A company’s resources and capabilities are integral to achieving sustainable competitive advantage. Refer to your readings and the required videos. For this assignment, consider your own company or on

Final PDF to printer tho75109_ch04_086-121.indd 87 12/18/18 11:45 AM Organizations succeed in a competitive marketplace over the long run because they can do certain things their customers value better than can their competitors. Robert Hayes, Gary Pisano, and David Upton— Professors and consultants Crucial, of course, is having a difference that matters in the industry. Cynthia Montgomery— Professor and author If you don’t have a competitive advantage, don’t compete. Jack Welch— Former CEO of General Electric company a lasting competitive advantage over rival companies? 3. What are the company’s strengths and weak - nesses in relation to the market opportunities and external threats? 4. How do a company’s value chain activities impact its cost structure and customer value proposition? 5. Is the company competitively stronger or weaker than key rivals? 6. What strategic issues and problems merit front- burner managerial attention?

In probing for answers to these questions, five analytic tools—resource and capability analysis, SWOT analysis, value chain analysis, benchmark - ing, and competitive strength assessment—will be used. All five are valuable techniques for revealing a company’s competitiveness and for helping com - pany managers match their strategy to the compa - ny’s particular circumstances. Chapter 3 described how to use the tools of indus - try and competitor analysis to assess a company’s external environment and lay the groundwork for matching a company’s strategy to its external situ - ation. This chapter discusses techniques for evalu - ating a company’s internal situation, including its collection of resources and capabilities and the activities it performs along its value chain. Internal analysis enables managers to determine whether their strategy is likely to give the company a signifi - cant competitive edge over rival firms. Combined with external analysis, it facilitates an understand - ing of how to reposition a firm to take advantage of new opportunities and to cope with emerging competitive threats. The analytic spotlight will be trained on six questions:

1. How well is the company’s present strategy working? 2. What are the company’s most important resources and capabilities, and will they give the Final PDF to printer 88 PART 1 tho75109_ch04_086-121.indd 88 12/18/18 11:45 AM Before evaluating how well a company’s present strategy is working, it is best to start with a clear view of what the strategy entails. The first thing to examine is the company’s competitive approach. What moves has the company made recently to attract customers and improve its market position—for instance, has it cut prices, improved the design of its product, added new features, stepped up advertising, entered a new geographic mar - ket, or merged with a competitor? Is it striving for a competitive advantage based on low costs or a bet ter product of fer i ng? Is it concentrati ng on ser v i ng a broad spectr u m of cus - tomers or a narrow market niche? The company’s functional strategies in R&D, produc - tion, marketing, finance, human resources, information technology, and so on further characterize company strategy, as do any efforts to establish alliances with other enter - prises. Figure 4.1 shows the key components of a single-business company’s strategy. A determination of the effectiveness of this strategy requires a more in-depth type of analysis. The three best indicators of how well a company’s strategy is working are (1) whether the company is achieving its stated financial and strategic objectives, (2) whether its financial performance is above the industry average, and (3) whether it is gaining customers and gaining market share. Persistent shortfalls in meeting company performance targets and weak marketplace performance relative to rivals are reliable QUESTION 1: HOW WELL IS THE COMPANY’S • L O 4 -1 company’s strategy is working.

FIGURE 4.1 Eforts to build competitively valuable partnerships and strategic alliances with other enterprises within its industry Production strategy Supply chain management strategy Finance strategy BUSINESS STRATEGY (The action plan for managing a single business) Eforts to expand or narro w geographic coverage KEY FUNCTIONAL STRATEGIES Human resource strategy Information technology strategy Sales, marketing, and distribution strategies Moves to respond to changin g conditions in the macro-environment or in industry and competitive conditions R&D, technology, product design strategy Initiatives to build competitive advantage based o n Superior ability to serve a ma rket niche or speci c group of buyers ?

A better product or service (design, features, quality, wider selection, etc.)?

Lower costs and prices relative to rivals ? Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 89 tho75109_ch04_086-121.indd 89 12/18/18 11:45 AM warning signs that the company has a weak strategy, suffers from poor strategy execu - tion, or both. Specific indicators of how well a company’s strategy is working include • Trends in the company’s sales and earnings growth. • Trends in the company’s stock price. • The company’s overall financial strength. • The company’s customer retention rate. • The rate at which new customers are acquired. • Evidence of improvement in internal processes such as defect rate, order fulfill - ment, delivery times, days of inventory, and employee productivity.

The stronger a company’s current overall performance, the more likely it has a well-conceived, well-executed strategy. The weaker a company’s financial perfor - mance and market standing, the more its current strategy must be questioned and the more likely the need for radical changes. Table 4.1 provides a compilation of the financial ratios most commonly used to evaluate a company’s financial perfor - mance and balance sheet strength. Sluggish financial perfor - mance and second-rate market accomplishments almost always signal weak strategy, weak execution, or both. Ratio How Calculated What It Shows Profitability ratios 1. Gross profit margin Sales revenues − Cost of goods sold _______________________________ Sales revenues Shows the percentage of revenues available to cover operating expenses and yield a profit. 2. Operating profit margin (or return on sales) Sales revenues − Operating expenses ________________________________ Sales revenues or Operating income _____________ Sales revenues Shows the profitability of current operations without regard to interest charges and income taxes. Earnings before interest and taxes is known as EBIT in financial and business accounting. 3. Net profit margin (or net return on sales) Profits after taxes ____________ Sales revenues Shows after-tax profits per dollar of sales. 4. Total return on assets Profits after taxes + Interest __________________________ Total assets A measure of the return on total investment in the enterprise. Interest is added to after-tax profits to form the numerator, since total assets are financed by creditors as well as by stockholders. 5. Net return on total assets (ROA) Profits after taxes ____________ Total assets A measure of the return earned by stockholders on the firm’s total assets. 6. Return on stockholders’ Profits after taxes __________________ Total stockholders ’ equity The return stockholders are earning on their capital investment in the enterprise. A return in the 12% to 15% range is average. 7. Return on invested capital (ROIC)—sometimes referred to as return on capital employed (ROCE) Profits after taxes _____________________________________ Long-term debt + Total stockholders ’ equity A measure of the return that shareholders are earning on the monetary capital invested in the enterprise. A higher return reflects greater bottom-line effectiveness in the use of long-term capital. TABLE 4.1 (continued) Final PDF to printer 90 PART 1 tho75109_ch04_086-121.indd 90 12/18/18 11:45 AM Ratio How Calculated What It Shows Liquidity ratios 1. Current ratio Current assets ____________ Current liabilities Shows a firm’s ability to pay current liabilities using assets that can be converted to cash in the near term. Ratio should be higher than 1.0. 2. Working capital Current assets  − Current liabilities The cash available for a firm’s day-to-day operations. Larger amounts mean the company has more internal funds to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital. Leverage ratios 1. Total debt-to- assets ratio Total debt ________ Total assets Measures the extent to which borrowed funds (both short-term loans and long-term debt) have been used to finance the firm’s operations. A low ratio is better—a high fraction indicates overuse of debt and greater risk of bankruptcy. 2. Long-term debt- to-capital ratio Long-term debt _____________________________________ Long-term debt + Total stockholders ’ equity A measure of creditworthiness and balance sheet strength. It indicates the percentage of capital investment that has been financed by both long-term lenders and stockholders. A ratio below 0.25 is preferable since the lower the ratio, the greater the capacity to borrow additional funds. Debt-to-capital ratios above 0.50 indicate an excessive reliance on long-term borrowing, lower creditworthiness, and weak balance sheet strength. 3. Debt-to-equity ratio Total debt __________________ Total stockholders ’ equity Shows the balance between debt (funds borrowed both short term and long term) and the amount that stockholders have invested in the enterprise. The further the ratio is below 1.0, the greater the firm’s ability to borrow additional funds. Ratios above 1.0 put creditors at greater risk, signal weaker balance sheet strength, and often result in lower credit ratings. 4. Long-term debt- to-equity ratio Long-term debt __________________ Total stockholders ’ equity Shows the balance between long-term debt and stockholders’ equity in the firm’s long-term capital structure. Low ratios indicate a greater capacity to borrow additional funds if needed. 5. Times-interest- earned (or coverage) ratio Operating income _____________ Interest expenses Measures the ability to pay annual interest charges. Lenders usually insist on a minimum ratio of 2.0, but ratios above 3.0 signal progressively better creditworthiness. Activity ratios 1. Days of inventory Inventory _________________ Cost of goods sold ÷ 365 Measures inventory management efficiency. Fewer days of inventory are better. TABLE 4.1 (continued) (continued) Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 91 tho75109_ch04_086-121.indd 91 12/18/18 11:45 AM Ratio How Calculated What It Shows 2. Inventory turnover Cost of goods sold _____________ Inventory Measures the number of inventory turns per year. Higher is better. 3. Average collection period Accounts receivable ______________ Total sales ÷ 365 or Accounts receivable ______________ Average daily sales Indicates the average length of time the firm must wait after making a sale to receive cash payment. A shorter collection time is better. Other important measures of financial performance 1. Dividend yield on common stock Annual dividends per share _____________________ Current market price per share A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2% to 3%. The dividend yield for fast-growth companies is often below 1%; the dividend yield for slow-growth companies can run 4% to 5%. 2. Price-to-earnings (P/E) ratio Current market price per share _____________________ Earnings per share P/E ratios above 20 indicate strong investor confidence in a firm’s outlook and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12. 3. Dividend payout ratio Annual dividends per share ___________________ Earnings per share Indicates the percentage of after-tax profits paid out as dividends. 4. Internal cash flow After-tax profits  + Depreciation A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or funding capital expenditures. 5. Free cash flow After-tax profits  + Depreciation  − Capital expenditures  − Dividends A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, taxes, dividends, and desirable reinvestments in the business. The larger a company’s free cash flow, the greater its ability to internally fund new strategic initiatives, repay debt, make new acquisitions, repurchase shares of stock, or increase dividend payments. TABLE 4.1 (continued) QUESTION 2: WHAT ARE THE COMPANY’S STRENGTHS AND WEAKNESSES IN RELATION TO THE MARKET OPPORTUNITIES AND EXTERNAL THREATS?

An examination of the financial and other indicators discussed previously can tell you how well a strategy is working, but they tell you little about the underlying r e a s o n s — why it’s working or not. The simplest and most easily applied tool for gaining some insight into the reasons for the success of a strategy or lack thereof is known as Final PDF to printer 92 PART 1 tho75109_ch04_086-121.indd 92 12/18/18 11:45 AM SWO T a na l ysi s. SWOT is an acronym that stands for a company’s internal Strengths and Weaknesses, market Opportunities, and external Threats. Another name for SWOT analysis is Situational Analysis. A first-rate SWOT analysis can help explain why a strategy is working well (or not) by taking a good hard look a company’s strengths in relation to its weaknesses and in relation to the strengths and weaknesses of com - petitors. Are the company’s strengths great enough to make up for its weaknesses?

Has the company’s strategy built on these strengths and shielded the company from its weaknesses? Do the company’s strengths exceed those of its rivals or have they been overpowered? Similarly, a SWOT analysis can help determine whether a strategy has been effective in fending off external threats and positioning the firm to take advantage of market opportunities. SWOT analysis has long been one of the most popular and widely used diagnostic tools for strategists. It is used fruitfully by organizations that range in type from large corporations to small businesses, to government agencies to non-profits such as churches and schools. Its popularity stems in part from its ease of use, but also because it can be used not only to evaluate the efficacy of a strategy, but also as the basis for crafting a strategy from the outset that capi - talizes on the company’s strengths, overcomes its weaknesses, aims squarely at capturing the company’s best opportunities, and defends against competitive and macro-environmental threats. Moreover, a SWOT analysis can help a company with a strategy that is working well in the present determine whether the company is in a position to pursue new market opportunities and defend against emerging threats to its future well-being. Identifying a Company’s Internal Strengths An internal strength is something a company is good at doing or an attribute that enhances its competitiveness in the marketplace. One way to appraise a company’s strengths is to ask: What activities does the company perform well? This question directs attention to the company’s skill level in performing key pieces of its business—such as supply chain management, R&D, pro - duction, distribution, sales and marketing, and customer service. A company’s skill or proficiency in performing different facets of its operations can range from the extreme of having minimal ability to perform an activity (perhaps having just struggled to do it the first time) to the other extreme of being able to perform the activity better than any other company in the industry. When a company’s proficiency rises from that of mere ability to perform an activ - ity to the point of being able to perform it consistently well and at acceptable cost, it is said to have a competence —a true capability, in other words. If a company’s com - petence level in some activity domain is superior to that of its rivals it is known as a distinctive competence. A core competence is a proficiently performed internal activ - ity that is central to a company’s strategy and is typically distinctive as well. A core competence is a more competitively valuable strength than a competence because of the activity’s key role in the company’s strategy and the contribution it makes to the company’s market success and profitability. Often, core competencies can be leveraged to create new markets or new product demand, as the engine behind a company’s growth. Procter and Gamble has a core competence in brand man - agement, which has led to an ever increasing portfolio of market-leading consumer products, including Charmin, Tide, Crest, Tampax, Olay, Febreze, Luvs, Pampers, • LO 4 -2 strengths and weaknesses in light of market opportunities and external threats. CORE CONCEPT SWOT analysis, or Situational Analysis is a popular, easy to use tool for sizing up a company’s strengths and weaknesses, its market opportunities, and external threats.

Basing a company’s strategy on its most competitively valuable strengths gives the company its best chance for market success.

A distinctive competence is a capability that enables a company to perform a par - ticular set of activities better than its rivals.

CORE CONCEPT A competence is an activity that a company has learned to perform with proficiency. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 93 tho75109_ch04_086-121.indd 93 12/18/18 11:45 AM and Swiffer. Nike has a core competence in designing and marketing innovative athletic footwear and sports apparel. Kellogg has a core competence in developing, producing, and marketing breakfast cereals.

Identifying Company Internal Weaknesses An internal weakness is something a company lacks or does poorly (in comparison to others) or a condition that puts it at a disadvantage in the marketplace. It can be thought of as a competitive deficiency. A company’s internal weaknesses can relate to (1) inferior or unproven skills, expertise, or intellectual capital in competi - tively important areas of the business, or (2) deficiencies in competitively important physical, organizational, or intangible assets. Nearly all companies have competi - tive deficiencies of one kind or another. Whether a company’s internal weaknesses make it competitively vulnerable depends on how much they matter in the market - place and whether they are offset by the company’s strengths. Table 4.2 lists many of the things to consider in compiling a company’s strengths and weaknesses. Sizing up a company’s complement of strengths and deficiencies is akin to constructing a strategic balance sheet, where strengths represent competitive assets and weaknesses represent competitive liabilities. Obviously, the ideal condition is for the company’s competitive assets to outweigh its competitive liabilities by an ample margin!

Identifying a Company’s Market Opportunities Market opportunity is a big factor in shaping a company’s strategy. Indeed, managers can’t properly tailor strategy to the company’s situation without first identifying its market opportunities and appraising the growth and profit potential each one holds.

Depending on the prevailing circumstances, a company’s opportunities can be plenti - ful or scarce, f leeting or lasting, and can range from wildly attractive to marginally interesting or unsuitable. Newly emerging and fast-changing markets sometimes present stunningly big or “golden” opportunities, but it is typically hard for managers at one company to peer into “the fog of the future” and spot them far ahead of managers at other companies. 9 But as the fog begins to clear, golden opportunities are nearly always seized rapidly— and the companies that seize them are usually those that have been staying alert with diligent market reconnaissance and preparing themselves to capitalize on shifting mar - ket conditions swiftly. Table 4.2 displays a sampling of potential market opportunities.

Identifying External Threats Often, certain factors in a company’s external environment pose threats to its prof it - ability and competitive well-being. Threats can stem from such factors as the emer - gence of cheaper or better technologies, the entry of lower- cost foreign competitors into a company’s market stronghold, new regulations that are more burdensome to a company than to its competitors, unfavorable demographic shifts, and political upheaval in a foreign country where the company has facilities. External threats may pose no more than a moderate degree of adversity (all companies confront some threatening elements in the course of doing business), or they may be imposing enough to make a company’s situation look tenuous. On rare occasions, market shocks can give birth to a sudden-death threat that throws a CORE CONCEPT A core competence is an activity that a company per - forms proficiently and that is also central to its strategy and competitive success.

CORE CONCEPT A company’s strengths represent its competitive assets; its weaknesses are shortcomings that constitute competitive liabilities.

Simply making lists of a company’s strengths, weak - nesses, opportunities, and threats is not enough; the payoff from SWOT analysis comes from the conclusions about a company’s situa - tion and the implications for strategy improvement that flow from the four lists. Final PDF to printer 94 PART 1 tho75109_ch04_086-121.indd 94 12/18/18 11:45 AM Strengths and Competitive Assets Weaknesses and Competitive Deficiencies • Ample financial resources to grow the business • Strong brand-name image or reputation • Distinctive core competencies • Cost advantages over rivals • Attractive customer base • Proprietary technology, superior technological skills, important patents • Strong bargaining power over suppliers or buyers • Superior product quality • Wide geographic coverage and/or strong global distribution capability • Alliances and/or joint ventures that provide access to valuable technology, competencies, and/or attractive geographic markets • No distinctive core competencies • Lack of attention to customer needs • Inferior product quality • Weak balance sheet, too much debt • Higher costs than competitors • Too narrow a product line relative to rivals • Weak brand image or reputation • Lack of adequate distribution capability • Lack of management depth • A plague of internal operating problems or obsolete facilities • Too much underutilized plant capacity Market Opportunities External Threats • Meet sharply rising buyer demand for the industry’s product • Serve additional customer groups or market segments • Expand into new geographic markets • Expand the company’s product line to meet a broader range of customer needs • Enter new product lines or new businesses • Take advantage of falling trade barriers in attractive foreign markets • Take advantage of an adverse change in the fortunes of rival firms • Acquire rival firms or companies with attractive technological expertise or competencies • Take advantage of emerging technological developments to innovate • Enter into alliances or other cooperative ventures • Increased intensity of competition • Slowdowns in market growth • Likely entry of potent new competitors • Growing bargaining power of customers or suppliers • A shift in buyer needs and tastes away from the industry’s product • Adverse demographic changes that threaten to curtail demand for the industry’s product • Adverse economic conditions that threaten critical suppliers or distributors • Changes in technology—particularly disruptive technology that can undermine the company’s distinctive competencies • Restrictive foreign trade policies • Costly new regulatory requirements • Tight credit conditions • Rising prices on energy or other key inputs TABLE 4.2 Opportunities, and Threats company into an immediate crisis and a battle to survive. Many of the world’s major financial institutions were plunged into unprecedented crisis in 2008–2009 by the after - effects of high-risk mortgage lending, inf lated credit ratings on subprime mortgage securities, the collapse of housing prices, and a market f looded with mortgage-related investments (collateralized debt obligations) whose values suddenly evaporated. It is management’s job to identify the threats to the company’s future prospects and to evaluate what strategic actions can be taken to neutralize or lessen their impact. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 95 tho75109_ch04_086-121.indd 95 12/18/18 11:45 AM What Do the SWOT Listings Reveal?

SWOT analysis involves more than making four lists. In crafting a new strategy, it offers a strong foundation for understanding how to position the company to build on its strengths in seizing new business opportunities and how to mitigate external threats by shoring up its competitive deficiencies. In assessing the effectiveness of an exist - ing strategy, it can be used to glean insights regarding the company’s overall business situation (thus the name Situational Analysis); and it can help translate these insights into recommended strategic actions. Figure 4.2 shows the steps involved in gleaning insights from SWOT analysis. The beauty of SWOT analysis is its simplicity; but this is also its primary limi - tation. For a deeper and more accurate understanding of a company’s situation, more sophisticated tools are required. Chapter 3 introduced you to a set of tools for analyzing a company’s external situation. In the rest of this chapter, we look more deeply at a company’s internal situation, beginning with the company’s resources and capabilities.

FIGURE 4.2 SWOT, Draw Conclusions, Translate Implications into Strategic Actions Identify company strengths and competitive assets Identify company weaknesses and competitive de ciencies Identify market opportunities Identify external threats Conclusions concerning the company’s overall business situation:

What are the underlying reasons for the success (or lack of success) of the company's strategy?

What are the attractive and unattractive aspects of the company’s situation?

Implications for improving company strategy:

Use company strengths as the foundation for the company’s strategy.

Shore up weaknesses that are interfering with the success of the strategy.

Use company strengths to lessen the impact of important external threats.

