blaming him.
C. A company cannot fully satisfy all of its stakeholders at the same time. To understand stakeholder needs and to develop effective strategies for satisfying those needs, companies use stakeholder impact analysis.1. To begin a stakeholder impact analysis, a company must first identify stakeholder groups, along
with their interests and concerns.2. Next, a company must identify the claims that each stakeholder group is likely to make on the
organization.3. Then, a company must decide the relative importance of each stakeholder group, from the
company’s perspective.4. This process will result in an identification of some critical strategic challenges.5. Based on this process, most firms identify the three most important stakeholder groups as
customers, employees, and stockholders.D. Among stakeholders, stockholders’ position is unique because the stockholders are the legal owners
of the firm as well as the providers of funds. Their unique position leads to an emphasis on satisfying the needs of this key stakeholder group.1. The money provided by stockholders is called risk capital, because the stockholders are
making a risky investment in the firm with no guarantee of returns or even the preservation of their original investment.
2. Because of their willingness to assume risk, managers are obliged to reward stockholders by pursuing strategies that maximize returns to them.
3. When employees become stockholders too, for example through employee stock ownership plans (ESOPs), the importance of maximizing stockholder return grows.
E. Companies can satisfy stakeholder claims by increasing profitability.1. Managers can best serve the interests of stockholders (the most important group of
stakeholders) by increasing profitability.a. Stockholders receive returns as dividends and as appreciation in share value.b. Increasing profitability (that can be measured by ROIC) tends to both increase the funds
available for dividends and to drive up the value of the stock.2. Profitability satisfies the claims of several other stakeholder groups, in addition to stockholders.
a. Higher profits generate more funds for paying high salaries and offering more benefits to employees.
b. Higher profits generate more funds for satisfying debt obligations to creditors.c. Higher profits generate more funds for philanthropic activities, which benefit local
communities and the general public.3. The cause-and-effect relationship between profitability and satisfying stakeholder claims shows
that profitability must be the cause, leading to the ability to satisfy.a. If the relationship works in the opposite direction, where stakeholders must first be
satisfied before the firm can be profitable, the results are overly high costs and no guarantee that the firm can bear those costs.
b. Once a company is profitable, then it can satisfy stakeholders. In return, satisfied stakeholders provide more generously for the firm, which leads to further increases in profitability. Thus the process is a self-reinforcing cycle. See Figure 11.2 for a graphic depiction of the process.
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Figure 11.2: Relationship Between ROIC, Stakeholder Satisfaction, and Stakeholder Support
4. Not all stakeholder groups are satisfied by high profitability.a. Suppliers want to sell to a profitable company, because it will pay for what it receives.
Customers want to buy from a profitable company that will exist long enough to provide customer service and additional sales. However, neither group wants the firm to profit at their expense.
b. Governments expect every company to make profits only within the limits set by law. The general public expects companies to profit in a manner consistent with societal expectations.
c. Every stakeholder group disapproves of the unfettered pursuit of profit, if it leads to unethical or illegal behavior.
STRATEGY IN ACTION 11.2: PRICE FIXING AT SOTHEBY’S AND CHRISTIE’S
Sotheby’s and Christie’s, the two largest fine art auction houses in the world, were earning low commissions in the 1990s, as sellers negotiated simultaneously with both firms for the best rates. Sotheby’s CEO, Dede Brooks, secretly met with CEO Christopher Davidge of Christie’s, to establish together a fixed, nonnegotiable rate structure. This had the effect of illegally fixing prices and reducing competition. The deal was exposed, and the auction houses paid settlements to sellers that totaled $512 million, in addition to federal fines. The conspirators, and the chairmen that were their superiors, lost their jobs and received jail time or probation from federal courts.
Teaching Note: In this case, illegal price fixing led to higher commissions paid by sellers. It also might have contributed to buyers paying higher prices, as sellers tried to recover some of their additional expenses. Finally, it was not in the best interests of shareholders, because the lawsuits and fines led to lower profitability. Use this case to spark classroom discussion by asking students to examine other times when corporations acted to either protect stakeholder interests or hurt their interests by acting unethically or illegally. Examples could include Exxon’s cover-up of the Valdez oil spill, Union Carbide’s Bhopal disaster, or Johnson & Johnson’s exemplary response to
Tylenol tampering. After describing the facts of the situation, ask students to indicate how the corporation’s actions either helped or hurt stakeholders.
LXIX. Agency TheoryA. Agency theory looks at the problems that can arise in a business relationship when one person
delegates decision making authority to another. It offers a way to understand why managers do not always act in the best interests of stakeholders.
B. An agency relationship occurs whenever one person delegates decision-making authority to another. The principal is the person delegating authority, and the agent is the person to whom the authority is delegated.
C. The agency problem is that principals and agents may have different goals, and therefore, that agents may act in ways that are not in the best interests of their principals.1. Agents may do this because of information asymmetry, that is, because the agent almost
always has more information about the resources they are managing than does the principal.2. Thus, it is difficult for the principals to measure the agent’s performance or to hold them
accountable for their performance.3. To some extent, it’s impossible for a principal to know for sure whether the agent is acting in
the principal’s best interests, and so the principal must trust the agent.4. The principals also make efforts to monitor agents, evaluate their performance, and if
necessary, take corrective actions.D. The agency problem exists in corporations, as stockholders (the principals) are the company’s owners,
but they delegate decision-making power to the company’s managers (the agents).1. Managers, like other people, desire status, power, job security, and income. They can use their
decision-making authority and control over corporate funds to satisfy those desires at the expense of stockholders. This is called on-the-job consumption.
2. Boards of directors typically make executive pay decisions, in order to control expenses. However, CEOs can use their influence with the board to get pay increases. The historically high level of CEO pay in the U.S. can be attributed to this cause.a. CEO pay is rapidly increasing and is at the highest level it has ever been.b. CEO pay is rising more rapidly than workers’ pay. In 1980, the average CEO earned 42
times what the average worker did; by 1990, CEO pay was 400 times greater.c. CEO compensation is increasing, including stock options or other forms of indirect
payment. For most CEOs, stock options are a far bigger part of their total compensation than is their base salary.
d. CEO compensation doesn’t seem to be linked to corporate profitability; many CEOs of companies that posted an overall financial loss received large increases in pay for that same period.
3. To increase power, status, and income, a CEO might engage in empire building, that is, buying many new businesses to increase the size of the firm through diversification.a. Empire building, which is diversifying without an appropriate reason for doing so,
reduces profitability, because funds are now used to pay the debt incurred to finance growth.
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Figure 11.3: The Tradeoff Between Profitability and Revenue Growth Rates
b. Too much growth too quickly also leads organizations to pay too much for acquisition targets, further depressing profits.
E. The agency problem also exists in the relationship between higher-level managers and their lower-level subordinates. For example, a subordinate may withhold information to increase his pay or job security or get more than his unit’s fair share of organizational resources.
STRATEGY IN ACTION 11.3: THE AGENCY PROBLEM AND THE COLLAPSE OF BARINGS BANK
Barings Bank of England, a 233-year-old institution with a venerable history, was made bankrupt in 1995 by the actions of just one employee, 27-year-old Nick Leeson, of the firm’s Singapore office. Although young, Leeson was a trusted securities trader. However, his compensation and position within the firm were both based upon the profitability of his trades, encouraging him to take very high risks in exchange for potentially high returns (or
potentially high losses). At first his moves were profitable, but when the Nikkei stock exchange became more volatile, the losses began to mount. Leeson’ reaction was to bet bigger. His colleagues believed Leeson was using funds from a client, but in fact, he had used Barings’ own money to set up a trading account. Lack of controls and monitoring allowed the charade to continue until Barings had no money left. Leeson ultimately served jail time, and several other Barings executives lost their position, but the penniless firm was sold to ING, a Dutch bank, for $1.
Teaching Note: Leeson exploited the information asymmetry that existed between himself and senior managers to pursue his own interests. Ask students to describe other situations that they are aware of, either from business or their own experiences, in which the agency problem was present. Ask them to answer these questions: “What led to the problem?”, “What was the outcome?”, and “How could the situation have been handled differently so as to reduce or eliminate the problem?”
