Business Policy and Strategy Question

4 The Internal Assessment

CHAPTER OBJECTIVES

After studying this chapter, you should be able to do the following:

• 1. Explain how the nature and role of chief marketing officer has changed.

• 2. Be able to work out breakeven analysis business problems.

• 3. Describe how to perform an internal strategic-management audit.

• 4. Discuss the resource-based view (RBV) in strategic management.

• 5. Discuss key interrelationships among the functional areas of business.

• 6. Identify the basic functions or activities that make up management, marketing, finance and accounting, production and operations, research and development, and management information systems.

• 7. Explain how to determine and prioritize a firm’s internal strengths and weaknesses.

• 8. Explain the importance of financial ratio analysis.

• 9. Discuss the nature and role of management information systems in strategic management.

• 10. Develop an internal factor evaluation (IFE) matrix.

• 11. Explain cost/benefit analysis, value chain analysis, and benchmarking as strategic-management tools.

ASSURANCE OF LEARNING EXERCISES

The following exercises are found at the end of this chapter.

• EXERCISE 4A Apply Breakeven Analysis

• EXERCISE 4B Comparing Priceline.com with Expedia.com

• EXERCISE 4C Perform a Financial Ratio Analysis for PepsiCo

• EXERCISE 4D Construct an IFE Matrix for PepsiCo

• EXERCISE 4E Construct an IFE Matrix for Your University

This chapter focuses on identifying and evaluating a firm’s strengths and weaknesses in the functional areas of business, including management, marketing, finance and accounting, production and operations, research and development (R&D), and management information systems (MIS). Relationships among these areas of business are examined. Strategic implications of important functional area concepts are examined. The process of performing an internal audit is described. The resource-based view (RBV) of strategic management is introduced as is the value chain analysis (VCA) concept. Priceline.com does an excellent job using its strengths to capitalize on external opportunities. Priceline is showcased in the opening chapter boxed insert.

The Nature of an Internal Audit

All organizations have strengths and weaknesses in the functional areas of business. No enterprise is equally strong or weak in all areas. Maytag, for example, is known for excellent production and product design, whereas Procter & Gamble is known for superb marketing. Internal strengths and weaknesses, coupled with external opportunities and threats and clear vision and mission statements, provide the basis for establishing objectives and strategies. Objectives and strategies are established with the intention of capitalizing on internal strengths and overcoming weaknesses. The internal-audit part of the strategic-management process is illustrated in Figure 4-1 with white shading.

Priceline.com , Inc.: EXCELLENT STRATEGIC MANAGEMENT SHOWCASED

Do you prefer Priceline or Expedia to find low travel prices? Headquartered in Norwalk, Connecticut, Priceline.com Inc. is the leading online travel company where buyers “name their own price” for airline tickets, hotel rooms, rental cars, cruises, and vacation packages. Founded in 1997 with a patented business model, Priceline.com operates through the Booking.com, Priceline.com, TravelJigsaw, and Agoda brand names. Priceline.com uses excellent strategic management to dominate the online travel business. For example, the company generates annual sales of more than $4 billion and has an EPS of more than $30. Priceline’s common stock (PCLN) had the best five-year (2007–2011) performance of all companies in the S&P 500: a total return of 972 percent. Many analysts have a $750.00/share price target for Priceline stock. In the last 12 months, PCLN’s return on assets was 23.08 percent, compared to its competitors Expedia (EXPE)’s 4.19 percent and Orbitz World Wide (OWW)’s 2.60. PCLN’s return on equity was 48.41 percent, much higher than EXPE’s 13.44 percent and Orbitz World Wide OWW’s negative 21.25. PCLN’s profit margin for the last 12 months was 25.58 percent, compared to EXPE’s 10.42 percent and OWW’s negative 4.83.

With more than 5,000 employees, Priceline’s customers can choose set-price options. For airline tickets and hotel reservations, Priceline.com generates sales on the margin, keeping the difference between the price paid by the individual and what Priceline.com paid for the ticket or hotel room. Priceline’s recent success has been especially driven by international travel, particularly to emerging market destinations. About 65 percent of Priceline.com hotel room bookings are expected to be non-European going forward, up from 42 percent the prior year.