Pursue those market opportunities best suited to company strengths.

Correct weaknesses that impair pursuit of important market opportunities.

Repair weaknesses that heighten vulnerability of external threats.

What Can Be Gleaned from the SWOT Listings?

Final PDF to printer 96 PART 1 tho75109_ch04_086-121.indd 96 12/18/18 11:45 AM QUESTION 3: WHAT ARE THE COMPANY’S MOST CORE CONCEPT A company’s resources and capabilities represent its competitive assets and are determinants of its competi - tiveness and ability to suc - ceed in the marketplace. • LO 4 -3 - pany’s resources and capabilities are critical for gaining a competi - tive edge over rivals. CORE CONCEPT A resource is a competi - tive asset that is owned or controlled by a company; a capability (or competence ) is the capacity of a firm to perform some internal activ - ity competently. Capabilities are developed and enabled through the deployment of a company’s resources. An essential element of a company’s internal environment is the nature of resources and capabilities. A company’s resources and capabilities are its competitive assets and determine whether its competitive power in the marketplace will be impres - sively strong or disappointingly weak. Companies with second-rate competitive assets nearly always are relegated to a trailing position in the industry. Resource and capability analysis provides managers with a powerful tool for siz - ing up the company’s competitive assets and determining whether they can provide the foundation necessary for competitive success in the marketplace. This is a two- step process. The first step is to identify the company’s resources and capabilities.

The second step is to examine them more closely to ascertain which are the most competitively important and whether they can support a sustainable competitive advantage over rival firms. 1 This second step involves applying the four tests of a resource’s competitive power.

Identifying the Company’s Resources and Capabilities A firm’s resources and capabilities are the fundamental building blocks of its com - petitive strategy. In crafting strategy, it is essential for managers to know how to take stock of the company’s full complement of resources and capabilities. But before they can do so, managers and strategists need a more precise definition of these terms. In brief, a resource is a productive input or competitive asset that is owned or con - trolled by the firm. Firms have many different types of resources at their disposal that vary not only in kind but in quality as well. Some are of a higher quality than others, and some are more competitively valuable, having greater potential to give a firm a competitive advantage over its rivals. For example, a company’s brand is a resource, as is an R&D team—yet some brands such as Coca-Cola and Xerox are well known, with enduring value, while others have little more name recognition than generic products.

In similar fashion, some R&D teams are far more innovative and productive than oth - ers due to the outstanding talents of the individual team members, the team’s composi - tion, its experience, and its chemistry. A capability ( or competence) is the capacity of a firm to perform some internal activity competently. Capabilities or competences also vary in form, quality, and competitive importance, with some being more competitively valuable than others.

American Express displays superior capabilities in brand management and market - ing; Starbucks’s employee management, training, and real estate capabilities are the drivers behind its rapid growth; Microsoft’s competences are in developing operating systems for computers and user software like Microsoft Office ®. Organizational capa - bilities are developed and enabled through the deployment of a company’s resources. 2 Fo r example, Nestlé’s brand management capabilities for its 2,000 + fo o d , b e v e r a g e , a n d pet care brands draw on the knowledge of the company’s brand managers, the expertise of its marketing department, and the company’s relationships with retailers in nearly Resource and capability analysis is a powerful tool for sizing up a company’s competitive assets and determining whether the assets can support a sustainable competitive advantage over market rivals. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 97 tho75109_ch04_086-121.indd 97 12/18/18 11:45 AM 200 countries. W. L. Gore’s product innovation capabilities in its fabrics and medical and industrial product businesses result from the personal initiative, creative talents, and technological expertise of its associates and the company’s culture that encourages accountability and creative thinking.

Types of Company Resources  A useful way to identify a company’s resources is to look for them within categories, as shown in Table 4.3. Broadly speaking, resources can be divided into two main categories: tangible and intangible resources. Although human resources make up one of the most important parts of a company’s resource base, we include them in the intangible category to emphasize the role played by the skills, tal - ents, and knowledge of a company’s human resources. Tangible resources are the most easily identified, since tangible resources are those that can be touched or quantified readily. Obviously, they include various types of physical resources such as manufacturing facilities and mineral resources, but they also include a company’s financial resources, technological resources, and organizational resources such as the company’s communication and control systems. Note that tech - nological resources are included among tangible resources, by convention, even though some types, such as copyrights and trade secrets, might be more logically categorized as intangible. Intangible resources are harder to discern, but they are often among the most important of a firm’s competitive assets. They include various sorts of human assets and intellectual capital, as well as a company’s brands, image, and reputational assets. Tangible resources • Physical resources: land and real estate; manufacturing plants, equipment, and/or distribution facilities; the locations of stores, plants, or distribution centers, including the overall pattern of their physical locations; ownership of or access rights to natural resources (such as mineral deposits) • Financial resources: cash and cash equivalents; marketable securities; other financial assets such as a company’s credit rating and borrowing capacity • Technological assets: patents, copyrights, production technology, innovation technologies, technological processes • Organizational resources: IT and communication systems (satellites, servers, workstations, etc.); other planning, coordination, and control systems; the company’s organizational design and reporting structure Intangible resources • Human assets and intellectual capital: the education, experience, knowledge, and talent of the workforce, cumulative learning, and tacit knowledge of employees; collective learning embedded in the organization, the intellectual capital and know-how of specialized teams and work groups; the knowledge of key personnel concerning important business functions; managerial talent and leadership skill; the creativity and innovativeness of certain personnel • Brands, company image, and reputational assets: brand names, trademarks, product or company image, buyer loyalty and goodwill; company reputation for quality, service, and reliability; reputation with suppliers and partners for fair dealing • Relationships: alliances, joint ventures, or partnerships that provide access to technologies, specialized know-how, or geographic markets; networks of dealers or distributors; the trust established with various partners • Company culture and incentive system: the norms of behavior, business principles, and ingrained beliefs within the company; the attachment of personnel to the company’s ideals; the compensation system and the motivation level of company personnel TABLE 4.3 Final PDF to printer 98 PART 1 tho75109_ch04_086-121.indd 98 12/18/18 11:45 AM While intangible resources have no material existence on their own, they are often embodied in something material. Thus, the skills and knowledge resources of a firm are embodied in its managers and employees; a company’s brand name is embodied in the company logo or product labels. Other important kinds of intangible resources include a company’s relationships with suppliers, buyers, or partners of various sorts, and the company’s culture and incentive system. A more detailed listing of the various types of tangible and intangible resources is provided in Table 4.3. Listing a company’s resources category by category can prevent managers from inadvertently overlooking some company resources that might be competitively impor - tant. At times, it can be difficult to decide exactly how to categorize certain types of resources. For example, resources such as a work group’s specialized expertise in developing innovative products can be considered to be technological assets or human assets or intellectual capital and knowledge assets; the work ethic and drive of a com - pany’s workforce could be included under the company’s human assets or its culture and incentive system. In this regard, it is important to remember that it is not exactly how a resource is categorized that matters but, rather, that all of the company’s different types of resources are included in the inventory. The real purpose of using categories in identifying a company’s resources is to ensure that none of a company’s resources go unnoticed when sizing up the company’s competitive assets.

Identifying Capabilities  Organizational capabilities are more complex entities than resources; indeed, they are built up through the use of resources and draw on some combination of the firm’s resources as they are exercised. Virtually all organizational capabilities are knowledge-based, residing in people and in a company’s intellectual capital, or in organizational processes and systems, which embody tacit knowledge. For example, Amazon’s speedy delivery capabilities rely on the knowledge of its fulfillment center managers, its relationship with the United Postal Service, and the experience of its merchandisers to correctly predict inventory f low. Bose’s capabilities in auditory sys - tem design arise from the talented engineers that form the R&D team as well as the company’s strong culture, which celebrates innovation and beautiful design. Because of their complexity, capabilities are harder to categorize than resources and more challenging to search for as a result. There are, however, two approaches that can make the process of uncovering and identifying a firm’s capabilities more systematic. The first method takes the completed listing of a firm’s resources as its starting point. Since capabilities are built from resources and utilize resources as they are exercised, a firm’s resources can provide a strong set of clues about the types of capabilities the f irm is likely to have accumulated. This approach simply involves look - ing over the firm’s resources and considering whether (and to what extent) the firm has built up any related capabilities. So, for example, a f leet of trucks, the latest RFID tracking technology, and a set of large automated distribution centers may be indica - tive of sophisticated capabilities in logistics and distribution. R&D teams composed of top scientists with expertise in genomics may suggest organizational capabilities in developing new gene therapies or in biotechnology more generally. The second method of identifying a firm’s capabilities takes a functional approach. Many capabilities relate to fairly specific functions; these draw on a limited set of resources and typically involve a single department or organizational unit. Capabilities in injection molding or continuous casting or metal stamping are manufacturing- related; capabilities in direct selling, promotional pricing, or database marketing all connect to the sales and marketing functions; capabilities in basic research, strate - gic innovation, or new product development link to a company’s R&D function. This Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 99 tho75109_ch04_086-121.indd 99 12/18/18 11:45 AM approach requires managers to survey the various functions a firm performs to find the different capabilities associated with each function. A problem with this second method is that many of the most important capabili - ties of firms are inherently cross-functional. Cross-functional capabilities draw on a number of different kinds of resources and are multidimensional in nature—they spring from the effective collaboration among people with different types of exper - tise working in different organizational units. Warby Parker draws from its cross- functional design process to create its popular eyewear. Its design capabilities are not just due to its creative designers, but are the product of their capabilities in market research and engineering as well as their relations with suppliers and manu - facturing companies. Cross-functional capabilities and other complex capabilities involving numerous linked and closely integrated competitive assets are sometimes referred to as resource bundles. It is important not to miss identifying a company’s resource bundles, since they can be the most competitively important of a firm’s competitive assets. Resource bun - dles can sometimes pass the four tests of a resource’s competitive power (described below) even when the individual components of the resource bundle cannot. Although PetSmart’s supply chain and marketing capabilities are matched well by rival Petco, the company continues to outperform competitors through its customer service capa - bilities (including animal grooming and veterinary and day care services). Nike’s bun - dle of styling expertise, marketing research skills, professional endorsements, brand name, and managerial know-how has allowed it to remain number one in the athletic footwear and apparel industry for more than 20 years.

Assessing the Competitive Power of a Company’s Resources and Capabilities To assess a company’s competitive power, one must go beyond merely identifying its resources and capabilities to probe its caliber. 3 Thus, the second step in resource and capability analysis is designed to ascertain which of a company’s resources and capa - bilities are competitively superior and to what extent they can support a company’s quest for a sustainable competitive advantage over market rivals. When a company has competitive assets that are central to its strategy and superior to those of rival firms, they can support a competitive advantage, as defined in Chapter 1. If this advantage proves durable despite the best efforts of competitors to overcome it, then the com - pany is said to have a sustainable competitive advantage. While it may be difficult for a company to achieve a sustainable competitive advantage, it is an important strategic objective because it imparts a potential for attractive and long-lived profitability.

The Four Tests of a Resource’s Competitive Power  The competitive power of a resource or capability is measured by how many of four specific tests it can pass. 4 These tests are referred to as the VRIN tests for sustainable competitive advantage —VRIN is a shorthand reminder standing for Valuable, Rare, Inimitable, and Nonsubstitutable. The first two tests determine whether a resource or capability can support a competitive advantage. The last two determine whether the competitive advantage can be sustained.

1 . Is the resource or capability competitively Valuable? To be competitively valuable, a resource or capability must be directly relevant to the company’s strategy, mak - ing the company a more effective competitor. Unless the resource or capability contributes to the effectiveness of the company’s strategy, it cannot pass this first CORE CONCEPT A resource bundle is a linked and closely inte - grated set of competitive assets centered around one or more cross-functional capabilities.

CORE CONCEPT The VRIN tests for sustain - able competitive advantage ask whether a resource is valuable, rare, inimitable, and nonsubstitutable.

CORE CONCEPT Recall that a competitive advantage means that you can produce more value (V) for the customer than rivals can, or the same value at lower cost (C). In other words, your V-C is greater than the V-C of competitors. V-C is what we call the Total Economic Value produced by a company. Final PDF to printer 100 PART 1 tho75109_ch04_086-121.indd 100 12/18/18 11:45 AM test. An indicator of its effectiveness is whether the resource enables the company to strengthen its business model by improving its customer value proposition and/ or profit formula (see Chapter 1). Google failed in converting its technological resources and software innovation capabilities into success for Google Wallet, which incurred losses of more than $300 million before being abandoned in 2016. While these resources and capabilities have made Google the world’s number-one search engine, they proved to be less valuable in the mobile payments industry. CORE CONCEPT Social complexity and causal ambiguity are two factors that inhibit the ability of rivals to imitate a firm’s most valuable resources and capabilities. Causal ambi - guity makes it very hard to figure out how a complex resource contributes to competitive advantage and therefore exactly what to imitate.

CORE CONCEPT The Total Economic Value produced by a company is equal to V-C. It is the differ - ence between the buyer ’s perceived value regarding a product or service and what it costs the company to produce it. 2. Is the resource or capability Rare —is it something rivals lack? Resources and capabilities that are common among firms and widely available cannot be a source of competitive advantage. All makers of branded cereals have valuable marketing capabilities and brands, since the key success factors in the ready-to-eat cereal indus - try demand this. They are not rare. However, the brand strength of Oreo cookies is uncommon and has provided Kraft Foods with greater market share as well as the opportunity to benefit from brand extensions such as Golden Oreos, Oreo Thins, and Mega Stuf Oreos. A resource or capability is considered rare if it is held by only a small number of firms in an industry or specific competitive domain. Thus, while general management capabilities are not rare in an absolute sense, they are relatively rare in some of the less developed regions of the world and in some business domains. 3. Is the resource or capability Inimitable —is it hard to copy? The more difficult and more costly it is for competitors to imitate a company’s resource or capability, the more likely that it can also provide a sustainable competitive advantage. Resources and capa - bilities tend to be difficult to copy when they are unique (a fantastic real estate loca - tion, patent-protected technology, an unusually talented and motivated labor force), when they must be built over time in ways that are difficult to imitate (a well-known brand name, mastery of a complex process technology, years of cumulative experience and learning), and when they entail financial outlays or large-scale operations that few industry members can undertake (a global network of dealers and distributors).

Imitation is also difficult for resources and capabilities that ref lect a high level of social complexity (company culture, interpersonal relationships among the managers or R&D teams, trust-based relations with customers or suppliers) and causal ambigu - it y, a term that signifies the hard-to-disentangle nature of the complex resources, such as a web of intricate processes enabling new drug discovery. Hard-to-copy resources and capabilities are important competitive assets, contributing to the longevity of a company’s market position and offering the potential for sustained profitability.

4. Is the resource or capability Nonsubstitutable —is it invulnerable to the threat of substitution from different types of resources and capabilities? Even resources that are competitively valuable, rare, and costly to imitate may lose much of their ability to offer competitive advantage if rivals possess equivalent substitute resources. For example, manufacturers relying on automation to gain a cost-based advantage in production activities may find their technology-based advantage nullified by rivals’ use of low-wage offshore manufacturing. Resources can contribute to a sustainable competitive advantage only when resource substitutes aren’t on the horizon.

The vast majority of companies are not well endowed with standout resources or capabilities, capable of passing all four tests with high marks. Most firms have a mixed bag of resources—one or two quite valuable, some good, many satisfactory to medio - cre. Resources and capabilities that are valuable pass the first of the four tests. As key contributors to the effectiveness of the strategy, they are relevant to the firm’s competi - tiveness but are no guarantee of competitive advantage. They may offer no more than competitive parity with competing firms. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 101 tho75109_ch04_086-121.indd 101 12/18/18 11:45 AM Passing both of the first two tests requires more—it requires resources and capabilities that are not only valuable but also rare. This is a much higher hurdle that can be cleared only by resources and capabilities that are competitively superior. Resources and capabili - ties that are competitively superior are the company’s true strategic assets. They provide the company with a competitive advantage over its competitors, if only in the short run. To pass the last two tests, a resource must be able to maintain its competitive superi - ority in the face of competition. It must be resistant to imitative attempts and efforts by competitors to find equally valuable substitute resources. Assessing the availability of substitutes is the most difficult of all the tests since substitutes are harder to recognize, but the key is to look for resources or capabilities held by other firms or being devel - oped that can serve the same function as the company’s core resources and capabilities. 5 Very few firms have resources and capabilities that can pass all four tests, but those that do enjoy a sustainable competitive advantage with far greater profit potential. Costco is a notable example, with strong employee incentive programs and capabilities in sup - ply chain management that have surpassed those of its warehouse club rivals for over 35 years. Lincoln Electric Company, less well known but no less notable in its achieve - ments, has been the world leader in welding products for over 100 years as a result of its unique piecework incentive system for compensating production workers and the unsur - passed worker productivity and product quality that this system has fostered.

A C o m p a n y ’ s R e s o u r c e s a n d C a p a b i l i t i e s M u s t B e M a n a g e d D y n a m i c a l l y  Even companies like Costco and Lincoln Electric cannot afford to rest on their laurels. Rivals that are initially unable to replicate a key resource may develop better and better substi - tutes over time. Resources and capabilities can depreciate like other assets if they are managed with benign neglect. Disruptive changes in technology, customer preferences, distribution channels, or other competitive factors can also destroy the value of key strategic assets, turning resources and capabilities “from diamonds to rust.” 6 Resources and capabilities must be continually strengthened and nurtured to sus - tain their competitive power and, at times, may need to be broadened and deepened to allow the company to position itself to pursue emerging market opportunities. 7 Organizational resources and capabilities that grow stale can impair competitiveness unless they are refreshed, modified, or even phased out and replaced in response to ongoing market changes and shifts in company strategy. Management’s challenge in managing the firm’s resources and capabilities dynamically has two elements: (1) attending to the ongoing modification of existing competitive assets, and (2) cast - ing a watchful eye for opportunities to develop totally new kinds of capabilities.

The Role of Dynamic Capabilities  Companies that know the importance of recalibrating and upgrading their most valuable resources and capabilities ensure that these activities are done on a continual basis. By incorporating these activi - ties into their routine managerial functions, they gain the experience necessary to be able to do them consistently well. At that point, their ability to freshen and renew their competitive assets becomes a capability in itself—a dynamic capability. A dynamic capability is the ability to modify, deepen, or augment the company’s existing resources and capabilities. 8 This includes the capacity to improve existing resources and capabilities incrementally, in the way that Toyota aggressively upgrades the company’s capabilities in fuel-efficient hybrid engine technology and constantly fine-tunes its famed Toyota production system. Likewise, management at BMW developed new organizational capabilities in hybrid engine design that allowed the company to launch its highly touted i3 and i8 plug-in hybrids. A dynamic capability CORE CONCEPT A dynamic capability is an ongoing capacity of a com - pany to modify its existing resources and capabilities or create new ones.

A company requires a dynamically evolving portfolio of resources and capabilities to sustain its competitiveness and help drive improvements in its performance. Final PDF to printer 102 PART 1 tho75109_ch04_086-121.indd 102 12/18/18 11:45 AM also includes the capacity to add new resources and capabilities to the company’s com - petitive asset portfolio. One way to do this is through alliances and acquisitions. An example is General Motor’s partnership with Koren electronics firm LG Corporation, which enabled GM to develop a manufacturing and engineering platform for producing electric vehicles. This enabled GM to beat the likes of Tesla and Nissan to market with the first affordable all-electric car with good driving range—the Chevy Bolt EV. • LO 4-4 chain activities can affect a company’s cost structure and customer value proposition.

QUESTION 4: HOW DO VALUE CHAIN ACTIVITIES AND CUSTOMER VALUE PROPOSITION? Company managers are often stunned when a competitor cuts its prices to “unbeliev - ably low” levels or when a new market entrant introduces a great new product at a sur - prisingly low price. While less common, new entrants can also storm the market with a product that ratchets the quality level up so high that customers will abandon com - peting sellers even if they have to pay more for the new product. This is what seems to have happened with Apple’s iPhone 7 and iMac computers. Regardless of where on the quality spectrum a company competes, it must remain competitive in terms of its customer value proposition in order to stay in the game.

Patagonia’s value proposition, for example, remains attractive to customers who value quality, wide selection, and corporate environmental responsibility over cheaper out - erwear alternatives. Since its inception in 1925, the New Yorker ’s customer value prop - osition has withstood the test of time by providing readers with an amalgam of well-crafted, rigorously fact-checked, and topical writing. Recall from our discussion of the Customer Value Proposition in Chapter 1: The value (V) provided to the customer depends on how well a customer’s needs are met for the price paid (V-P). How well customer needs are met depends on the perceived quality of a product or service as well as on other, more tangible attributes. The greater the amount of customer value that the company can offer profitably compared to its rivals, the less vulnerable it will be to competitive attack.