LXX. Governance MechanismsA. Governance mechanisms are put in place by principals to align agents’ incentives with their own,
and to monitor and control agents.B. There are four main types of governance mechanisms.
1. U.S. and U.K. firms tend to rely heavily upon corporate boards of directors, elected by stockholders, to represent the interests of the stockholders.a. Boards of directors are charged with several responsibilities.
(1) Boards of directors are legally responsible for the firm’s actions and act to oversee the actions of the firm’s CEO and top managers.
(2) The board makes decisions about hiring, firing and compensating top corporate executives.
(3) The board ensures that the audited financial statement, which is the primary reporting tool from managers to stockholders, presents a true picture of the organization’s health.
b. Boards of directors are typically composed of a mix of corporate insiders and outsiders. (1) Inside directors are senior employees of the firm and are charged with bringing
information about the company to the board. However, they are employees and their interests tend to be aligned with management.
(2) Outside directors are not full-time corporate employees, and they are charged with bringing objectivity to the board. Full-time professional directors hold positions on several boards and do a good job, because their professional reputations are at stake.
c. Many boards perform admirably, but some, such as that of Enron, do not.(1) One criticism of boards of directors is that insiders often dominate and therefore
can manipulate perceptions.(2) Another criticism of boards is that many are dominated by the CEO, particularly
when the CEO is also chairman of the board. When this occurs, the CEO may choose both the inside and the outside directors, who may feel loyalty to the CEO or allow the CEO to control the agenda.
d. In recent years, boards of directors have been playing a more active role in corporate governance.(1) One reason for the enhanced oversight is the lawsuits that stockholders have filed
against board members. In some cases, board members must pay damages out of their own pocket.
(2) Another rationale for active boards of directors is the increasing number of institutional investors, such as the managers of large pension funds, that are putting their own employees on the boards of firms whose stock they own.
(3) Other trends in increased vigilance include boards calling for CEO removal and an increase in outsiders serving as chairmen.
2. Another governance is stock-based compensation for principals. If agents are working under a pay-for-performance system, then it will be in their best interests to increase profitability.a. The most common pay-for-performance grants stock options to managers, which give
them the right to buy shares at a predetermined price (called the strike price) at some
point in the future. Typically, the strike price is the trading price at the time the option was granted.
b. However, when CEOs exercise their options several years later, their compensation increases dramatically. Some claim that stock options are too generous, especially when the strike price is set deliberately low.
c. Another criticism of stock options is that issuing more shares of stock dilutes the equity of the existing stockholders. Some critics would like options to be shown on financial statements as an expense, but at this time, companies are not required to do so, although some do so voluntarily. Table 11.1 shows the significant impact that this change in accounting policy would have on several firm’s stated earnings.
3. A third governance mechanism is the use of independently audited financial statements.a. Publicly traded companies are required to file with the Securities and Exchange
Commission periodic statements that comply with Generally Accepted Accounting Principles (GAAP).
b. To ensure that the statements are consistent, detailed, and accurate, companies must employ independent auditors to evaluate each statement.
c. However, although most companies file accurate statements and most auditors do a careful job reviewing that information, a minority of companies have abused the system, in some cases aided by their auditors.
STRATEGY IN ACTION 11.4: DID COMPUTER ASSOCIATES INFLATE REVENUES TO ENRICH MANAGERS?
The share price of Computer Associates’ stock rose during the 1990s, as revenues increased. Three of the company’s top executives were looking forward to bonus compensation of over $1 billion total, if the stock price remained high over 60 days. COO Sanjay Kumar announced high earnings, the stock rose above the trigger price and remained there, and they received their bonuses. Less than one month after the bonus was awarded, Kumar announced that earnings would fall substantially. CEO Charles Wang resigned, and Kumar took on the position, but federal regulators investigated the firm. They found evidence to support their contention that the firm’s executives deliberately overstated earnings in order to achieve the bonus, and that they did so with the help of their auditors, KPMG and Ernst & Young. Stockholders claim that the value of their shares was reduced; the case is ongoing.
Teaching Note: This case illustrates the hazards of inadequate or inappropriate controls, both in pay-for-performance and in reliance upon auditors’ oversight. As in the Strategy in Action 11.3 about Barings Bank, managers were encouraged by the structure of their compensation to commit acts that increased their pay, rather than acts that would further the firm’s long-term interests. Also, independent auditors failed to discover or report, or perhaps even conspired in, unethical financial reporting. For classroom discussion purposes, ask students to comment on the following statement: “A white-collar crime, such as banking fraud or ‘cooking the books,’ isn’t a serious crime because it doesn’t really hurt anyone.”
(1) One problem is that GAAP guidelines are loose enough that they can be manipulated by unethical managers.
(2) It also appears that sometimes auditors face a conflict of interest in auditing the books of companies that also have lucrative consulting contracts. Thus, the accountants may be reluctant to blow the whistle and risk losing a client.
(3) Boards of directors are supposed to be the ultimate overseers of financial statements, and apparently they are not always careful enough. Too many inside directors adds to this concern.
(4) In 2002, new legislation was passed, in response to Enron and other accounting-driven debacles. The law solved some problems but not all. In addition the true problem may not be too few laws, but too little enforcement of existing laws.
4. Yet another corporate governance mechanism is the threat of a hostile takeover. This could happen if many stockholders decide to sell the stock, causing the value of the shares to decline below the book value of its assets. An acquirer could then purchase the firm, sell the assets, and profit. This threat is called the takeover constraint.
a. In the 1980s and early 1990s, hostile takeovers were executed by corporate raiders for that very reason. Raiders are individuals or corporations that buy up large blocks of shares in companies that they think are pursuing strategies that do not maximize wealth.
b. Corporate raiders plan to take over and run the company themselves or to replace the top management team with better strategists.
c. If raiders succeed in their takeover bid, the new strategies they institute can create millions of dollars of wealth for shareholders, including the raiders themselves.
d. Even if the raiders do not succeed in the takeover, the defending company will often buy back their shares just to be rid of them, paying a premium price. This practice is called greenmail.
e. The takeover constraint has not been invoked as frequently in the late 1990s and 2000s, because of changed circumstances, such as the heavy debt acquired by many firms in recent years, which makes firms less attractive as takeover targets. But takeovers tend to run in cycles, and it’s likely another cycle will come around someday.
f. The takeover constraint is the last resort, used only when all other forms of corporate governance have failed.
5. When agency relationships exist within a company, such as between supervisor and subordinate, strategic control mechanisms better align the interests of top managers and employees.a. Strategic control mechanisms are the primary mechanism of internal governance. These
systems consist of the formal goal setting, measurement, and feedback systems that allow managers to evaluate the effectiveness of their firm’s strategy.
b. The process requires top managers to establish standards, create a system for periodic measurement, compare actual performance to the standards, and evaluate results.
c. These steps ensure that lower-level managers, as the agent of top managers, are acting in the best interests of top managers.
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Figure 11.4: A Balanced Scorecard Approach
d. The balanced scorecard approach to strategic control asks top managers to evaluate performance on efficiency, quality, innovation, and responsiveness to customers, in addition to the financial information used in traditional strategic control systems. The additional information focuses on future performance, whereas financial information relates to decisions and actions that were taken in the past.(1) Measures of efficiency include production costs, raw materials costs, and number
of labor hours needed to make a product.(2) Measures of quality include the reject rate, the rate of returns of defective items
from customers, and the product reliability over time.(3) Measures of innovation include the number of new products introduced, the time
taken to develop a product, and the revenues generated from new products.(4) Measures of responsiveness to customers include the number of repeat customers,
on-time delivery rates, and level of customer service.e. Reliance on several different types of measures, rather than just financial measures,
makes the balanced scorecard approach more accurate and useful to managers.6. Another mechanism for aligning the interests of lower-level managers with that of top managers
involves the use of employee incentives to motivate employees to work towards goals focused on maximizing profitability.a. Employee stock ownership plans and stock option grants can be effective tools, especially
if employees at lower levels of the organization are included.b. Another approach is to tie employee compensation to the attainment of strategic goals, as
is commonly done with bonus pay.LXXI. Ethics and Strategy
A. Ethics is another important consideration as managers make and implement strategic decisions. An ethical decision is one that reasonable stakeholders would find acceptable because it aids
stakeholders, the organization, or society. An unethical decision is a decision that managers would prefer to disguise because it helps the company or an individual gain at the expense of society or other stakeholders.
