Note
to
Reader:

This
document
is
a
rough
draft.



When
we
assign
various
articles
and
book
chapters,

students
wonder
how
the
concepts
relate
to
each
other
–
academics
sometimes
do
and
sometimes

do
not
put
their
ideas
in
context
of
other
ideas
in
the
field.

We
put
this
document
together
in
order

to
present
relevant
strategy
frameworks
and
concepts
in
a
way
that
you
can
clearly
see
how
they

might
relate
to
each
other—this
document
represents
the
opinions
of
its
authors.

Strategy

Essentials
is
meant
to
be
a
convenience
for
you…a
one­stop
shop
for
the
concepts
covered
in
an

advanced
strategy
course.

You
are
encouraged
to
read
the
ideas
in
their
original
form
as

well…consider
these
the
“Cliff
Notes”
(or
a
cheat
sheet).

There
are
still
typos
and
need
for

refinement…but
tolerate
the
flaws
and
appreciate
the
simplicity
of
having
the
concepts
all
in
one

place.

This
document
will
surely
improve
over
time
in
large
part
due
to
your
comments
and

suggestions
–
keep
them
coming!


 1



Acknowledgements



We would like to profusely thank the following individuals from the Stern EMBA Class of August 2009.
Collectively, these individuals contributed significant insights, examples, ideas for organization, and they
found many spelling and grammatical errors. All remaining errors are ours alone.

Rama Bangad
Marco Barcella
Matthew Beaulieu
Thomas Bridgeforth
Marcus Bring
Rebecca Carter
John Chard
Taharka Farrell
Greg Gilbert
Cesar Gonzalez
Luis Gonzalez
Pankaj Gupta
Rosamond Hampton
Lutz Hilbrich
Heather Hobson
Robert Johnson
John Kent
Judy Lee
James Lempenau
Narayan Menon
Josh Nasella
Andrew Nelson
Hemant Porwal
Thomas Ma
Jamal Mazhar
Boris Nossovskoi
Yoni Ophir
Scott Osman
Suguna Rachakonda
Ramesh Rao
Erik Rodriguez
Hrishikesh Samant
Thomai Serdari
Lalit Shinde
Joseph Spiro
Jeffrey Stern
Wonkyu Sun
Anantha Sundaram
Angel Texidor


 2

 

Table of Contents
WHAT
IS
STRATEGY? ..................................................................................................................................................... 4

STRATEGY
VS.
TACTICS ................................................................................................................................................... 5

INTRODUCTION ............................................................................................................................................................ 6

VALUE
CREATION.......................................................................................................................................................... 8

Defining
Willingness‐to‐Pay .............................................................................................................................. 10

Value
Capture ................................................................................................................................................... 15

Added
Value ...................................................................................................................................................... 16

Value
Chain ....................................................................................................................................................... 21

INDUSTRY
ANALYSIS .................................................................................................................................................... 26

Porter’s
Five
Forces
Framework ........................................................................................................................ 26

Disruptive
Technologies .................................................................................................................................... 31

Other
Forces...................................................................................................................................................... 32

Template
for
Analysis........................................................................................................................................ 33

Resisting
Commoditization ............................................................................................................................... 35

Understanding
Value
Summary ........................................................................................................................ 40

POSITIONING ............................................................................................................................................................. 42

Segmentation.................................................................................................................................................... 42

Segment
Selection............................................................................................................................................. 45

Generic
Strategies ............................................................................................................................................. 45

Overall
Cost
Leadership..................................................................................................................................... 46

Differentiation................................................................................................................................................... 47

Focus ................................................................................................................................................................. 47

PREEMPTION
AND
SUSTAINABILITY ................................................................................................................................. 49

Investing
in
Capital
Intensive
Assets ................................................................................................................. 49

Securing
Superior
Scarce
Resources .................................................................................................................. 50

Sustainability..................................................................................................................................................... 53

RESOURCE‐BASED
VIEW .............................................................................................................................................. 61

Wealth‐Creating,
Sustainable
Competitive
Advantage..................................................................................... 62

Resource‐Based
View
vs.
Positional
View
of
the
Firm ....................................................................................... 69

SHIFTING
PERSPECTIVES:
COMPONENTS
OF
FIRM
VALUE .................................................................................................... 69

Assets
and
Capabilities
Value............................................................................................................................ 72

Employed
Resource
Value ................................................................................................................................. 72

Governance
Value ............................................................................................................................................. 73

Value
from
ACV‐ERV‐GV
Interactions ............................................................................................................... 77

FINANCIAL
METRICS .................................................................................................................................................... 79

FIRM
BOUNDARIES...................................................................................................................................................... 82

EXTERNALITIES
AND
CSR .............................................................................................................................................. 95

Remedial
CSR .................................................................................................................................................... 96

Strategic
CSR ................................................................................................................................................... 102

ENCAPSULATION
OF
CORE
CONCEPTS ........................................................................................................................... 108

Strategy........................................................................................................................................................... 108

Value ............................................................................................................................................................... 109

Industry
Analysis ............................................................................................................................................. 111

Positioning ...................................................................................................................................................... 112

Preemption
and
Sustainability ........................................................................................................................ 113

Resource‐Based
View ...................................................................................................................................... 114

Shifting
Perspectives:
Components
of
Firm
Value........................................................................................... 116

GLOSSARY ............................................................................................................................................................... 118

REFERENCE
LIST........................................................................................................................................................ 120



 3

CONCEPTS
A successful firm is like an alchemist who is able to turn lead into gold. Such a firm is
able to take inputs that cost x, and transform these inputs into outputs that are worth
more than x. This fundamental value transformation is the core of all wealth-creation.

What Is Strategy?

Strategy is how firms capture a share of the value they create, and how they
sustain returns over time. The goal of strategic analysis is to engineer a unique
offering to customers and/or suppliers. By offering something inimitable and valuable,
the firm will have leverage to retain a share of the value created in the form of firm
profits. A wise firm that uses its advantage judiciously will be able to sustain its position
in the value chain.

Highly successful firms are marked by their ability to create strategic advantage,
and retain this advantage over extended periods of time.

“In their words,” strategy is:

• The pursuit of economic rents1 [Edward Bowman]
• Leverage of key activities to achieve competitive advantage [Michael Porter]
• Choosing a different set of activities to deliver a unique mix of value [Hamel and
Prahalad]
• Use of valuable, rare, non-substitutable, and inimitable resources and capabilities to
create sustainable advantage [Resource-based view]






























































1

Economic profits (or rents as they are often called) are not the same as accounting profit. While accounting profits simply measure a firm’s
revenue less all costs actually incurred, economic profit is a more fundamental indicator of firm health, performance, and strategic success,
because economic profit takes into account the opportunity cost of the capital employed by the firm on the basis of which it earned its
accounting profit. In the simplest of forms, economic profit is accounting profit less opportunity cost of capital employed. A firm could have
positive accounting profit but negative economic profit if it could have earned more profit employing the same capital in another investment
opportunity. As you read the text, profits where not qualified otherwise, are implicitly referring to economic profits.




 4



Strategy vs. Tactics

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the
noise before defeat.” -Sun Tzu

It is important that students of strategy recognize the important difference between

strategy and tactics. Strategy will include goals and objectives for a firm. They may be
short term and long term. A firm needs to have a goal for what it wants to be when it
grows up, and how it will sustain a strategic advantage. Tactics, on the other hand, are
what a firm uses in order to ensure that the plan happens as the firm intended. Thus,
strategy is differentiated from tactics, or immediate actions, with resources at hand by its
nature of being extensively premeditated, and often practically rehearsed.

Alan Emrich2 notes that “many authors resort to military examples when explaining the
strategy vs. tactics paradigm. Strategy focuses on the “big picture”; it looks at the entire
forest, and not individual trees. Military concepts of objective, simplicity, unity of
command, etc. represent examples of strategy. Tactics, on the other hand, are about
the “small picture,” focusing on the individual trees.” He highlighted these concepts in a
course on game design:

Tactics vary with circumstances and, especially, technology. If I were to teach

you how to be a soldier during the American Revolution, you would learn how to
form and maneuver in lines, perform the 27 steps in loading and firing a musket,
and how to ride and tend to a horse. Naturally, yesterdayʼs tactics wonʼt win
todayʼs wars—but yesterdayʼs strategies still win todayʼs wars…and will win them
tomorrow and into the future.

Seth Godin,3 a popular author and speaker, uses a skiing analogy to crystallize the
concepts:

Carving your turns better is a tactic [while skiing]. Choosing the right ski area in
the first place is a strategy. Everyone skis better in Utah, it turns out.
The right strategy makes any tactic work better. The right strategy puts less
pressure on executing your tactics perfectly.

For a firm to be successful, it has to have a strategy as well as the tactics to help
materialize the strategy.


























































2
See www.alanemrich.com/PGD/PGD_Strategy.htm
3
http://sethgodin.typepad.com/seths_blog/2007/01/the_difference_.html


 5

Introduction

As we develop the tool kit that we consider to be Strategy Essentials, we will reflect on
the home-security industry through the lens of the home-security firm supplier, SAFE. 4
Considering questions around SAFE (see below) will help highlight the utility of the
tools, techniques, and frameworks presented here.

SAFE enters the Home Security industry

The year is 1995 and according to Consumerʼs Reports©, shoppers for home security
systems base their purchase decision upon several variables, including the reputation of
the security company (especially its security force), features offered by the company,
and price. Home security companies tend to focus their selling efforts regionally, while
maintaining their own individual security force.

An enterprising group of former police officers form a company, SAFE, offering

themselves as a substitute for the home security firmsʼ in-house security force. Thus,
instead of each security firm having its own independent team of security personnel, a
home security company could contract with SAFE to provide surveillance for the home
security companyʼs customers (surveillance includes both alarm monitoring and alarm
response). SAFE offers equal or better quality of surveillance relative to the best in-
house security team as maintained by current companies, and can also cover wider
geographic areas. Finally, contracting with SAFE is significantly less expensive than
using an in-house security force because of lower payroll expenses and SAFEʼs
commitment to setting price caps on its services.

Questions:

 Does SAFE make the firms in the Home Security industry better off or worse off?
o How?
 How should the typical firm in the industry respond to the entry of SAFE?
 How would the response of the typical firm differ from the potential response of
the industry leader?
 Could the entry of a firm like SAFE have been anticipated?
o How?

The following diagram demonstrates how various strategy concepts relate to each other
and to the central themes of strategy.


























































4

SAFE represents the type of home-security industry where the home is wired to a security company that deploys a guard to the home when
the alarm is triggered.



 6


 7

The crux of business strategy is the creation of value by an enterprise, the capture of
some portion of that value by the enterprise in the form of economic profits, and the
sustainability of these profits over time. If a firm is able to sustain economic profits
(profits that are in excess of all of costs, including the opportunity cost of the capital and
resources utilized), we say the firm is competitively advantaged and benefiting from a
strategy that is protecting the firmʼs returns from being contracted towards zero
economic profit. Threats to returns exist in the firmʼs external environment, where
environment is made up of both the industry as well as society at large. Strategy also
faces internal threats stemming from inefficiencies in the firmʼs own execution and
operations. We will learn to explicitly argue for or against a firmʼs likelihood of sustaining
its economic profits over time. Complementing sustainability analysis, we will evaluate
issues of corporate scope—is the firm able to create more value, capture and/or sustain
higher economic profits if it operated in more markets?