For managers, the key is to keep close track of how cost-effectively the company can deliver value to customers relative to its competitors. If it can deliver the same amount of value with lower expenditures (or more value at the same cost), it will maintain a competitive edge. Two analytic tools are particularly useful in determining whether a company’s costs and customer value proposition are competitive: value chain analysis and benchmarking. The Concept of a Company Value Chain Every company’s business consists of a collection of activities undertaken in the course of producing, marketing, delivering, and supporting its product or service.

All the various activities that a company performs internally combine to form a value chain —so called because the underlying intent of a company’s activities is ulti - mately to create value for buyers. As shown in Figure 4.3, a company’s value chain consists of two broad catego - ries of activities: the primary activities foremost in creating value for customers and the requisite support activities that facilitate and enhance the performance of the The higher a company’s costs are above those of close rivals, the more com - petitively vulnerable the company becomes.

The greater the amount of customer value that a com - pany can offer profitably rel - ative to close rivals, the less competitively vulnerable the company becomes.

CORE CONCEPT A company’s value chain identifies the primary activi - ties and related support activities that create cus - tomer value. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 103 tho75109_ch04_086-121.indd 103 12/18/18 11:45 AM FIGURE 4.3 OperationsDistribution Sales and Marketing ServicePro t Margin Supply Chain Manage- ment Primary Activities and Costs Support Activities and Costs Product R& D, Technology , and Systems Development Human R esource Management General Administration PRIMAR Y ACTIVITIES Supply Chain Management— Activities, costs, and assets associated with purchasing fuel, energy , raw materials, parts and components, merchandise, and consumable items from vendors; receiving, storing, and disseminating inputs from suppliers; inspection; and inventory management.

Operations— Activities, costs, and assets associated with converting inputs into nal product form (production, assembly , packaging, equipment maintenance, facilities, operations, quality assurance, environmental protection).

Distribution— Activities, costs, and assets dealing with physically distributing the product to buyers ( nished goods warehousing, order processing, order picking and packing, shipping, delivery vehicle operations, establishing and maintaining a network of dealers and distributors).

Sales and Marketing— Activities, costs, and assets related to sales force eforts, advertising and promotion, market research and planning, and dealer/distributor support.

Service— Activities, costs, and assets associated with providing assistance to buyers, such as installation, spare parts delivery , maintenance and repair , technical assistance, buyer inquiries, and complaints.

SUPPORT A CTIVITIES Product R& D, Technology , and Systems Development— Activities, costs, and assets relating to product R&D , process R&D , process design improvement, equipment design, computer software development, telecommuni- cations systems, computer-assisted design and engineering, database capabilities, and development of computerized support systems.

Human R esource Management— Activities, costs, and assets associated with the recruitment, hiring, training, development, and compensation of all types of personnel; labor relations activities; and development of knowledge-based skills and core competencies.

General Administration— Activities, costs, and assets relating to general management, accounting and nance , legal and regulatory afairs, safety and security , management information systems, forming strategic alliances and collaborating with strategic partners, and other “overhead” functions. Source: Based on the discussion in Michael E. Porter, Competitive Advantage (New York: Free Press, 1985), pp. 37–43. 104 PART 1 tho75109_ch04_086-121.indd 104 12/18/18 11:45 AM primary activities. 10 The kinds of primary and secondary activities that constitute a company’s value chain vary according to the specifics of a company’s business; hence, the listing of the primary and support activities in Figure 4.3 is illustrative rather than definitive. For example, the primary activities at a hotel operator like Starwood Hotels and Resorts mainly consist of site selection and construction, reservations, and hotel operations (check-in and check-out, maintenance and housekeeping, dining and room service, and conventions and meetings); principal support activities that drive costs and impact customer value include hiring and training hotel staff and handling general administration. Supply chain management is a crucial activity for Boeing and Amazon but is not a value chain component at Facebook, WhatsAPP, or Goldman Sachs. Sales and marketing are dominant activities at GAP and Match.com but have only minor roles at oil-drilling companies and natural gas pipeline companies. Customer delivery is a crucial activity at Domino’s Pizza and Blue Apron but insignificant at Starbucks and Dunkin Donuts. With its focus on value-creating activities, the value chain is an ideal tool for examining the workings of a company’s customer value proposition and business model. It permits a deep look at the company’s cost structure and ability to offer low prices. It reveals the emphasis that a company places on activities that enhance dif - ferentiation and support higher prices, such as service and marketing. It also includes a profit margin component (P-C), since profits are necessary to compensate the com - pany’s owners and investors, who bear risks and provide capital. Tracking the profit margin along with the value-creating activities is critical because unless an enterprise succeeds in delivering customer value profitably (with a sufficient return on invested capital), it can’t survive for long. Attention to a company’s profit formula in addi - tion to its customer value proposition is the essence of a sound business model, as described in Chapter 1. Illustration Capsule 4.1 shows representative costs for various value chain activities performed by Boll & Branch, a maker of luxury linens and bedding sold directly to consumers online.

Comparing the Value Chains of Rival Companies  Value chain analysis facili - tates a comparison of how rivals, activity by activity, deliver value to customers. Even rivals in the same industry may differ significantly in terms of the activities they per - form. For instance, the “operations” component of the value chain for a manufacturer that makes all of its own parts and components and assembles them into a finished product differs from the “operations” of a rival producer that buys the needed parts and components from outside suppliers and performs only assembly operations. How each activity is performed may affect a company’s relative cost position as well as its capacity for differentiation. Thus, even a simple comparison of how the activities of rivals’ value chains differ can reveal competitive differences.

A Company’s Primary and Secondary Activities Identify the Major Components of Its Internal Cost Structure  The combined costs of all the various primary and support activities constituting a company’s value chain define its internal cost struc - ture. Further, the cost of each activity contributes to whether the company’s overall cost position relative to rivals is favorable or unfavorable. The roles of value chain analy - sis and benchmarking are to develop the data for comparing a company’s costs activity by activity against the costs of key rivals and to learn which internal activities are a source of cost advantage or disadvantage. Final PDF to printer 105 tho75109_ch04_086-121.indd 105 12/18/18 11:45 AM ILLUSTRATION ©f izkes/Shutterstock A king-size set of sheets from Boll & Branch is made from . meters of fabric, requiring kilograms of raw cotton.

Raw Cotton $ .5. . Spinning/Weaving/Dyeing ..00 Cutting/Sewing/Finishing 2.30 Material Transportation 1.00 Factory Fee 3.50 Cost of Goods $ 68.46 Inspection Fees 5.48 Ocean Freight/Insurance 4.55 Import Duties 8.22 Warehouse/Packing 8.50 Packaging 15.15 Customer Shipping 14.00 Promotions/Donations* 30.00 Total Cost $154.38 Boll & Brand Markup About 60% Boll & Brand Retail Price $250.00 Gross Margin** $ 95.62 Source: Adapted from Christina Brinkley, “What Goes into the Price of Luxury Sheets?” March 29, 2014, www.wsj.com/articles/SB10001424052702303725404579461953672838672 Final PDF to printer 106 PART 1 tho75109_ch04_086-121.indd 106 12/18/18 11:45 AM Evaluating a company’s cost-competitiveness involves using what accountants call activity-based costing to deter mine the costs of per for ming each value chain activ - it y. 11 The degree to which a company’s total costs should be broken down into costs for specific activities depends on how valuable it is to know the costs of specific activ - ities versus broadly defined activities. At the very least, cost estimates are needed for each broad category of primary and support activities, but cost estimates for more specific activities within each broad category may be needed if a company discov - ers that it has a cost disadvantage vis-à-vis rivals and wants to pin down the exact source or activity causing the cost disadvantage. However, a company’s own internal costs may be insufficient to assess whether its product offering and customer value proposition are competitive with those of rivals. Cost and price differences among competing companies can have their origins in activities performed by suppliers or by distribution allies involved in getting the product to the final customers or end users of the product, in which case the company’s entire value chain system becomes relevant. The Value Chain System A company’s value chain is embedded in a larger system of activities that includes the value chains of its suppliers and the value chains of whatever wholesale distributors and retailers it utilizes in getting its product or service to end users. This value chain system (sometimes called a vertical chain) has implications that extend far beyond the company’s costs. It can affect attributes like product quality that enhance differentia - tion and have importance for the company’s customer value proposition, as well as its profitability. 12 Suppliers’ value chains are relevant because suppliers perform activi - ties and incur costs in creating and delivering the purchased inputs utilized in a com - pany’s own value-creating activities. The costs, performance features, and quality of these inputs inf luence a company’s own costs and product differentiation capabilities.

Anything a company can do to help its suppliers drive down the costs of their value chain activities or improve the quality and performance of the items being supplied can enhance its own competitiveness—a powerful reason for working collaboratively with suppliers in managing supply chain activities. 13 For example, automakers have encouraged their automotive parts suppliers to build plants near the auto assembly plants to facilitate just-in-time deliveries, reduce warehousing and shipping costs, and promote close collaboration on parts design and production scheduling. Similarly, the value chains of a company’s distribution-channel partners are rel - evant because (1) the costs and margins of a company’s distributors and retail dealers are part of the price the ultimate consumer pays and (2) the activities that distribu - tion allies perform affect sales volumes and customer satisfaction. For these reasons, companies normally work closely with their distribution allies (who are their direct customers) to perform value chain activities in mutually beneficial ways. For instance, motor vehicle manufacturers have a competitive interest in working closely with their automobile dealers to promote higher sales volumes and better customer satisfaction with dealers’ repair and maintenance services. Producers of kitchen cabinets are heav - ily dependent on the sales and promotional activities of their distributors and build - ing supply retailers and on whether distributors and retailers operate cost-effectively enough to be able to sell at prices that lead to attractive sales volumes. As a consequence, accurately assessing a company’s competitiveness entails scrutinizing the nature and costs of value chain activities throughout the entire value chain system for delivering its products or services to end-use customers. A typical value chain system that incorporates the value chains of suppliers and forward-channel allies (if any) is shown in Figure 4.4. As was the case with company value chains, the specific activities constituting A company’s cost-competitiveness depends not only on the costs of internally performed activities (its own value chain) but also on costs in the value chains of its suppliers and distribution-channel allies. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 107 tho75109_ch04_086-121.indd 107 12/18/18 11:45 AM value chain systems vary significantly from industry to industry. The primary value chain system activities in the pulp and paper industry (timber farming, logging, pulp mills, and papermaking) differ from the primary value chain system activities in the home appliance industry (parts and components manufacture, assembly, wholesale distribu - tion, retail sales) and yet again from the computer software industry (programming, disk loading, marketing, distribution).

Benchmarking: A Tool for Assessing the Costs and Effectiveness of Value Chain Activities Benchmarking entails comparing how different companies perform various value chain activities—how materials are purchased, how inventories are managed, how products are assembled, how fast the company can get new products to market, how customer orders are filled and shipped—and then making cross-company com - parisons of the costs and effectiveness of these activities. 14 The comparison is often made between companies in the same industry, but benchmarking can also involve comparing how activities are done by companies in other industries. The objectives of benchmarking are simply to identify the best means of performing an activity and to emulate those best practices. It can be used to benchmark the activities of a company’s internal value chain or the activities within an entire value chain system. A best practice is a method of performing an activity or business process that consistently delivers superior results compared to other approaches. 15 To qualify as a legitimate best practice, the method must have been employed by at least one enterprise and shown to be consistently more effective in lowering costs, improving quality or performance, shortening time requirements, enhancing safety, or achiev - ing some other highly positive operating outcome. Best practices thus identify a path to operating excellence with respect to value chain activities. Xerox pioneered the use of benchmarking to become more cost-competitive, quickly deciding not to restrict its benchmarking efforts to its office equipment rivals but to extend them to any company regarded as “world class” in performing any activity relevant to Xerox’s business. Other companies quickly picked up on Xerox’s approach. Toyota managers got their idea for just-in-time inventory deliveries by study - ing how U.S. supermarkets replenished their shelves. Southwest Airlines reduced the FIGURE 4.4 Supplier-R elated Value Chains Activities, costs, and margins of suppliers Internally performed activities, costs,and margins Activities, costs, and margins of forward-channel allies andstrategic partners Buyer or end-user value chains Forward-Channel V alue Chains A Company’ s Own Value Chain Source: Based in part on the single-industry value chain displayed in Michael E. Porter, Competitive Advantage (New York: Free Press, 1985), p. 35. CONCEPT Benchmarking is a potent tool for improving a value chain activities that is based on learning how other companies perform them and borrowing their “best practices.” CONCEPT A best practice is a method of performing an activity that consistently delivers superior results compared to other approaches. Final PDF to printer 108 PART 1 tho75109_ch04_086-121.indd 108 12/18/18 11:45 AM turnaround time of its aircraft at each scheduled stop by studying pit crews on the auto racing circuit. More than 80 percent of Fortune 500 companies reportedly use benchmarking for comparing themselves against rivals on cost and other competitively important measures. The tough part of benchmarking is not whether to do it but, rather, how to gain access to information about other companies’ practices and costs. Sometimes bench - marking can be accomplished by collecting information from published reports, trade groups, and industry research firms or by talking to knowledgeable industry ana - lysts, customers, and suppliers. Sometimes field trips to the facilities of competing or noncompeting companies can be arranged to observe how things are done, com - pare practices and processes, and perhaps exchange data on productivity and other cost components. However, such companies, even if they agree to host facilities tours and answer questions, are unlikely to share competitively sensitive cost information.

Furthermore, comparing two companies’ costs may not involve comparing apples to apples if the two companies employ different cost accounting principles to calculate the costs of particular activities. However, a third and fairly reliable source of benchmarking information has emerged. The explosive interest of companies in benchmarking costs and identify - ing best practices has prompted consulting organizations (e.g., Accenture, A. T.

Kearney, Benchnet—The Benchmarking Exchange, and Best Practices, LLC) and several associations (e.g., the QualServe Benchmarking Clearinghouse, and the Strategic Planning Institute’s Council on Benchmarking) to gather benchmarking data, distribute information about best practices, and provide comparative cost data without identifying the names of particular companies. Having an independent group gather the information and report it in a manner that disguises the names of individual companies protects competitively sensitive data and lessens the potential for unethical behavior on the part of company personnel in gathering their own data about competitors. Industry associations are another source of data that may be used for benchmarking purposes, as exemplified in the cement industry. Benchmarking data is also provided by some government agencies; data of this sort plays an important role in electricity pricing, for example. Illustration Capsule 4.2 describes benchmarking practices in the solar industry.

Strategic Options for Remedying a Cost or Value Disadvantage The results of value chain analysis and benchmarking may disclose cost or value disad - vantages relative to key rivals. Such information is vital in crafting strategic actions to eliminate any such disadvantages and improve profitability. Information of this nature can also help a company find new avenues for enhancing its competitiveness through lower costs or a more attractive customer value proposition. There are three main areas in a company’s total value chain system where company managers can try to improve its efficiency and effectiveness in delivering customer value: (1) a company’s own inter - nal activities, (2) suppliers’ part of the value chain system, and (3) the forward-channel portion of the value chain system.

Improving Internally Performed Value Chain Activities  Managers can pursue any of several strategic approaches to reduce the costs of internally performed value chain activities and improve a company’s cost-competitiveness. They can implement best practices throughout the company, particularly for high-cost activities. They can Benchmarking the costs of company activities against those of rivals provides hard evidence of whether a com - pany is cost-competitive. Final PDF to printer 109 tho75109_ch04_086-121.indd 109 12/18/18 11:45 AM ILLUSTRATION leading to lower solar power prices for consumers and an expanding market for solar companies. According to the Solar Energy Industries Association, over 11 gigawatts (GW) of solar serving electric utilities were installed in 2016—enough to supply power for approxi - mately 1.8 million households. Simultaneously, the solar landscape is becoming more competitive. As of 2017, 46 firms had installed a cumulative total of over 45 GW of solar serving electric utilities in the United States. As competition grows, benchmarking plays an increas - ingly critical role in assessing a solar company’s relative costs and price positioning compared to other firms. This is often measured using the all-in installation and production costs per kilowatt hour generated by a solar asset, called the “Levelized Cost of Energy” (LCOE). Kilowatt hours are the units of electricity that are sold to consumers. In 2008, SunPower—one of the largest solar firms in the United States—used benchmarking to target a 50 percent decrease in its solar LCOE by 2012. This early benchmarking strategy helped the company to defend against new market entrants offering lower prices. But in the ensuing years, between 2009 and 2014, the overall industry solar LCOE fell by 78 percent, leading the com - pany to conclude that an even more aggressive approach was needed to manage downward pricing pressure. Over the course of 2017, SunPower’s quarterly earnings calls highlighted efforts to compete on benchmark prices by simplifying its company structure; divesting from non-core assets; and diversifying beyond the low-cost, large-scale utility solar market and into residential and commercial solar where it could compete more easily on price. Continuing to anticipate and adapt to falling solar prices requires reliable industry data on benchmark costs. The National Renewable Energy Laboratory (NREL) Quarterly U.S. Solar Photovoltaic System Cost Benchmark breaks down industry solar costs by inputs, including solar modules, structural hardware, and elec - trical components, as well as soft costs like labor and land expenses. This enables firms like SunPower to assess how their component costs compare to bench - marks and informs SunPower’s outlook for how solar prices will continue to fall over time. For solar to play a major role in U.S. power genera - tion, costs must keep decreasing. As solar companies race toward lower costs, benchmarking will continue to be a core strategic tool in determining pricing and mar - ket positioning. Benchmarking in the Solar Industry ©geniusey/Shutterstock Note: Developed with Mathew O’Sullivan. Sources: Solar Power World, “Top 500 Solar Contractors” (2017); SunPower, “The Drivers of the Levelized Cost of Electricity for Utility-Scale Photovoltaics” (2008); Lazard, “Levelized Cost of Energy Analysis, Version 8.0” (2014). 110 PART 1 tho75109_ch04_086-121.indd 110 12/18/18 11:45 AM that spur innovation, improve design, and enhance creativity. Additional approaches to managing value chain activities to lower costs and/or enhance customer value are dis - cussed in Chapter 5.

Improving Supplier-Related Value Chain Activities  Supplier-related cost disadvan - tages can be attacked by pressuring suppliers for lower prices, switching to lower-priced substitute inputs, and collaborating closely with suppliers to identify mutual cost-saving opportunities. 16 For example, just-in-time deliveries from suppliers can lower a company’s inventory and internal logistics costs and may also allow suppliers to economize on their warehousing, shipping, and production scheduling costs—a win–win outcome for both. In a few instances, companies may find that it is cheaper to integrate backward into the busi - ness of high-cost suppliers and make the item in-house instead of buying it from outsiders. Similarly, a company can enhance its customer value proposition through its sup - plier relationships. Some approaches include selecting and retaining suppliers that meet higher-quality standards, providing quality-based incentives to suppliers, and integrating suppliers into the design process. Fewer defects in parts from suppliers not only improve quality throughout the value chain system but can lower costs as well since less waste and disruption occur in the production processes.

Improving Value Chain Activities of Distribution Partners  Any of three means can be used to achieve better cost-competitiveness in the forward portion of the indus - try value chain:

1 . Pressure distributors, dealers, and other forward-channel allies to reduce their costs and markups. 2. Collaborate with them to identify win–win opportunities to reduce costs—for exam - ple, a chocolate manufacturer learned that by shipping its bulk chocolate in liquid form in tank cars instead of as 10-pound molded bars, it could not only save its candy bar manufacturing customers the costs associated with unpacking and melt - ing but also eliminate its own costs of molding bars and packing them. 3. Change to a more economical distribution strategy, including switching to cheaper distribution channels (selling direct via the Internet) or integrating forward into company-owned retail outlets. The means to enhancing differentiation through activities at the forward end of the value chain system include (1) engaging in cooperative advertising and promotions with forward allies (dealers, distributors, retailers, etc.), (2) creating exclusive arrangements with downstream sellers or utilizing other mechanisms that increase their incentives to enhance delivered customer value, and (3) creating and enforcing standards for down - stream activities and assisting in training channel partners in business practices. Harley- Davidson, for example, enhances the shopping experience and perceptions of buyers by selling through retailers that sell Harley-Davidson motorcycles exclusively and meet Harley-Davidson standards. The bottlers of Pepsi and Coca Cola engage in cooperative promotional activities with large grocery chains such as K roger, Publix, and Safeway.