B. The purpose of business ethics is to give people tools for dealing with moral complexity. It does not help people distinguish right from wrong. Most people know the difference between right and wrong, and they act on that information in their private lives, but fail to do so in their professional lives.
C. Business ethics emphasizes two points. First, that business decisions have an ethical component, and second, that managers must consider the ethical implications of strategic decision before choosing a course of action.
D. An important first step is for companies to establish an organizational climate that emphasizes the importance of ethics.1. Top managers must use their leadership position to incorporate an ethical dimension into the
values they stress.2. Ethical values must be incorporated into the company’s mission statement.3. Ethical values must be acted on, and should affect hiring, firing, and incentive systems to
reward adherence to ethical values.E. Another important action is to give managers a clear, consistent, systematic way to think about ethical
issues.1. The various ways to answer the question “What is ethical?” can be understood through the use
of three models: the utilitarian, moral rights, and justice models. The principles of each are summarized in Table 11.2.a. The utilitarian perspective asserts that an ethical decision is one that does the most good
for the most people.b. The moral rights perspective asserts that an ethical decision is one that does not violate
the rights of any stakeholders.c. The justice perspective asserts that an ethical decision is one that distributes benefits and
harms across stakeholder groups in a fair or impartial way.2. Another way to decide whether a decision or behavior is ethical is to examine the three
questions below. If one can answer yes to all three, then the decision or behavior is probably acceptable.a. “Does my decision fall within the accepted values or standards that typically apply in the
organizational environment?”b. “Am I willing to see the decision communicated to all stakeholders affected by it—for
example, by having it reported in newspapers or on television?”c. “Would the people with whom I have a significant personal relationship, such as family
members, friends, or even managers in other organizations, approve of the decision?”3. Yet another approach is to work through a four-step process.
a. First, managers should identify which stakeholders are affected by the decision and in what ways, paying close attention to the possibility of violating stakeholders’ rights.
b. Then the manager should judge the ethics of the proposed strategic decision using moral principles.
c. Next, the firm must establish moral intent, that is, must resolve to place moral concerns ahead of any other concerns if stakeholders’ rights or moral principles have been violated.
d. The final step is to implement the ethical decision or action.
CHAPTER 12
Implementing Strategy in Companies That Compete in a Single Industry
SYNOPSIS OF CHAPTERChapter 12 examines how managers can best implement their strategies in single-industry firms in order to achieve a competitive advantage and superior performance. First, the main elements of strategy implementation—structure, control systems, and culture—are analyzed in detail, focusing on the way they work together to create an organizing framework.
Then the chapter turns to the topic of using structure, control, and culture at the functional level to build distinctive competencies. After that, the chapter addresses the challenges of implementing the generic business strategies of cost leadership or differentiation in a single industry.
The final section covers restructuring and reengineering, two strategies that single-business firms can use to improve corporate performance.
The next chapter takes up where this one leaves off and examines strategy implementation across industries and across countries—that is, implementing corporate and global strategy in firms that compete in more than one industry.
TEACHING OBJECTIVES1. Introduce the main elements of strategy implementation—structure, control systems, and culture—and their
relationships to each other.
2. Demonstrate how structure, control, and culture can build distinctive competencies at the functional level.
3. Describe the use of structure, control, and culture in implementing a single-business firm’s generic business strategy.
4. Discuss the use of restructuring and reengineering in improving the performance of a single-business firm.
OPENING CASE: STRATEGY IMPLEMENTATION AT DELL COMPUTERDell Computer grew rapidly from its founding as one-person, dorm-room operation in 1984. As the company has grown, Dell’s structure, control systems, and culture has changed to keep the firm on track to reaching its strategic goals. Michael Dell hired managers with computer industry experience from firms such as IBM and Compaq. Together, they formed a functional structure with a taller hierarchy, in which Michael Dell delegated authority to his functional managers. Dell’s organizational culture emphasized hard work and customer service, leading to high profits and satisfied buyers. However, as Dell continued to grow, its functional structure could not support higher levels of coordination and specialization. So Dell moved to a customer structure, with divisions focused on the unique needs of each customer segment. As Dell grew even more, it developed even more specialized teams for different segments, and it increasingly turned to the Internet for coordination, allowing the firm to decentralize and become flatter.
Teaching Note: Dell has been forced to change its structure, control systems, and strategy several times as it has grown and the industry has matured. This situation is one that has been played out, over and over again, in many different companies. You can give other examples to students, such as the way in which GM moved to a divisional structure after acquiring competitors such as Cadillac, Pontiac, and Buick. Another discussion point is the interrelatedness of structure, control systems, and culture, which is shown in Dell’s centralization and subsequent decentralization, its taller then flatter structure, and so on.
LECTURE OUTLINELXXII. Overview
A. A well thought-out strategy can lead to success only if it is properly implemented, thus the study of implementation is critical to an understanding of strategy.
B. This chapter introduces concepts related to implementation, with a focus on functional- and business-level strategy implementation. Strategy implementation refers to the ways a firm creates, uses, and combines organizational structure, control systems, and culture to pursue strategies that lead to a competitive advantage and superior performance.
LXXIII. Implementing Strategy Through Organizational Structure, Control, and CultureA. The first component of strategy implementation is organizational structure, which assigns
employees to specific tasks and specifies how those tasks link together to realize a competitive advantage. The purpose of organizational structure is to coordinate and integrate the efforts of all employees at the corporate, business, and functional levels, and across functions and business units, so that they work together to help the firm achieve its strategies successfully.
B. Another component of implementation is a strategic control system, which provides the incentives that motivate employees to help the firm achieve its strategies. Control systems also provide performance feedback to managers so that corrective action can be taken if needed.
C. Organizational culture is another important component of strategy implementation, and it consists of the values, norms, beliefs, and attitudes that are shared by people in an organization. Culture guides the way that employees interact with each other and with stakeholders outside the organization, and thus will have an important impact on the implementation of an organization’s strategies.
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Figure 12.1: Implementing Strategy
LXXIV. Building Blocks of Organizational StructureA. One issue that managers must address as they design an organizational structure that will aid in
accomplishing the firm’s strategic goals is the grouping of items. Tasks must be grouped into functions and functions grouped into divisions or businesses.
B. The tasks an organization must perform are based on its strategy, and therefore an organization’s structure tends to match its strategy.
C. Tasks must be grouped into functions, which are a collection of people who work together and perform the same types of work or hold similar positions. Functions are designed to minimize bureaucratic costs—the costs of operating an organizational structure. Functions then are grouped into divisions.
D. One important characteristic of organizational structure is the way in which it allocates authority and responsibility.1. The hierarchy of authority refers to the organization’s chain of command, extending from the
CEO down to the lowest-level employees.2. Every manager at every level supervises some number of employees, which is called the span
of control.3. Managers decide how many levels to have in the organizational chain of command.
Organizations with many levels are called “tall,” because of the long and vertical appearance of their organization charts. Organizations with few levels are called “flat.”
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Figure 12.2: Tall and Flat Structures
4. As companies grow taller, problems may arise.a. Communication problems are prevalent in tall organizations, because the long delays that
occur as messages move up and down numerous levels can lead to confusion.b. Another reason for communication problems is that the large number of levels leads to
differing perceptions of the meaning of the messages.c. Another problem is that a tall organization has more managers, and managers are very
expensive.5. To avoid these problems, managers should follow the principle of the minimum chain of
command, that is, they should use the minimum number of hierarchical levels required for implementing a strategy successfully. Too many levels in the hierarchy cause a variety of problems.
6. Decentralization of decision-making authority is one tactic for overcoming the disadvantages associated with a tall organizational structure. Decentralization delegates authority to lower-level employees.
a. Decentralization reduces information overload because managers spend time making only those decisions that must be made at their organizational level.
b. Decentralization gives lower level employees autonomy, increasing flexibility, motivation, and accountability.
c. Decentralization reduces the need for expensive, high-level managers, because lower level employees can make their own decisions with little supervision.