Value Creation

Firms convert resources, such as capital, labor, and raw materials, from suppliers into
products and services, which are then sold to buyers (Brandenburger and Stuart 1996).

Although the SAFE case does not ask us to explicitly describe how value is created in
the home security industry, thinking about value creation is a productive way to warm up
and begin a strategic analysis. The firm takes inputs that are worth some amount, say
$X, and converts those resources into products that consumers value, in monetary
terms, as being greater than $X. Hence firms create a “value surplus” that is the source
of all the worldʼs financial prosperity. But to be precise, firms cannot create this
prosperity without the help of customers—indeed customers are the ones who perceive
the value of the firmʼs output to be greater than the cost of producing that output
(including the cost of inputs). To understand how some firms are able to retain a greater
share of their self-created “value surplus” than other firms, we will dissect the process of
value creation.

Value Creation5

Value creation is the key purpose for businesses to exist. To better understand value
creation, consider a simple visual concept. Value created is the difference between the
buyerʼs willingness to pay (WTP) and the firmʼs cost of bringing the output to the buyer
(C), as shown in Figure 1. WTP is the buyerʼs perception of the utility (measured in
monetary terms) that the firmʼs output delivers to the buyer. We will often refer to the
monetary difference between WTP and C as the “wedge.” The goal of strategy is to
convert a portion of this wedge into firmʼs economic profits, and to sustain those profits
over time. To understand this process, we need to examine how market interactions
lead to a particular price (P). These interactions are based on the firmʼs market position

























































5
The section draws from Brandenburger, Adam M., and Harborne W. Stuart, Jr. 1996. Value-Based Business Strategy. Journal of Economics &
Management Strategy 5 (1):5-24.


 8

as well as on the dynamics of the market in which the firm operates. Markets fall along a
continuum from uncontested—those with considerable scarcity of firmsʼ output, to
contested—those characterized by heavy competition. In uncontested markets
(markets with more demand relative to capacity), firms can attempt to capture
value through pricing, directly moving P. In contested markets (many firms
competing), firms must add value by increasing the wedge between WTP and C.
Keep in mind that if the gap between WTP and P increases, the firm gains share
(all else equal). If the firm maintains the gap between WTP and P, but C
decreases, the firmʼs margin increases, the firm makes more on each sale.

Figure 1

WTP: Buyers Willingness-to-Pay Per Unit

Buyer
Surplus
TOTAL ECONOMIC VALUE CREATED

P: Unit Price of Good or Service

Firm
Surplus
C: Unit Production Cost

Quantity/Market Share

This may suggest that the market conditions in which the firm operates are exogenous
(externally caused), while the firmʼs position and the activities it chooses to add value
are responses to market conditions and perceived opportunities. We will see, however,
that reality is much more complex, with markets and firms reacting to each other.

Entrepreneurs (inside existing or pioneering new firms) find innovative ways to combine
inputs from suppliers to satisfy the needs and wants of buyers. If the cost of inputs is
lower than the price paid by buyers, the entrepreneurs have created value. An
example is when Under Armour commands a premium price and acquires market share
by designing a new line of sweat absorbent sportswear.

Typically, the wedge between WTP and C is divided such that both the firm and buyers
benefit. However, if the firm creates value in an imitable way, the firm may quickly face
substantial competition. In this case, very little of the wedge accrues to the firm as
economic profits over time.


 9























 10

 WTP:
•Customer perception of need – same as before
•Reputation – same as before or slightly increased
•Features of the security system – same as before
•Service features – same as before
TOTAL ECONOMIC VALUE CREATED

Buyer
Surplus

P:
(our conjectures): For now, firms still
enjoy geographic monopolies, and do
not face direct price competition

Producer (We might conclude):

Surplus
C: Cost of Inputs
(our conjectures)
Organizational slack – same
Operational choices – same
Technology choices—same
Optimality of firm boundaries –
improved so costs decrease.
While profits of home security firms will
still vary across markets based on cost
differences and differences in penetration
rates, SAFE, with it operations in many
markets, will offer firms an opportunity
to outsource an activity that represents
a high share of cost. SAFE offers efficiency
and quality to all firms who contract with it.
Profits of SAFE’s clients will likely
increase in the short run.


 11


 12

Defining Willingness to Pay

A buyerʼs WTP measures in monetary terms the subjective value (the utility) of goods or
services. In general, WTP and P are separable; the extent that buyers value their goods
or derive utility from those goods ought to be evaluated separately from the price they
pay. WTP must be measured in relation to the internal (and unobservable) desires of
buyers, but P and C are easily observed during transactions. For example, the after-the-
fact rebate of the original Apple iPhone for $100 did not affect the perceived value of the
iPhone (WTP), even though it clearly reduced what consumers spent (P).

Over time, P can come to affect what buyers perceive is their utility or WTP. Focus
group outcomes aside, WTP and P are conceptually separate. An exception is of
products for which P is a signal of unobservable attributes, such as wine for which price
is taken by some drinkers as a signal of quality. The consumer might reason that price
is an indicator of quality. In cases such as these, P can influence demand by altering the
consumerʼs perception that the product has highly desirable features or functions. For
example, WTP and P are dependent for certain luxury goods, where part of the
perceived value is exclusivity, a function of P. iPhone users paid $999 for a small
application icon that displayed the phrase “I am rich!” This icon had no functionality
beyond declaring the consumer wealthy (among other questionable attributes). To be
clear, cases where P and WTP are intertwined are more the exception than the rule. In
the majority of cases, WTP is conceptually and actually separable from P, even if the
consumer him or herself comes to believe that their WTP is equivalent to P. So what is
WTP?

Brandenburger and Stuart (1996) on buyersʼ WTP:

Imagine that the buyer is first simply given this quantity of product free
of charge. The buyer must find this situation preferable—typically, in
fact, strictly preferable—to the original status quo. Now start taking
money away from the buyer. If only a little money is taken away, the
buyer will still gauge the new situation (product minus a little money) as
better than the original status quo.


 13

But as more and more money is taken away, there will come a point at which the buyer
gauges the new situation as equivalent to the original status quo. (Beyond this amount
of money, the buyer will gauge the new situation as worse.) The amount of money at
which equivalence arises is the buyerʼs willingness-to-pay for the quantity of product in
question.

The willingness-to-pay of an industrial buyer for a piece of capital equipment

may come down to the savings in the buyerʼs operating costs that installation
of the new equipment would afford. Assessing the willingness-to-pay of
consumers for household products is often harder [than for products/services
that have quantifiable benefits to the user] (p. 8)6.

Firms ultimately want to maintain a gap between P and C over a share of the market,
maximizing profits in the process. We define profits as V*(P−C) or (Volume)*(Margin).
The firmʼs approach to earning profits will vary with market conditions, but will generally
fall into one of two broad categories: value capture and added value. In weakly
contested or uncontested markets, firms can apply pressure on P. Directly affecting P
is a value capture strategy. This approach “hurts” buyers or competitors (moving P
around is a zero-sum game). By contrast, in highly contested markets, firms cannot
effectively alter market prices or market costs. When competitive market conditions
make direct movements of P challenging, firms will focus on influencing P by increasing
the gap between P and WTP. By creating additional value in the chain (raising WTP)
while maintaining the allocation of value to suppliers and buyers (holding P−C), they

























































6

For numerical examples of the WTP concept, see Creating Competitive Advantage, by Pankaj Ghemawat and Jan
W. Rivkin.


 14

increase the value accumulated by the firm (WTP−P). Firms that indirectly affect P by
raising WTP like this employ an added value strategy. Movements of C are trickier
to categorize: sometimes a firm increases efficiency, reducing C without taking surplus
from suppliers (added value), but sometimes a firm reduces C through negotiations
empowered by suppliersʼ lack of outside options, which reduces supplier surplus (value
capture).

Value Capture

When firms produce unique goods and therefore have power in their pricing strategy,
they can capture considerable value. Price adjustments that push value capture are
dictated by two factors: industry elasticity of demand, and the firmʼs source of
advantage. As shown in Figure 2, two situations provide healthy opportunity for value
capture through pricing strategy. Note that total value creation remains fixed -- firms
use pricing to capture value.

Firms with cost advantages in industries with high price elasticity should price below
their competition, and enjoy considerable share gains. Consider Dellʼs precipitous
growth in the past. A low cost manufacturing processes in the home PC market
combined with WTP parity7 allowed Dell to under-price competition and dominate the
market, producing considerable profits for a number of years.

Firms with product advantages in industries with low price elasticity should charge
premium prices, which will cause only modest share loss. High quality product design in
the market for MP3 players allowed Apple to price above competition without suffering
share loss, producing considerable profits.


























































7
Consumers perceived their WTP for Dell to be approximately the same as for other branded PCs. One could argue that customization
options increased Dell’s WTP, or perhaps that its initially weaker brand diminished WTP and it caught up, but all things considered, WTP parity
is a fair stance.


 15

Figure 2

BIG PRICE HIKE MODEST PRICE CUT

LOSES LITTLE MARKET SHARE GAINS CONSIDERABLE MARKET SHARE
Some firms can premium price Other firms can underprice
and capture value from buyers and capture value from competitors

WTP: Buyers Willingness-to-Pay WTP

Buyer Buyer
Surplus Surplus
P’: Price of Goods or Services

TOTAL ECONOMIC VALUE CREATED

TOTAL ECONOMIC VALUE CREATED

Price Increase

Price Cut P
P
P’

Firm Firm
Surplus Surplus
C: Cost of Inputs C

Loss of Market Share Gain of Market Share

INTITIAL MARKET SHARE INITIAL MARKET SHARE

Added Value

In markets where buyers perceive that firms produce fairly homogenous goods, firms
have little room to sustain value capture above costs8. Should one of these firms
disappear, suppliers and buyers would simply switch to competitors with little perceived
loss or pain. In these markets, firms cannot simply adjust their prices irrespective of the
prices of other firms. The value of an enterprise is best measured by the extent to which
suppliers and/or buyers would miss that enterprise if it were absent—the more missed
the enterprise, the more is its added value. The more of the wedge the firm can capture
as profits, and the longer the firm can sustain those profits, the greater the market value
of the firm. As indicated above, profit capture and sustainability depend on whether the
firmʼs process for creating added value is proprietary.


























































8
While firms can earn returns above cost in the absence of added value, we don’t expect this to be a long-run equilibrium. We expect entry
and/or rivalry among undifferentiated sellers to drive returns down to “normal” or cost inclusive of opportunity costs.