Priceline provides price-disclosed hotel and rental car reservation services on a worldwide basis with approximately 185,000 hotels and accommodations in 160 countries. The company’s rental car services operate through its Name Your Own Price demand-collection system, as well as vacation packages consisting of airfare, hotel, and rental car components; cruise trips; and destination services, including parking, event tickets, ground transfers, and tours in the USA. Priceline provides an optional travel insurance package that covers trip cancellation, trip interruption, medical expenses, and emergency evacuation, as well as for loss of baggage, property, and travel documents for air, hotel, and vacation package customers; and collision damage waiver insurance for rental car customers in the USA.

Priceline’s major competitor, Expedia, was founded in 1996, a year before Priceline. Priceline has four times the volume of revenues of Expedia, but the two firms aggressively compete every day for customers worldwide.

FIGURE 4-1 A Comprehensive Strategic-Management Model

Source: Fred R. David, “How Companies Define Their Mission,” Long Range Planning 22, no. 3 (June 1988): 40.

Key Internal Forces

It is not possible in a strategic-management text to review in depth all the material presented in courses such as marketing, finance, accounting, management, management information systems, and production and operations; there are many subareas within these functions, such as customer service, warranties, advertising, packaging, and pricing under marketing. But strategic planning must include a detailed assessment of how the firm is doing in all internal areas.

For different types of organizations, such as hospitals, universities, and government agencies, the functional business areas, of course, differ. In a hospital, for example, functional areas may include cardiology, hematology, nursing, maintenance, physician support, and receivables. Functional areas of a university can include athletic programs, placement services, housing, fund-raising, academic research, counseling, and intramural programs. Within large organizations, each division has certain strengths and weaknesses.

A firm’s strengths that cannot be easily matched or imitated by competitors are called distinctive competencies. Building competitive advantages involves taking advantage of distinctive competencies. Strategies are designed in part to improve on a firm’s weaknesses, turning them into strengths—and maybe even into distinctive competencies.

FIGURE 4-2 The Process of Gaining Competitive Advantage in a Firm

Figure 4-2 illustrates that all firms should continually strive to improve on their weaknesses, turning them into strengths, and ultimately developing distinctive competencies that can provide the firm with competitive advantages over rival firms.

The Process of Performing an Internal Audit

The process of performing an internal audit closely parallels the process of performing an external audit. Representative managers and employees from throughout the firm need to be involved in determining a firm’s strengths and weaknesses. The internal audit requires gathering and assimilating information about the firm’s management, marketing, finance and accounting, production and operations, R&D, and MIS operations. Key factors should be prioritized as described in Chapter 3 so that the firm’s most important strengths and weaknesses can be determined collectively.

Compared to the external audit, the process of performing an internal audit provides more opportunity for participants to understand how their jobs, departments, and divisions fit into the whole organization. This is a great benefit because managers and employees perform better when they understand how their work affects other areas and activities of the firm. For example, when marketing and manufacturing managers jointly discuss issues related to internal strengths and weaknesses, they gain a better appreciation of the issues, problems, concerns, and needs of all the functional areas. In organizations that do not use strategic management, marketing, finance, and manufacturing managers often do not interact with each other in significant ways. Performing an internal audit thus is an excellent vehicle or forum for improving the process of communication in the organization. Communication may be the most important word in management.