STRATEGY IN ACTION 12.1: UNION PACIFIC DECENTRALIZES TO INCREASE CUSTOMER RESPONSIVENESS
Union Pacific used a very centralized organizational structure in an effort to reduce costs. However, the central scheduling and planning led to long delays, missed freight, and irate customers. The company changed to a decentralized structure in which managers have the authority to make operational decisions, leading to increased responsiveness to customers.
Teaching Note: This case shows some of the difficulties organizations experience as they attempt to find the optimal level of centralization/decentralization. You can point out to students that both centralization and decentralization have disadvantages, and that companies must continually strike the right balance somewhere between the two. For class discussion, you can ask students whether they would prefer to work in a highly centralized or a highly decentralized company. This discussion should highlight for students the advantages and disadvantages of both.
7. On the other hand, centralization also offers some advantages. Therefore, organizations must balance the advantages and disadvantages of differing levels of centralization as they design their organizational structure.a. Centralization implies a coordinated strategy and quicker decision making when needed.b. Centralization ensures that decisions reflect the organization’s overall strategy.c. Centralization fosters strong leadership because authority is centered on one person or
group.E. In large, complex organizations, coordination through the hierarchy of command isn’t enough, and
organizations turn to other integrating mechanisms. Companies can choose from various integrating mechanisms to increase coordination and communication. These mechanisms fall on a continuum from single to complex. In general, the more complex the organization, the more need for complex forms of integration.1. Direct contact is a simple integrating mechanism that asks managers in different functions to
work together to solve mutual problems. However, when managers in different functions disagree, it is hard to achieve coordination because they all have equal authority.
2. When the volume of contacts between two departments increases, one person in each department is given the responsibility of coordinating activities between the two. This is called interdepartmental liaison roles. They meet to solve problems and then feed the outcomes of their discussion back to their respective departments.
3. When two or more functions share many common, on-going problems, a permanent integrating mechanism is needed, such as a team. A team consists of members who are managers of the various functions, and they meet to make decisions jointly.
LXXV. Strategic Control SystemsA. After managers establish an organization’s strategy and structure, then they turn their attention to
ensuring that the strategy and structure are, in fact, achieving the desired results. Strategic control systems provide the means by which a company monitors, evaluates, and changes the performance of its various functions and divisions.
B. Strategic control is not just about current performance; it also means keeping an organization on track and future focused.
C. Strategic control is important because it helps managers achieve superior efficiency, quality, innovation, and responsiveness to customers.
D. Strategic control systems consist of target-setting, monitoring, and feedback mechanisms; and the process contains four steps.
Figure 12.3: Steps in Designing an Effective Control System
1. Step 1 is to establish the standards against which performance is to be evaluated. Standards express the way the company chooses to evaluate its performance; they are generally derived from its strategy.
2. Step 2 requires managers to create the measuring and monitoring systems that indicate whether or not the targets are being achieved. This can be a complex task because many activities are difficult to evaluate.
3. In Step 3, managers compare actual performance against the established targets. If performance is lower than expected, it is often difficult to explain why.
4. Step 4 is about initiating corrective action when it is decided that the standards and targets are not being achieved. Appropriate corrections depend upon an appropriate diagnosis.
E. Control systems are used to measure performance at all levels in the organization—corporate, divisional, functional, and individual levels. Care must be taken to ensure that the controls used at different levels are compatible.
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Figure 12.4: Levels of Organizational Control
F. There are several types of strategic controls.1. One type is the balanced scorecard approach, which was discussed in Chapter 11.2. Another type of control is personal control, in which superiors or peers interact face-to-face
with an employee, influencing the employee’s behavior.3. A third type of control is output control, which is used when a company forecasts performance
goals and then monitors goal achievement. Output control is used at all levels of the organization.a. At the divisional level, challenging goals are set for efficiency, quality, innovation, and
responsiveness to customers.b. At the functional level, goals are set for functional managers to develop skills leading to
competitive advantage in support of divisional goals.c. Employees are given individual goals that support the achievement of divisional and
functional goals.d. Output controls must be used carefully, because they can encourage conflict between
units, as well as provide an incentive for dishonesty.4. A fourth type of control is behavior control, which establishes rules and procedures to guide
individual action. Rules specify how things are to be done and thus standardize behavior so that the result is predictable.a. Operating budgets are one type of behavior control. They specify the amount of
resources available to achieve goals. Managers decide how to allocate the funds across the various activities. Performance is then measured by looking at profits relative to resources.
b. Standardization is also a very important means of behavior control.(1) Inputs can be standardized by screening them so that only high-quality inputs enter
the company.(2) Conversion activities are standardized so that tasks are done in the same way time
and time again. This improves predictability.(3) Organizational outputs are standardized by specifying performance characteristics
of the final product. Only goods and services that meet these criteria are allowed to leave the organization.
c. Managers must periodically review behavior controls to ensure they are still effective. Companies tend to accumulate rules over time, reducing flexibility and ultimately reducing effectiveness.
G. Information technology (IT) is playing an increasing role in strategy implementation at many firms.1. IT’s ability to provide better and faster information aids managers as they use control systems.2. IT can provide standardization, which can be used to control behavior or to perform output
control.3. IT is an integration mechanism, because of information sharing.
STRATEGY IN ACTION 12.2: CONTROL AT CYPRESS SEMICONDUCTOR
Cypress CEO T. J. Rodgers wanted to maintain a flat and decentralized organizational structure with a minimum of management layers in order to increase flexibility in the rapidly changing semiconductor industry. At the same time, he needed to control his employees to ensure that they perform in a manner that is consistent with the goals of the company. Rodgers implemented a computer-based information system through which he can manage every employee’s progress towards meeting his/her goals. Rodgers claims that he can review the goals of all 1,500 employees in about four hours, and he does so each week.
Teaching Note: This case shows how IT can be used to give better information to managers, and thus can aid in establishing effective control systems. Share with students additional examples of IT used as a control mechanism, or ask students to share other examples with which they are familiar. Examples might include: software houses monitoring employees’ code production, computerized timekeeping systems such as are used by delivery or law firms, and so on.
H. Linking reward systems to control systems facilitates control.1. Managers must decide what behaviors to reward and then link one of the control systems to the
reward system.2. The design of the organization’s incentive system is crucial because it motivates and reinforces
desired behaviors. It helps overcome the agency problem and align the interests of shareholders, managers, and employees at other levels in the organization.
3. Typically, companies use some combination of base pay, bonuses, and stock options.LXXVI. Organizational Culture
A. Another factor in successful strategy implementation is organizational culture, the values and norms shared by people and groups in an organization. Organizational values are beliefs about what kinds of goals members of an organization should pursue and about the appropriate standards of behavior organizational members should use.
B. Based on their values, organizations develop organizational norms, that is, expectations that prescribe appropriate behavior.
C. Managers use organizational culture as a strategic control when they develop and nurture values that support employees in achieving the organization’s objectives. Because different organizations have different goals, they also have different cultures.
D. Employees learn organizational culture through a process called socialization. 1. Culture is transmitted to organizational members through the stories, myths, and language
people use in an organizational setting.2. Once an employee is socialized into an organization’s culture, they will behave appropriately
without much conscious thought. Thus, culture is a very powerful form of control.E. The values of an organization’s culture are strongly influenced by the values of its founder and top
managers. People are often attracted to a company because they share its founder’s values, and many organizations select only such people for employment. Hence the cultures of different organizations tend to become more distinct and different over time.
STRATEGY IN ACTION 12.3: HOW RAY KROC ESTABLISHED MCDONALD’S CULTURE
In the fast food industry, quality control and standardization are very important. But as McDonald’s grew, founder Ray Kroc made extensive use of output control and behavior control to standardize both outputs and employee behaviors at the firm’s thousands of franchises. He established a comprehensive system of rules and procedures, and then trained managers in their use. Kroc used the franchising system itself as a form of control because, when the managers are the owners, the agency problems are solved, and they are more motivated to control quality. In
addition, McDonald’s values are taught to employees and norms are strictly enforced by supervisors. McDonald’s includes even customers in its culture by offering family-friendly products and services.
Teaching Note: This case explains how McDonald’s culture is taught to workers and managers, how it was influenced by the founder’s values, and how it has become part of American culture, so that virtually every customer could explain the McDonald’s values. For classroom discussion, ask about ways in which McDonald’s transmits its culture, in addition to the ways mentioned in the case. Ask students: “How does the restaurant design reflect the culture? the uniforms? the prices? the products themselves?”