 16

Only by adding value to increase the gap between WTP and C in an inimitable way can
firms expect to sustain value capture. Added value represents the upper boundary on
how much value the firm can capture. Typically, firms can take one of two approaches
to add value: cut C with only marginal losses to WTP, or increase WTP with relatively
small increases in C. These are shown in Figure 3.

Firms in under-served markets should incur higher costs and add features, while
firms in over-served markets should cut costs by removing features.


 17

Starbucks recognized the coffee shop market was under-served at the time it entered.
Consumers craved more variety and more of a coffee house experience. In the under-
served markets, where firms sell products that are missing highly desirable features,
entrepreneurial firms can add value by becoming differentiators. These firms add
features that cost less than the perceived value to the buyer.

In the over-served markets, where firms sell products with unused or unnecessary
features, entrepreneurial firms can add value by becoming low cost operators. But only
so much cost cutting can be achieved through pure efficiencies—sometimes real
features must go as well. The flat panel TV market recently minted some millionaires
who secured distribution deals and then delivered super-low-priced TVs produced by
contract manufacturers from all over the globe. These firms eliminated features whose
costs were greater than their value to buyers. Costs fall much more than WTP, so P
does not fall as much as C, creating incremental surplus for the firm.

Firm Surplus ultimately increases as a result of the WTP−C gap widening. Note that
Buyer Surplus is fixed (because the firm operates in a competitive market).

Adding Value By Raising WTP

To increase WTP, the perceived benefits of the firmʼs output must be improved. Benefits
can be derived from tangible attributes, such as improved sound quality, improved
flavor, or improved speed. Benefits can also be derived from intangible attributes, such
as improved image or improved prestige. The Apple retail store, for example, offers
benefits through an improved shopping experience. These feature improvements
directly make the product better. Firms can also improve WTP by making the product
less costly to use (that is, WTP increases because the “net user cost” falls). For
example, by selling the product through more channels or by changing the packaging to
increase convenience (single serving vs. bulk) the consumer incurs less costs in
acquiring and/or consuming the good.

Increases in WTP, creates the opportunity to increase some combination of price and
market share—that is, increase price (P), quantity (Q), or both. Methods to raise WTP
are shown in the following diagram:


 18

 Methods to Enhance Willingness to Pay


 19

Adding Value By Lowering C

To lower C, firms must reduce the costs of critical inputs or gain efficiency in production.
Adding value by lowering C means that C fall by more than WTP. In fact, if the firm
discovers it is “over-serving” its customer (providing too many product features relative
to the customerʼs need), the firm should reduce features (which would drop WTP only a
little since the features were not valued) and costs would fall proportionately more.

Input costs reductions can be accomplished by reducing the relative attractiveness of an

inputʼs outside options,9 enabling the firm to negotiate lower C. The inputs the firm uses
to produce output normally have outside options. For example, wheat input could be
sold to other firms or employees could work at other firms. To reduce the perceived
value of outside options of physical inputs, a firm might absorb transport costs (in the
case of wheat inputs) or provide attractive benefits (in the case of labor inputs, say
health insurance). These strategies require the firm to face a lower cost structure than
their suppliers, in the above examples as a result of economies of scale for transport, or
by pooling risk, for example, for insurance benefits. Other strategies may require
structural adjustment, such as offering flexible work schedules to employees who are
willing to sacrifice some costly benefit. Methods to lower C are shown below:

Methods to Lower C
(1) Drive cost reductions through product market activities. These activities may
have first mover advantages, though they are generally easy to imitate.

Easy to Imitate
Increase scale or accumulate experience by “buying share” through lower prices
Introduce new products that utilize shared facilities
Enter new geographies to increase capacity utilization


























































9
Outside option refers to the inputs next best alternative. If the input is, say, wheat, then the outside option is the next most attractive selling
opportunity for the owner of the wheat. If the input is labor, then the outside option is that laborer’s next most attractive employment
opportunity. In this section, we continually compare the input’s currently opportunity to its next best alternative or outside options.


 20

(2) Control cost drivers within the firmʼs activities.

Easy to Imitate
Reallocate production within existing facilities
Reallocate facilities to regions with lower input costs
Input substitutions (labor for capital or vice versa)

Enhance worker productivity with incentive systems

Outsource major cost centers
Eliminate work force redundancies
Difficult to Imitate
Improve material yields
Reduce product operation complexities (reduce SKUs)
Alter product design to improve manufacturability
Reduce inventories and improve asset management
Enhance worker productivity with organizational change

Earlier we considered value creation and then distinguished between value capture via
market power versus added value. If this were a meal, added value would be the main
course of strategy: strategy is all about the firm being different and moving away from
price competition. Most firm strategies can be related to the general approaches
outlined above for reducing C and increasing WTP.

We now consider the value chain. The value chain depicts the execution of value
creation and (hopefully) added value. Here strategy meets operations, marketing,
finance, and management. Benchmarking or relative cost analysis is the practical
alternative to the unobservable “productivity frontier.” 10Operating inefficiently increases
the likelihood that the firm suffers resource constraints and under-invests (partially or
completely) in its strategy.

Value Chain

The firmʼs value chain, shown in Figure 4, is a taxonomy of all the firmʼs activities
undertaken to create value. Each box contributes something to a buyerʼs WTP and
something to a firmʼs C.

Competitive advantage is created by the discrete set of activities companies perform.

The sources of a firmʼs advantage reside in some combination of primary activities and
secondary activities. By analyzing a firm as a set of activities, managers can identify
ways to widen the WTP−C gap.

























































10
Being on the “productivity frontier” means the firm is efficient—and efficient means it is not possible to reduce costs without eliminating
valued product/service attributes.


 21

 FIG 4: VALUE CHAIN / ACTIVITY ANALYSIS

A firm’s activities are divided into two areas

FUNCTIONAL ACTIVITIES CORPORATE OVERHEAD ACTIVITIES

INBOUND LOGISTICS

COST PRICE WTP

OPERATIONS
FIRM INFRASTRUCTURE

COST PRICE WTP

COST PRICE WTP

HUMAN RESOURCES
OUTBOUND LOGISTICS

COST PRICE WTP Every individual

COST PRICE WTP activity has some
contribution to
customer’s WTP
and firm’s cost

MARKETING & SALES

TECHNOLOGY DEVELOPMENT
COST PRICE WTP
COST PRICE WTP

AFTER-SALES SERVICES
INPUT PROCUREMENT

COST PRICE WTP

COST PRICE WTP

MARGINS

Activities sum to
the firm’s total
WTP & cost

COST PRICE WILLINGNESS TO PAY

©EFM Design LLC


 22

Activity Analysis

Activity analysis informs managers about the cost of its activities. There are several
possible goals of activity analysis. One goal is to benchmark the productivity of a firm to
its competitors. The firm can then explicitly consider how much WTP it produces by
undertaking its activities in a particular way. Another goal is to identify opportunities for
increased efficiency. Efficiency means that the only way for the firm to cut costs is to
reduce WTP—that is, there is no way to perform an activity for less money without
sacrificing some attributes valued by consumers.

Many management-consulting projects begin with or culminate in an activity cost

analysis. Ghemawat and Rivkin (2006) focus on the WTP−C gap, describing a four-step
process of activity analysis based on the value chain. Below we describe the goals and
outline the structure of this four-step analysis.

First, the analyst and/or the managers of a firm catalog the firmʼs activities. Second, the
managers examine the costs associated with each activity, and they use differences in
activities to understand how and why their costs diverge from those of competitors.
Third, they assess how each activity generates customer willingness to pay, and they
analyze differences in activities to examine how and why customers are willing to pay
more or less for the goods or services of rivals. Finally, the managers evaluate
alternatives in the firmʼs activities. The objective is to identify changes that will widen the
wedge between costs and willingness to pay.

The goal of activity analysis is to understand the specific WTP−C implications of

each box in the value chain. Armed with this understanding, a firm can adjust
activities to maximize its overall WTP−C gap and the firm can seek or preserve
added value.

Step 1: Catalog Activities

Using the Value Chain as a guide, a firmʼs activities are divided into primary activities
and support activities. Primary activities include inbound logistics, operations, outbound
logistics, marketing and sales, and after-sales service. Support activities include firm
infrastructure, human resource management, technology development, and input
procurement.

Step 2: Understand C by Activity

Next, these activities must be analyzed, relative to competitors, in terms of C and WTP.

Competitive cost analysis requires understanding the cost drivers of each of a firmʼs
activities—those factors that make the cost of an activity rise or fall. By linking cost
drivers numerically to activities, a firm can compare its actual activity costs to the


 23

estimated activity costs of its competitors. Firms focus on cost drivers to better estimate
the unobservable costs of competitor activities.

It is critical to focus on differences in individual activities instead of total cost, because

firms may face different internal cost structures even though total costs are comparable.
This analysis should emphasize an industryʼs largest costs to ensure overall relevance.
These activities should be defined narrowly enough to highlight applicable differences,
especially for larger companies. In some cases this requires looking at activity costs on
an individual product basis, although in other cases activity costs on a product group are
sufficient.

Step 3: Understand WTP by Activity

Just as activities are associated with different C for different firms, activities are
associated with different contributions to WTP. Linking individual activities to WTP is
more complex than linking them to C, particularly with support activities. Firms must first
understand who the customers are and what they desire. They must also understand
which competitors enjoy relative success in satisfying different customer needs. As
customers become varied, this process requires effective segmentation, and linking
activities to WTP of different customer segments.

Differences in WTP usually account for more observed variation in profitability among
competitors than disparities in cost levels. While any activity in the value chain can
affect WTP, physical product attributes and product image tend to have the strongest
effects. However, activities associated with reducing costs to purchase also generate
considerable WTP, such as speed of delivery, availability of credit, and quality of
presale advice. Consider how the purchase and delivery experience at a car dealership
affects the buyerʼs overall initial ownership experience and WTP.

Step 4: Identify Activity Changes

Identifying activity changes is the final step of activity analysis. Change falls into two
classes: (1) opportunities to raise WTP at relatively low cost increases and (2) activities
that generate considerable reductions in C, but little change in WTP. Firms that
fundamentally understand competitorsʼ strategies can isolate critical activities that they
themselves do not fully exploit. Often, the full value chain activity analysis leads to
unexpected activities where changes can increase the WTP−C wedge.

In each of these steps, weʼve referenced our competitorsʼ strategies, activities, costs,
and WTP without defining which firms should be treated as competitors. A firm
participates in one or more industries through its products. Industries are related
through the inputs necessary for the product—each product serves as an input to a
subsequent industry. These relationships create a vertical chain of industries. Figure 5
provides a conceptual model for the relationships between a firmʼs productʼs value
chain, industries, and the vertical chain.


 24

Each box of the vertical chain is an industry, and each industry has attributes that
constrain profit opportunities and attributes that, if exploited, yield high returns. Firms sit
in one or more industries along the vertical chain from raw materials to final goods.

Figure 5

EACH INDUSTRY HAS ITS OWN VALUE CHAIN

NATURAL GAS

ETHANE

STYRENE

POLYSTYRENE

CARTONS

RESTAURANT


 25

Industry Analysis

Porterʼs Five Forces is a framework to understand the opportunities and constraints in

the competitive context of an industry of firms. Industry analysis is helpful in
understanding the constraints a typical firm in an industry faces in developing
and/or defending its added value.