Translating Proficient Performance of Value Chain Activities into Competitive Advantage A company that does a first-rate job of managing the activities of its value chain or value chain system relative to competitors stands a good chance of profiting from its Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 111 tho75109_ch04_086-121.indd 111 12/18/18 11:45 AM competitive advantage. A company’s value-creating activities can offer a competitive advantage in one of two ways (or both):

1 . They can contribute to greater efficiency and lower costs relative to competitors. 2. They can provide a basis for differentiation, so customers are willing to pay rela - tively more for the company’s goods and services. Achieving a cost-based competitive advantage requires determined management efforts to be cost-efficient in performing value chain activities. Such efforts have to be ongoing and persistent, and they have to involve each and every value chain activ - ity. The goal must be continuous cost reduction, not a one-time or on-again–off-again effort. Companies like Dollar General, Nucor Steel, Irish airline Ryanair, T.J.Maxx, and French discount retailer Carrefour have been highly successful in managing their value chains in a low-cost manner. Ongoing and persistent efforts are also required for a competitive advantage based on differentiation. Superior reputations and brands are built up slowly over time, through continuous investment and activities that deliver consistent, reinforcing mes - sages. Differentiation based on quality requires vigilant management of activities for quality assurance throughout the value chain. While the basis for differentiation (e.g., status, design, innovation, customer service, reliability, image) may vary widely among companies pursuing a differentiation advantage, companies that succeed do so on the basis of a commitment to coordinated value chain activities aimed purposefully at this objective. Examples include Rolex (status), Braun (design), Room and Board (craftsmanship), Zappos and L.L. Bean (customer service), Salesforce.com and Tesla ( innovation), and FedEx (reliability).

How Value Chain Activities Relate to Resources and Capabilities  There is a close relationship between the value-creating activities that a company performs and its resources and capabilities. An organizational capability or competence implies a capacity for action; in contrast, a value-creating activity initiates the action. With respect to resources and capabilities, activities are “where the rubber hits the road.” When companies engage in a value-creating activity, they do so by drawing on specific com - pany resources and capabilities that underlie and enable the activity. For example, brand-building activities depend on human resources, such as experienced brand man - agers (including their knowledge and expertise in this arena), as well as organizational capabilities in advertising and marketing. Cost-cutting activities may derive from orga - nizational capabilities in inventory management, for example, and resources such as inventory tracking systems. Because of this correspondence between activities and supporting resources and capabilities, value chain analysis can complement resource and capability analysis as another tool for assessing a company’s competitive advantage. Resources and capabili - ties that are both valuable and rare provide a company w ith what it takes for competitive advantage. For a company with competitive assets of this sort, the potential is there.

When these assets are deployed in the form of a value-creating activity, that potential is realized due to their competitive superiority. Resource analysis is one tool for identify - ing competitively superior resources and capabilities. But their value and the competi - tive superiority of that value can be assessed objectively only after they are deployed. Value chain analysis and benchmarking provide the type of data needed to make that objective assessment. There is also a dynamic relationship between a company’s activities and its resources and capabilities. Value-creating activities are more than just the embodiment Final PDF to printer 112 PART 1 tho75109_ch04_086-121.indd 112 12/18/18 11:45 AM of a resource’s or capability’s potential. They also contribute to the formation and development of capabilities. The road to competitive advantage begins with manage - ment efforts to build organizational expertise in performing certain competitively important value chain activities. With consistent practice and continuous invest - ment of company resources, these activities rise to the level of a reliable organiza - tional capability or a competence. To the extent that top management makes the growing capability a cor nerstone of the company’s strateg y, this capability becomes a core competence for the company. Later, with further organizational learning and gains in proficiency, the core competence may evolve into a distinctive com - petence, giving the company superiority over rivals in performing an important value chain activity. Such superiority, if it gives the company significant competitive clout in the marketplace, can produce an attractive competitive edge over rivals. Whether the resulting competitive advantage is on the cost side or on the differentiation side (or both) will depend on the company’s choice of which types of competence-building activities to engage in over this time period. Performing value chain activities with capabilities that permit the company to either outmatch rivals on dif - ferentiation or beat them on costs will give the company a competitive advantage. QUESTION 5: IS THE COMPANY COMPETITIVELY Using resource analysis, value chain analysis, and benchmarking to determine a company’s competitiveness on value and cost is necessary but not sufficient. A more comprehensive assessment needs to be made of the company’s overall competitive strength. The answers to two questions are of particular interest: First, how does the company rank relative to competitors on each of the important factors that determine market success? Second, all things considered, does the company have a net competi - tive advantage or disadvantage versus major competitors? An easy-to-use method for answering these two questions involves developing quantitative strength ratings for the company and its key competitors on each indus - try key success factor and each competitively pivotal resource, capability, and value chain activity. Much of the information needed for doing a competitive strength assessment comes from previous analyses. Industry and competitive analyses reveal the key success factors and competitive forces that separate industry winners from losers. Benchmarking data and scouting key competitors provide a basis for judging the competitive strength of rivals on such factors as cost, key product attributes, cus - tomer service, image and reputation, financial strength, technological skills, distri - bution capability, and other factors. Resource and capability analysis reveals which of these are competitively important, given the external situation, and whether the company’s competitive advantages are sustainable. SWOT analysis provides a more forward-looking picture of the company’s overall situation. Step 1 in doing a competitive strength assessment is to make a list of the industry’s key success factors and other telling measures of competitive strength or weakness (6 to 10 measures usually suffice). Step 2 is to assign weights to each of the measures of competitive strength based on their perceived importance. (The sum of the weights for each measure must add up to 1.) Step 3 is to calculate weighted strength ratings by scoring each competitor on each strength measure (using a 1-to-10 rating scale, where 1 is very weak and 10 is very strong) and multiplying the assigned rating by the assigned weight. Step 4 is to sum the weighted strength ratings on each factor to get an • LO 4-5 - hensive evaluation of a company’s competitive situation can assist managers in making critical decisions about their next strategic moves. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 113 tho75109_ch04_086-121.indd 113 12/18/18 11:45 AM overall measure of competitive strength for each company being rated. Step 5 is to use the overall strength ratings to draw conclusions about the size and extent of the com - pany’s net competitive advantage or disadvantage and to take specific note of areas of strength and weakness. Table 4.4 provides an example of competitive strength assessment in which a hypo - thetical company (ABC Company) competes against two rivals. In the example, rela - tive cost is the most telling measure of competitive strength, and the other strength measures are of lesser importance. The company with the highest rating on a given measure has an implied competitive edge on that measure, with the size of its edge Competitive Strength Assessment  (rating scale: 1  = very weak, 10  = very strong) ABC Co. Rival 1 Rival 2 Key Success Factor/Strength Measure Importance Weight Strength Rating Weighted Score Strength Rating Weighted Score Strength Rating Weighted Score Quality/product performance 0.10 8 0.80 5 0.50 1 0.10 Reputation/image 0.10 8 0.80 7 0.70 1 0.10 Manufacturing capability 0.10 2 0.20 10 1.00 5 0.50 Technological skills 0.05 10 0.50 1 0.05 3 0.15 Dealer network/distribution capability 0.05 9 0.45 4 0.20 5 0.25 New product innovation capability 0.05 9 0.45 4 0.20 5 0.25 Financial resources 0.10 5 0.50 10 1.00 3 0.30 Relative cost position 0.30 5 1.50 10 3.00 1 0.30 Customer service capabilities 0.15 5 0.75 7 1.05 1 0.15 Sum of importance weights 1.00 Overall weighted competitive strength rating 5.95 7.70 2.10 TABLE 4.4 Final PDF to printer 114 PART 1 tho75109_ch04_086-121.indd 114 12/18/18 11:45 AM ref lected in the difference between its weighted rating and rivals’ weighted ratings.

For instance, Rival 1’s 3.00 weighted strength rating on relative cost signals a consider - able cost advantage over ABC Company (with a 1.50 weighted score on relative cost) and an even bigger cost advantage over Rival 2 (with a weighted score of 0.30). The measure-by-measure ratings reveal the competitive areas in which a company is stron - gest and weakest, and against whom. The overall competitive strength scores indicate how all the different strength measures add up—whether the company is at a net overall competitive advantage or disadvantage against each rival. The higher a company’s overall weighted strength rating, the stronger its overall competitiveness versus rivals. The bigger the difference between a company’s overall weighted rating and the scores of lower-rated rivals, the greater is its implied net competitive advantage. Thus, Rival 1’s overall weighted score of 7.70 indicates a greater net competitive advantage over Rival 2 (with a score of 2.10) than over ABC Company (with a score of 5.95). Conversely, the bigger the difference between a company’s overall rating and the scores of higher- rated rivals, the greater its implied net competitive disadvantage. Rival 2’s score of 2.10 gives it a smaller net competitive disadvantage against ABC Company (with an overall score of 5.95) than against Rival 1 (with an overall score of 7.70). Strategic Implications of Competitive Strength Assessments In addition to showing how competitively strong or weak a company is relative to rivals, the strength ratings provide guidelines for designing wise offensive and defen - sive strategies. For example, if ABC Company wants to go on the offensive to win addi - tional sales and market share, such an offensive probably needs to be aimed directly at winning customers away from Rival 2 (which has a lower overall strength score) rather than Rival 1 (which has a higher overall strength score). Moreover, while ABC has high ratings for technological skills (a 10 rating), dealer network/distribution capabil - ity (a 9 rating), new product innovation capability (a 9 rating), quality/product perfor - mance (an 8 rating), and reputation/image (an 8 rating), these strength measures have low importance weights—meaning that ABC has strengths in areas that don’t translate into much competitive clout in the marketplace. Even so, it outclasses Rival 2 in all five areas, plus it enjoys substantially lower costs than Rival 2 (ABC has a 5 rating on relative cost position versus a 1 rating for Rival 2)—and relative cost position carries the highest importance weight of all the strength measures.

ABC also has greater competitive strength than Rival 3 regarding customer service capabilities (which carries the second-highest importance weight). Hence, because ABC’s strengths are in the very areas where Rival 2 is weak, ABC is in a good posi - tion to attack Rival 2. Indeed, ABC may well be able to persuade a number of Rival 2’s customers to switch their purchases over to its product. But ABC should be cautious about cutting price aggressively to win customers away from Rival 2, because Rival 1 could interpret that as an attack by ABC to win away Rival 1’s customers as well. And Rival 1 is in far and away the best position to compete on the basis of low price, given its high rating on relative cost in an indus - try where low costs are competitively important (relative cost carries an importance weight of 0.30). Rival 1’s strong relative cost position vis-à-vis both ABC and Rival 2 arms it with the ability to use its lower-cost advantage to thwart any price cutting on High-weighted competitive strength ratings signal a strong competitive position and possession of competi - tive advantage; low ratings signal a weak position and competitive disadvantage.

A company’s competitive strength scores pinpoint its strengths and weak - nesses against rivals and point directly to the kinds of offensive and defensive actions it can use to exploit its competitive strengths and reduce its competitive vulnerabilities. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 115 tho75109_ch04_086-121.indd 115 12/18/18 11:45 AM ABC’s part. Clearly ABC is vulnerable to any retaliatory price cuts by Rival 1—Rival 1 can easily defeat both ABC and Rival 2 in a price-based battle for sales and market share. If ABC wants to defend against its vulnerability to potential price cutting by Rival 1, then it needs to aim a portion of its strategy at lowering its costs. The point here is that a competitively astute company should utilize the strength scores in deciding what strategic moves to make. When a company has important competitive strengths in areas where one or more rivals are weak, it makes sense to consider offensive moves to exploit rivals’ competitive weaknesses. When a company has important competitive weaknesses in areas where one or more rivals are strong, it makes sense to consider defensive moves to curtail its vulnerability.

QUESTION 6: WHAT STRATEGIC ISSUES AND PROBLEMS MERIT FRONT-BURNER MANAGERIAL ATTENTION?

The final and most important analytic step is to zero in on exactly what strategic issues company managers need to address—and resolve—for the company to be more financially and competitively successful in the years ahead. This step involves draw - ing on the results of both industry analysis and the evaluations of the company’s internal situation. The task here is to get a clear fix on exactly what strategic and competitive challenges confront the company, which of the company’s competi - tive shortcomings need fixing, and what specific problems merit company manag - ers’ front-burner attention. Pinpointing the specific issues that management needs to address sets the agenda for deciding what actions to take next to improve the company’s performance and business outlook. The “priority list” of issues and problems that have to be wrestled with can include such things as how to stave off market challenges from new foreign competi - tors, how to combat the price discounting of rivals, how to reduce the company’s high costs, how to sustain the company’s present rate of growth in light of slowing buyer demand, whether to cor rect the company’s competitive def iciencies by acqui r - ing a rival company with the missing strengths, whether to expand into foreign mar - kets, whether to reposition the company and move to a different strategic group, what to do about growing buyer interest in substitute products, and what to do to combat the aging demographics of the company’s customer base. The priority list thus always centers on such concerns as “how to . . . ,” “what to do about . . . ,” and “whether to . . .” The purpose of the priority list is to identify the specific issues and problems that management needs to address, not to figure out what specific actions to take. Deciding what to do—which strategic actions to take and which strategic moves to make—comes later (when it is time to craft the strategy and choose among the various strategic alternatives). If the items on the priority list are relatively minor—which suggests that the company’s strategy is mostly on track and reasonably well matched to the company’s overall situation—company managers seldom need to go much beyond fine-tuning the present strategy. If, however, the problems confronting the company are serious and indicate the present strategy is not well suited for the road ahead, the task of crafting a better strategy needs to be at the top of management’s action agenda. A good strategy must con - tain ways to deal with all the strategic issues and obsta - cles that stand in the way of the company’s financial and competitive success in the years ahead.

Compiling a “priority list” of problems creates an agenda of strategic issues that merit prompt manage - rial attention. Final PDF to printer 116 PART 1 tho75109_ch04_086-121.indd 116 12/18/18 11:45 AM KEY POINTS There are six key questions to consider in evaluating a company’s ability to compete successfully against market rivals:

1 . How well is the present strategy working? This involves evaluating the strategy in terms of the company’s financial performance and market standing. The stronger a company’s current overall performance, the less likely the need for radical strategy changes. The weaker a company’s performance, the more its current strategy must be questioned. 2 . What is the company’s overall situation, in terms of its internal strengths and weaknesses in relation to its market opportunities and external threats? The answer to this question comes from performing a SWOT analysis. A company’s strengths and competitive assets are strategically relevant because they are the most logical and appealing build - ing blocks for strategy; internal weaknesses are important because they may repre - sent vulnerabilities that need correction. External opportunities and threats come into play because a good strategy necessarily aims at capturing a company’s most attractive opportunities and at defending against threats to its well-being. 3 . What are the company’s most important resources and capabilities and can they give the company a sustainable advantage? A company’s resources can be identified using the tangible/intangible typology presented in this chapter. Its capabilities can be identified either by starting with its resources to look for related capabilities or looking for them within the company’s different functional domains. The answer to the second part of the question comes from conducting the four tests of a resource’s competitive power—the VRIN tests. If a company has resources and capabilities that are competitively valuable and rare, the firm will have a com - petitive advantage over market rivals. If its resources and capabilities are also hard to copy (inimitable), with no good substitutes (nonsubstitutable), then the firm may be able to sustain this advantage even in the face of active efforts by rivals to overcome it. 4 . Are the company’s cost structure and value proposition competitive? One telling sign of whether a company’s situation is strong or precarious is whether its costs are com - petitive with those of industry rivals. Another sign is how the company compares with rivals in terms of differentiation—how effectively it delivers on its customer value proposition. Value chain analysis and benchmarking are essential tools in determining whether the company is performing particular functions and activities well, whether its costs are in line with those of competitors, whether it is differen - tiating in ways that really enhance customer value, and whether particular internal activities and business processes need improvement. They complement resource and capability analysis by providing data at the level of individual activities that provide more objective evidence of whether individual resources and capabilities, or bundles of resources and linked activity sets, are competitively superior. 5 . On an overall basis, is the company competitively stronger or weaker than key rivals? The key appraisals here involve how the company matches up against key rivals on industry key success factors and other chief determinants of competitive success and whether and why the company has a net competitive advantage or disadvan - tage. Quantitative competitive strength assessments, using the method presented in Table 4.4, indicate where a company is competitively strong and weak and provide insight into the company’s ability to defend or enhance its market position. As a rule, a company’s competitive strategy should be built around its competitive strengths and should aim at shoring up areas where it is competitively vulnerable. Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 117 tho75109_ch04_086-121.indd 117 12/18/18 11:45 AM When a company has important competitive strengths in areas where one or more rivals are weak, it makes sense to consider offensive moves to exploit rivals’ com - petitive weaknesses. When a company has important competitive weaknesses in areas where one or more rivals are strong, it makes sense to consider defensive moves to curtail its vulnerability. 6 . What strategic issues and problems merit front-burner managerial attention? This ana - lytic step zeros in on the strategic issues and problems that stand in the way of the company’s success. It involves using the results of industry analysis as well as resource and value chain analysis of the company’s competitive situation to identify a “priority list” of issues to be resolved for the company to be financially and com - petitively successful in the years ahead. Actually deciding on a strategy and what specific actions to take is what comes after developing the list of strategic issues and problems that merit front-burner management attention. Like good industry analysis, solid analysis of the company’s competitive situation vis- à-vis its key rivals is a valuable precondition for good strategy making.

ASSURANCE OF LEARNING EXERCISES LO 4-1 2016–2017 4 (in thousands, except per share data) ................................ $1,4:4,35: $1,::4, 1: Cost of sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ,1, , 6 , :1, 1 Selling, general, and administrative ....................... 5,2,,62 6:6,1 1 (continued) Final PDF to printer 118 PART 1 tho75109_ch04_086-121.indd 118 12/18/18 11:45 AM 2016 2017 Operating income ...................................... 338,527 353,579 Other income (expense) ................................. Other expenses ...................................... (4,587) (5,449) Interest income and other, net ......................... 4159 1901 Income before income taxes ............................. 338,099 350,031 Provision for income taxes ............................... 119,979 125,542 Net income ............................................ $218,120 $224,489 Basic earnings per share .............................. $ 1.87 $ 1.79 Diluted earnings per share ............................ $ 1.86 $ 1.78 Source: Urban Outfitters, Inc., 2017. Consolidated Balance Sheets for Urban Outfitters, Inc., 2016–2017 (in thousands, except per share data) 1, 6 January : , 1, 2 Assets Current Assets Cash and cash equivalents .............................. $ 248,140 $ 248,140 Short-term investments ................................. 111,067 61,061 Receivables, net ....................................... 54,505 75,723 Merchandise inventories ................................ 338,590 330,223 Prepaid expenses and other current assets ................ 129,095 102,078 Total current assets ..................................... 881,397 834,361 ............................. 867,786 863,137 Deferred income taxes and Other assets .................. 153,454 135,803 Total assets ............................................ $1,902,637 $1,833,301 Liabilities and Shareholders’ Equity Current Liabilities Accounts payable ...................................... $ 119,537 $ 118,035 Accrued salaries and benefits ............................ 58,782 41,474 Accrued expenses and Other current liabilities ............. 174,609 169,722 Total current liabilities ................................... 352,928 329,231 (continued) Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 119 tho75109_ch04_086-121.indd 119 12/18/18 11:45 AM January 31, 2017 January 31, 2016 Long-term debt ........................................ 0 150,000 Deferred rent and other liabilities ......................... 236,625 216,843 Total liabilities .......................................... 589,553 696,074 Commitments and Contingencies Equity Preferred stock $0.001 par value; 10,000,000 shares authorized; no shares issued and outstanding 0 0 Common stock $0.001 par value; 200,000,000 shares authorized; 116,233,781 and 117,321,120 shares issued and outstanding 12 12 Additional paid-in capital ................................ $ 0 $ 0 Retained earnings ...................................... 1,347,141 1,160,666 Total stockholders’ equity ............................... 1,313,084 1,137,227 Total Liabilities and Equity .............................. $1,902,637 $1,833,301 Source: Urban Outfitters, Inc., 2017 10-K. 2 . Cinnabon, famous for its cinnamon rolls, is an American chain commonly located in high traffic areas, such as airports and malls. They operate more than 1,200 bakeries in more than 48 countries. How many of the four tests of the competitive power of a resource does the store network pass? Using your general knowledge of this industry, perform a SWOT analysis. Explain your answers. 3 . Review the information in Illustration Capsule 4.1 concerning Boll & Branch’s average costs of producing and selling a king-size sheet set, and compare this with the representative value chain depicted in Figure 4.3. Then answer the f ollowing questions: a. Which of the company’s costs correspond to the primary value chain activities depicted in Figure 4.3? b. Which of the company’s costs correspond to the support activities described in Figure 4.3? c. What value chain activities might be important in securing or maintaining Boll & Branch’s competitive advantage? Explain your answer. 4 . Using the methodology illustrated in Table 4.3 and your knowledge as an auto - mobile owner, prepare a competitive strength assessment for General Motors and its rivals Ford, Chrysler, Toyota, and Honda. Each of the five automobile manu - facturers should be evaluated on the key success factors and strength measures of cost-competitiveness, product-line breadth, product quality and reliability, financial resources and profitability, and customer service. What does your com - petitive strength assessment disclose about the overall competitiveness of each automobile manufacturer? What factors account most for Toyota’s competitive success? Does Toyota have competitive weaknesses that were disclosed by your analysis? Explain. LO 4-2, LO 4-3 120 PART 1 tho75109_ch04_086-121.indd 120 12/18/18 11:45 AM EXERCISE FOR SIMULATION PARTICIPANTS 1 . Using the formulas in Table 4.1 and the data in your company’s latest financial statements, calculate the following measures of financial performance for your company: a. Operating profit margin b. Total return on total assets c. Current ratio d. Working capital e. Long-term debt-to-capital ratio f. Price-to-earnings ratio 2 . On the basis of your company’s latest financial statements and all the other avail - able data regarding your company’s performance that appear in the industry report, list the three measures of financial performance on which your company did best and the three measures on which your company’s financial performance was worst. 3 . What hard evidence can you cite that indicates your company’s strategy is working fairly well (or perhaps not working so well, if your company’s performance is lag - ging that of rival companies)? 4 . What internal strengths and weaknesses does your company have? What external market opportunities for growth and increased profitability exist for your company?