F. Organizational structure also affects organizational culture. The way an organization designs its structure affects the cultural norms and values that develop within the organization.
G. Adaptive cultures are those that are innovative and encourage initiative-taking by middle- and lower-level managers. Inert cultures are those that are more cautious and conservative, and do not value initiative and innovation as highly.1. Organizations with adaptive cultures adapt more readily to environmental changes.2. Adaptive cultures share several traits.
a. Adaptive cultures have a bias toward action, which emphasizes autonomy and entrepreneurship and encourages people to take risks and adopt a hands-on approach.
b. Adaptive cultures promote the organization’s mission and protect the source of its competitive advantage. Companies should stick to what they do best and stay close to their customers. This is called “stick to the knitting.”
c. Adaptive cultures help organizations improve the way they operate. They help to motivate employees, increase coordination and integration, and reward employees for good performance.
LXXVII. Building Distinctive Competencies at the Functional LevelA. There are three important components of implementing strategy at the functional level.
1. Organizational structure is an important component of implementing strategy at the functional level.a. As the organization grows, the range of value chain activities to be performed expands. It
becomes clear that each person can only effectively perform one value chain activity.b. A functional organizational structure groups people together if they perform similar
tasks or if they use the same skills or equipment.
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Figure 12.5: Functional Structure
c. The functional structure has several advantages for organizational structure.(1) When people who perform similar tasks are grouped together, they can learn from
one another and become more expert and specialized.(2) They can also monitor one another and prevent shirking by other team members.(3) Because there are many different functional hierarchies (one in production, one in
finance, and so on), there is more control in the structure.2. Strategic control has an important role in managing an organization with a functional structure.
a. Strategic control helps managers to set ambitious goals and then encourages employees to meet those goals.
b. Strategic control enables organizational learning, as employees and their superiors work closely together.
c. Output control is easy with a functional structure because each function can clearly see its contribution to the performance of the organization.
d. Strategic control facilitates implementation of a fair, objective system of rewards.3. Functional structures make it easy to build a cohesive culture, which also supports effective
control.
STRATEGY IN ACTION 12.4: GATEWAY’S NEW RULES BACKFIRE
Gateway, the personal computer maker, began to experience increasing customer dissatisfaction and falling sales in 2001. The problem was traced to a new set of policies for the firm’s customer service personnel, in an effort to reduce after-sales service expenses. One problematic rule stated that, if the customer installed any software in addition to what was on the machine at the time of sale, the warranty would be invalidated. The other problem area was a new policy that rewarded customer service representatives more the less time they spent on each call. The result of these two changes were that customers often had very unsatisfying service, and the reps felt that they now could not deliver the excellent service that Gateway’s culture encouraged. Managers abolished the rules, but it may have been too late. Today, Gateway is struggling to hold onto a market share that is less than 10 percent, compared to industry leader Dell with more than 25 percent.
Teaching Note: This case illustrates the problems that may arise as a result of inappropriate control systems. Although the idea behind the policies—to reduce service costs—was sound, the implementation was catastrophic. Use this case as an example of how just one strategic mistake may have enduring, disastrous consequences. Give other examples in class, or ask students if they know of any other examples. For example, the near-disaster that resulted when Coca-Cola switched to New Coke, or the pay-for-speed policy that led Domino’s (pizza delivery) into several lawsuits related to fatal car crashes.
B. Even large companies usually retain some elements of a functional structure because of its benefits, but a functional structure does entail some bureaucratic costs.1. Functions can become increasingly remote from one another because they each develop a
unique perspective over time, leading to communication problems.2. As the number of its products grows, a company struggles to measure the contribution of one
product to overall profitability.3. Growth in products also causes interaction with more varied types of customers. Firms have a
difficult time coping with the expanded product range that results.4. A functional structure is too centralized for controlling production or sales in many different
regions, because managers cannot be sensitive to the needs of their diverse customers.5. Finally, as managers spend more and more time and resources coping with the above problems,
long-term strategic considerations may be ignored.C. If a firm is growing too complex to use an exclusively functional structure, one way that the firm may
respond is to switch to the use of outsourcing in one or more functions.1. A firm should not outsource in an area in which it has an important distinctive competency.2. However, use of outsourcing can free up managerial and other resources to focus on the truly
important functions.LXXVIII. Implementing Strategy in a Single Industry
A. To pursue its business-level strategy successfully, managers must find the right combination of structure, control, and culture that links and combines the competencies in a company’s value chain functions.
B. Effective strategy implementation allows the company to be more successful in pursuing a cost leader or differentiation strategy.
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Figure 12.6: How Organizational Design Increases Profitability
C. Strategy implementation aids firms in pursuing a cost leader strategy, because it can help them reduce expenses in all functions through improved coordination and control.1. Managers must choose the combination of structure, control, and culture that will lead to the
lowest costs.2. Managers must continuously monitor their structure, control, and culture to ensure that costs are
continuously driven down.D. Strategy implementation aids firms that are pursuing a differentiation strategy, because it helps the
company to add value and uniqueness to its products.1. A differentiation strategy requires a broad product line, leading to high bureaucratic costs. Thus
an effective coordination mechanism is especially important.2. To successfully pursue a differentiation strategy, a company’s functions must work
cooperatively together. Behavior controls and culture are more effective than output controls in
a cooperative situation, because it’s hard to measure the relative contribution of different groups when they are cooperating.
3. Thus, differentiators tend to have a very different culture than cost leaders. Differentiators tend to have a collegial or professional culture, based on expertise and cooperation.
E. As companies try to both increase differentiation and reduce costs simultaneously, strategy implementation becomes much more complex. This leads to new forms of structure and control systems.1. To cope with the complexity of producing many products for many market segments,
companies can adopt a product structure.a. To implement a product structure, a company must first group its products into categories
targeted at specific groups of customers and managed by one set of managers.b. Support activities from the value chain are centralized to keep costs low. However, sub-
groups within each function specialize in meeting the needs of a particular product group.c. The organization then develops a control system that examines each product group
separately. This creates an ability to rapidly spot problem areas, and also a way to give rewards for high performance.
d. However, rewards still are closely tied to organizational, and not group, performance, to ensure that managers work together across units as needed.
STRATEGY IN ACTION 12.5: KODAK’S PRODUCT STRUCTURE
In the 1970s, Kodak, the leading maker of photographic film in the world, began to face intensifying competitive pressure from cost leaders such as Fuji. CEO Daniel Carp wanted to bring about new and improved products at a relatively low cost, and he decided that a product structure would best support that strategy. The new strategy organizes on product lines, such as digital imaging or health care applications. Product managers are responsible for cost cutting within groups, and they share centralized support functions. The new structure encourages cost reduction, but it also facilitates sharing of knowledge throughout the organization.
Teaching Note: Kodak provides an exemplary case for studying the implementation of a product structure. The chosen structure is appropriate for the firm’s strategy, and the implementation has been very effective. For classroom discussion, have students offer example of other firms that might benefit from the use of a product structure. Ask them, “What do these firms have in common?”
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Kodak’s Product Structure
2. Companies that are focused on meeting the needs of many different groups of customers can use the market structure.
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Figure 12.7: Market Structure
a. To group people into units based on the customers they serve, it is first important to clearly understand the needs of each customer group.
b. Employees then become close to each customer segment, while support functions are centralized.
3. Geographic structures are appropriate for firms that are attempting to expand their geographic reach.
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Figure 12.8: Geographic Structure
a. Geographic regions become the basis for grouping organizational activities.
b. Activities at the level of the region are controlled by regional managers, but there is still control by top managers at the center, as well as centralized support from the specialist functions.
4. Companies competing in a fast-changing, high-tech environment can use either the matrix or the product-team structure.a. Fast-paced environments make the costs associated with lack of communication and
coordination even greater.b. Often the firm must organize around the needs of the R&D function. However, managers
must work to ensure that the new high-tech products meet customer needs and are affordable.
c. A structure that addresses these concerns is the matrix structure, in which value chain activities are grouped in two different ways at the same time.
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Figure 12.9: Matrix Structure
(1) Activities are grouped by function, to obtain the advantages of a functional structure.