Consider these quotes from Michael Porterʼs Competitive Strategy (1998, pp. 3−5):

• The essence of formulating competitive strategy is relating a company to

its environment.…the key aspect of the firmʼs environment is the industry
or industries in which it competes.

• Competition in an industry continually works to drive down the rate of

return on invested capital toward the…return that would be earned by the
economistʼs “perfectly competitive” industry.

• The goal of competitive strategy for a business unit in an industry is to find

a position in the industry where the company can best defend itself against
these competitive forces or can influence them in its favor.

• [The Five Forces are] concerned with identifying the key structural
features of industries that determine the strength of the competitive forces
and hence industry profitability.

Understanding this competitive situation is crucial for firms. Below we will discuss two
vantage points for performing an industry analysis. One, we will look at the framework
from an industry attractiveness standpoint. Here we will outline industry features that
increase the likelihood that the industry will face opportunities or constraints. Two, we
will suggest that intense rivalry is analogous to the “commoditization” of an industry.
From this standpoint, we will ask how each of the four constituents (buyers, suppliers,
substitutes, and entrants) might drive commoditization (the situation where customers
perceive that firmsʼ outputs are nearly indistinguishable) into the industry.

Porterʼs Five Forces Framework

The Five Forces framework provides a systematic way to catalogue the

competitive situation a firm will face in its industry (see Figure 6).


 26

 FIG. 6: PORTER’S FIVE FORCES

Buyer Power

trants Buyer Power

Pressure from En

Pressure from Substitute Industries

Supplier Power

©EFM Design LLC

When we do a Five Forces analysis for any industry, we keep two questions in mind:

(1) Does the underlying structure of this industry indicate that competitive forces
will be strong or weak? Bottom line, is the industry attractive or unattractive?

(2) If the competitive forces in the industry are strong, is there some strategy that
firms might employ to influence the forces in their own favor?

Ultimately, the attractiveness of an industry has to do with the extent to which price is


 27

the single or among a few key criteria that determine from whom the customer buys.
Rivalry is outright competition among firms – firms compete in price or they compete by
adding features (ie, free delivery) without raising price enough to cover additional costs.
The diagram above visually demonstrates the relationship among the five forces. Buyer
power, supplier power, threat of substitutes and threat of entry can play roles in making
price an increasingly central part of the customerʼs decision regarding from whom to
buy. If buyer/supplier power and threat of substitutes/entry contribute to the outcome
whereby firms continually make price and nonprice moves that reduce the profit
contribution of each sale, then the “muddled middle” in the above picture indicates that
the end game is rivalry. To be clear, even without buyer/supplier power or threat of
substitutes/entry – “bad behavior” among firms could lead to competition and reduced
industry profitability– always keep in mind, Porterʼs five forces turns the US antitrust
laws on their heads – Antitrust authorities take the customerʼs perspective -- what is bad
for firms is often good for customers.

Defining the Industry/Market

It is critical to carefully define the market or industry in question. In defining an industry,

we seek to identify a set of close competitors—a group of firms that customers and
suppliers see as reasonably close alternatives to each other. We label an industry as
one of the “boxes” along a vertical chain. In reality, industry definition is more an art than
a science. The quality of the analysis depends on framing the industry: too broad a
definition (for example, “beverages”) or too narrow a definition (such as “colas”) tends to
yield few useful insights.

Getting the industry definition right, and implementing the five forces analysis well, will
produce valuable information. It is often valuable to perform industry analysis based on
a variety of industry definition.

Two common ways to define markets are in terms of products and in terms of
geography. Firms are considered competitors if consumers are willing to use their
products for the same purpose. Therefore, product similarity is the most common way
that a market is defined. Geography matters as well, since firms located far from each
other may not sell to the same set of customers. The importance of geography varies
widely by industry.

Rivals

In Porterʼs framework, rivalry refers to any firms operating in the same industry or
market. Rivalry is in the center of the five forces schematic, and all the other forces point
to it. Rivalry results in price competition that drives away profits. The other forces
describe the competitive strength of less-direct competitors. If any of these forces are
strong, rivalry inevitably becomes stronger as well.


 28

There are many sources of rivalry within an industry—firms may:
• Face numerous competitors
• Face equally-balanced competitors
• Exist in a slow growth industry
• Have high fixed costs or storage costs
• Lack differentiation
• Augment capacity in large increments
• Face high exit barriers
• Easily adjust prices
• Have easily observable prices and terms

Buyers

Under some conditions, buyers may be able to capture a larger share of the surplus,
leaving little for the firms. Suppose an industry has little rivalry. Even if the possibility of
new entrants and substitute products does not pose a substantial competitive threat,
there may be considerable surplus for the firm to earn. When conditions tempt firms to
compete on price, the buyers receive the surplus. The conditions below all result from a
context in which buyers are motivated to invest in information about what they are
buying. This information often has the effect of reducing negotiations to a pure price
dimension. The price conditions that lead buyers to behave this way are discussed in
the section on commoditization.

Buyer power is caused by a number of factors:

• Buyers purchase large volumes of firm output
• Firm output represents a significant fraction of buyersʼ costs
• Buyer industry is more concentrated than firm industry
• Buyers purchase a standard or undifferentiated product from firms
• Buyers face few switching costs between firms
• Buyers pose a credible threat of backward integration
• Firm output is unimportant to the quality of buyersʼ product
• Buyers have full information

Suppliers

Supplier power emerges in industries where firms are fungible intermediaries for
suppliers whose scarce or differentiated inputs ultimately satisfy end user needs.
Even when other forces are weak, firms may face competitive pressures from their
suppliers. If suppliers have power, they can force price increases (or quality reductions)
onto buyers, which they may not recover in their own prices. Labor is often a very
powerful supplier because it can legally form unions to collectively bargain for prices.
Consider the fact that patients want doctors when they go to a hospital, as a hospital
without doctors cannot deliver very much. Many patients perceive hospitals as “low
added value” intermediaries of doctor services. Under the right circumstances, doctors
can be powerful suppliers.


 29

Supplier power is caused by a number of factors:
• Firmʼs industry is an unimportant customer of supplierʼs industry
• Supplier industry is more concentrated than firm industry
• Few other substitute products available to the firmʼs industry
• Firms face switching costs between suppliers
• Suppliers pose a credible threat of forward integration
• Supplierʼs product is an important input to the firmʼs business
• Firms have little information on suppliers

New Entrants

When firms generate healthy profits, we expect new firms to attempt to join the market.
If entry occurs, capacity and output increase putting downward pressure on prices.
Furthermore, entry can put upward pressure on input prices. The risk of entry is
determined by the relationship between the overall size of the market and the scale of
operation necessary to achieve cost parity, as well as on the entrantʼs access to
potentially scarce but necessary resources. If the entrant has to be relatively large to
operate at an efficient scale, entry is daunting due to factors such as capital
requirements and the need to steal a lot of market share to amortize the cost of
entering. Firms may be protected from competitive threats when barriers to entry hinder
potential entrants from gaining traction in the industry.

Barriers to entry that limit new entrants include:

• Economies of scale
• Product differentiation
• Capital requirements
• Access to distribution channels
• Government policy and regulations
• Proprietary product technology
• Favorable access to raw materials or locations
• Considerable learning/experience curve

Substitutes

Substitute products are those that can perform the same (or some of the same) function
for consumers as the industryʼs product. All firms in an industry are, in a broad sense,
competing with substitute products. When substitute products are more plentiful, closer
in “product space,” and doing better in the market, the firms in the given industry will be
worse off. Identifying substitute products is a matter of searching for other products that
can perform the same function for consumers as the product of the industry. Pepsi and
Coke are direct competitors, while noncarbonated beverages might be classified as a
substitute for cola. We might debate whether particular firms and products are direct
competitors or substitutes, but conceptually it is clear that competitors and substitutes
fall along a continuum. Substitutes often come rapidly into play if some development


 30

increases competition in their industry, causing price reduction or product improvement.

Disruptive Technologies

Here we will apply [HBS] Professor Clayton Christensenʼs concept of disruptive

technology to fully explore the threat to an industry from substitute products. A
disruptive technology is a technological innovation, product, or service that uses a
“disruptive,” rather than an “evolutionary” or “sustaining” strategy, to overturn the
existing dominant technologies or status quo products in a market. The insight brought
out by Porterʼs analysis of substitutes and Christensenʼs analysis of competition among
technology products is that technically superior products can be at risk of losing sales to
technically inferior products when the buyer deems the inferior product to be sufficient
for their needs.

Christensen, in The Innovatorʼs Dilemma, writes:

When the performance of two or more competing products has improved

beyond what the market demands, customers can no longer base their
choice on which is the higher performing product. The basis of product
choice often evolves from functionality to reliability, then to convenience
and ultimately, to price (p. xxiii).

New products (disruptive products) targeted at different segments (usually lower price
markets) become substitutes when consumer expectations grow more slowly than
increases in product quality. This occurs in “over served” industries, shown in Figure 7.
PERFORMANCE

Sustaining Technology

Disruptive Technology

Demand for Performance

t0 t* TIME


 31

In the above diagram, we consider a “sustaining technology” such as the mainframe
industry. We see that, eventually the mainframe industry faces competitive pressure
from the substitute product (the disruptive technology), which in this case is the personal
computer industry. At time t=0, the performance of the PC is below the level of
performance consumers are demanding. At this point, the mainframe industry does not
perceive much of a threat from the PC because consumers of the mainframe are
unsatisfied by PCs.

In this scenario, both the mainframe and the PC improve over time (the assumption
here is that they improve at the same rate, but this assumption is not critical). In
considering substitutes, the critical assumption is that demand for performance
increases at a lower rate than the substitute product improves. Given this
situation, there will be a time (t*) when the substitute satiates the consumer. This is the
point when the industry (mainframes) feels strong pricing pressure from the substitute
industry (PCs). Note that at t* the mainframe is over serving its customers. The
mainframeʼs performance is so far ahead of demand for performance that the customer
likely has little WTP for it. At t* the mainframe has trouble monetizing its research and
development investments.

Other Forces

Many consider two other important industry forces: complements and the government.

When a firmʼs product is dependent on another industryʼs product, that other industry is
considered a complementary industry. Complementary industries can have significant
impact on value creation in the firmʼs industry. For example, complementary industries
can affect rivalries through price shocks. When oil prices rise, complementary industries
such as airline travel can be forced to increase short-term price competition because of
relatively fixed capacity.

The government is also a force on industry. Some factors include:

• Antitrust laws that limit concentration
• Government purchasing contracts
• Labor policy
• Trade policy
• Tax policy
• Environmental regulation
• Financial securities regulation
• Advertising regulation
• Product safety regulation
• Production subsidies


 32

Template for Analysis

Equipped with this analysis, a firm has a much more comprehensive picture of how
profitable operating in this industry is likely to be. To be most effective, a firmʼs strategy
will outline offensive or defensive actions designed to create a defendable position that
exploits the opportunities and neutralizes the constraints found among the five forces.
Below we provide a template that may be used to have an initial dialogue about the
structural attractiveness of an industry. Refer to this template as an example rather than
as the best possible template imaginable.