Performing an internal audit requires gathering, assimilating, and evaluating information about the firm’s operations. Key internal factors, consisting of both strengths and weaknesses, can be identified and prioritized in the manner discussed in Chapter 3. According to William King, a task force of managers from different units of the organization, supported by staff, should be charged with determining the 20 most important strengths and weaknesses that should influence the future of the organization. He says:

• The development of conclusions on the 20 most important organizational strengths and weaknesses can be, as any experienced manager knows, a difficult task, when it involves managers representing various organizational interests and points of view. Developing a 20-page list of strengths and weaknesses could be accomplished relatively easily, but a list of the 20 most important ones involves significant analysis and negotiation. This is true because of the judgments that are required and the impact which such a list will inevitably have as it is used in the formulation, implementation, and evaluation of strategies.1

Strategic management is a highly interactive process that requires effective coordination among management, marketing, finance and accounting, production and operations, R&D, and MIS managers. Although the strategic-management process is overseen by strategists, success requires that managers and employees from all functional areas work together to provide ideas and information. Financial managers, for example, may need to restrict the number of feasible options available to operations managers, or R&D managers may develop products for which marketing managers need to set higher objectives. A key to organizational success is effective coordination and understanding among managers from all functional business areas. Through involvement in performing an internal strategic-management audit, managers from different departments and divisions of the firm come to understand the nature and effect of decisions in other functional business areas in their firm. Knowledge of these relationships is critical for effectively establishing objectives and strategies.

A failure to recognize and understand relationships among the functional areas of business can be detrimental to strategic management, and the number of those relationships that must be managed increases dramatically with a firm’s size, diversity, geographic dispersion, and the number of products or services offered. Governmental and nonprofit enterprises traditionally have not placed sufficient emphasis on relationships among the business functions. Some firms place too great an emphasis on one function at the expense of others. Ansoff explained:

• During the first fifty years, successful firms focused their energies on optimizing the performance of one of the principal functions: production/operations, R&D, or marketing. Today, due to the growing complexity and dynamism of the environment, success increasingly depends on a judicious combination of several functional influences. This transition from a single function focus to a multifunction focus is essential for successful strategic management.2

Financial ratio analysis exemplifies the complexity of relationships among the functional areas of business. A declining return on investment or profit margin ratio could be the result of ineffective marketing, poor management policies, R&D errors, or a weak MIS. The effectiveness of strategy formulation, implementation, and evaluation activities hinges on a clear understanding of how major business functions affect one another. For strategies to succeed, a coordinated effort among all the functional areas of business is needed. In the case of planning, George wrote:

• We may conceptually separate planning for the purpose of theoretical discussion and analysis, but in practice, neither is it a distinct entity nor is it capable of being separated. The planning function is mixed with all other business functions and, like ink once mixed with water, it cannot be set apart. It is spread throughout and is a part of the whole of managing an organization.3

The Resource-Based View

Some researchers emphasize the importance of the internal audit part of the strategic-management process by comparing it to the external audit. Robert Grant concluded that the internal audit is more important, saying:

• In a world where customer preferences are volatile, the identity of customers is changing, and the technologies for serving customer requirements are continually evolving, an externally focused orientation does not provide a secure foundation for formulating long-term strategy. When the external environment is in a state of flux, the firm’s own resources and capabilities may be a much more stable basis on which to define its identity. Hence, a definition of a business in terms of what it is capable of doing may offer a more durable basis for strategy.4

The resource-based view (RBV) approach to competitive advantage contends that internal resources are more important for a firm than external factors in achieving and sustaining competitive advantage. In contrast to the Industrial Organization (I/O) theory presented in the previous chapter, proponents of the RBV view contend that organizational performance will primarily be determined by internal resources that can be grouped into three all-encompassing categories: physical resources, human resources, and organizational resources.5 Physical resources include all plant and equipment, location, technology, raw materials, machines; human resources include all employees, training, experience, intelligence, knowledge, skills, abilities; and organizational resources include firm structure, planning processes, information systems, patents, trademarks, copyrights, databases, and so on. RBV theory asserts that resources are actually what helps a firm exploit opportunities and neutralize threats.

The basic premise of the RBV is that the mix, type, amount, and nature of a firm’s internal resources should be considered first and foremost in devising strategies that can lead to sustainable competitive advantage. Managing strategically according to the RBV involves developing and exploiting a firm’s unique resources and capabilities, and continually maintaining and strengthening those resources. The theory asserts that it is advantageous for a firm to pursue a strategy that is not currently being implemented by any competing firm. When other firms are unable to duplicate a particular strategy, then the focal firm has a sustainable competitive advantage, according to RBV theorists.