(2) Activities are also grouped by product, to obtain those advantages. This results in a complex design of reporting relationships.
(3) The matrix structure is very flat because above the functional bosses and the project bosses there is only the CEO. Mid- and lower-level managers and employees report to two bosses—both the functional boss and the project boss. The bosses are responsible for maintaining coordination between the functions and projects.
(4) A matrix structure has the advantage of strong cross-functional integration, which improves the organization’s speed and flexibility in dealing with change.
(5) In the matrix structure, hierarchical control is minimal, and employees are expected to coordinate their own activities to get the work done.
(6) Matrix structures also allow team members to join and then leave to join other teams, as their skills are needed.
(7) Well-thought-out matrix structures can free managers from spending lots of time on operating matters, as employees and teams are self-directed to a great extent.
(8) An effective implementation of the matrix structure requires a culture based on innovation and quality.
(9) A disadvantage of the matrix structure is the time and effort that it spent just formulating the teams and getting them started on their tasks.
(10) Another disadvantage is the conflict that can occur between the two bosses—the project manager and the functional manager—due to different goals. The former seek cost reduction; the latter seek improved quality.
(11) Another disadvantage is the difficulty in monitoring ever-changing teams in which each worker is reporting to two bosses.
d. Companies may also use the product-team structure in high-tech environments.
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Figure 12.10: Product-Team Structure
(1) The product-team structure is very similar to the matrix structure, except that the teams are permanent, rather than the temporary teams of the matrix design.
(2) Product teams are formed at the beginning of the process, so that every function is involved in a project from the start.
(3) Product teams also have decentralized authority and are ultimately responsible for new product development.
(4) Product teams differ from the product structure, because support functions are not centralized, but are distributed to each team.
(5) The costs of coordinating the teams’ activities are lower in a product team than in a matrix structure, but a company still obtains the gains from close cooperation across functional boundaries.
F. Companies that compete with a focus strategy often use a functional structure, which both increases differentiation and reduces costs.1. Focusers tend to be smaller firms, and therefore the functional structure may be sufficient for
their integration and coordination needs.2. A functional structure is also very flexible, which is important to focusers, who must adapt to
customer’s constantly-changing requirements.
STRATEGY IN ACTION 12.6: RESTRUCTURING AT LEXMARK
Lexmark, a printer and typewriter manufacturer, was formed when IBM sold an underperforming business unit. CEO Marvin Mann had the task of turning the company around. He changed the firm’s tall, centralized, multidivisional structure—inherited from IBM—to a flatter, decentralized, product-team structure. He also reduced the variety in the product line, created four product groups with cross-functional teams to develop and manufacture new products, and advocated benchmarking and a stock ownership incentive plan. Lexmark’s new structure has been very successful.
Teaching Note: Lexmark’s case illustrates the benefits of the product-team structure and a reduced product line. In a class discussion, ask students to suggest specific ways that Mann could have implemented this strategy, in addition to those mentioned in the case. For example, he must have provided training for managers in the effective use of teams, and so on.
LXXIX. Restructuring and ReengineeringA. To improve corporate performance, a single-business firm can use restructuring and reengineering.B. Restructuring involves reducing the number of levels in the organizational hierarchy (flattening the
organization) and downsizing the workforce. These measures are implemented to reduce costs.1. There are valid reasons for restructuring, however, many times restructuring occurs because
firms have not made incremental changes as they were needed, and so a radical readjustment is called for.
C. Another way to improve corporate performance is through the use of reengineering, which is a radical rethinking and redesign of a firm’s business processes. Note that reengineering focuses on processes, not on functions.1. A business process is any activity that is vital to competitive advantage and involves several
functions simultaneously.2. Firms that are reengineering ignore their traditional tasks, functions, groupings, and so on.
Instead, they look at what they do from a customer’s point of view, and attempt to maximize the value the customer receives from the organization.
3. Reengineering is compatible with, and complementary to, TQM. Firms often use both together to first redesign processes and then to further refine the processes and improve quality.
4. Advances in information technology that have led to more and better quality information help firms reengineer.
CHAPTER 13
Implementing Strategy in Companies That Compete Across Industries and Countries
SYNOPSIS OF CHAPTERChapter 13 is the second chapter to address the topic of strategy implementation. In this chapter, the focus is on firms that compete in more than one industry and/or more than one country. The first section describes the multidivisional structure, emphasizing its advantages and disadvantages.
Next, the chapter describes four global strategies and describes how firms choose the correct strategy. This part of the chapter then details the relationship between global strategy and organizational structure.
The chapter goes on to discuss entry modes for firms wishing to enter new industries, including internal new venturing, joint venturing, and mergers and acquisitions. This section contains a detailed description of actions that firms can effectively use for each of these entry modes.
The final section relates the impact that information technology (IT) has had on strategy implementation, such as the increase in quality and quantity of information that can facilitate decision making. This section also mentions the ways in which IT has impacted firms, through enabling creation of a virtual organization and outsourcing.
TEACHING OBJECTIVES1. Introduce the multidivisional structure, and its costs and benefits.
2. Describe the four global strategies and describe how firms choose the correct global strategy.
3. Define the relationship between global strategy and organizational structure.
4. Describe three entry modes for firms wishing to enter a new industry, and show how those entry modes can be implemented effectively.
5. Explain the impact that information technology has had on strategy implementation.
OPENING CASE: THE “NEW HP” GETS UP TO SPEEDThe “new” HP was created in May 2002 with the merger of Hewlett Packard and Compaq. The new firm must find a way to effectively compete against other multibusiness computer providers, such as IBM. The firm also must address competition with PC industry leader Dell. To do that, the combined firm has been organized into four product-related divisions: Hardware, Software, Services, and Printing. Responsibility is split between CEO Carly Fiorina who is in overall leadership, and President Michael Capellas, former Compaq CEO, who takes over in global business, sales, supply chain management, and e-commerce.
Capellas will focus on improvements in areas where both HP and Compaq had been weak. Both firms had abandoned their matrix structure, due to slow decision making and lack of attention to organizationwide goals. Both HP and Compaq had previously been slow to adopt an Internet-based operation, and therefore had lost touch with customers and experienced unnecessarily high costs. Lack of an Internet focus had also hindered supply chain management and standardization.
Teaching Note: This case sets the stage for the remainder of the chapter, with its focus on multidivisional structures and global competition. Class discussion can address HP’s different classes of competitors. Ask students, “How does the use of a multidivisional structure hinder HP relative to single-business firms, such as Dell?” and “How does the structure help HP?”
LECTURE OUTLINELXXX. Overview
A. This chapter addresses issues of implementing strategy in multibusiness organizations, which in some cases, are extensions of concepts explored in Chapter 12 (implementation in single business firms).
B. In other cases, the increased complexity of simultaneously managing more than one business creates new concerns and issues.
LXXXI. Managing Corporate Strategy Through the Multidivisional StructureA. Bureaucratic costs are likely to be higher in multibusiness firms than in single business ones.B. For multibusiness firms, the multidivisional structure is superior to the functional structure, for
1. Each business unit is placed in a self-contained division and supplied with all support functions. Thus each part essentially operates separately from the other parts of the company.
2. The office of corporate headquarters staff is created to control and oversee the divisions. Headquarters also provides corporate support functions, such as finance and R&D.
3. Divisional managers have operating responsibility; corporate managers have strategic responsibility.
4. Each division is treated as a profit center and can adopt the structure and control systems that best serve its strategy.
STRATEGY IN ACTION 13.1: GM’S MULTIDIVISIONAL STRUCTURE CHANGES OVER TIME
Over the years, GM has changed its structure several times, beginning with the 25 autonomous operating divisions that comprised the firm in the 1910s. To better compete with centralized, single-business Ford Motors, CEO Alfred Sloan invented the multidivisional structure in 1920. This structure allowed GM to benefit from the cost savings that come from centralization, while keeping the flexibility and innovation inherent in a decentralized structure. Sloan saw advantages from the multidivisional structure, including improved accountability, easier resource allocation, and higher autonomy and morale. In the 1980s, to better compete with the cost-efficient Japanese automakers, GM again re-structured, reducing the number of divisions and centralizing design and engineering. All GM vehicles began to look alike, sales dropped, and the structure was abandoned. Today, the firm continues to struggle with issues of centralization, experimenting to find the right level.