 33


 34

 


FACTORS AFFECTING BUYER POWER


 35

Resisting Commoditization

When close competitors vie for customers using price as the key distinguishing
feature, it is reasonable to say the industry has been commoditized. Technically, a
commodity market is one in which leverage through a unique value proposition is not
possible. Through the “gale of creative destruction,” industries are inevitably
commoditized, while subsets of these industries are un-commoditized through astute
entrepreneurial acts.

Porterʼs Five Forces framework builds around rivalry because when a group of firms
become rivals and compete on price, profits are quickly dissipated. Buyers are
unimpressed with non-price differences among firms and force down product prices.
Suppliers of critical and/or branded inputs (such as Intel in microprocessors) may also
extract surplus by forcing up input prices or driving competition in the industry they
supply to so as to create demand for themselves.

Buyers, suppliers, as well as emerging competitors and substitute firms all benefit from
an industryʼs commoditization. It is critical to trace how each of the four outer forces can
drive commoditization on an industry. Understanding how and under what conditions
industries are commoditized is the source for ideas to resist it.

Buyer Power

Path to commoditization: If the industry sells an input that is a high share of its
customersʼ cost of goods sold (COGS), the customers will almost certainly pave a path
to commoditization of the industry under consideration. We will consider two cases to
demonstrate this path: the industry sells something that is “high stakes” and a high
share of its customersʼ COGS, and the case where the industry sells something that is
“low stakes” and a high share of COGS.

For the first case, consider the microprocessor industryʼs output is high stakes to their
customers, PC assemblers, as the microprocessor performance is critical. Furthermore,
the microprocessor is a reasonably high share of the assemblerʼs overall COGS. In this
case, assemblers will create demand for information and for infrastructure that will
enable them to easily shop and compare microprocessors from various firms and
sources. In fact, assemblers are strongly incentivized to keep themselves highly
informed about virtually every aspect of the microprocessor business. This motivation to
be informed gives rise to informed transactions based on salient product attributes
rather than based on brands or other “quick and dirty” signals of quality and
performance.

Alternatively, if the industryʼs output is reasonably low stakes (for example, the tin can is
not the most compelling aspect of a canned vegetable), but still a high share of COGS,


 36

the customer will be inclined to experiment with various firms and alternatives. This
experimentation will give rise to a group of customers who are highly informed and who
are, ultimately, price shoppers. The difference between the cases of high stakes and
low stakes is that in the former case, the customer must become informed before that
customer can credibly threaten the industry with “cost plus” demands. In the latter case,
the customer may go directly to experimentation and this willingness to experiment
“commoditizes” the industry under consideration.

Supplier Power

Path to commoditization: Supplier profits increase as the industry in question competes

on price (see figure below). From the perspective of the supplier, the more the industry
which it supplies competes on price, the more final goods prices in the industry fall.
Since demand curves slope downward, the lower prices drive up the quantity sold. The
higher quantity sold results in greater profits for suppliers.

Next, consider that there are suppliers whose inputs are seen as critical to end-users—
these suppliers provide inputs that make the final product most appealing or functional
to final consumers. We like computers with “Intel on the Inside,” and diet drinks
sweetened with Splenda and restaurants that serve Coke or Pepsi. Suppliers of these
critical inputs benefit from price competition in the industries they serve. This fact
suggests the suppliers may seek opportunities to “cram down” price competition on the
industries they supply.

As an example, consider Intelʼs decision to sell motherboards. By performing much of

the complex assembly and handing it over to assemblers, more firms could enter the
assembly business. Intelʼs choice to produce motherboards ultimately reduced the entry
costs to the PC manufacturing industry. With more entrants coming in, and more
consumers focused on “Intel on the Inside,” the PC assembly business becomes
focused on prices competition—that is, the industry becomes commoditized. The effect
on Intel is positive. Shown in Figure 8, as PC assembly becomes commoditized, Intel
faces higher demand, and this drives up volume for the powerful supplier.


 37

Figure 8

PRICE

Competition among firms making PCs

results in a movement DOWN the demand curve
for PCs Quantity increases and price decreases

Demand for Performance

QUANTITY
QUANTITY
PRICE

The movement DOWN the demand curve

for PC’s results in a SHIFT RIGHTWARD
for the demand curve for microproccessors

Demand for Microprocessors

Demand for Microprocessors

QUANTITY


 38

New Entrants

Path to commoditization: As discussed above, entry leads to increased capacity and

downward pressure on price (commoditization). Here we probe into the factors that
ultimately enable entry. As previously discussed having to be large relative to the
market, or having to secure particular inputs will create entry barriers. This suggests that
there are settings in which entry is preempted by firms who move first and “fill up” the
industry with the capacity needed to satisfy demand—that is, incumbents leave no room
for entrants. One factor that may enable entry is innovation, which may make it possible
for entrants to at least match the incumbentʼs value proposition or productivity while
operating at a reduced scale or with available resources.

Another context in which entry is a factor is an environment of rapid change either in

buyer tastes or in the optimal configuration of production facilities. In this setting,
“staging” investments (making the investment as the firm becomes informed) reduces
the odds of superfluous big fixed investments. On the other hand, preemption (reducing
the odds of entry) becomes difficult when relatively rapid change discourages firms from
coming in big enough to discourage future entrants.

If the mode of production and/or the nature of demand are in flux, it is difficult and
unattractive to make large capital investments in an effort to stake a claim on a large
portion of the market. Firms fear their investments will be nearly worthless if their guess
about production and/or demand turn out, ex post, to be incorrect. Firms that make


 39

incorrect bets end up unable to preempt future entry. If we look back on the computer
industry, there were many computer assemblers who preceded Apple and IBM.
However, since their bets on production technology and demand attributes were
incorrect, their investments in production capacity did not, ultimately, dissuade
subsequent entrants.

Substitutes (Distant Competitors)

Path to commoditization: When customers view a substitute or “distant competitor”

satisfactory, price becomes more important—and commoditization has set in. If the
industry over-serves customers, customers may choose to pay less to get less once the
substitute reaches some threshold of performance. Customers switch to the “substitute”
and the firms in the industry must compete for revenues to recover expenditures in
research and development (which are also the source of both costs and features which
over-serve buyers). Unable to extract a premium, they price closer to par with
“disruptive” firms.

Understanding Value Summary: Refer to Figure 9

• The vertical chain is production from materials (natural gas) to goods (restaurants)
• Each box in the vertical chain is a single industry, made up of few or many firms
• Each firm may sit in one or more industries
• Each industry faces opportunities and constraints based on Five Forces effects
• Each firmʼs value chain is made up of activities, which each contribute to the firmʼs
total WTP−C wedge
• Each activity makes some contribution to WTP and some contribution to C
• Value creation varies significantly across industries, firms, and activities


 40


 41

Positioning

Up to now, we have mainly paid attention to the attractiveness of the industry as a

central exercise in strategic analysis. Under each of the five forces, we examined
features that affect the likelihood that firms face opportunities or constraints in a given
market. We suggested that intense rivalry is equivalent to the commoditization of an
industry -- buyers, suppliers, substitutes, entrants and competitors themselves can drive
commoditization.

We now turn to the application of what we learn from doing a good analysis of an
industry -- positioning. Positioning involves segmenting an industry to find a defensible
position in that industry. Firms are actively positioning when they configure their value
chain to neutralize industry constraints and exploit industry opportunities. When
we describe a strategy process or a firm behaving strategically, we mean the firm
understands the opportunities and constraints inherent in its industry and responds by
seeking a “position” that is more attractive than the industry is on average –in a sense a
strategy is the pursuit of an attractive position.

Segmentation11

Industry segmentation involves creating an industry within an industry that targets the
needs and wants of a given group of customers. Within each industry there is a range of
products and a distribution of customer types with varying wants and needs. An industry
segment can be based on a particular variety of product (e.g. the luxury car market), or
it can be based on customers (e.g., overnight shipping for small businesses). In most
industries, a variety of products have emerged to satisfy the range of customer wants.
For luxury cars, market segmentation is used to market them to their target audience.
Buyers of luxury cars exhibit considerable variety in terms of tastes, income, and
gender. Market segmentation identifies the specific group or groups to which the firm
has competitive advantage and can achieve a high penetration rate within the target
luxury car market.

Segmentation should reflect differences in effects of Porterʼs Five Forces. For

example, in the candy industry, there may be no economies of scale in producing
crunchy candy, but considerable economies of scale in producing chewy candy (of
course, this is totally made up!). As a result, there will likely be many more firms that
make crunchy candy than make chewy candy. The reason is, firms can make crunchy
candy and achieve minimum efficient scale (the level of output at which costs get as low
are they will go given the technology) at a low level of output. Hence, many crunchy
candy makers will “fit” in the market. Chewy candy production, on the other hand,

























































11

 This section is based on and summarizes Michael Porter’s Industry Segmentation and Competitive Advantage, pp. 231-272. A chapter in
Competitive Advantage: Creating and Sustaining Superior Performance (1998 edition).


 42

demonstrates economies of scale. This means a firm has to make a lot of candy before
reaching minimum efficient scale—hence, fewer chewy candy makers “fit” in the market
(if lots of firms entered and made candy until they got to scale, there would be too much
chewy candy relative to demand). Hence, crunchy and chewy may be meaningful
segments of the overall candy market.

There are value chain based segmentations possible if product or customer type alters:

• The cost of the firmʼs activity on its part of the value chain
• The uniqueness of the firmʼs activity on its part of the value chain
• The configuration of the firmʼs activity on its part of the value chain
• The buyerʼs own value chain, when the buyer is using the firmʼs output as an input

Firms in the same industry compete in different segments, with competitive advantage
coming from different activities along the value chain. There are four observable classes
of industry segmentation that capture differences among firms:

• Product variety: discrete product differences that do or could potentially exist.

• Buyer type: age, gender, industry, purchase size, etc.
• Distribution channel: catalog, retail store, internet, etc.
• Buyer location: country, zip code, rural vs. urban, etc.