What external threats to your company’s future well-being and profitability do you and your co-managers see? What does the preceding SWOT analysis indicate about your company’s present situation and future prospects—where on the scale from “exceptionally strong” to “alarmingly weak” does the attractiveness of your com - pany’s situation rank? 5 . Does your company have any core competencies? If so, what are they?

6 . What are the key elements of your company’s value chain? Refer to Figure 4.3 in developing your answer. 7 . Using the methodology presented in Table 4.4, do a weighted competitive strength assessment for your company and two other companies that you and your co-managers consider to be very close competitors. LO 4-1 LO 4-1 LO 4-1 LO 4-2, LO 4-3 LO 4-2, LO 4-3 LO 4-4 LO 4-5 pp. 34–41; Danny Miller, Russell Eisenstat, and Nathaniel Foote, “Strategy from the Inside Out: Building Capability-Creating Organizations,” 44, no. 3 (Spring 2002), pp. 37–54.

Resource-Based Tangle,” Decision Economics 24, no. 4 (June–July 2003), pp. 309–323.5 Margaret A. Peteraf and Mark E. Bergen, “Scanning Dynamic Competitive Landscapes: A Market-Based and Resource-Based Framework,” 24 (2003), pp. 1027–1042.6 C. Montgomery, “Of Diamonds and Rust: A New Look at Resources,” in C. Montgomery 1 Birger Wernerfelt, “A Resource-Based View of the Firm,” 5, no. 5 (September–October 1984), pp. 171–180; Jay Barney, “Firm Resources and Sustained Competitive Advantage,” Management 17, no. 1 (1991), pp. 99–120. Assets and Organizational Rent,” Management Journal 14 (1993). 3 Jay B. Barney, “Looking Inside for Competitive Advantage,” Management Executive 9, no. 4 (November 1995), pp. 49–61; Christopher A. Bartlett and Sumantra Ghoshal, “Building Competitive Advantage through People,” Management Review 43, no. 2 (Winter 2002), (ed.), Resource-Based and Evolutionary Theories of the Firm (Boston: Kluwer Academic, 1995), pp. 251–268.

Peteraf, “The Dynamic Resource-Based View: Capability Lifecycles,” Journal 24, no. 10 (2003). Capabilities and Strategic Management,” 18, no. 7 (1997), pp. 509–533; K. Eisenhardt and J. Martin, “Dynamic Capabilities: What Are They?” 21, no. 10–11 (2000), pp. 1105–1121; M. Zollo and S. Winter, “Deliberate Learning and the Evolution of Dynamic Capabilities,” Final PDF to printer CHAPTER 4 Evaluating a Company’s Resources, Capabilities, and Competitiveness 121 tho75109_ch04_086-121.indd 121 12/18/18 11:45 AM Robin Cooper and Robert S. Kaplan, “Measure Costs Right: Make the Right Decisions,” Business Review 66, no. 5 (September– October, 1988), pp. 96–103; Joseph A. Ness and Thomas G. Cucuzza, “Tapping the Full Potential of ABC,” 73, no. 4 (July–August 1995), pp. 130–138. Competitive Advantage, p. 34. 82, no. 10 (October 2004), pp. 102–112.14 Gregory H. Watson, Strategic Benchmarking: How to Rate Your Company’s Performance Science 13 (2002), pp. 339–351; C. Helfat et al., Dynamic Capabilities: Understanding Strategic Change in Organizations (Malden, MA: Blackwell, 2007).9 Donald Sull, “Strategy as Active Waiting,” 83, no. 9 (September 2005), pp. 121–126.

Competitive Advantage (New York: Free Press).11 John K. Shank and Vijay Govindarajan, Strategic Cost Management (New York: Free Press, 1993), especially chaps. 2–6, 10, and 11; against the World’s Best (New York: Wiley, 1993); Robert C. Camp, Benchmarking: The Search for Industry Best Practices That Lead to Superior Performance (Milwaukee: ASQC Quality Press, 1989); Dawn Iacobucci and Christie Nordhielm, “Creative Benchmarking,” 78 no. 6 (November–December 2000), pp. 24–25. best�practice6html (accessed December 2, 2009). 16 Reuben E. Stone, “Leading a Supply Chain Turnaround,” 82, no. 10 (October 2004), pp. 114–121. tho75109_ch05_122-151.indd 122 12/18/18 07:56 PM chapter 5 The Five Generic Competitive Strategies ©JDawnInk/DigitalVision Vectors/Getty Images Learning Objectives This chapter will help you LO 5-1 Distinguish each of the five generic strategies and explain why some of these strategies work better in certain kinds of competitive conditions than in others. LO 5-2 Identify the major avenues for achieving a competitive advantage based on lower costs. LO 5-3 Identify the major avenues to a competitive advantage based on differentiating a company’s product or service offering from the offerings of rivals. LO 5-4 Explain the attributes of a best-cost strategy—a hybrid of low-cost and differentiation strategies.

Final PDF to printer tho75109_ch05_122-151.indd 123 12/18/18 07:56 PM I learnt the hard way about positioning in business, about catering to the right segments. Shaffi Mather— Social entrepreneur It’s all about strategic positioning and competition. Michele Hutchins— Consultant Strategic positioning means performing different activities from rivals or performing similar activities in different ways. Michael E. Porter— Professor, author, and cofounder of Monitor Consulting to delivering value the company takes, it nearly always requires performing value chain activities differently than rivals and building competitively valuable resources and capabilities that rivals can - not readily match or trump. This chapter describes the five generic competi - tive strategy options. Each of the five generic strat - egies represents a distinctly different approach to competing in the marketplace. Which of the five to employ is a company’s first and foremost choice in crafting an overall strategy and beginning its quest for competitive advantage. A company can employ any of several basic approaches to gaining a competitive advantage over rivals, but they all involve delivering more value to customers than rivals or delivering value more efficiently than rivals (or both). More value for customers can mean a good product at a lower price, a superior product worth paying more for, or a best-value offering that represents an attractive combination of price, features, service, and other appealing attributes. Greater efficiency means delivering a given level of value to customers at a lower cost to the company. But whatever approach Final PDF to printer 124 PART 1 tho75109_ch05_122-151.indd 124 12/18/18 07:56 PM TYPES OF GENERIC COMPETITIVE STRATEGIES A company’s competitive strategy lays out the specific efforts of the company to position itself in the marketplace, please customers, ward off competitive threats, and achieve a particular kind of competitive advantage. The chances are remote that any two companies—even companies in the same industry—will employ com - petitive strategies that are exactly alike in every detail. However, when one strips away the details to get at the real substance, the two biggest factors that distinguish one competitive strategy from another boil down to (1) whether a company’s market target is broad or narrow and (2) whether the company is pursuing a competitive advantage linked to lower costs or differentiation. These two factors give rise to four distinct competitive strategy options, plus one hybrid option, as shown in Figure 5.1 and listed next. 1 1 . A broad, low-cost strategy —striving to achieve broad lower overall costs than rivals on comparable products that attract a broad spectrum of buyers, usually by under - pricing rivals. 2. A broad differentiation strategy —seeking to differentiate the company’s product offering from rivals’ with attributes that will appeal to a broad spectrum of buyers. 3. A focused low-cost strategy —concentrating on the needs and requirements of a nar - row buyer segment (or market niche) and striving to meet these needs at lower costs than rivals (thereby being able to serve niche members at a lower price). 4. A focused differentiation strategy —concentrating on a narrow buyer segment (or mar - ket niche) and offering niche members customized attributes that meet their tastes and requirements better than rivals’ products. • L O 5 -1 five generic strategies and explain why some of these strategies work better in certain kinds of competitive conditions than in others.

FIGURE 5.1 L ower Cost T ype of Competitive Advantage Being Pursued Mark et Target Diferentiation Broad Diferentiation Strategy Broad L ow-Cost S trategy Best-Cost Strategy Focused L ow-Cost S trategy Focused Diferentiation Strategy A Broad Cross-Section of Buyer s A Narrow Buyer Segment (or Mark et Niche) Source: This is an expanded version of a three-strategy classification discussed in Michael E. Porter, Competitive Strategy (New York: Free Press, 1980). Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 125 tho75109_ch05_122-151.indd 125 12/18/18 07:56 PM 5. A best-cost strategy —striving to incorporate upscale product attributes at a lower cost than rivals. Being the “best-cost” producer of an upscale, multifeatured prod - uct allows a company to give customers more value for their money by underpricing rivals whose products have similar upscale, multifeatured attributes. This competi - tive approach is a hybrid strategy that blends elements of the previous four options in a unique and often effective way. It may be focused or broad in its appeal.

The remainder of this chapter explores the ins and outs of these five generic com - petitive strategies and how they differ. A low-cost advantage over rivals can translate into superior profitability through lower price and higher mar - ket share or higher profit margins.

• LO 5 -2 - nues for achieving a competitive advantage based on lower costs.

CORE CONCEPT The essence of a broad, low-cost strategy is to pro - duce goods or services for a broad base of buyers at a lower cost than rivals. BROAD LOW-COST STRATEGIES Striving to achieve lower costs than rivals targeting a broad spectrum of buyers is an especially potent competitive approach in markets with many price-sensitive buyers.

A company achieves low-cost leadership when it becomes the industry’s lowest-cost producer rather than just being one of perhaps several competitors with comparatively low costs. But a low-cost producer’s foremost strategic objective is meaning fully lower costs than rivals— not necessarily the absolutely lowest possible cost. In striving for a cost advantage over rivals, company managers must incorporate features and services that buyers consider essential. A product offering that is too frills-free can be viewed by consumers as offering little value regardless of its pricing. A company has two options for translating a low-cost advantage over rivals into superior profit performance. Option 1 is to use the lower-cost edge to underprice competitors and attract price-sensitive buyers in great enough numbers to increase total profits. Option 2 is to maintain the present price, be content with the present market share, and use the lower-cost edge to raise total profits by earning a higher profit margin on each unit sold. While many companies are inclined to exploit a low-cost advantage by using option 1 (attacking rivals with lower prices), this strategy can backfire if rivals respond with retaliatory price cuts (in order to protect their customer base and defend against a loss of sales). A rush to cut prices can often trigger a price war that lowers the profits of all price discounters. The bigger the risk that rivals will respond with matching price cuts, the more appealing it becomes to employ the second option for using a low-cost advantage to achieve higher profitability.

The Two Major Avenues for Achieving a Cost Advantage To achieve a low-cost edge over rivals, a firm’s cumulative costs across its overall value chain must be lower than competitors’ cumulative costs. There are two major avenues for accomplishing this: 2 1 . Perform value chain activities more cost-effectively than rivals. 2. Revamp the firm’s overall value chain to eliminate or bypass some cost-producing activities. Cost-Efficient Management of Value Chain Activities  For a company to do a more cost-effective job of managing its value chain than rivals, managers must diligently search out cost-saving opportunities in every part of the value chain. No CORE CONCEPT A cost driver is a factor that has a strong influence on a company’s costs. Final PDF to printer 126 PART 1 tho75109_ch05_122-151.indd 126 12/18/18 07:56 PM activity can escape cost-saving scrutiny, and all company personnel must be expected to use their talents and ingenuity to come up with innovative and effective ways to keep down costs. Particular attention must be paid to a set of factors known as cost drivers that have a strong effect on a company’s costs and can be used as levers to lower costs.

Figure 5.2 shows the most important cost drivers. Cost-cutting approaches that demon - strate an effective use of the cost drivers include 1 . Capturing all available economies of scale. Economies of scale stem from an abil - ity to lower unit costs by increasing the scale of operation. Economies of scale may be available at different points along the value chain. Often a large plant is more economical to operate than a small one, particularly if it can be oper - ated round the clock robotically. Economies of scale may be available due to a large warehouse operation on the input side or a large distribution center on the output side. In global industries, selling a mostly standard product worldwide tends to lower unit costs as opposed to making separate products (each at lower scale) for each country market. There are economies of scale in advertising as well. For example, Anheuser-Busch InBev SA/NV could afford to pay the $5 million cost of a 30-second Super Bowl ad in 2018 because the cost could be spread out over the hundreds of millions of units of Budweiser that the company sells. FIGURE 5.2 Learning and experience Capacity utilization Supply chain efciencies Bargaining power Outsourcing or vertical integration Incentive systems and culture Economies of scale Input costs Communicationsystems andinformationtechnology Production technology and design COST DRIVERS Source: Adapted from Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 127 tho75109_ch05_122-151.indd 127 12/18/18 07:56 PM 2. Taking full advantage of experience and learning-curve effects. The cost of perform - ing an activity can decline over time as the learning and experience of company personnel build. Learning and experience economies can stem from debugging and mastering newly introduced technologies, using the experiences and suggestions of workers to install more efficient plant layouts and assembly procedures, and the added speed and effectiveness that accrues from repeatedly picking sites for and building new plants, distribution centers, or retail outlets. 3. Operating facilities at full capacity. Whether a company is able to operate at or near full capacity has a big impact on unit costs when its value chain contains activities associated with substantial fixed costs. Higher rates of capacity utilization allow depreciation and other fixed costs to be spread over a larger unit volume, thereby lowering fixed costs per unit. The more capital-intensive the business and the higher the fixed costs as a percentage of total costs, the greater the unit-cost penalty for operating at less than full capacity. 4. Improving supply chain efficiency. Partnering with suppliers to streamline the ordering and purchasing process, to reduce inventory carrying costs via just- in-time inventory practices, to economize on shipping and materials handling, and to ferret out other cost-saving opportunities is a much-used approach to cost reduction. A company with a distinctive competence in cost-efficient sup - ply chain management, such as Colgate-Palmolive or Unilever (leading consumer products companies), can sometimes achieve a sizable cost advantage over less adept rivals. 5. Substituting lower-cost inputs wherever there is little or no sacrifice in product quality or performance. If the costs of certain raw materials and parts are “too high,” a company can switch to using lower-cost items or maybe even design the high-cost components out of the product altogether. 6. Using the company’s bargaining power vis-à-vis suppliers or others in the value chain system to gain concessions. Home Depot, for example, has sufficient bargaining clout with suppliers to win price discounts on large-volume purchases. 7 . Using online systems and sophisticated software to achieve operating efficiencies. For example, sharing data and production schedules with suppliers, coupled with the use of enterprise resource planning (ERP) and manufacturing execution system (MES) software, can reduce parts inventories, trim production times, and lower labor requirements. 8. Improving process design and employing advanced production technology. Often pro - duction costs can be cut by (1) using design for manufacture (DFM) procedures and computer-assisted design (CAD) techniques that enable more integrated and efficient production methods, (2) investing in highly automated robotic production technology, and (3) shifting to a mass-customization production process. Dell’s highly automated PC assembly plant in Austin, Texas, is a prime example of the use of advanced product and process technologies. Many companies are ardent users of total quality management (TQM) systems, business process reengineering, Six Sigma methodology, and other business process management techniques that aim at boosting efficiency and reducing costs. 9. Being alert to the cost advantages of outsourcing or vertical integration. Outsourcing the performance of certain value chain activities can be more economical than performing them in-house if outside specialists, by virtue of their expertise and vol - ume, can perform the activities at lower cost. On the other hand, there can be times when integrating into the activities of either suppliers or distribution-channel allies Final PDF to printer 128 PART 1 tho75109_ch05_122-151.indd 128 12/18/18 07:56 PM can lower costs through greater production efficiencies, reduced transaction costs, or a better bargaining position. 10. Motivating employees through incentives and company culture. A company’s incen - tive system can encourage not only greater worker productivity but also cost-saving innovations that come from worker suggestions. The culture of a company can also spur worker pride in productivity and continuous improvement. Companies that are well known for their cost-reducing incentive systems and culture include Nucor Steel, which characterizes itself as a company of “20,000 teammates,” Southwest Airlines, and DHL Express (rival of FedEx). Revamping of the Value Chain System to Lower Costs  Dramatic cost advan - tages can often emerge from redesigning the company’s value chain system in ways that eliminate costly work steps and entirely bypass certain cost-producing value chain activities. Such value chain revamping can include • Selling direct to consumers and bypassing the activities and costs of distributors and dealers. To circumvent the need for distributors and dealers, a company can create its own direct sales force, which adds the costs of maintaining and supporting a sales force but may be cheaper than using independent distributors and dealers to access buyers. Alternatively, they can conduct sales operations at the company’s website, since the costs for website operations and shipping may be substantially cheaper than going through distributor-dealer channels). Costs in the wholesale and retail portions of the value chain frequently represent 35 to 50 percent of the final price consumers pay, so establishing a direct sales force or selling online may offer big cost savings. • Streamlining operations by eliminating low-value-added or unnecessary work steps and activities. At Walmart, some items supplied by manufacturers are delivered directly to retail stores rather than being routed through Walmart’s distribution centers and delivered by Walmart trucks. In other instances, Walmart unloads incoming shipments from manufacturers’ trucks arriving at its distribution centers and loads them directly onto outgoing Walmart trucks headed to particular stores without ever moving the goods into the distribution center. Many supermarket chains have greatly reduced in-store meat butchering and cutting activities by shifting to meats that are cut and packaged at the meatpacking plant and then delivered to their stores in ready-to-sell form. • Reducing materials-handling and shipping costs by having suppliers locate their plants or warehouses close to the company’s own facilities. Having suppliers locate their plants or warehouses close to a company’s own plant facilitates just-in-time deliver - ies of parts and components to the exact workstation where they will be used in assembling the company’s product. This not only lowers incoming shipping costs but also curbs or eliminates the company’s need to build and operate storerooms for incoming parts and to have plant personnel move the inventories to the work - stations as needed for assembly.

Illustration Capsule 5.1 describes the path that Vanguard has followed in achieving its position as the low-cost leader of the investment management industry.

Examples of Companies That Revamped Their Value Chains to Reduce Costs   Nucor Corporation, the most profitable steel producer in the United States and one of the largest steel producers worldwide, drastically revamped the value chain process for Final PDF to printer 129 tho75109_ch05_122-151.indd 129 12/18/18 07:56 PM Success in achieving a low- cost edge over rivals comes from out-managing rivals in finding ways to perform value chain activities faster, more accurately, and more cost-effectively. ILLUSTRATION management companies. It became an industry giant by leading the way in low-cost passive index investing. In active trading, an investment manager is compensated for making an educated decision on which stocks to sell and which to buy. This incurs both transactional and man - agement fees. In contrast, passive index portfolios aim to mirror the movements of a major market index like the S&P 500, Dow Jones Industrial Average, or NASDAQ.