Teaching Note: This case does a good job at describing the challenges of a multidivisional structure. GM seems to be too decentralized at first, then to centralize too much, then to overcorrect by too much decentralization, and so on. The firm is apparently unable to find the right amount of centralization to gain cost advantages without sacrificing flexibility. Students should recognize, based on this case, that organization structure is not static, and that firms are constantly assessing the tradeoffs inherent in each structural change.
C. A multidivisional structure has several advantages.1. Enhanced corporate financial control is one advantage of the multidivisional structure. The
profitability of the different divisions is very clear, allowing the corporate staff to readily determine the best resource allocation scheme.
2. Enhanced strategic control is another benefit, because corporate staffs are freed from operating responsibilities, and can concentrate on corporate strategy.
3. The structure overcomes limits to growth because it permits the company to operate many businesses without information overload or requiring too much intervention from corporate managers.
4. Because divisional performance has greater visibility, divisional managers realize that corporate managers can detect inefficiencies, and thus are motivated to perform at a higher level.
D. Implementing a multidivisional structure has drawbacks as well, and the advantages must be balanced against them.1. Managing the balance of power between corporate and divisional managers is difficult. The
problem lies in deciding how much authority to centralize at the corporate level and how much to decentralize at the divisional level. Too much centralizing puts divisional managers in a straitjacket. Too much decentralizing, however, may cause the company to lose control over its strategy, damaging corporate performance.
STRATEGY IN ACTION 13.2: AMOCO, ARCO, AND BURMAH CASTROL BECOME PART OF BP
For years, Amoco was organized into three operating subsidiaries: exploration, refining, and chemicals manufacturing. Combined with a centralized structure, this led to a tall hierarchy and slow decision making. Intense price competition in the 1990s spurred the firm to look for cost savings, and the firm switched to a
decentralized, multidivisional structure. The structure worked, and when the firm merged with BP and then acquired ARCO and Burmah Castrol, it allowed for a smooth integration of the new businesses.
Teaching Note: In contrast to the Strategy in Action 13.1 about GM, this case illustrates how Amoco was able to find a level of centralization that enabled cost savings while also enabling flexibility. Amoco’s success in integrating two acquisitions and a merger partner shows that the structure is working effectively. Ask students to compare Amoco’s structure with GM’s and to identify reasons why one firm has succeeded while the other has not.
2. If the corporate center puts too much financial pressure on the divisions, they may be encouraged to distort the information they supply to corporate managers. For example, they may pursue short-run rather than long-run profit maximization.
3. Divisions may start to compete for resources, which reduces cooperation and learning across units.
4. When divisions are competing, it is difficult to set fair prices for trading resources between them. Each division tries to set the highest price it can to maximize its own ROIC, but such efforts can hurt corporate performance and corporate ROIC. This is referred to as the transfer pricing problem.
5. If divisions are being evaluated strictly on return on investment targets, they might cut back on R&D to improve their financial performance.
6. Each division has its own support services, which can lead to a duplication of functions and increased expenses. This is an especially critical problem in regard to highly expensive R&D.
E. After a company chooses a multidivisional structure, it then must develop the control mechanisms that are appropriate for that structure. The type of control mechanisms that are used depends on whether the firm is using unrelated diversification, vertical integration, or related diversification.
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Table 13.1: Corporate Strategy, Structure, and Control
1. Because there are no linkages between divisions, unrelated diversification is the easiest and cheapest strategy to manage, with the lowest level of bureaucratic costs.a. Normally, a multidivisional structure is used for this strategy and the corporate
headquarters tends to be small because the need for integration among divisions is low.b. The control used is principally financial control and corporate headquarters uses
measures such as ROIC as the main means of evaluating each division’s performance. They treat the corporation’s businesses as an investment portfolio, attempting to allocate resources so as to realize the greatest profitability.
c. Divisions are completely autonomous, thus the idea of corporate culture is meaningless.
STRATEGY IN ACTION 13.3: ALCO STANDARD GETS IT RIGHT
Alco pursues a strategy of unrelated diversification in two main industries: office products and paper distribution. Corporate managers make no attempt to intervene in the operations of each division. They see their role primarily as information gatherers and providers of the resources that the divisions need to improve their performance. Divisional managers are rewarded with stock options based on the performance of their divisions, and corporate performance has been improving steadily.
Teaching Note: Alco is a clear example of the benefits of pursuing a strategy of unrelated diversification. To spark discussion, ask students to list some of the potential costs or pitfalls of this strategy, and to then describe actions that Alco’s managers could take to lessen the negative consequences.
2. Vertical integration is the next most expensive strategy to coordinate. Bureaucratic costs are higher because corporate headquarters must control sequential resource transfers from one division to the next.a. By adopting the multidivisional structure, a vertically integrated company gains
centralized control, and corporate managers can control resource transfers between divisions.
b. Market and behavior controls are also applied as the company seeks to standardize resource transfers and to use budgets, as well as ROIC, to evaluate divisional performance. The company also uses rules as a control mechanism.
c. In addition, handling resource transfers increases the need for integration, and task forces are likely to be established to guide interdivisional coordination.
3. Related diversification increases the number of linkages between divisions that have to be managed, making this strategy the most expensive.a. Output control is difficult to measure due to extensive cooperation, so culture control is
used more frequently.b. Integrating roles and teams are required to integrate the work of multiple divisions.c. Reward systems must be carefully designed, to ensure that managers have an incentive to
share resources.F. Information technology helps divisions share knowledge and leverage competencies, and it facilitates
strategic control by providing better, more timely information. IT eases decentralization and makes it more difficult to distort information. IT eases the transfer pricing problem, because it makes comparisons with external sources of inputs easier.
LXXXII. Implementing Strategy Across CountriesA. Most large companies have a global dimension to their strategies because they sell their products in
global markets.B. There are four strategies that firms that compete in the global market can follow.
1. A multidomestic strategy is oriented toward local responsiveness, and a company decentralizes authority to each country in which it operates, which leads to customized products for each local market.
2. In an international strategy, R&D and marketing are centralized in the home country, whereas all other functions are performed locally.
3. A global strategy requires centralization of all functions, and thus leads to low costs.4. Companies pursuing a transnational strategy centralize some functions and decentralize
others, depending on each product’s and region’s characteristics.C. As a company moves from a multidomestic, to an international, to a global, and then to a
transnational strategy, the need for coordination increases, and companies adopt a more complex structure and more complex ways of controlling their activities. As complexity increases, so too do management challenges and bureaucratic costs.
D. To choose from the four preceding strategies, a firm must answer three questions.1. The firm must decide how to distribute authority between the home country and local
operations to maintain effective control.2. The firm must choose the organizational structure that allows the most efficient allocation of
resources and the best service to customers.3. The firm must design control systems and organizational culture to allow the structure to work
effectively.
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Table 13.2: Global Strategy/Structure Relationships
E. When a firm chooses a multidomestic strategy, it generally chooses a global-area structure.
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Figure 13.2: Global-Area Structure
1. The global-area structure duplicates all its value-creation functions in every country in which it operates and establishes a foreign division in every country.
2. The need for integration is low, and control over business strategy is decentralized to these divisions.
3. Managers at global headquarters use output and market control to evaluate the business unit’s performance.
4. Each region or country is virtually an autonomous operating entity and no corporate culture develops on a global level.
5. A disadvantage of this choice is the probability of duplicating some expensive specialist functions. Also, this strategy reduces the chances of organizationwide learning.
F. With an international strategy, a company often adopts an international division structure to coordinate and oversee their activities.
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Figure 13.3: International Division Structure
1. In an international division structure, the company creates an international division, which is just one of the company’s divisions. It handles the distribution of products to the foreign subsidiaries on a country-by-country basis.
2. The international division integrates between the domestic divisions and foreign subsidiaries and allows a company to engage in complex foreign operations with relatively low bureaucratic costs.
3. Disadvantages include the potential for conflict between domestic and international managers and the resistance of foreign managers to adopting business practices that are at odds with their local cultural practices.