Product Variety Segments

• Physical size: TVs can be segmented by screen size

• Price level: fashion is often segmented by price level (e.g., Chanel vs. Kmart)
• Features: automobiles may be safety focused, or performance focused
• Technology: halogen bulbs vs. incandescent bulbs
• Packaging: individually-wrapped vs. bulk box
• Product age: new vs. replacement or antique
• Primacy: product vs. ancillary services (e.g., gas station vs. convenience store)
• Bundles: season passes vs. single event tickets

Buyer Type Segments (Consumer)

• Demographics: family size, age, marriage status, income, education

• Lifestyle: vegetarian, vegan, organic
• Language: particularly for education services
• Purchase occasion: Hallmarkʼs seasonal vs. birthday cards


 43

Buyer Type Segments (Commercial)

• Buyer industry: indicates price sensitivity

• Buyer strategy: high quality vs. low quality producers
• Technological sophistication: grammar schools vs. universities
• Buyer stage: direct users of firmʼs product vs. packagers who sell downstream
• Vertical integration: less information is available on more integrated firms
• Purchase process: computer purchases by IT department vs. non-specialists
• Size: will effect value of costly sales activity
• Structure: public vs. private may affect willingness to spend frivolously
• Financial strength: will affect demand for credit alongside product
• Order pattern: quick-turnover vs. constant flow

Distribution Channel Segments

• Direct vs. distributors

• Direct mail vs. retail
• Distributors vs. brokers
• Exclusive vs. nonexclusive outlets

Geographic Segments

• Localities, regions, or countries

• Weather zones
• Economic development stage (for countries)

Relationships among variables must be examined to identify the most meaningful

segmentation pattern. Typically, segmentation variables are correlated, for example,
segmenting by age effectively segments by height, up to adulthood. We can use a
variety of statistical processes and techniques to eliminate redundant variables and
simplify segmentation.

Finalizing the industry segmentation matrix involves trying a number of different

segmentation schemes that reveal the industryʼs most important product and buyer
differences. Ultimately, we want one axis to represent combined product variables, and
one axis to represent combined c


 44

Segment Selection

Effective segmentation is based on meaningful differences among product and

customer segments. Firms should select which segments to serve based on segment
attractiveness, while they should determine the breadth of segments to serve based on
segment relationships. While segments reflect underlying realities that firms seek
to discover, positions are choices to serve specific segments.

Firms can attempt to serve several segments at once, or they can focus on a single
segment. There are advantages and disadvantages to each approach. Diversified
firms—those that choose to serve multiple segments—may face cost disadvantages,
while focused firms may have more volatile earnings since their fortunes are tied to one
segment. Focusers usually get cost advantages or stronger differentiation than firms
who try to serve several segments. However, firms who serve several segments may
reduce costs for customers through one-stop-shopping.

Segment attractiveness is a function of several factors:

• Low structural risk of Five Forces pressure
• Large size and high growth
• Segment interrelationships, particularly on scale/scope economies

Generic Strategies

Positioning reflects a firmʼs choices in response to industry opportunities and

constraints. Porter describes three generic strategies that are responses to industry
conditions: cost leadership, differentiation, and focus. Below we describe these three
strategies in some detail because the generic strategies have become part of the
strategy vernacular.


 45

Not all strategy experts believe that the three generic strategies span all possibilities or
even that any of them can best describe a particular firmʼs position. That said, Porterʼs
generic strategies are widely used. Most firm strategies can be described by one of the
three, or by some combination of the three. At the same time, however, simply
categorizing a firmʼs strategy is not valuable on its own. We learn more when we
describe a firmʼs strategy in detail and then discuss that description with others.
Identifying a firmʼs position as one of the three generic strategies is unimportant
relative to learning during a discussion of what position the firm is attempting to
secure and serve.

Overall Cost Leadership

The low-cost strategy is not simply about pursuing operational effectiveness; all firms
benefit from and should incorporate widely understood best practices. To qualify as the
low-cost producer with a sustainable cost advantage, the source of a firmʼs low-
cost position must not be available to rivals. Generally, a low-cost strategy is
focused on protecting some cost advantage the firm already enjoys.

As shown below in Table 4, cost advantages stem from specific superior resources
because in homogenous product markets, rival firms always attempt to imitate firms with
the best cost positions. Without superior resources, sustaining a low-cost position is
difficult.

Table 4

Required Skills and Organizational Risks

Resources Requirements

Sustained access to Tight cost control Technology change may

capital investment nullify past investments

Process engineering Frequent detailed control Low cost learning by

reports newcomers through
imitation or investment

Intense labor supervision Structured organization Inability to see required

and responsibilities product or marketing
change

Products designed for Incentives based on strict Cost inflation which

ease in manufacture quantitative targets narrows profit margin

Low cost distribution


 46

Differentiation

In almost every market, there is some variation in product offerings. And even in those
markets with physically similar products, customers may perceive important differences.
Given that each customer has some ideal product in mind, firms that offer distinct
products will likely be able to receive premium prices from at least some customers. The
inherent trade-off of a differentiation strategy is market share for margin. With a
differentiation strategy, while firms may not reach as many customers, they can charge
higher prices if they locate a meaningful segment with a higher desire for their good.
Differentiators look to offer product varieties that approach some set of customersʼ ideal
for that product. For the differentiator to justify serving this segment, these customers
need to be willing to pay a sufficient margin. This is summarized in Table 5.

Table 5

Required Skills and Organizational Risks

Resources Requirements

Strong creative and Strong coordination among If cost difference grows,

marketing insights R&D, product development, consumers may sacrifice
and marketing features for savings

Product engineering and Subjective measurement of Buyersʼ need for

basic research skills incentives with qualitative
focus
Corporate reputation for Amenities to attract highly
quality or technology skilled labor, scientists, or
leadership marketers
differentiation may fall as
they become
sophisticated
Imitation may narrow
perceived differences as
industry matures

Strong cooperation from

channels to distribute
products to segments

Focus

A pure focus strategy is a customer-centric approach in which customers have attributes

different from the customers of a non-focuser. That is, while differentiation identifies
underserved product categories and varieties, a focus strategy identifies underserved
segments of customers. A focus strategy requires tailoring activities for particular
customer groups or segments. Focus can be combined with differentiation—selling
particular customers a particular variety of product. However, focus may exist without
differentiated product offerings. A pure focus strategy is a customer-centric approach in
which customers have attributes different from the customers of the firmʼs rivals. Again,
differentiation entails changing product attributes, while focus entails changing


 47

distribution and transaction attributes to better serve clientsʼ needs. That is, the focuser
must reduce system costs; for example, by setting up delivery systems ideal for fast
food chain customers.

By lowering overall transaction costs (by taking advantage of “win-win” opportunities to

customize activities for the target customer) while maintaining price parity or near parity,
the focuser can raise its own margin. If the customersʼ “all in” or net costs are lower
when dealing with the focuser, those customers would be willing to pay the firm at least
as much as they were paying the competition. The customers of the focuser may even
be willing to pay more—as long as the net cost to the customer is lower. Net costs take
into account all costs of using the product in question. For some customers, Jiffy Lube
reduces the cost of getting an oil change. Jiffy Lube may charge higher prices than
some options the customer has, but for many segments, the “all in” cost is much lower.
Jiffy Lube sells the same product as many service stations—but its distribution channel
is different.

Focusing carries specific risks:

• The cost difference between a value chain configured for a particular segment and
one for a broader market can widen due to idiosyncratic events. For example, if the
segment makes or experiences some change in its own value chain, this will have a
spillover effect on the focuser. The effect of these changes in the customerʼs value
chain may ultimately eliminate the cost advantages of serving narrow target.
• It is also possible that the difference between the strategic target and the market as
a whole narrows. This would put the focuser in direct competition with competitors
who serve the whole market.
• It is also possible that competitors find submarkets within the target and out-focus
the focuser. In this case, the focuser did not initially configure itself in an optimal way
and left itself open to entry.

Whatever a firmʼs position, it can enhance its value by reducing costs. Firms enjoy a
cost side advantage when they own a process, or when they uniquely face a
lower input cost. Regardless of whether a firm has the potential for a true cost
advantage, no firm should operate below the productivity frontier. Operating below the
productivity frontier is the same as expending resources with no opportunity for return.
Firms will find that while cost advantages are rare, cost parity is necessary.

To understand where a firm stands regarding costs, we must answer these questions:
(1) Where is the firm relative to the productivity frontier?
(2) Can we increase WTP by more than we increase costs?
(3) Can we decrease C by more than we decrease WTP?
(4) Can we organize operations in response to commoditization in industries adjacent
to us to gain more than our competitors? (Do we take advantage of volume
opportunities in response to commoditization in industries we sell to? Do we take
advantage of cost reduction opportunities in industries we buy from?)


 48

In an effort to create cost advantages, there are groups of activities through which firms
can reduce costs. Unfortunately, these are easy to imitate, but nonetheless may create
positional or early-mover advantages, so being first is key.

• “Buy” share in existing markets through low prices to increase scale

• “Buy” share in existing markets to accumulate experience
• Introduce new products to better utilize shared facilities
• Enter new geographies to improve capacity utilization or increase scale

Below are two sets of drivers to control cost within the firmʼs activities. Some (first
grouping) are easily imitable, while others (second grouping) are difficult to imitate:

Easily Imitable:
• Reallocate production within existing facilities
• Relocate facilities to low input-cost regions
• Input substitution (e.g., capital for labor)
• Use lower-cost components
• Bring economies of scope activities in house, but outsource major cost centers
• Enhance worker productivity through formal incentive systems
• Reduce work force

More Difficult to Imitate:

• Improve material yields
• Reduce complexity of production operations (e.g., reduce SKUs)
• Alter product design to improve manufacturability
• Push improvements in asset management such as lower inventories
• Enhance worker productivity through changes in organizational architecture

Preemption and Sustainability

The benefits of a strategy is the ability of the firm to “own” (sustain) some position.
Firms own positions and can sustain returns when followers are preempted. When a
firm owns its position, the cost, risk, and complexity a potential entrant would face is
sufficient to discourage entry.

Strategies for value creation and value capture generally fall along a continuum between
the two general forms of preemption described below: investing in capital-intensive
assets and securing superior scarce resources.

Investing in Capital Intensive Assets

The first form of preemption consists of investing in capital-intensive activities. These

investments reduce subsequent returns on capital invested by either incumbents or new
entrants. Think of a first mover that invests in the capacity and infrastructure necessary
to serve a segment of the market. The firm chooses product attributes and modes of


 49

production and organization. Collectively, the choices are the firmʼs position. If the firmʼs
capacity is a high share of the size of the overall opportunity, then the successful early
mover preempts followers by “taking up the space” with their investments. These
investments are said to be preemptive because subsequent investments deliver lower
returns than they would have without the early moverʼs investments. Ideally, a
preemptive investment also delivers the firmʼs value proposition (in addition to reducing
the return on subsequent capital).

Sometimes firms are able to stage their investments over time. For example, while
Microsoftʼs investment in developing the operating system grew to be preemptive, they
did not have to make a big bet on day one. In other markets, such as CD pressing or
airlines, large upfront investments under more uncertainty are required to “own”
markets. These firms have a more difficult time fragmenting investments.