For a resource to be valuable, it must be either (a) rare, (b) hard to imitate, or (c) not easily substitutable. Often called empirical indicators, these three characteristics of resources enable a firm to implement strategies that improve its efficiency and effectiveness and lead to a sustainable competitive advantage. The more a resource(s) is rare, nonimitable, and nonsubstitutable, the stronger a firm’s competitive advantage will be and the longer it will last.

Rare resources are resources that other competing firms do not possess. If many firms have the same resource, then those firms will likely implement similar strategies, thus giving no one firm a sustainable competitive advantage. This is not to say that resources that are common are not valuable; they do indeed aid the firm in its chance for economic prosperity. However, to sustain a competitive advantage, it is more advantageous if the resource(s) is also rare.

It is also important that these same resources be difficult to imitate. If firms cannot easily gain the resources, say RBV theorists, then those resources will lead to a competitive advantage more so than resources easily imitable. Even if a firm employs resources that are rare, a sustainable competitive advantage may be achieved only if other firms cannot easily obtain these resources.

The third empirical indicator that can make resources a source of competitive advantage is substitutability. Borrowing from Porter’s Five-Forces Model, to the degree that there are no viable substitutes, a firm will be able to sustain its competitive advantage. However, even if a competing firm cannot perfectly imitate a firm’s resource, it can still obtain a sustainable competitive advantage of its own by obtaining resource substitutes.

RBV has continued to grow in popularity and continues to seek a better understanding of the relationship between resources and sustained competitive advantage in strategic management. However, as alluded to in Chapter 3, one cannot say with any degree of certainty that either external or internal factors will always or even consistently be more important in seeking competitive advantage. Understanding both external and internal factors, and more importantly, understanding the relationships among them, will be the key to effective strategy formulation (discussed in Chapter 6). Because both external and internal factors continually change, strategists seek to identify and take advantage of positive changes and buffer against negative changes in a continuing effort to gain and sustain a firm’s competitive advantage. This is the essence and challenge of strategic management, and oftentimes survival of the firm hinges on this work.

Integrating Strategy and Culture

Relationships among a firm’s functional business activities perhaps can be exemplified best by focusing on organizational culture, an internal phenomenon that permeates all departments and divisions of an organization. Organizational culture can be defined as “a pattern of behavior that has been developed by an organization as it learns to cope with its problem of external adaptation and internal integration, and that has worked well enough to be considered valid and to be taught to new members as the correct way to perceive, think, and feel.”6 This definition emphasizes the importance of matching external with internal factors in making strategic decisions.

Organizational culture captures the subtle, elusive, and largely unconscious forces that shape a workplace. Remarkably resistant to change, culture can represent a major strength or weakness for the firm. It can be an underlying reason for strengths or weaknesses in any of the major business functions.

Defined in Table 4-1, cultural products include values, beliefs, rites, rituals, ceremonies, myths, stories, legends, sagas, language, metaphors, symbols, heroes, and heroines. These products or dimensions are levers that strategists can use to influence and direct strategy formulation, implementation, and evaluation activities. An organization’s culture compares to an individual’s personality in the sense that no two organizations have the same culture and no two individuals have the same personality. Both culture and personality are enduring and can be warm, aggressive, friendly, open, innovative, conservative, liberal, harsh, or likable.

At Google, the culture is informal. Employees are encouraged to wander the halls on employee-sponsored scooters and brainstorm on public whiteboards provided everywhere. In contrast, the culture at Procter & Gamble (P&G) is so rigid that employees jokingly call themselves “Proctoids.” Despite this difference, the two companies are swapping employees and participating in each other’s staff training sessions. Why? Because P&G spends more money on advertising than any other company and Google desires more of P&G’s $8.7 billion in annual advertising expenses; P&G has come to realize that the next generation of laundry-detergent, toilet-paper, and skin-cream customers now spend more time online than watching TV.