Passive portfolios incur fewer fees and can be managed with lower operating costs. A measure used to compare operating costs in this industry is known as the expense ratio, which is the percentage of an investment that goes toward expenses. In 2017, Vanguard’s expense ratio was less than 18 percent of the industry’s average expense ratio. Vanguard was the first to capitalize on what was at the time an underappreciated fact: over long horizons, well-managed index funds, with their lower costs and fees, typically outperform their actively trading competitors. Vanguard provides low-cost investment options for its clients in several ways. By creating funds that track index(es) over a long horizon, the client does not incur transaction and management fees normally charged in actively managed funds. Possibly more important, Vanguard was created with a unique client-owner struc - ture. When you invest with Vanguard you become an owner of Vanguard. This structure effectively cut out traditional shareholders who seek to share in profits.

Under client ownership, any returns in excess of operat - ing costs are returned to the clients/investors. Vanguard keeps its costs low in several other ways. One notable one is its focus on its employees and orga - nizational structure. The company prides itself on low turnover rates (8 percent) and very flat organizational structure. In several instances Vanguard has been able to capitalize on being a fast follower. They launched several product lines after their competitors introduced those products. Being a fast follower allowed them to develop superior products and reach scale more quickly—both further lowering their cost structure. The low-cost structure has not come at the expense of performance. Vanguard now has 370 funds, over 20 million investors, has surpassed $4.5 trillion in AUM (assets under management), and is growing faster than all its competitors combined. When Money published its January 2018 list of recommended investment funds, 42 out of 100 products listed were Vanguard funds. Vanguard’s low-cost strategy has been so successful that industry experts now refer to The Vanguard Effect.

This refers to the pressure that this investment manage - ment giant has put on competitors to lower their fees in order to compete with Vanguard’s low-cost value proposition. Vanguard’s Path to Becoming the Low- Cost Leader in Investment Management Note: Developed with Vedrana B. Greatorex. Sources: https://www.nytimes.com/2017/04/14/business/mutfund/vanguard-mutual-index-funds-growth.html ; https://investor .vanguard.com ; Sunderam, A., Viceira, L., & Ciechanover, A. (2016) HBS No. 9-216-026. ©Kristoffer Tripplaar/Alamy Stock Photo manufacturing steel products by using relatively inexpensive electric arc furnaces and continuous casting processes. Using electric arc furnaces to melt recycled scrap steel eliminated many of the steps used by traditional steel mills that made their steel prod - ucts from iron ore, coke, limestone, and other ingredients using costly coke ovens, basic oxygen blast furnaces, ingot casters, and multiple types of finishing facilities— plus Nucor’s value chain system required far fewer employees. As a consequence, Nucor produces steel with a far lower capital investment, a far smaller workforce, and far lower operating costs than traditional steel mills. Nucor’s strategy to replace the Final PDF to printer 130 PART 1 tho75109_ch05_122-151.indd 130 12/18/18 07:56 PM traditional steelmaking value chain with its simpler, quicker value chain approach has made it one of the world’s lowest-cost producers of steel, allowing it to take a huge amount of market share away from traditional steel companies and earn attractive profits. This approach has allowed the company to remain steadily profitable even as a f lood of ille - gally subsidized imports wreaked havoc on the rest of the North American steel market. Southwest Airlines has achieved considerable cost savings by reconfiguring the traditional value chain of commercial airlines, thereby permitting it to offer travel - ers lower fares. Its mastery of fast turnarounds at the gates (about 25 minutes versus 45 minutes for rivals) allows its planes to f ly more hours per day. This translates into being able to schedule more f lights per day with fewer aircraft, allowing Southwest to generate more revenue per plane on average than rivals. Southwest does not offer assigned seating, baggage transfer to connecting airlines, or first-class seating and service, thereby eliminating all the cost-producing activities associated with these features. The company’s fast and user-friendly online reservation system facilitates e-ticketing and reduces staffing requirements at telephone reservation centers and air - port counters. Its use of automated check-in equipment reduces staffing requirements for terminal check-in. The company’s carefully designed point-to-point route system minimizes connections, delays, and total trip time for passengers, allowing about 75 percent of Southwest passengers to f ly nonstop to their destinations and at the same time reducing Southwest’s costs for f light operations.

The Keys to a Successful Broad Low-Cost Strategy While broad, low-cost companies are champions of frugality, they seldom hesitate to spend aggressively on resources and capabilities that promise to drive costs out of the business. Indeed, having competitive assets of this type and ensuring that they remain competitively superior is essential for achieving competitive advantage as a broad, low- cost leader. Wal ma r t , for example, has been a n ea rly adopter of st ate - of- the - a r t tech nol - ogy throughout its operations; however, the company carefully estimates the cost savings of new technologies before it rushes to invest in them. By continuously investing in com - plex, cost-saving technologies that are hard for rivals to match, Walmart has sustained its low-cost advantage for over 45 years. Uber and Lyft, employing a formidable low-cost provider strategy and an inno - vative business model, have stormed their way into hundreds of locations across the world, totally disrupting and seemingly forever changing competition in the taxi mar - kets where they have a presence. And, most significantly, the ultra-low fares charged by Uber and Lyft have resulted in dramatic increases in the demand for taxi services, particularly those provided by these two low-cost providers. Other companies noted for their successful use of broad low-cost strategies include Spirit Airlines, EasyJet, and Ryanair in airlines; Briggs & Stratton in small gasoline engines; Huawei in networking and telecommunications equipment; Bic in ballpoint pens; Stride Rite in footwear; and Poulan in chain saws.

When a Low-Cost Strategy Works Best A low-cost strategy becomes increasingly appealing and competitively powerful when 1 . Price competition among rival sellers is vigorous. Low-cost leaders are in the best position to compete offensively on the basis of price, to gain market share at the expense of rivals, to win the business of price-sensitive buyers, to remain profitable despite strong price competition, and to survive price wars. Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 131 tho75109_ch05_122-151.indd 131 12/18/18 07:56 PM 2. The products of rival sellers are essentially identical and readily available from many eager sellers. Look-alike products and/or overabundant product supply set the stage for lively price competition; in such markets, it is the less efficient, higher-cost com - panies whose profits get squeezed the most. 3. It is difficult to achieve product differentiation in ways that have value to buyers. When the differences between product attributes or brands do not matter much to buyers, buyers are nearly always sensitive to price differences, and industry-leading compa - nies tend to be those with the lowest-priced brands. 4. Most buyers use the product in the same ways. With common user requirements, a standardized product can satisfy the needs of buyers, in which case low price, not features or quality, becomes the dominant factor in causing buyers to choose one seller’s product over another’s. 5. Buyers incur low costs in switching their purchases from one seller to another. Low switching costs give buyers the f lexibility to shift purchases to lower-priced sell - ers having equally good products or to attractively priced substitute products. A low-cost leader is well positioned to use low price to induce potential customers to switch to its brand. Pitfalls to Avoid in Pursuing a Low-Cost Strategy Perhaps the biggest mistake a low-cost producer can make is getting carried away with overly aggressive price cutting. Higher unit sales and market shares do not automatically translate into higher profits. Reducing price results in earning a lower profit margin on each unit sold. Thus reducing price improves profitability only if the lower price increases unit sales enough to offset the loss in revenues due to the lower per unit profit margin. A simple numerical example tells the story: Suppose a firm selling 1,000 units at a price of $10, a cost of $9, and a profit margin of $1 opts to cut price 5 percent to $9.50 —which reduces the firm’s profit margin to $0.50 per unit sold. If unit costs remain at $9, then it takes a 100 percent sales increase to 2,000 units just to offset the narrower profit margin and get back to total profits of $1,000. Hence, whether a price cut will result in higher or lower profitability depends on how big the resulting sales gains will be and how much, if any, unit costs will fall as sales volumes increase. A second pitfall is relying on cost reduction approaches that can be easily copied by rivals. If rivals find it relatively easy or inexpensive to imitate the leader’s low-cost methods, then the leader’s advantage will be too short-lived to yield a valuable edge in the marketplace. A third pitfall is becoming too f ixated on cost reduction. Low costs cannot be pur - sued so zealously that a firm’s offering ends up being too feature-poor to generate buyer appeal. Furthermore, a company driving hard to push down its costs has to guard against ignoring declining buyer sensitivity to price, increased buyer interest in added features or service, or new developments that alter how buyers use the product. Otherwise, it risks losing market ground if buyers start opting for more upscale or feature-rich products. Even if these mistakes are avoided, a low-cost strategy still entails risk. An innovative rival may discover an even lower-cost value chain approach. Important cost-saving technological breakthroughs may suddenly emerge. And if a low-cost producer has heavy investments in its present means of operating, then it can prove costly to quickly shift to the new value chain approach or a new technology. A low-cost producer is in the best position to win the business of price-sensitive buyers, set the floor on market price, and still earn a profit.

Reducing price does not lead to higher total profits unless the added gains in unit sales are large enough to offset the loss in rev - enues due to lower margins per unit sold.

A low-cost producer’s prod - uct offering must always contain enough attributes to be attractive to prospective buyers—low price, by itself, is not always appealing to buyers. Final PDF to printer 132 PART 1 tho75109_ch05_122-151.indd 132 12/18/18 07:56 PM BROAD DIFFERENTIATION STRATEGIES • LO 5 -3 avenues to a competi - tive advantage based on differentiating a company’s product or service offering from the offerings of rivals. CORE CONCEPT The essence of a broad differentiation strategy is to offer unique product attri - butes that a wide range of buyers find appealing and worth paying more for.

CORE CONCEPT A value driver is a factor that can have a strong differentiating effect. Differentiation strategies are attractive whenever buyers’ needs and preferences are too diverse to be fully satisfied by a standardized product offering. Successful prod - uct differentiation requires careful study to determine what attributes buyers will find appealing, valuable, and worth paying for. 3 T hen the compa ny must i ncor porate a com - bination of these desirable features into its product or service that will be different enough to stand apart from the product or service offerings of rivals. A broad differen - tiation strategy achieves its aim when a wide range of buyers find the company’s offer - ing more appealing than that of rivals and worth a somewhat higher price. Successful differentiation allows a firm to do one or more of the following:

• Command a premium price for its product. • Increase unit sales (because additional buyers are won over by the differentiat - ing features). • Gain buyer loyalty to its brand (because buyers are strongly attracted to the dif - ferentiating features and bond with the company and its products).

Differentiation enhances profitability whenever a company’s product can com - mand a sufficiently higher price or generate sufficiently bigger unit sales to more than cover the added costs of achieving the differentiation. Company differentiation strategies fail when buyers don’t place much value on the brand’s uniqueness and/or when a company’s differentiating features are easily matched by its rivals. Companies can pursue differentiation from many angles: a unique taste (Red Bull, Listerine); multiple features (Microsoft Office, Apple Watch); wide selection and one-stop shopping (Home Depot, Alibaba.com); superior service (Ritz-Carlton, Nordstrom); spare parts availability (John Deere; Morgan Motors); engineering design and performance (Mercedes, BMW); high fashion design (Prada, Gucci); product reli - ability (Whirlpool, LG, and Bosch in large home appliances); quality manufacture (Michelin); technological leadership (3M Corporation in bonding and coating prod - ucts); a full range of services (Charles Schwab in stock brokerage); and wide product selection (Campbell’s soups).

Managing the Value Chain to Create the Differentiating Attributes Differentiation is not something hatched in marketing and advertising departments, nor is it limited to the catchalls of quality and service. Differentiation opportuni - ties can exist in activities all along an industry’s value chain. The most systematic approach that managers can take, however, involves focusing on the value drivers , a set of factors—analogous to cost drivers—that are particularly effective in creat - ing differentiation. Figure 5.3 contains a list of important value drivers. Ways that managers can enhance differentiation based on value drivers include the following: 1 . Create product features and performance attributes that appeal to a wide range of buy - ers. The physical and functional features of a product have a big inf luence on differ - entiation, including features such as added user safety or enhanced environmental protection. Styling and appearance are big differentiating factors in the apparel and motor vehicle industries. Size and weight matter in binoculars and mobile devices. Most companies employing broad differentiation strategies make a point Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 133 tho75109_ch05_122-151.indd 133 12/18/18 07:56 PM of incorporating innovative and novel features in their product or service offering, especially those that improve performance and functionality. 2. Improve customer service or add extra services. Better customer services, in areas such as delivery, returns, and repair, can be as important in creating differentia - tion as superior product features. Examples include superior technical assistance to buyers, higher-quality maintenance services, more and better product informa - tion provided to customers, more and better training materials for end users, better credit terms, quicker order processing, and greater customer convenience. 3. Invest in production-related R&D activities. Engaging in production R&D may permit custom-order manufacture at an efficient cost, provide wider product variety and selection through product “versioning,” or improve product quality. Many manufac - turers have developed f lexible manufacturing systems that allow different models and product versions to be made on the same assembly line. Being able to provide buyers with made-to-order products can be a potent differentiating capability. 4. Strive for innovation and technological advances. Successful innovation is the route to more frequent first-on-the-market victories and is a powerful differentiator. If the innovation proves hard to replicate, through patent protection or other means, it can provide a company with a first-mover advantage that is sustainable. 5. Pursue continuous quality improvement. Quality control processes reduce product defects, prevent premature product failure, extend product life, make it economical to offer longer warranty coverage, improve economy of use, result in more end-user FIGURE 5.3 Customer services Production R&D Sales and marketing Quality control processes Product features and performance Technology and innovation Employee skill, training, experience Input quality VALUE DRIVERS Source: Adapted from Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). Final PDF to printer 134 PART 1 tho75109_ch05_122-151.indd 134 12/18/18 07:56 PM convenience, or enhance product appearance. Companies whose quality manage - ment systems meet certification standards, such as the ISO 9001 standards, can enhance their reputation for quality with customers. 6. Increase marketing and brand-building activities. Marketing and advertising can have a tremendous effect on the value perceived by buyers and therefore their willing - ness to pay more for the company’s offerings. They can create differentiation even when little tangible differentiation exists otherwise. For example, blind taste tests show that even the most loyal Pepsi or Coke drinkers have trouble telling one cola drink from another. 4 Brands create customer loyalty, which increases the perceived “cost” of switching to another product. 7 . Seek out high-quality inputs. Input quality can ultimately spill over to affect the performance or quality of the company’s end product. Starbucks, for example, gets high ratings on its coffees partly because it has very strict specifications on the cof - fee beans purchased from suppliers. 8. Emphasize human resource management activities that improve the skills, expertise, and knowledge of company personnel. A company with high-caliber intellectual capi - tal often has the capacity to generate the kinds of ideas that drive product inno - vation, technological advances, better product design and product performance, improved production techniques, and higher product quality. Well-designed incen - tive compensation systems can often unleash the efforts of talented personnel to develop and implement new and effective differentiating attributes. Revamping the Value Chain System to Increase Differentiation  Just as pursu - ing a cost advantage can involve the entire value chain system, the same is true for a dif - ferentiation advantage. Activities performed upstream by suppliers or downstream by distributors and retailers can have a meaningful effect on customers’ perceptions of a company’s offerings and its value proposition. Approaches to enhancing differentiation through changes in the value chain system include • Coordinating with downstream channel allies to enhance customer value. Coordinating with downstream partners such as distributors, dealers, brokers, and retailers can con - tribute to differentiation in a variety of ways. Methods that companies use to inf luence the value chain activities of their channel allies include setting standards for down - stream partners to follow, providing them with templates to standardize the selling environment or practices, training channel personnel, or cosponsoring promotions and advertising campaigns. Coordinating with retailers is important for enhancing the buying experience and building a company’s image. Coordinating with distributors or shippers can mean quicker delivery to customers, more accurate order filling, and/or lower shipping costs. The Coca-Cola Company considers coordination with its bottler- distributors so important that it has at times taken over a troubled bottler to improve its management and upgrade its plant and equipment before releasing it again. 5 • Coordinating with suppliers to better address customer needs. Collaborating with suppliers can also be a powerful route to a more effective differentiation strategy.

Coordinating and collaborating with suppliers can improve many dimensions affecting product features and quality. This is particularly true for companies that engage only in assembly operations, such as Dell in PCs and Ducati in motorcycles.

Close coordination with suppliers can also enhance differentiation by speeding up new product development cycles or speeding delivery to end customers. Strong relationships with suppliers can also mean that the company’s supply requirements are prioritized when industry supply is insufficient to meet overall demand. Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 135 tho75109_ch05_122-151.indd 135 12/18/18 07:56 PM Delivering Superior Value via a Broad Differentiation Strategy Differentiation strategies depend on meeting customer needs in unique ways or creat - ing new needs through activities such as innovation or persuasive advertising. The objective is to offer customers something that rivals can’t—at least in terms of the level of satisfaction. There are four basic routes to achieving this aim: The first route is to incorporate product attributes and user features that lower the buyer’s overall costs of using the company’s product. This is the least obvious and most overlooked route to a differentiation advantage. It is a differentiating factor since it can help business buyers be more competitive in their markets and more profitable.

Producers of materials and components often win orders for their products by reduc - ing a buyer’s raw-material waste (providing cut-to-size components), reducing a buyer’s inventory requirements (providing just-in-time deliveries), using online systems to reduce a buyer’s procurement and order processing costs, and providing free techni - cal support. This route to differentiation can also appeal to individual consumers who are looking to economize on their overall costs of consumption. Making a company’s product more economical for a consumer to use can be done by incorporating energy- efficient features (energy-saving appliances and lightbulbs help cut buyers’ utility bills; fuel-efficient vehicles cut buyer costs for gasoline) and/or by increasing maintenance intervals and product reliability to lower buyer costs for maintenance and repairs. A second route is to incorporate tangible features that increase customer satisfac - tion with the product, such as product specifications, functions, and styling. This can be accomplished by including attributes that add functionality; enhance the design; save time for the user; are more reliable; or make the product cleaner, safer, quieter, simpler to use, more portable, more convenient, or longer-lasting than rival brands.

Smartphone manufacturers are in a race to introduce next-generation devices capable of being used for more purposes and having simpler menu functionality. A third route to a differentiation-based competitive advantage is to incorporate intangible features that enhance buyer satisfaction in noneconomic ways. Toyota’s Prius and GM’s Chevy Bolt appeal to environmentally conscious motorists not only because these drivers want to help reduce global carbon dioxide emissions but also because they identify with the image conveyed. Bentley, Ralph Lauren, Louis Vuitton, Burberry, Cartier, and Coach have differentiation-based competitive advantages linked to buyer desires for status, image, prestige, upscale fashion, superior craftsmanship, and the finer things in life. Intangibles that contribute to differentia - tion can extend beyond product attributes to the reputation of the company and to customer relations or trust. The fourth route is to signal the value of the company’s product offering to buyers. The value of certain differentiating features is rather easy for buyers to detect, but in some instances buyers may have trouble assessing what their experience with the prod - uct will be. Successful differentiators go to great lengths to make buyers knowledgeable about a product’s value and employ various signals of value. Typical signals of value include a high price (in instances where high price implies high quality and perfor - mance), more appealing or fancier packaging than competing products, ad content that emphasizes a product’s standout attributes, the quality of brochures and sales pre - sentations, and the luxuriousness and ambience of a seller’s facilities. The nature of a company’s facilities are important for high-end retailers and other types of companies whose facilities are frequented by customers); They make potential buyers aware of the professionalism, appearance, and personalities of the seller’s employees and/or make Differentiation can be based on tangible or intangible attributes. Final PDF to printer 136 PART 1 tho75109_ch05_122-151.indd 136 12/18/18 07:56 PM potential buyers realize that a company has prestigious customers. Signaling value is particularly important (1) when the nature of differentiation is based on intangible features and is therefore subjective or hard to quantify, (2) when buyers are making a first-time purchase and are unsure what their experience with the product will be, (3) when repurchase is infrequent, and (4) when buyers are unsophisticated. Regardless of the approach taken, achieving a successful differentiation strategy requires, first, that the company have capabilities in areas such as customer service, marketing, brand management, and technology that can create and support differentia - tion. That is, the resources, competencies, and value chain activities of the company must be well matched to the requirements of the strategy. For the strategy to result in competitive advantage, the company’s competencies must also be sufficiently unique in delivering value to buyers that they help set its product offering apart from those of rivals. They must be competitively superior. There are numerous examples of compa - nies that have differentiated themselves on the basis of distinctive capabilities. Health care facilities like M.D. Anderson, Mayo Clinic, and Cleveland Clinic have specialized expertise and equipment for treating certain diseases that most hospitals and health care providers cannot afford to emulate. When a major news event occurs, many peo - ple turn to Fox News and CNN because they have the capabilities to get reporters on the scene quickly, break away from their regular programming (without suffering a loss of advertising revenues associated with regular programming), and devote extensive air time to newsworthy stories. The most successful approaches to differentiation are those that are difficult for rivals to duplicate. Indeed, this is the route to a sustainable competitive advan - tage based on differentiation. While resourceful competitors can, in time, clone almost any tangible product attribute, socially complex intangible attributes such as company reputation, long-standing relationships with buyers, and image are much harder to imitate. Differentiation that creates switching costs that lock in buyers also provides a route to sustainable advantage. For example, if a buyer makes a substantial investment in learning to use one type of system, that buyer is less likely to switch to a competitor’s system. (This has kept many users from switching away from Microsoft Office products, despite the fact that there are other applications with superior features.) As a rule, differentiation yields a longer-lasting and more profitable competitive edge when it is based on a well-established brand image, patent-protected product innovation, complex technical superiority, a reputation for superior product quality and reliability, relationship-based customer service, and unique competitive capabilities.