In both cases, the cost of preemptive investments is large. In the case where
investment can be staged, capacity choices tend to be more optimal, so an industryʼs
overall return on capital is often higher. Upfront preemptive investments are sometimes
excessive, particularly when they cannot be staged. Furthermore, investments that
should act as preemption may still fail in some circumstances. Consider a first-mover
who identifies an attractive market opportunity but who underestimates the size of the
opportunity or who simply cannot secure enough capital to satisfy the market. Then
along comes a competitor who also believes in the market. If competition takes on the
form of “winner-takes-all” (more on this below), competitors will escalate their
investments in an attempt to secure market supremacy. The more the competitors sink
into the market, the more they are motivated to keep investing to preserve the value of
what they have invested in already. This is an unfortunate outcome for firms in a setting
that otherwise would have lent itself to preemptive investments and attractive returns on
capital. Firms that can make preemptive investments often enjoy high and sustainable
returns. Analysts should ask themselves how well preemptive investments will hold
going forward, how matched past capacity choices are with future demand conditions,
and what alternative means of satisfying demand are on the horizon.

Securing Superior Scarce Resources

Another preemptive approach involves securing superior scarce resources. Here we

consider a firm that has secured inputs that are not widely available to other producers.

The firm employing superior scarce resources produces a superior product and/or
operates more efficiently and thereby generates a higher return on capital than other
firms. If the firm employing superior resources is earning economic profits, then that firm
was, by definition, able to secure its resources for less than their value to the firm; if this
were not the case, then the economic profits would be dissipated. Here, the cost of
preemption was secured for a “bargain” price. On the other hand, firms often need to
account for the “opportunity cost” of owning resources that ultimately revealed
themselves to be more valuable than they appeared at the time of acquisition.


 50

Employing scarce and superior resources that the firm secured at a cost lower than the
return those resources generate is preemptive.

Preemption through physical investments and preemption through locking up valuable

resources are anything but mutually exclusive. Once a firm employs superior resources,
it should invest in assets and capabilities that are complementary to those resources.
Superior resources employed in the context of complementary assets and capabilities
are even more productive. Furthermore, dependence on these complementary assets
enhances the value of the resources to the firm relative to the outside option of the
resources. In other words, the complementary assets connect the resources to the firm.
This discussion anticipates some of the insights of the resource-based view of the firm,
which is described in detail later in this document. The resource-based view concludes
that it is critical that the firmʼs resources and its investments be mutually dependent.

We described two forms of preemption: physically taking up the space with investments
in capacity, assets, and capabilities on the one hand, and employment of scarce and
superior resources on the other hand. In the most valuable firms we find that preemption
includes use of superior resources combined with preemptive physical investments in
superior assets and capabilities. The productivity of resources is enabled by firm
investments and firm investments are more valuable when combined with particular
resources. This is shown in Figure 10.


 51


 52

Sustainability (or in Warren Buffet speak, “Moats”)12

As firms invest in physical and nonphysical assets, and employ owned and non-owned
resources, the nature of their investments and their businesses give rise to various
forms of preemption with various degrees of sustainability. Warren Buffet is credited
with using the term “moat” to connote both the form of preemption and the degree of
sustainability of a business. While increasing return businesses enjoy the deepest and
widest moats, Figure 11 below outlines many types of moats, in order from least to most
powerful. The strength of the moat indicates how long a firmʼs competitive advantage
will last. While some individual moats are strong, almost all firms with sustained above-
market returns have multiple moats, some of which are ingeniously engineered.

Figure 11: Sustaining Resources

most important
Increasing Returns product performance W I L L A DVA N TAG E B E U N D E R M I N E D BY S H I FT S I N T E C H N O L O GY O R C U S T O M E R P R I O R I T I E S ?
Advantages track records & reputation
installed base in a network market
cumulative experience on a learning curve

Information
Information Gaps
Gaps “black magic” W I L L T H E Y P R E V E N T U S F RO M R E P L I C AT I N G O U R S U C C E S S F O R M U L A A S W E G RO W ?
& Complexity
& Complexity social complexity
path dependance
need to imitate on numerous dimensions

Economies of Scale,
Market Size, & W I L L A DVA N TAG E B E U N D E R M I N E D A S M A R K E T G RO W S ?
Sunk Cost market big enough to support
just one efficient-scale firm

One-of-a-Kind
Information Gaps W I L L T H E Y R E TA I N E CO N O M I C P O W E R ? G AT E WAY S T O P RO FI TA B L E G RO W T H ?
superior locations
Strategic
& Assets
Complexity
human talent
trade secrets
intellectual property
brand names

least important Information Gaps W H AT D O YO U D O W H E N T H E Y E X P I R E ? W O R T H M O R E T O O T H E R FI R M S ?

Legal Barriers
& Complexity
superior locations
human talent
trade secrets
intellectual property
brand names


























































12
See for instance, “How Morningside Measures Moats,” by Jeremy Lopez at Morningside.com
(http://news.morningstar.com/articlenet/article.aspx?id=91441), which refers to Buffet’s annual letters to investors such as
(http://www.ifa.tv/Library/Buffet.html)


 53

Legal Barriers

Legal barriers include patents, copyrights, trademarks, and operating licenses. Their
strength is determined by how long they last before expiration, and the breadth of
protection they provide against potential competition. Patents, for example, vary widely
in the degree of protection they provide to the owner, and in fact, competitors often
“invent around” them. For example, Compaq was able to invent around IBMʼs
formidable patents when Compaq entered the personal computer industry. Moreover,
courts are notoriously unpredictable in their findings when it comes to copyright and
patent infringements. The courts could view what appears to be strong legal protection
as weak. Apple thought its patents were foolproof when it sued Microsoft for copying the
look and feel of its operating system, and was surprised when Microsoft emerged
victorious. Furthermore, with value chains now spanning many countries, the
consistency of U.S. courts matters less and less, and enforcing intellectual property
rights across national boundaries is a challenge of mind-boggling proportions.

One-of-a-Kind Strategic Assets

Assets such as superior locations, human talent, trade secrets, and brand names can
be gateways to profitable growth. While this type of moat is generally more powerful
than many legal barriers, there are many factors to consider when the firmʼs
sustainability is dependent on its continued employment of particular assets. The
resource-based view explores the nuance associated with dependency on particular
inputs (see discussion below). In the end, when a firm is employing scarce strategic
assets, the sustainability is determined by the firmʼs ability to retain economic power
over time without offsetting upkeep costs. A classic example of this is the Coca-Cola
formula, which has been a hugely valuable asset that requires no upkeep.

Economies of Scale, Market Size, and Sunk Cost

Economies of scale, market size, and sunk costs are moderately powerful in sustaining
a firmʼs competitive advantage, with history showing that the protection from low costs
resulting from economies of scale is not the most long-lived of moats. Some markets
are not big enough to support multiple firms at efficient scale. Yet they can be overcome
when competitor firms find important and unserved segments. Through effective
segmentation and differentiation, entrants can make inroads even if they operate
without the benefits of full-scale economies. Firms may enter and compensate for
operating at lower scale and higher costs by differentiating. Alternatively, innovation
often enables entry at lower scale without a cost disadvantage. Finally, the market may
grow and support additional firms.

Information Gaps and Complexity

Often the most enduring, multi-factor moats are those that are “path dependent,” and
socially or otherwise complex. Path dependent outcomes are dependent on being


 54

developed in a particular order and in a particular context. Coca-colaʼs brand image is
an example of path dependency. Without Cokeʼs rich and varied history, Coke would not
enjoy its current brand equity. By definition, path dependency is nearly impossible to
replicate. Additionally, products that need to be imitated on numerous dimensions (e.g.,
features, image, brand, distribution, reputation) enjoy powerful moats indeed. By
definition, path dependency and complexity cannot be engineered.

Increasing Returns Advantages

Under perfect competition, economic profits, or profits in excess of all costs including
the cost of capital, are ultimately dissipated. Potential entrants seize the opportunity and
share in these high returns by entering the market, expanding capacity and output, and,
ultimately, reducing prices. Eventually, profits converge to the competitive level
(accounting profits just sufficient to compensate for all costs). However, many firms in a
diverse array of industries avoid this downward spiral. Strategy frameworks are useful
for understanding how firms such as Crown, Southwest Airlines, Wal*Mart, Nucor,
Pepsi, Coca-Cola, Disney, Google, and others sustained high returns over long periods.

At a high level, the sustainability of high returns is due to:

1. Potential entrants cannot imitate profitable opportunities
2. Barriers exist that prevent the entry of potential imitators

The value in learning strategy is to be able to develop thorough analyses of how either
or both of these explanations for profits plays out in the case of a particular firm.

There is a third category of explanations for sustained competitive advantage. Neither of

the above two explanations explicitly factor in the benefit some firms gain, in terms of
cost or product advantage, due to being an established producer in the market for a
long period. When time in the market matters, we need to factor the mechanisms
through which a firm gains an “early-mover advantage” into our explanation of the firmʼs
sustained returns. Recognize that simply being the first mover into a market doesnʼt
necessarily bestow any advantages on a firm. As any angel investor and venture
capitalist will attest, most first-movers fail. Being the first firm with a desirable product is
not what the term “early-mover advantage” refers to. Here we are looking for a situation
referred to as “increasing returns”—the bigger the firm gets, the better the firm gets.
This is explained in Figure 12. The terms “increasing returns” and “early mover
advantage” should be reserved for cases in which the firmʼs time in the market is
correlated with the depth of its cost and/or product advantage from the perspective of a
typical customer transaction.


 55


 56

Hardware platforms, particularly operating systems, are highly complementary with
platform-specific applications. However, there are very weak economies of scope for
application developers to make their software cross-platform because of significant up-
front knowledge creation costs. As a result, software developers will tend to align with a
single hardware platform, typically the most dominant system. This in turn reinforces the
value to consumers of the dominant operating system, because that system has the
bulk of available software applications. Over time, more consumers adopt the dominant
platform, and fewer application developers make software for the lower share platforms.

While tenure (time spent in a business) can lead a firm to higher share or to lower costs
due to spreading fixed costs across more units, only in the case of early mover
advantage does the cost fall and/or the benefit to the customer rise continually as the
firmʼs time in the market increases. This is shown in Figure 13. To be clear, we do not
expect Kelloggʼs Corn Flakes to taste better as its market share grows. When early
mover advantages are present, consumers derive more benefit from the product as the
firmʼs time in the market increases, or the firm realizes production cost reductions
beyond any due to spreading of fixed costs. Given these caveats in what is an early
mover advantage, we see that the term does not apply nearly as broadly as it is used.
Furthermore, if several firms recognize the advantage of being the first mover and
spend resources trying to achieve this position, they could conceivably dissipate any
profits they would ultimately earn.


 57

There is more than one source of increasing returns or early mover advantage.
However, in all cases the key is that a firm will have a product and/or cost advantage in
year 2 by virtue of having been operating in the market in year 1.

Below we describe some common increasing return or early-mover

advantages

Experience Effects

The experience effects describe any situation in which cumulative experience in

producing a product lowers a firmʼs average variable cost. The experience effect is
captured by the learning curve. Note the distinction between the learning curve and
economies-of-scale—an experienced firm (with learning curve economies) would have
lower costs at any scale of production. It may be an advantage for learning curve firms
to underbid rivals for business at first, in order to build up their cumulative experience. In
cases where a learning curve is present, the advantage may accrue to one or only a few
firms because of how difficult learning is and/or that learning by doing is a significant
cost driver—if these conditions were not present, the learning would be widely acquired
and not a source of advantage. Also note that, just as in the case of scale, there are
usually diminishing (or potentially even negative) additional cost savings at very high
levels of cumulative experience.

