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a company resource weakness or competitive deficiency

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CHAPTER 4

Evaluating a Company’s Resources, Capabilities, and Competitiveness

© Ikon Images/Alamy Stock Photo

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Learning Objectives THIS CHAPTER WILL HELP YOU UNDERSTAND:

LO 1 How to take stock of how well a company’s strategy is working.

LO 2 Why a company’s resources and capabilities are centrally important in giving the company a competitive edge over rivals.

LO 3 How to assess the company’s strengths and weaknesses in light of market opportunities and external threats.

LO 4 How a company’s value chain activities can affect the company’s cost structure and customer value proposition.

LO 5 How a comprehensive evaluation of a company’s competitive situation can assist managers in making critical decisions about their next strategic moves.

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

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

Chapter 3 described how to use the tools of industry and competitor analysis to assess a company’s external environment and lay the groundwork for matching a company’s strategy to its external situation. This chapter discusses techniques for evaluating 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 significant competitive edge over rival firms. Combined with external analysis, it facilitates an understanding 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 company a

lasting competitive advantage over rival companies? 3. What are the company’s strengths and weaknesses 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?

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In probing for answers to these questions, five analytic tools—resource and capability analysis, SWOT analysis, value chain analysis, benchmarking, and competitive strength assessment—will be used. All five are valuable techniques for revealing a company’s competitiveness and for helping company managers match their strategy to the company’s particular circumstances.

QUESTION 1: HOW WELL IS THE COMPANY’S PRESENT STRATEGY WORKING?

LO 1 How to take stock of how well a company’s strategy is working.

In evaluating how well a company’s present strategy is working, the best way to start is with a clear view of what the strategy entails. Figure 4.1 shows the key components of a single-business company’s strategy. 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 market, or merged with a competitor? Is it striving for a competitive advantage based on low costs or a better product offering? Is it concentrating on serving a broad spectrum of customers or a narrow market niche? The company’s functional strategies in R&D, production, marketing, finance, human resources, information technology, and so on further characterize company strategy, as do any efforts to establish alliances with other enterprises.

FIGURE 4.1 Identifying the Components of a Single-Business Company’s Strategy

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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 warning signs that the company has a weak strategy, suffers from poor strategy execution, 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 fulfillment,

delivery times, days of inventory, and employee productivity.

Sluggish financial performance and second-rate market accomplishments almost always signal weak strategy, weak execution, or both.

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 performance and market standing, the more its current strategy must be questioned and the more likely the need for radical changes. Table 4.1 provides

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a compilation of the financial ratios most commonly used to evaluate a company’s financial performance and balance sheet strength.

TABLE 4.1 Key Financial Ratios: How to Calculate Them and What They Mean

Ratio How Calculated What It Shows

Profitability ratios

1.  Gross profit margin Shows the percentage of

revenues available to cover operating expenses and yield a profit.

2.  Operating profit margin (or return on sales)

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)

Shows after-tax profits per dollar of sales.

4.  Total return on 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

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Ratio How Calculated What It Shows

financed by creditors as well as by stockholders.

5.  Net return on total assets (ROA)

A measure of the return earned by stockholders on the firm’s total assets.

6.  Return on stockholders’ equity (ROE)

The return stockholders are earning on their capital investment in the enterprise. A return in the 12%–15% range is average.

7.  Return on invested capital (ROIC) —sometimes referred to as return on capital employed (ROCE)

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.

Liquidity ratios

1.  Current ratio Shows a firm’s ability to pay

current liabilities using assets that can be converted to

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Ratio How Calculated What It Shows

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

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

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Ratio How Calculated What It Shows

and greater risk of bankruptcy.

2.  Long-term debt-to- capital ratio

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 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

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Ratio How Calculated What It Shows

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

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

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 Measures inventory

management efficiency. Fewer

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Ratio How Calculated What It Shows

days of inventory are better.

2.  Inventory turnover Measures the number of

inventory turns per year. Higher is better.