TABLE 4-1 Example Cultural Products Defined

Source: Based on H. M. Trice and J. M. Beyer, “Studying Organizational Cultures through Rites and Ceremonials,” Academy of Management Review 9, no. 4 (October 1984): 655.

Dimensions of organizational culture permeate all the functional areas of business. It is something of an art to uncover the basic values and beliefs that are deeply buried in an organization’s rich collection of stories, language, heroes, and rituals, but cultural products can represent both important strengths and weaknesses. Culture is an aspect of an organization that can no longer be taken for granted in performing an internal strategic-management audit because culture and strategy must work together.

Table 4-2 provides some example (possible) aspects of an organization’s culture. Note you could ask employees and managers to rate the degree that the dimension characterizes the firm. When one firm acquires another firm, integrating the two cultures can be important. For example, in Table 4-2, one firm may score mostly 1’s (low) and the other firm may score mostly 5’s (high), which would present a challenging strategic problem.

The strategic-management process takes place largely within a particular organization’s culture. Lorsch found that executives in successful companies are emotionally committed to the firm’s culture, but he concluded that culture can inhibit strategic management in two basic ways. First, managers frequently miss the significance of changing external conditions because they are blinded by strongly held beliefs. Second, when a particular culture has been effective in the past, the natural response is to stick with it in the future, even during times of major strategic change.7 An organization’s culture must support the collective commitment of its people to a common purpose. It must foster competence and enthusiasm among managers and employees.

Organizational culture significantly affects business decisions and thus must be evaluated during an internal strategic-management audit. If strategies can capitalize on cultural strengths, such as a strong work ethic or highly ethical beliefs, then management often can swiftly and easily implement changes. However, if the firm’s culture is not supportive, strategic changes may be ineffective or even counterproductive. A firm’s culture can become antagonistic to new strategies, with the result being confusion and disorientation.

TABLE 4-2 Fifteen Example (Possible) Aspects of an Organization’s Culture

An organization’s culture should infuse individuals with enthusiasm for implementing strategies. Allarie and Firsirotu emphasized the need to understand culture:

• Culture provides an explanation for the insuperable difficulties a firm encounters when it attempts to shift its strategic direction. Not only has the “right” culture become the essence and foundation of corporate excellence, it is also claimed that success or failure of reforms hinges on management’s sagacity and ability to change the firm’s driving culture in time and in time with required changes in strategies.8

The potential value of organizational culture has not been realized fully in the study of strategic management. Ignoring the effect that culture can have on relationships among the functional areas of business can result in barriers to communication, lack of coordination, and an inability to adapt to changing conditions. Some tension between culture and a firm’s strategy is inevitable, but the tension should be monitored so that it does not reach a point at which relationships are severed and the culture becomes antagonistic. The resulting disarray among members of the organization would disrupt strategy formulation, implementation, and evaluation. In contrast, a supportive organizational culture can make managing much easier.

Internal strengths and weaknesses associated with a firm’s culture sometimes are overlooked because of the interfunctional nature of this phenomenon. It is important, therefore, for strategists to understand their firm as a sociocultural system. Success is often determined by linkages between a firm’s culture and strategies. The challenge of strategic management today is to bring about the changes in organizational culture and individual mind-sets that are needed to support the formulation, implementation, and evaluation of strategies.

Management

The functions of management consist of five basic activities: planning, organizing, motivating, staffing, and controlling. An overview of these activities is provided in Table 4-3. These activities are important to assess in strategic planning because an organization should continually capitalize on its management strengths and improve on its management weak areas.

Planning

The only thing certain about the future of any organization is change, and planning is the essential bridge between the present and the future that increases the likelihood of achieving desired results. Planning is the process by which one determines whether to attempt a task, works out the most effective way of reaching desired objectives, and prepares to overcome unexpected difficulties with adequate resources. Planning is the start of the process by which an individual or business may turn empty dreams into achievements. Planning enables one to avoid the trap of working extremely hard but achieving little.