G. When a global strategy is used, a global product division structure is chosen.
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Figure 13.4: Global Product Division Structure
1. A product division headquarters is created to coordinate the activities of both domestic and foreign operations.
2. Product division managers coordinate all aspects of global value-creation activities—for example, deciding what should be produced or designed at which global location. Each major activity is performed at only one global location.
3. Problems include a lack of local responsiveness to the needs of each country and the difficulty of integrating the activities of the different product groups.
H. A company embarking on a transnational strategy typically adopts the global matrix structure.
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Figure 13.5: Global Matrix Structure
1. One aspect of the structure is based on the company’s major product groups. The second aspect is the foreign divisions in the various countries in which a company competes. Thus, each worker reports to both a product boss and a regional boss.
2. Control is decentralized, but corporate managers still retain some control. Managers in the foreign subsidiary control foreign operations and are responsible for local responsiveness.
3. The global matrix strategy is best for sharing information and enabling learning.
4. A global culture is very important in helping to provide the integration that makes a matrix structure work effectively, and global networks of managers provide extra coordination.
STRATEGY IN ACTION 13.4: USING IT TO MAKE NESTLÉ’S GLOBAL STRUCTURE WORK
Nestlé, the world’s largest food company, grew through acquisition, purchasing Perrier, Carnation, Stouffer, and other food businesses. The firm used to pursue a multidomestic strategy, relying on a global area structure and decentralizing control to each national unit. However, during the 1990s Nestlé moved to a global matrix structure, decentralizing authority to managers in charge of seven global product groups—coffee, candy, and so on. Then it grouped all the divisions within a country into one business. This allowed the firm to pursue a transnational strategy, leading to lower costs and improved differentiation. The matrix structure facilitated sharing information within countries, but Nestlé wished to share more information across countries. To accomplish this, the firm used leading-edge information technology to share data across the globe. Today, the company is using IT to standardize computer systems and business practices around the world.
Teaching Note: This case shows the positive impact that cutting-edge technology can have on implementing a complex organizational structure. Ask students to answer this question: “Could Nestlé have adopted the matrix structure without the use of sophisticated IT? If so, how?” The students will probably answer, “No.” Answering this question will require students to consider the relationship between sophisticated IT systems and organizational structure.
5. One factor that is important in making the global matrix strategy work is the development of a strong cross-country organizational culture.
6. Information technology, such as teleconferencing, e-mail, and global intranets, is facilitating strong global cultures and easing the difficulties of worldwide coordination mechanisms.
LXXXIII. Entry Mode and ImplementationA. Over time, strategies change and corporations wish to enter new industries. One mode of entry into a
new business is through internal new venturing.1. Internal new ventures create organizational arrangements that allow employees to be
entrepreneurial. Internal entrepreneurs are called intrapreneurs. This mode of entry is often used by large, established companies.
2. Organizations must design their structures, control mechanisms, and culture to encourage innovation and risk-taking, while also ensuring that the new ventures contribute to the organization’s overall strategy. One approach encourages intrapreneurs throughout the organization.a. One way to accomplish this is to encourage researchers to spend time developing their
own ideas.b. Another way is through the establishment of cross-functional teams to foster values of
cooperation and innovation.c. The use of reward systems that place a high value on innovations leads to an innovative
culture.3. Other organizations believe that new ventures have the highest chances for success when they
are removed from the day-to-day pressures of the organization.a. This is accomplished by the creation of new-venture divisions. The company sets up a
division separate from other divisions and not subject to day-to-day scrutiny of top management and allows it to develop a culture for innovation.
b. Preserving the autonomy of the new-ventures division is crucial; top management must not be allowed to put it in a straitjacket. Therefore, output controls are de-emphasized while culture is used as a control mechanism instead.
4. Companies that follow the develop-in-place model, such as 3M, have enjoyed greater success than those who created separate new-venture divisions. Many of their products failed to reach market, and those that did were burdened with high costs. Scientists may not be qualified to develop successful business models, because they lack training in that area.
B. Another mode of entering a new industry is joint venturing.1. Joint ventures are created when two or more companies agree to pool resources and work
2. Monitoring the performance of the venture is necessary for both parties, and neither wants to give up any proprietary knowledge. Sometimes ownership of the new venture is split 51/49 rather than 50/50, to make it clear which company “owns” any new products.
3. The purpose of the joint venture (new product development, joint distribution and marketing, and so on) and whether the partners are also competitors are factors that affect implementation.
4. The CEO and top managers are chosen from both firms, and that team together develops a business model, decides upon the organization’s structure and control systems, and creates a company culture.
5. Some companies prefer to avoid the uncertainty and risk associated with joint venturing, and just acquire a company that possesses the necessary skills.
C. Mergers and acquisitions are also used to enter new industries.1. Mergers and acquisitions have a high failure, at least in part due to the lack of forethought about
integration issues.2. One of the key challenges is to establish new lines of authority and responsibility. Managers
who are dissatisfied may leave the company, taking valuable expertise with them.3. Then the new units must be integrated with the rest. The more these new businesses differ from
the core business, the greater are the problems.4. When the company is pursuing unrelated diversification, corporate managers should not make
radical changes that will interfere with the performance of the new unit.5. Companies use output and behavior controls to standardize practices across all the units,
including the new ones.6. Acquired companies probably have different cultures so it is often difficult to integrate the new
divisions into the company’s existing structure.LXXXIV. IT, the Internet, and Outsourcing
A. IT has a number of benefits that aid in strategy implementation.1. Information technology (IT) makes it easier to implement strategy, because of better and more
timely information and information sharing.2. IT consists of both physical systems, which are relatively easy to imitate, and IT know-how,
which can be very hard to imitate.3. IT provides knowledge that allows managers to better differentiate their products. IT
contributes to innovation by helping managers use knowledge competitively.4. IT has also affected organizational structure, aiding the development of flatter structures,
greater decentralization, and increased integration, while reducing the organization’s dependence on other, more costly forms of coordination.
STRATEGY IN ACTION 13.5: ORACLE’S NEW APPROACH TO CONTROL
In 1999, Oracle, the world’s second-largest software producer, found that it was not using the latest Internet software for internal control, even though it had written the software! In fact, the firm was using over 70 different computer systems for strategic control. CEO Larry Ellison ordered employees to standardize and to discover and implement new Internet-based applications, such as employee expense reporting. A new sales system allows salespeople to capture data that can then be used throughout the company. Ellison’s goal is to eventually automate all support functions.
Teaching Note: Oracle’s case vividly demonstrates the strategic benefits of IT. Classroom discussion can be initiated by asking students to describe tasks from their daily lives or from business practices of organization with which they are familiar, that are not currently automated but could be. Then ask them to describe the benefits that the automation would bring.
B. The enhanced capabilities of IT have led to the development of the virtual organization, composed of workers who are linked by computers, e-mail, fax, and so on, and who hardly ever meet face-to-face.
C. Another major impact of IT on strategy implementation is an increased ability to outsource. IT enables outsourcing by allowing better coordination of the flow of parts and products, while also allowing better sharing of competencies, such as design.
D. One application of IT that has had a big impact on many businesses is the development of business-to-business (B2B) networks. These networks provide an online way for companies in the same industry to link with suppliers and buyers, improving supply chain operations.
STRATEGY IN ACTION 13.6: LI & FUNG’S GLOBAL SUPPLY CHAIN MANAGEMENT
Li & Fung is one of the firms whose business model is providing intermediary or broker services to firms that are looking for the lowest-cost international suppliers. As foreign manufacturers increasingly specialize in just one small part of the supply chain, brokers are more in demand than ever. The firm employs over 3,000 agents in 37 countries, and charges fees for its services that are less than a firm’s cost to employ its own agents.
Teaching Note: This case highlights a growing but little-known industry, that of foreign intermediaries for multinational manufacturers. The growth and success of these firms is one impact of the increasing use of IT.
E. IT has also reduced information costs so that global strategic alliances are more attractive, in many cases, than is vertical integration.
F. To implement outsourcing, many firms use a network structure, that is, a set of strategic alliances with suppliers, manufacturers, and distributors.1. Network structures allow many firms to cooperate, while reducing the bureaucratic costs that
would be incurred if the activities occurred in one complex organization.2. Network structures lead to low costs, adaptability to change, and structural flexibility.