3.  Average collection period

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

A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2%–3%. The dividend yield for fast-growth companies is often below 1%; the dividend yield for slow- growth companies can run 4%–5%.

2.  Price-to- earnings (P/E) ratio

P/E ratios above 20 indicate strong investor confidence in a firm’s outlook

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Ratio How Calculated What It Shows

and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12.

3.  Dividend payout ratio 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

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Ratio How Calculated What It Shows

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.

QUESTION 2: WHAT ARE THE COMPANY’S MOST IMPORTANT RESOURCES AND CAPABILITIES, AND WILL THEY GIVE THE COMPANY A LASTING COMPETITIVE ADVANTAGE OVER RIVAL COMPANIES?

An essential element of deciding whether a company’s overall situation is fundamentally healthy or unhealthy entails examining the attractiveness of its resources and capabilities. A company’s resources and capabilities are its competitive assets and determine whether its competitive power in the marketplace will be impressively strong or disappointingly weak. Companies with second-rate competitive assets nearly always are relegated to a trailing position in the industry.

CORE CONCEPT A company’s resources and capabilities represent its competitive assets and are determinants of its competitiveness and ability to succeed in the marketplace.

Resource and capability analysis provides managers with a powerful tool for sizing 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.

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.

Identifying the Company’s Resources and Capabilities

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A firm’s resources and capabilities are the fundamental building blocks of its competitive 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.

LO 2 Why a company’s resources and capabilities are centrally important in giving the company a competitive edge over rivals.

In brief, a resource is a productive input or competitive asset that is owned or controlled 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 others due to the outstanding talents of the individual team members, the team’s composition, 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 marketing; Starbucks’s employee management, training, and real estate capabilities are the drivers behind its rapid growth; LinkedIn relies on superior software innovation capabilities to increase new user memberships. Organizational capabilities are developed and enabled through the deployment of a company’s resources.2 For example, Nestlé’s brand management capabilities for its 2,000+ food, beverage, and 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 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.

CORE CONCEPT A resource is a competitive asset that is owned or controlled by a company; a capability (or competence) is the capacity of a firm to perform some internal activity competently. Capabilities are developed and enabled through the deployment of a company’s resources.

Types of Company Resources A useful way to identify a company’s resources is to look for them within categories, as shown in Table 4.2. 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, talents, and knowledge of a company’s human resources.

Table 4.2 Types of Company Resources

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

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Tangible resources

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

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 technological 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

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company’s brands, image, and reputational assets. 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 4.2.

Listing a company’s resources category by category can prevent managers from inadvertently overlooking some company resources that might be competitively important. 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 company’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 flow. Bose’s capabilities in auditory system 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 firm is likely to have accumulated. This approach simply involves looking over the firm’s resources and considering whether (and to what extent) the firm has built up any related capabilities. So, for example, a fleet of trucks, the latest RFID tracking technology, and a set of large automated distribution centers may be indicative 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, strategic innovation, or new product development link to a company’s R&D function. This 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 capabilities 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 expertise 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 manufacturing companies. Cross-functional capabilities and other complex capabilities involving numerous linked and closely integrated competitive assets are sometimes referred to as resource bundles.

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CORE CONCEPT A resource bundle is a linked and closely integrated set of competitive assets centered around one or more cross-functional capabilities.

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 bundles 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 has and continues to outperform competitors through its customer service capabilities (including animal grooming and veterinary and day care services). Nike’s bundle 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 capabilities 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 company 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.

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

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, making 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 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). Companies have to guard against contending that something they do well is necessarily competitively valuable. Apple’s OS X operating system for its personal computers

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by some accounts is superior to Microsoft’s Windows 10, but Apple has failed in converting its resources devoted to operating system design into anything more than moderate competitive success in the global PC market.

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 industry 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 Double Stuf Oreos and Mini 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 capabilities tend to be difficult to copy when they are unique (a fantastic real estate location, 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 reflect 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 ambiguity, 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.

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 ambiguity makes it very hard to figure out how a complex resource contributes to competitive advantage and therefore exactly what to imitate.