When a Differentiation Strategy Works Best Differentiation strategies tend to work best in market circumstances where • Buyer needs and uses of the product are diverse. Diverse buyer preferences allow industry rivals to set themselves apart with product attributes that appeal to par - ticular buyers. For instance, the diversity of consumer preferences for menu selec - tion, ambience, pricing, and customer service gives restaurants exceptionally wide latitude in creating a differentiated product offering. Other industries with diverse buyer needs include magazine publishing, automobile manufacturing, footwear, and kitchen appliances. • There are many ways to differentiate the product or service that have value to buy - ers. Industries in which competitors have opportunities to add features to products Easy-to-copy differentiating features cannot produce sustainable competitive advantage. Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 137 tho75109_ch05_122-151.indd 137 12/18/18 07:56 PM and services are well suited to differentiation strategies. For example, hotel chains can differentiate on such features as location, size of room, range of guest ser - vices, in-hotel dining, and the quality and luxuriousness of bedding and furnish - ings. Similarly, cosmetics producers are able to differentiate based on prestige and image, formulations that fight the signs of aging, UV light protection, exclusivity of retail locations, the inclusion of antioxidants and natural ingredients, or prohibi - tions against animal testing. Basic commodities, such as chemicals, mineral depos - its, and agricultural products, provide few opportunities for differentiation. • Few rival firms are following a similar differentiation approach. The best differen - tiation approaches involve trying to appeal to buyers on the basis of attributes that rivals are not emphasizing. A differentiator encounters less head-to-head rivalry when it goes its own separate way in creating value and does not try to out-differentiate rivals on the very same attributes. When many rivals base their differentiation efforts on the same attributes, the most likely result is weak brand differentiation and “strategy overcrowding”—competitors end up chasing much the same buyers with much the same product offerings. • Technological change is fast-paced and competition revolves around rapidly evolv - ing product features. Rapid product innovation and frequent introductions of next-version products heighten buyer interest and provide space for companies to pursue distinct differentiating paths. In smartphones and wearable Internet devices, drones for hobbyists and commercial use, automobile lane detection sen - sors, and battery-powered cars, rivals are locked into an ongoing battle to set them - selves apart by introducing the best next-generation products. Companies that fail to come up with new and improved products and distinctive performance features quickly lose out in the marketplace. Pitfalls to Avoid in Pursuing a Differentiation Strategy Differentiation strategies can fail for any of several reasons. A differentiation strat - egy keyed to product or service attributes that are easily and quickly copied is always suspect. Rapid imitation means that no rival achieves differentiation, since when - ever one firm introduces some value-creating aspect that strikes the fancy of buy - ers, fast-following copycats quickly reestablish parity. This is why a firm must seek out sources of value creation that are time-consuming or burdensome for rivals to match if it hopes to use differentiation to win a sustainable competitive edge. Differentiation strategies can also falter when buyers see little value in the unique attri - butes of a company’s product. Thus, even if a company succeeds in setting its product apart from those of rivals, its strategy can result in disappointing sales and profits if the product does not deliver adequate perceived value to buyers. A ny time many poten - tial buyers look at a company’s differentiated product offering with indifference, the company’s differentiation strategy is in deep trouble. The third big pitfall is overspending on efforts to differentiate the company’s product offering, thus eroding profitability. Company efforts to achieve differentiation nearly always raise costs—often substantially, since marketing and R&D are expensive under - takings. The key to profitable differentiation is either to keep the unit cost of achieving differentiation below the price premium that the differentiating attributes can com - mand (thus increasing the profit margin per unit sold) or to offset thinner profit mar - gins per unit by selling enough additional units to increase total profits. If a company goes overboard in pursuing costly differentiation, it could be saddled with unaccept - ably low profits or even losses. Any differentiating feature that works well is a magnet for imitators. Final PDF to printer 138 PART 1 tho75109_ch05_122-151.indd 138 12/18/18 07:56 PM Other common mistakes in crafting a differentiation strategy include • Offering only trivial improvements in quality, service, or performance features vis- à-vis rivals’ products. Trivial differences between rivals’ product offerings may not be visible or important to buyers. If a company wants to generate the fiercely loyal customer following needed to earn superior profits and open up a differentiation-based competitive advantage over rivals, then its strategy must result in strong rather than weak product differentiation. In markets where dif - ferentiators do no better than achieve weak product differentiation, customer loyalty is weak, the costs of brand switching are low, and no one company has enough of a differentiation edge to command a price premium over rival brands. • Over-differentiating so that product quality, features, or service levels exceed the Over-differentiating and overcharging are fatal differ - entiation strategy mistakes.

A low-cost strategy can defeat a differentiation strategy when buyers are satisfied with a basic prod - uct and don’t think “extra” attributes are worth a higher price. needs of most buyers. A dazzling array of features and options not only drives up product price but also runs the risk that many buyers will conclude that a less deluxe and lower-priced brand is a better value since they have little occasion to use the deluxe attributes. • Charging too high a price premium. While buyers may be intrigued by a product’s deluxe features, they may nonetheless see it as being overpriced relative to the value delivered by the differentiating attributes. A company must guard against turning off would-be buyers with what is perceived as “price gouging.” Normally, the bigger the price premium for the differentiating extras, the harder it is to keep buyers from switching to the lower-priced offerings of competitors. FOCUSED (OR MARKET NIC hE) STRATEGIES What sets focused strategies apart from broad low-cost and broad differentiation strate - gies is concentrated attention on a narrow piece of the total market. The target segment, or niche, can be in the form of a geographic segment (such as New England), or a cus - tomer segment (such as young urban creatives or “yuccies”), or a product segment (such as a class of models or some version of the overall product type). Community Coffee, the largest family-owned specialty coffee retailer in the United States, has a geographic focus on the state of Louisiana and communities across the Gulf of Mex ico. Community holds only a small share of the national coffee market but has recorded sales in excess of $10 0 m i l l ion a nd ha s won a st ron g fol low i n g i n t he Sout he a st er n Un it e d St at e s . E x a mple s of firms that concentrate on a well-defined market niche keyed to a particular product or buyer segment include Zipcar (hourly and daily car rental in urban areas), Airbnb and HomeAway (owner of VRBO) (by-owner lodging rental), Fox News Channel and HGT V (cable T V), Blue Nile (online jewelry), Tesla Motors (electric cars), and CGA, Inc. (a specialist in providing insurance to cover the cost of lucrative hole-in-one prizes at golf tournaments). Microbreweries, local bakeries, bed-and-breakfast inns, and retail boutiques have also scaled their operations to serve narrow or local customer segments.

A Focused Low-Cost Strategy A focused low-cost strategy aims at securing a competitive advantage by serving buyers in the target market niche at a lower cost (and usually lower price) than those of rival compet - itors. This strategy has considerable attraction when a firm can lower costs significantly by limiting its customer base to a well-defined buyer segment. The avenues to achieving a cost advantage over rivals also serving the target market niche are the same as those for broad low-cost leadership—use the cost drivers to perform value chain activities more Final PDF to printer 139 tho75109_ch05_122-151.indd 139 12/18/18 07:56 PM efficiently than rivals and search for innovative ways to bypass nonessential value chain activities. The only real difference between a broad low-cost strategy and a focused low- cost strategy is the size of the buyer group to which a company is appealing—the former involves a product offering that appeals to almost all buyer groups and market segments, whereas the latter aims at just meeting the needs of buyers in a narrow market segment. Budget motel chains, like Motel 6, Sleep Inn, and Super 8, cater to price-conscious travelers who just want to pay for a clean, no-frills place to spend the night. Illustration Capsule 5.2 describes how Clinícas del Azúcar’s focus on lowering the costs of diabe - tes care is allowing it to address a major health issue in Mexico.

ILLUSTRATION leading cause of death in Mexico. Over 14 million adults (14 percent of all adults) suffer from diabetes, 3.5 million cases remain undiagnosed, and more than 80,000 die due to related complications each year. The key driver behind this public health crisis is limited access to afford - able, high-quality care. Approximately 90 percent of the population cannot access diabetes care due to finan - cial and time constraints; private care can cost upwards of $1,000 USD per year (approximately 45 percent of Mexico’s population has an annual income less than $2,000 USD) while average wait times alone at public clinics surpass five hours. Clinícas del Azúcar (CDA), however, is quickly scaling a solution that uses a focused low-cost strategy to provide affordable and convenient care to low-income patients. By relentlessly focusing only on the needs of its target population, CDA has reduced the cost of diabetes care by more than 70 percent and clinic visit times by over 80 percent. The key has been the use of proprietary technol - ogy and a streamlined care system. First, CDA leverages evidence-based algorithms to diagnose patients for a frac - tion of the costs of traditional diagnostic tests. Similarly, its mobile outreach significantly reduces the costs of sup - porting patients in managing their diabetes after leaving CDA facilities. Second, CDA has redesigned the care pro - cess to implement a streamlined “patient process flow” that eliminates the need for multiple referrals to other care providers and brings together the necessary pro - fessionals and equipment into one facility. Consequently, CDA has become a one-stop shop for diabetes care, pro - viding every aspect of diabetes treatment under one roof. The bottom line: CDA’s cost structure allows it to keep its prices for diabetes treatment very low, saving patients both time and money. Patients choose from three different care packages, ranging from preventive to comprehensive care, paying an annual fee that runs between approximately $70 and $200 USD. Given this increase in affordability and convenience, CDA esti - mates that it has saved its patients over $2 million USD in medical costs and will soon increase access to afford - able, high-quality care for 10 to 80 percent of the popu - lation. These results have attracted investment from major funders including Endeavor, Echoing Green, and the Clinton Global Initiative. As a result, CDA and oth - ers expect CDA to grow from 5 clinics serving approxi - mately 5,000 patients to more than 50 clinics serving over 100,000 patients throughout Mexico by 2020. Clinícas del Azúcar’s Focused Low-Cost Strategy ©Rob Marmion/Shutterstock Note: Developed with David B. Washer. Sources: www.clinicasdelazucar.com; June 2014; Jude Webber, “Mexico Sees Poverty Climb Despite Rise in Incomes,” online, July 2015, www.ft.com/intl/cms/s/3/98460bbc-31e1-11e5-8873- org/content/javier-lozano . Final PDF to printer 14 0 PART 1 tho75109_ch05_122-151.indd 140 12/18/18 07:56 PM Focused low-cost strategies are fairly common. Costco, BJ’s, and Sam’s Club sell large lots of goods at wholesale prices to small businesses and bargain-hunters. Producers of private-label goods are able to achieve low costs in product development, marketing, distribution, and advertising by concentrating on making generic items imitative of name-brand merchandise and selling directly to retail chains wanting a low-priced store brand. The Perrigo Company Plc has become a leading manufacturer of over-the-counter health care products, with 2017 sales of over $5 billion, by focusing on producing private- label brands for retailers such as Walmart, CVS, Walgreens, Rite Aid, and Safeway.

A Focused Differentiation Strategy Focused differentiation strategies involve offering superior products or services tai - lored to the unique preferences and needs of a narrow, well-defined group of buyers.

Successful use of a focused differentiation strategy depends on (1) the existence of a buyer segment that is looking for special product or service attributes and (2) a firm’s ability to create a product or service offering that stands apart from that of rivals com - peting in the same target market niche. Companies like Molton Brown in bath, body, and beauty products, Bugatti in high performance automobiles, and Four Seasons Hotels in lodging employ successful differentiation-based focused strategies targeted at upscale buyers wanting products and services with world-class attributes. Indeed, most markets contain a buyer segment willing to pay a big price premium for the very finest items available, thus opening the strategic window for some competitors to pursue differentiation-based focused strategies aimed at the ver y top of the market pyramid. Whole Foods Market, which bills itself as “A merica’s Healthiest Grocery Store,” has become the largest organic and natural foods supermarket chain in the United States (2017 sales of over $16 billion) by catering to health- conscious consumers who prefer organic, natural, minimally processed, and locally grown foods.

W hole Foods pr ides itsel f on stock i ng the h ig hest- qual it y organ ic and nat u ral foods it can find; the company defines quality by evaluating the ingredients, freshness, taste, nutritive value, appearance, and safety of the products it carries. Illustration Capsule 5.3 describes how Canada Goose has been gaining attention with a focused differentiation strategy.

When a Focused Low-Cost or Focused Differentiation Strategy Is Attractive A focused strategy aimed at securing a competitive edge based on either low costs or dif - ferentiation becomes increasingly attractive as more of the following conditions are met:

• The target market niche is big enough to be profitable and offers good growth potential. • Industry leaders have chosen not to compete in the niche—in which case focusers can avoid battling head to head against the industry’s biggest and strongest competitors. • It is costly or difficult for multisegment competitors to meet the specialized needs of niche buyers and at the same time satisfy the expectations of their mainstream customers. • The industry has many different niches and segments, thereby allowing a focuser to pick the niche best suited to its resources and capabilities. Also, with more niches there is room for focusers to concentrate on different market segments and avoid competing in the same niche for the same customers. • Few if any rivals are attempting to specialize in the same target segment—a condi - tion that reduces the risk of segment overcrowding. Final PDF to printer 141 tho75109_ch05_122-151.indd 141 12/18/18 07:56 PM ILLUSTRATION People and you will prob - ably see photos of a celebrity sporting a Canada Goose parka. Recognizable by a distinctive red, white, and blue arm patch, the brand’s parkas have been spotted on movie stars like Emma Stone and Bradley Cooper, on New York City streets, and on the cover of Sports Illustrated. Lately, Canada Goose has become extremely successful thanks to a focused dif - ferentiation strategy that enables it to thrive within its niche in the $1.2 trillion fashion industry. By target - ing upscale buyers and providing a uniquely func - tional and stylish jacket, Canada Goose can charge nearly $1,000 per jacket and never need to put its products on sale. While Canada Goose was founded in 1957, its recent transition to a focused differentiation strategy allowed it to rise to the top of the luxury parka market.

In 2001, CEO Dani Reiss took control of the company and made two key decisions. First, he cut private-label and non-outerwear production in order to focus on the branded outerwear portion of Canada Goose’s business. Second, Reiss decided to remain in Canada despite many North American competitors moving pro - duction to Asia to increase profit margins. Fortunately for him, these two strategy decisions have led directly to the company’s current success. While other luxury brands, like Moncler, are priced similarly, no competi - tor’s products fulfill the promise of handling harsh winter weather quite like a Canada Goose “Made in Canada” parka. The Canadian heritage, use of down sourced from rural Canada, real coyote fur (humanely trapped), and promise to provide warmth in sub-25 °F temperatures have let Canada Goose break away from the pack when it comes to selling parkas. The com - pany’s distinctly Canadian product has made it a hit among buyers, which is reflected in the willingness to pay a steep premium for extremely high-quality and warm winter outerwear. Since Canada Goose’s shift to a focused differ - entiation strategy, the company has seen a boom in revenue and appeal across the globe. Prior to Reiss’s strategic decisions in 2001, Canada Goose had annual revenue of about $3 million. Within a decade, the com - pany had experienced over 4,000 percent growth in annual revenue; by the end of 2017, revenues from purchases in more than 50 countries had exceeded $300 million. At this pace, it looks like Canada Goose will remain a hot commodity as long as winter tempera - tures remain cold. Canada Goose’s Focused Differentiation Strategy ©Galit Rodan/Bloomberg via Getty Images Note: Developed with Arthur J. Santry. Sources: Drake Bennett, “How Canada Goose Parkas Migrated South,” March 13, 2015, www.bloomberg.com; Shaw, “Canada Goose’s Made-in-Canada Marketing Strategy Translates into Success,” May 18, 2012, www.financialpost.com; “The Economic Impact of the Fashion Industry,” June 13, 2015, www.maloney.house.gov; February : , :1 .). The advantages of focusing a company’s entire competitive effort on a single market niche are considerable, especially for smaller and medium-sized companies that may lack the breadth and depth of resources to tackle going after a broader cus - tomer base with a more complex set of needs. YouTube became a household name by concentrating on short video clips posted online. Papa John’s, Little Caesars, and Domino’s Pizza have created impressive businesses by focusing on the home delivery segment. Final PDF to printer 14 2 PART 1 tho75109_ch05_122-151.indd 142 12/18/18 07:56 PM The Risks of a Focused Low-Cost or Focused Differentiation Strategy Focusing carries several risks. One is the chance that competitors outside the niche will find effective ways to match the focused firm’s capabilities in serving the target niche—perhaps by coming up with products or brands specifically designed to appeal to buyers in the target niche or by developing expertise and capabilities that offset the focuser’s strengths. In the lodging business, large chains like Marriott and Hilton have launched multibrand strategies that allow them to compete effectively in several lodging segments simultaneously. Hilton has f lagship hotels with a full complement of services and amenities that allow it to attract travelers and vacationers going to major resorts; it has Waldorf Astoria, Conrad Hotels & Resorts, Hilton Hotels & Resorts, and DoubleTree hotels that provide deluxe comfort and service to business and leisure travelers; it has Homewood Suites, Embassy Suites, and Home2 Suites designed as a “home away from home” for travelers staying five or more nights; and it has nearly 700 Hilton Garden Inn and 2,100 Hampton by Hilton locations that cater to travelers looking for quality lodging at an “affordable” price. Tru by Hilton is the company’s newly introduced brand focused on value-conscious travelers seeking basic accom - modations. Hilton has also added Curio Collection, Tapestr y Collection, and Canopy by Hilton hotels that offer stylish, distinctive decors and personalized services that appeal to young professionals seeking distinctive lodging alternatives. Multibrand strategies are attractive to large companies such as Hilton precisely because they enable a company to enter a market niche and siphon business away from companies that employ a focus strategy. A second risk of employing a focused strategy is the potential for the preferences and needs of niche members to shift over time toward the product attributes desired by buyers in the mainstream portion of the market. An erosion of the differences across buyer segments lowers entry barriers into a focuser’s market niche and provides an open invitation for rivals in adjacent segments to begin competing for the focuser’s customers. A third risk is that the segment may become so attractive that it is soon inundated with competitors, intensifying rivalry and splintering segment profits. And there is always the risk for segment growth to slow to such a small rate that a focuser’s prospects for future sales and profit gains become unacceptably dim. CORE CONCEPT Best-cost strategies are a hybrid of low-cost and dif - ferentiation strategies, incor - porating features of both simultaneously. BEST-COST ( hYBRID) STRATEGIES To profitably employ a best-cost strategy, a company must have the capability to incor - porate upscale attributes into its product offering at a lower cost than rivals. When a com - pany can incorporate more appealing features, good to excellent product performance or quality, or more satisfying customer service into its product offering at a lower cost than rivals, then it enjoys “best-cost” status—it is the low-cost provider of a product or service with upscale attributes. A best-cost producer can use its low-cost advantage to underprice rivals whose products or services have similarly upscale attributes and still earn attractive profits. As Figure 5.1 indicates, best-cost strategies are a hybrid of low-cost and differentiation strategies, incorporating features of both simultaneously. They may address either a broad or narrow (focused) customer base. This permits companies to aim squarely at the sometimes great mass of value- conscious buyers looking for a better product or service at an economical price.