TABLE 4-3 The Basic Functions of Management

Planning is an up-front investment in success. Planning helps a firm achieve maximum effect from a given effort. Planning enables a firm to take into account relevant factors and focus on the critical ones. Planning helps ensure that the firm can be prepared for all reasonable eventualities and for all changes that will be needed. Planning enables a firm to gather the resources needed and carry out tasks in the most efficient way possible. Planning enables a firm to conserve its own resources, avoid wasting ecological resources, make a fair profit, and be seen as an effective, useful firm. Planning enables a firm to identify precisely what is to be achieved and to detail precisely the who, what, when, where, why, and how needed to achieve desired objectives. Planning enables a firm to assess whether the effort, costs, and implications associated with achieving desired objectives are warranted.9 Planning is the cornerstone of effective strategy formulation. But even though it is considered the foundation of management, it is commonly the task that managers neglect most. Planning is essential for successful strategy implementation and strategy evaluation, largely because organizing, motivating, staffing, and controlling activities depend on good planning.

The process of planning must involve managers and employees throughout an organization. The time horizon for planning decreases from two to five years for top-level to less than six months for lower-level managers. The important point is that all managers do planning and should involve subordinates in the process to facilitate employee understanding and commitment.

Planning can have a positive impact on organizational and individual performance. Planning allows an organization to identify and take advantage of external opportunities as well as minimize the impact of external threats. Planning is more than extrapolating from the past and present into the future (long-range planning). It also includes developing a mission, forecasting future events and trends, establishing objectives, and choosing strategies to pursue (strategic planning).

An organization can develop synergy through planning. Synergy exists when everyone pulls together as a team that knows what it wants to achieve; synergy is the 2 + 2 = 5 effect. By establishing and communicating clear objectives, employees and managers can work together toward desired results. Synergy can result in powerful competitive advantages. The strategic-management process itself is aimed at creating synergy in an organization.

Planning allows a firm to adapt to changing markets and thus to shape its own destiny. Strategic management can be viewed as a formal planning process that allows an organization to pursue proactive rather than reactive strategies. Successful organizations strive to control their own futures rather than merely react to external forces and events as they occur. Historically, organisms and organizations that have not adapted to changing conditions have become extinct. Swift adaptation is needed today more than ever because changes in markets, economies, and competitors worldwide are accelerating. Many firms did not adapt to the global recession of late and went out of business.

Organizing

The purpose of organizing is to achieve coordinated effort by defining task and authority relationships. Organizing means determining who does what and who reports to whom. There are countless examples in history of well-organized enterprises successfully competing against—and in some cases defeating—much stronger but less-organized firms. A well-organized firm generally has motivated managers and employees who are committed to seeing the organization succeed. Resources are allocated more effectively and used more efficiently in a well-organized firm than in a disorganized firm.

The organizing function of management can be viewed as consisting of three sequential activities: breaking down tasks into jobs (work specialization), combining jobs to form departments (departmentalization), and delegating authority. Breaking down tasks into jobs requires the development of job descriptions and job specifications. These tools clarify for both managers and employees what particular jobs entail. In The Wealth of Nations, published in 1776, Adam Smith cited the advantages of work specialization in the manufacture of pins:

• One man draws the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head. Ten men working in this manner can produce 48,000 pins in a single day, but if they had all wrought separately and independently, each might at best produce twenty pins in a day.10

Combining jobs to form departments results in an organizational structure, span of control, and a chain of command. Changes in strategy often require changes in structure because positions may be created, deleted, or merged. Organizational structure dictates how resources are allocated and how objectives are established in a firm. Allocating resources and establishing objectives geographically, for example, is much different from doing so by product or customer.

The most common forms of departmentalization are functional, divisional, strategic business unit, and matrix. These types of structure are discussed further in Chapter 7.

Delegating authority is an important organizing activity, as evidenced in the old saying “You can tell how good a manager is by observing how his or her department functions when he or she isn’t there.” Employees today are more educated and more capable of participating in organizational decision making than ever before. In most cases, they expect to be delegated authority and responsibility and to be held accountable for results. Delegation of authority is embedded in the strategic-management process.