Value-conscious buyers frequently shy away from both cheap low-end products and Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 14 3 tho75109_ch05_122-151.indd 143 12/18/18 07:56 PM expensive high-end products, but they are quite willing to pay a “fair” price for extra features and functionality they find appealing and useful. The essence of a best-cost strategy is giving customers more value for the money by satisfying buyer desires for appealing features and charging a lower price for these attributes compared to rivals with similar-caliber product offerings. 6 A best cost strategy is different from a low-cost strategy because the additional attrac - tive attributes entail additional costs (which a low-cost producer can avoid by offering buyers a basic product with few frills). Moreover, the two strategies aim at a distin - guishably different market target. The target market for a best-cost producer is value- conscious buyers —buyers who are looking for appealing extras and functionality at a comparatively low price, regardless of whether they represent a broad or more focused segment of the market. Value-hunting buyers (as distinct from price-conscious buyers looking for a basic product at a bargain-basement price) often constitute a very sizable part of the overall market for a product or service. A best cost strategy differs from a differentiation strategy because it entails the ability to produce upscale features at a lower cost than other high-end producers. This implies the ability to profitably offer the buyer more value for the money. B e s t c o s t p r o d u c e r s n e e d no t o f fe r t h e h i g h e s t e nd p r o d u c t s a nd s e r v i c e s (a l t ho u g h they may); often the quality levels are simply better than average. Positioning of this sort permits companies to aim squarely at the sometimes great mass of value- conscious buyers looking for a better product or service at an economical price.

Value-conscious buyers frequently shy away from both cheap low-end products and expensive high-end products, but they are quite willing to pay a “fair” price for extra features and functionality they find appealing and useful. The essence of a best-cost strategy is the ability to provide more value for the money by satisfying buyer desires for better quality while charging a lower price compared to rivals with similar-caliber product offerings. Toyota has employed a classic best-cost strategy for its Lexus line of motor vehicles. It has designed an array of high-performance characteristics and upscale features into its Lexus models to make them comparable in performance and luxury to Mercedes, BMW, Audi, Jaguar, Cadillac, and Lincoln models. To signal its positioning in the luxury market segment, Toyota established a network of Lexus dealers, separate from Toyota dealers, dedicated to providing exceptional customer service. Most important, though, Toyota has drawn on its considerable know-how in making high-quality vehi - cles at low cost to produce its high-tech upscale-quality Lexus models at substantially lower costs than other luxury vehicle makers have been able to achieve in producing their models. To capitalize on its lower manufacturing costs, Toyota prices its Lexus models below those of comparable Mercedes, BMW, Audi, and Jaguar models to induce value-conscious luxury car buyers to purchase a Lexus instead. The price differ - ential has typically been quite significant. For example, in 2017 a well-equipped Lexus R X 350 (a midsized SU V) had a sticker price of $54,370, whereas the sticker price of a comparably equipped Mercedes GLE-class SU V was $62,770 and the sticker price of a comparably equipped BMW X5 SU V was $66,670.

When a Best-Cost Strategy Works Best A best-cost strategy works best in markets where product differentiation is the norm and an attractively large number of value-conscious buyers can be induced to purchase m id ra nge products rat her t ha n cheap, basic products or expensive, top - of- t he - l i ne prod - ucts. In markets such as these, a best-cost producer needs to position itself near the • LO 5-4 of a best-cost strategy—a hybrid of low-cost and differen - tiation strategies. Final PDF to printer 14 4 tho75109_ch05_122-151.indd 144 12/18/18 07:56 PM ILLUSTRATION like following by offering a limited selection of highly popular private-label products at great prices, under the Trader Joe’s brand. By pursuing a focused best-cost strategy, Trader Joe’s has been able to thrive in the notoriously low-margin grocery business. Today, Trader Joe’s earns over $1,700 of annual sales per square foot— One key to Trader Joe’s success, and a major part of its strategy, is its unique approach to product selec - tion. By selling mainly private label goods under its own brand, Trader Joe’s keeps its costs low, enabling it to offer lower prices. By being very selective about the particular products that it carries, it has also man - aged to ensure that its brand is associated with very high quality. The company’s policy is to swiftly replace any product that does not prove popular with another more appealing product. This has paid off: when you ask U.S. consumers which grocery store represents quality, Trader Joe’s tops the list. On a recent YouGov Brand Index poll, nearly 40 percent of consumers ranked Trader Joe’s best for quality—the highest among its competitors. While Trader Joe’s offers far fewer stock- keeping units (SKUs) than a typical grocery store—only 4,000 SKUs as compared to 50,000  +  in a Kroger or Safeway—the upside for customers is that this also helps to keep costs and prices low. It results in higher inven - tory turns (a key measure of efficiency in retail), lower inventory costs, and lower rents since stores in any given location can be smaller. Trader Joe’s also intentionally locates its stores in areas with value-focused customers who appreciate quality.

Trader Joe’s identifies potential sites for expansion by eval - uating demographic information. This enables Trader Joe’s to focus on serving young educated singles and couples who may not be able to afford more expensive groceries but prefer organics and ready-to-eat products. Given that it occupies smaller sized retail spaces, Trader Joe’s can locate in walkable areas and urban centers, the very same neighborhoods in which its chosen customer base lives.

Because of its focused best-cost strategy, it is unlikely that the company’s loyal customers will quit lining up to buy its tasty corn salsa or organic cold brew coffee any time soon. Trader Joe’s Focused Best-Cost Strategy ©Ken Wolter/Shutterstock Note: Developed with Stephanie K. Berger. Sources: Company website; Beth Kowitt, “Inside the Secret World of Trader Joe’s,” (August 2010); Elain Watson, “Quirky, Cult-life, Aspirational, but Affordable: The Rise and Rise of Trader Joes,” Food Navigator USA (April 2014). middle of the market with either a medium-quality product at a below-average price or a high-quality product at an average or slightly higher price. But as the Lexus example shows, a firm with the capabilities to produce top -of-the-line products more efficiently than its rivals, would also do well to pursue a best cost strategy. Best-cost strategies also work well in recessionary times, when masses of buyers become more value-conscious and are attracted to economically priced products and services with more appealing attributes. However, unless a company has the resources, know-how, and capabilities to incorporate upscale product or service attributes at a lower cost than rivals, adopt - ing a best-cost strategy is ill-advised. Illustration Capsule 5.4 describes how Trader Joe’s has applied the principles of a focused best- cost strategy to thrive in the competi - tive grocery store industry. Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 14 5 tho75109_ch05_122-151.indd 145 12/18/18 07:56 PM The Risk of a Best-Cost Strategy A company’s biggest vulnerability in employing a best-cost strategy is getting squeezed between the strategies of firms using low-cost and high-end differentiation strategies.

Low-cost producers may be able to siphon customers away with the appeal of a lower price (despite less appealing product attributes). High-end differentiators may be able to steal customers away with the appeal of better product attributes (even though their products carry a higher price tag). Thus, to be successful, a firm employing a best-cost strategy must achieve significantly lower costs in providing upscale features so that it can outcompete high-end differentiators on the basis of a significantly lower price. Likewise, it must offer buyers significantly better product attributes to justify a price above what low-cost leaders are charging. In other words, it must offer buyers a more attractive customer value proposition. A company’s competitive strategy should be well matched to its internal situation and predicated on leveraging its collection of competitively valuable resources and capabilities. Th E CONTRASTING FEATURES OF T hE GENERIC COMPETITIVE STRATEGIES Deciding which generic competitive strategy should serve as the framework on which to hang the rest of the company’s strategy is not a trivial matter. Each of the five generic competitive strategies positions the company differently in its market and competitive environment. Each establishes a central theme for how the company will endeavor to outcompete rivals. Each creates some boundaries or guidelines for ma neuver i ng as ma rket ci rcu mst a nces u n fold a nd as ideas for i mprov i ng the strateg y are debated. Each entails differences in terms of product line, production emphasis, marketing emphasis, and means of maintaining the strategy, as shown in Table 5.1 Thus a choice of which generic strategy to employ spills over to affect many aspects of how the business will be operated and the manner in which value chain activities must be managed. Deciding which generic strategy to employ is perhaps the most important strategic commitment a company makes—it tends to drive the rest of the strategic actions a company decides to undertake.

Successful Generic Strategies Are Resource-Based For a company’s competitive strategy to succeed in delivering good performance and gain a competitive edge over rivals, it has to be well matched to a company’s internal situation and underpinned by an appropriate set of resources, know-how, and competitive capabili - ties. To succeed in employing a low-cost strategy, a company must have the resources and capabilities to keep its costs below those of its competitors. This means having the exper - tise to cost-effectively manage value chain activities better than rivals by leveraging the cost drivers more effectively, and/or having the innovative capability to bypass certain value chain activities being performed by rivals. To succeed in a differentiation strategy, a com - pany must have the resources and capabilities to leverage value drivers more effectively than rivals and incorporate attributes into its product offering that a broad range of buyers will find appealing. Successful focus strategies (both low cost and differentiation) require the capability to do an outstanding job of satisfying the needs and expectations of niche buyers. Success in employing a best-cost strategy requires the resources and capabilities to incorporate upscale product or service attributes at a lower cost than rivals. For all types of generic strategies, success in sustaining the competitive edge depends on having resources and capabilities that rivals have trouble duplicating and for which there are no good substitutes. Final PDF to printer 14 6 tho75109_ch05_122-151.indd 146 12/18/18 07:56 PM Broad Low-Cost Broad Differentiation Focused Low-Cost Focused Differentiation Best-Cost Strategic target • A broad cross-section of the market.

• A broad cross-section of the market.

• A narrow market niche where buyer needs and preferences are distinctively different. • A narrow market niche where buyer needs and preferences are distinctively different. • A broad or narrow range of value-conscious buyers. Basis of competitive strategy • Lower overall costs than competitors.

• Ability to offer buyers something attractively different from competitors’ • Lower overall cost than rivals in serving niche members. • Attributes that appeal specifically to niche members. • Ability to incorporate upscale features and attributes at lower costs than rivals. Product line • A good basic product with few frills (acceptable quality and limited selection). • Many product variations, wide selection; emphasis on differentiating features. • Features and attributes tailored to the tastes and requirements of niche members. • Features and attributes tailored to the tastes and requirements of niche members. • Items with appealing attributes and assorted features; better quality, not necessarily best. Production emphasis • A continuous search for cost reduction without sacrificing acceptable quality and essential features. • Build in whatever differentiating features buyers are willing to pay for; strive for product superiority. • A continuous search for cost reduction for products that meet basic needs of niche members. • Small-scale production or custom-made products that match the tastes and requirements of niche members. • Build in appealing features and better quality at lower cost than rivals. Marketing emphasis • Low prices, good value. • Try to make a virtue out of product features that lead to low cost. • Tout differentiating features. • Charge a premium price to cover the extra costs of differentiating features. • Communicate attractive features of a budget-priced product offering that fits niche buyers’ expectations. • Communicate how product offering does the best job of meeting niche buyers’ expectations. • Emphasize delivery of best value for the money. Keys to maintaining the strategy • Strive to manage costs down, year after year, in every area of the business. • Stress continuous improvement in products or services and constant innovation to stay ahead of imitative competitors. • Stay committed to serving the niche at the lowest overall cost; don’t blur the firm’s image by entering other market segments or adding other products to widen market appeal. • Stay committed to serving the niche better than rivals; don’t blur the firm’s image by entering other market segments or adding other products to widen market appeal. • Stress continuous improvement in products or services and constant innovation, along with continuous efforts to improve efficiency. Resources and capabilities required • Capabilities for driving costs out of the value chain system. • Examples:

large-scale automated plants, an efficiency-oriented culture, bargaining power. • Capabilities concerning quality, design, intangibles, and innovation. • Examples:

marketing capabilities, R&D teams, technology. • Capabilities to lower costs on niche goods. • Examples:

lower input costs for the specific product desired by the niche, batch production capabilities. • Capabilities to meet the highly specific needs of niche members. • Examples:

custom production, close customer relations. • Capabilities to simultaneously deliver lower cost and higher-quality/differentiated features. • Examples:

TQM practices, mass customization. TABLE 5.1 Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 147 tho75109_ch05_122-151.indd 147 12/18/18 07:56 PM Generic Strategies and the Three Different Approaches to Competitive Advantage Just as a company’s resources and capabilities underlie its choice of generic strategy, its generic strategy determines its approach to gaining a competitive advantage. There are three such approaches. Clearly, low-cost strategies aim for a cost advantage over rivals, differentiation strategies strive to create relatively more perceived value for consumers, while best-cost strategies aim to do better than the average rival on both dimensions.

Whether the strategy is broad based or focused makes no difference as to the basic approach employed (see Figure 5.1). Exactly how this works is best understood with the use of the value-price-cost frame - work, first introduced in Chapter 1 in the context of different kinds of business models.

Figure 5.4 illustrates the three basic approaches to competitive advantage in terms of the value-price-cost framework. The left figure in the diagram represents an average competitor’s cost (C) of producing a good, how highly the consumer values it (V), and its price (P). The difference between the good’s value to the consumer (V) and its cost (C) is the total economic value (V- C) produced by the average competitor. A nd as explained in Chapter 4, a company has a competitive advantage over another if its strat - egy generates more total economic value. It is this excess in total economic value over rivals that allows the company to offer consumers a better value proposition or earn larger profits (or both). The dashed yellow lines facilitate a comparison of the average competitor’s costs (C) and perceived value (V) with the costs and value produced by each of the three basic types of generic strategies (low cost, differentiation, best cost).

In this way, it also facilitates a comparison of the total economic value generated by each of the three representative generic strategies in relation to the average competitor, thereby shedding light on the nature of each strategy’s competitive advantage.

FIGURE 5.4 Cost Framework - V - P - C Av erage Competitor Low-Cost Strategy Diferentiation Strategy Best-Cost Strategy -P - P -P - V -V -V - C - C - C Total EconomicValue Customer Value Proposition Company’s Pro t Formula Final PDF to printer 14 8 PART 1 tho75109_ch05_122-151.indd 148 12/18/18 07:56 PM As Figure 5.4 shows, a low-cost generic strategy aims to achieve lower costs than an average competitor, at the sacrifice of some of the perceived value to the consumer.

If the decrease in costs is less than the decrease in perceived value, then the total eco - nomic value (V-C) for the low-cost leader will be greater than the total economic value produced by its average rival and the low-cost leader will have a competitive advantage.

This is clearly the case for the example of a low-cost strategy depicted in Figure 5.4. As is common with low-cost strategies, the example company has chosen to charge a lower price than its average rival. The result is that even with a lower V, the low-cost leader offers the consumer a more attractive (larger) consumer value proposition (depicted in mauve) and finds itself with a better profit formula (depicted in blue). In contrast, the example of a differentiation strategy shows that costs might well exceed those of the average competitor. But with a successful differentiation strategy, that disadvantage is more than made up for by the rise in the perceived value (V) of the differentiated good, giving the differentiator a clear competitive advantage over the average rival (greater V-C). And while the price charged in this example is a good deal higher in comparison with the average rival’s price, this differentiation strategy enables both a larger consumer value proposition (in mauve) as well as greater profits (in blue). The depiction of a best-cost strategy shows a company pursuing the middle ground of offering neither the most highly valued goods in the market nor the lowest costs. But in comparison with the average rival, it does better on both scores, resulting in more total economic value (V- C) and a substantial competitive advantage. Once again, the example shows both a larger customer value proposition as well as a more attractive profit formula. The last thing to note is that the generic strategies depicted in Figure 5.4 are exam - ples of successful generic strategies. Being successful with a generic strategy depends on much more than positioning. It depends on the competitive context (the company’s external situation) and on the company’s internal situation, including its complement of resources and capabilities. Importantly, it also depends on how well the strategy is executed—the topic of this text’s three concluding chapters. KEY POINTS 1 . Deciding which of the five generic competitive strategies to employ—broad low- cost, broad differentiation, focused low-cost, focused differentiation, or best cost—is perhaps the most important strategic commitment a company makes. It tends to drive the remaining strategic actions a company undertakes and sets the whole tone for pursuing a competitive advantage over rivals. 2 . In employing a broad low-cost strategy and trying to achieve a low-cost advantage over rivals, a company must do a better job than rivals of cost-effectively managing value chain activities and/or it must find innovative ways to eliminate cost-producing activi - ties. An effective use of cost drivers is key. Low-cost strategies work particularly well when price competition is strong and the products of rival sellers are virtually identi - cal, when there are not many ways to differentiate, when buyers are price-sensitive or have the power to bargain down prices, when buyer switching costs are low, and when industry newcomers are likely to use a low introductory price to build market share. 3 . Broad differentiation strategies seek to produce a competitive edge by incorporat - ing attributes that set a company’s product or service offering apart from rivals in ways that buyers consider valuable and worth paying for. This depends on the appropriate use of value drivers. Successful differentiation allows a firm to (1) command a premium price for its product, (2) increase unit sales (if additional Final PDF to printer ChAPTER 5 The Five Generic Competitive Strategies 14 9 tho75109_ch05_122-151.indd 149 12/18/18 07:56 PM ASSURANCE OF LEARNING EXERCISES 1 . Best Buy is the largest consumer electronics retailer in the United States, w ith fis - cal 2017 sales of nearly $40 billion. The company competes aggressively on price with such rivals as Costco, Sam’s Club, Walmart, and Target, but it is also known by consumers for its first-rate customer service. Best Buy customers have com - mented that the retailer’s sales staff is exceptionally knowledgeable about the com - pany’s products and can direct them to the exact location of difficult-to-find items.

Best Buy customers also appreciate that demonstration models of PC monitors, digital media players, and other electronics are fully powered and ready for in-store use. Best Buy’s Geek Squad tech support and installation services are additional customer service features that are valued by many customers. How would you characterize Best Buy’s competitive strategy? Should it be clas - sified as a low-cost strategy? A differentiation strategy? A best-cost strategy? Also, has the company chosen to focus on a narrow piece of the market, or does it appear to pursue a broad market approach? Explain your answer. LO 5-1, LO 5-2, LO 5-3, LO 5-4 150 PART 1 tho75109_ch05_122-151.indd 150 12/18/18 07:56 PM EXERCISE FOR SIMULATION PARTICIPANTS 1 . Which one of the five generic competitive strategies best characterizes your com - pany’s strategic approach to competing successfully? 2 . Which rival companies appear to be employing a broad low-cost strategy?

3 . Which rival companies appear to be employing a broad differentiation strategy?

4 . Which rival companies appear to be employing a best-cost strategy?

5 . Which rival companies appear to be employing some type of focused strategy?

6 . What is your company’s action plan to achieve a sustainable competitive advantage over rival companies? List at least three (preferably more than three) specific kinds of decision entries on specific decision screens that your company has made or intends to make to win this kind of competitive edge over rivals. LO 5-1, LO 5-2, LO 5-3, LO 5-4 3 Richard L. Priem, “A Consumer Perspective on Value Creation,” Review 32, no. 1 (2007), pp. 219–235. 5 D. Yoffie, “Cola Wars Continue: Coke and Pepsi in 2006,” Harvard Business School case 9-706-447. 1 Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1980), chap. 2; Michael E. Porter, “What Is Strategy?” 74, no. 6 (November–December 1996).2 Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). 6 Peter J. Williamson and Ming Zeng, “Value-for-Money Strategies for Recessionary Times,” 87, no. 3 (March 2009), pp. 66–74. 2 . Illustration Capsule 5.1 discusses Vanguard’s position as the low-cost leader in the investment management industry. Based on information provided in the capsule, explain how Vanguard built its low-cost advantage in the industry and why a low- cost strategy can succeed in the industry. 3 . USAA is a Fortune 500 insurance and financial services company with 2017 annual sales exceeding $27 billion. The company was founded in 1922 by 25 Army officers who decided to insure each other’s vehicles and continues to limit its member - ship to active-duty and retired military members, officer candidates, and adult chil - dren and spouses of military-affiliated USAA members. The company has received countless awards, including being listed among Fortune ’s World’s Most Admired Companies in 2014 through 2018 and 100 Best Companies to Work For in 2010 through 2018. USAA was also ranked as the number-one Bank, Credit Card, and Insurance Company by Forrester Research from 2013 to 2017. You can read more about the company’s history and strategy at www.usaa.com. How would you characterize USAA’s competitive strategy? Should it be clas - sified as a low-cost strategy? A differentiation strategy? A best-cost strategy? Also, has the company chosen to focus on a narrow piece of the market, or does it appear to pursue a broad market approach? Explain your answer. 4 . Explore Kendra Scott’s website at www.kendrascott.com and see if you can iden - tify at least three ways in which the company seeks to differentiate itself from rival jewelry firms. Is there reason to believe that Kendra Scott’s differentiation strategy has been successful in producing a competitive advantage? Why or why not? LO 5-2 LO 5-1, LO 5-2, LO 5-3, LO 5-4 tho75109_ch05_122-151.indd 151 12/18/18 07:56 PM Final PDF to printer