Network Effects or Installed Base Advantages

A network effects (also called network externalities) describes the situation in which
each user of a good or service impacts the value of that product to other users. The
classic example is the telephone. The more people use telephones, the more valuable
the telephone is to each owner. This creates a positive network externality because
each user purchases their phone for their own use and quite unintentionally creates
value for other users. The expression “network effect” is applied most commonly to
positive network externalities as in the case of the telephone. Negative network
externalities can also occur, where more users make a product less valuable, but are
more commonly referred to as “congestion” (as in traffic congestion or network
congestion). Over time, positive network effects can create a bandwagon effect as the
network becomes more valuable and more people join, in a positive feedback loop.

The idea here is that when a “network” of users exists, there is an “external” benefit to
additional consumers. If network externalities operate, firms can gain advantage by
building up sales in early periods and developing a large “installed base” of users. The
idea of network externalities can be captured graphically using the “S-curve” (see figure
14). The diagonal line represents what might be considered a “standard” market with
stable market share and no network externalities. Sales to new customers are roughly
proportional to the installed base. When network externalities are present, this


 58

relationship takes on an “S” shape. At very low levels of installed base, the share of new
sales is even lower. When the share of the installed base is high, however, an even
greater share of new consumers will purchase the product. As shown in the figure, over
time, firms with a larger market share will gradually become larger and the share of the
smaller firms will dwindle.

100

90
YEAR 1 MARKET SHARE

80

70

60

50 Unstable Equilibrium
40

30

20

10

0
0 10 20 30 40 50 60 70 80 90 100

INSTALLED BASE - MARKET SHARE AT START OF YEAR 1

Winner-Takes-All Outcomes

The presence of network externalities can be associated with outcomes where the
market converges or nearly converges to a single standard (which can be supported by
a single firm or by many firms who cooperate in that standard). These outcomes are
referred to as “winner-takes-all.” A winner-take-all market is one in which reward
depends heavily on relative, not absolute, performance, and the lure is the high value of
the top prize. A small difference in performance between the firms produces a large
difference in economic profits. Understanding whether a networked market is likely to be
served by a single standard or by multiple standards is crucial for strategy formulation.
Below are considerations for judging the likelihood of convergence to a single winner13 :

 High Network Externalities: When network effects are strong, users will want
access to as big a network as possible. A standard that attracts only a subset of
the market (or a situation in which the market breaks into sub-groups each on
different standards) is a less attractive situation for users. If network effects are
strong, this favors convergence.

























































13
This section draws from HBS Case Number 5-807-104 (October 2, 2007) Managing Networked Businesses: Course Overview for Educators by
Thomas R. Eisenmann


 59

  Multiple-Standard Association Is Painful/Costly: There are costs incurred in order
to “associate” with a particular standard. These costs include: outlays for
hardware (e.g., a CD player), costs for software (the CDs), learning costs, and
other transactions costs. Basically consider all the costs incurred in operating in a
standard that are only useful in that standard and not useful in another standard.
When users simultaneously operate in both standards (they own cassettes and
CDs) they incur redundant costs. The higher these redundant costs are, the more
users prefer to converge to a single standard. In many industries in which
standards exist, we donʼt see convergence to a single standard. We did see
cassettes, CDʼs and even LPs coexist. On the other hand, a very small fraction of
the market uses a Non-Wintel standard. Industries have an incentive to conform
to a single (or very few) standards (that is, consumers benefit from industry wide
standards) when the product is used in conjunction with a complementary good
and it is costly to offer several configurations of the complementary good. The
more expensive it is for the suppliers of complementary goods to produce their
output in multiple configurations, the more expensive it is for consumers to
support both standards, the more convergence we will see. Even if the
manufacturing costs are nominal, we have to consider the increase in distribution
costs if there are multiple standards. If multiple-standard association is costly (for
some combination of manufacturers, consumers, or distributors) convergence is
more likely.

 Opportunities for Product Differentiation Are Low. The question here is, is the
differentiation between the different standards valuable to enough consumers to
get them to pay enough to cover the redundant costs in the hardware and
software markets? If there is little demand for particular and distinct features,
then users will converge to a single standard. Only if the different products satisfy
different needs would be expect to see coexistence. In the case of the CD and
the cassette—one had higher sound quality and one was more portable for a
while. If segments of customers or individual customers have a wide range of
needs, standards can coexist. Buyers have to be willing to vote with their dollars
and pay for the redundant costs of multiple standards.

Buyer Uncertainty and Reputation

Goods for which quality is an issue can be placed into two categories. Search goods are
ones for which buyers can assess quality at the time of purchase, while for experience
goods, quality can only be assessed by buying and consuming the product. If buyers
are uncertain about a productʼs quality, firms that have built up a good reputation among
experienced users will have a distinct advantage. For an established product—one that
consumers have tried and liked—WTP increases a great deal relative to newer
products. New competitors would have to offer much lower prices in order to
compensate for the higher WTP of the established products.


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Buyer Switching Costs

For certain products, buyers may face a specific cost if they want to switch suppliers. A
great example is producing a product that requires training to be able to use it—when
the buyer purchases the product, she incurs a “training” cost that wonʼt have to be
repeated, so long as she doesnʼt switch to a competing product. In a consumer surplus
comparison, a competing product would have to provide either a higher WTP or lower P
to offset the additional cost of training to use the new product. As long as (WTP1−P1) >
(WTP2−P2−T2), the buyer will continue to use the original supplier, even if (WTP1−P1)
< (WTP2−P2).

Optimal firm pricing strategy for products with switching costs can be quite tricky. This is
because getting new customers requires that (WTP1−P1−T1) > (WTP2−P2−T2). The
price that maximizes profits from established users may not be low enough to attract
any new users. In some cases, it may be beneficial to keep prices low to attract and
“lock in” new buyers; in other cases, it might be more profitable to charge higher prices
and exploit the experienced users.

Resource-Based View14

At several points in this document, we have referred to the resource-based view (RBV).
Some firms must pay particular attention to relationships with internal inputs (most often,
but not limited to, key employees). Resources as a source of competitive advantage are
different from positioning. Positioning reflects the ideal response to industry conditions
and involves investing in tangible and intangible assets to secure that position. By
contrast, the RBV examines how firms can enjoy sustainable returns as a result of
resources employed. In this section, we will examine the RBV in some depth, and then
contrast it with the positional view.

The RBV is a compilation of the contributions of many scholars to the fields of strategy
and organizational behavior. Many scholars consider the paper The Cornerstones of
Competitive Advantage: A Resource-Based View by Margaret Peteraf (1993) to be a
comprehensive description of this work. Here we summarize and clarify the main ideas
of the RBV of strategy.

The RBV of the firm deals with the fundamental question: “Where does competitive
advantage come from?” This framework attempts to explain why some firms, over time,
outperform others in creating wealth for their owners. The RBVʼs answer starts with the
assumption that firms are endowed with inherently different bundles of resources. These
resources include assets such as locations, brand names, distribution channels, and
patents, and they all contribute to the firmʼs ability to create, produce, and deliver its

























































14
This section is based on The Cornerstones of Competitive Advantage: A Resource-Based View by Margaret Peteraf (1993). David Besanko (Kellogg
School of Managemen,) also provided several insights that we used in this section.


 61

goods and services to consumers. These resources also include capabilities such as
hiring practices, quality control processes, or corporate cultures that similarly play an
important role in value-creating activities.

The RBV emphasizes that a firmʼs competitive advantage arises by owning

unique resources that other firms do not possess and cannot acquire, and by
matching these resources to economically relevant environments. As a tool for
strategy formulation, the RBV implies that firms should examine their resources and find
environments appropriate for these resources. Within these environments the firm has a
competitive advantage because its resources are superior to those of competing firms.

However, there is no single framework for the analysis of a firmʼs competitive

advantage. Instead, we evaluate the firm through multiple frameworks and find that
each generates some insights, while no one framework alone “cracks the case.” The
RBV is one such paradigm that helps us identify the sources of a particular firmʼs
performance. For this reason, it has become one of the most important frameworks in
the modern field of strategy. In fact, Gary Hamel and C. K. Prahaladʼs notion of core
competences is a well-known strategy concept that reflects the basic logic of the
resource-based view of the firm.

Wealth-Creating, Sustainable Competitive Advantage

The primary goal outlined in Peterafʼs discussion of RBV is to provide a systematic way
to answer the question; “What characteristics must resources possess in order for them
to serve as the basis for a wealth-creating, sustainable, competitive advantage?”

A firm has a competitive advantage if it earns a rate of economic profit that exceeds the
industry average. A firmʼs competitive advantage is sustainable if that advantage
persists over a reasonably long period of time. That advantage creates wealth for the
firmʼs owners if the original costs incurred to create the advantage are less than the
present value of the stream of profits that now flow from the advantage.

There are four foundations of a wealth-creating, sustainable competitive advantage:

• Resource Heterogeneity
• Ex Post Limits to Competition
• Imperfect Mobility
• Ex Ante Limits to Competition

Resource Heterogeneity

Differences among firms are necessary for competitive advantage. According to the
RBV, these differences can be attributed to differences in the bundles of resources that
firms depend upon to make and sell their products. If firms in a particular industry are
different, there must be some firms whose resources are superior to others. The firms
with superior resources are able to produce their output more efficiently than rivals


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(lower C), or they can offer products that provide consumers with higher utility than the
goods offered by rival firms (higher WTP). Resource heterogeneity gives rise to two
kinds of rents15 . When superior resources lower production costs, Ricardian rents arise.
And when superior resources raise output quality, monopoly rents arise.

Ricardian Rents. Ricardian rents can occur in highly competitive markets. Picture an
industry in which many firms compete, each selling an identical commodity, such as
wheat. Wheat is wheat in this industry—there are no organic strains, or any other
possible type of differentiation. Suppose each wheat producer is so small in comparison
to the overall size of the market that no single producer can move the market price. This
is the economistʼs perfectly competitive industry.

Suppose that some wheat farmers are different from others. Some farmers have more
fertile land than others, and perhaps some have more skill at harvesting their crops.
Whatever the difference, a firm with superior resources might have lower costs, though
still a standard product (after all, wheat is wheat). The worst firm in the industry is the
firm that just breaks even. This firm just covers its average cost of production, and so
this “marginal” firmʼs cost (including opportunity costs of labor and capital) is equal to
the market price. The superior firm can capture the difference between its average cost
(as below, $3) and the market price ($6). This is demonstrated in Figure 15.

MC AC
$ PER UNIT

P*=$6

RICARDIAN RENT

AC*=$3

P = MC AT THIS LEVEL OF OUTPUT OUTPUT

(UNITS PER YEAR)

Letʼs pause for a moment and fully understand Figure 15. First, notice that the marginal
cost curve (MC) is upward sloping. Resulting from the Law of Diminishing Returns, as


























































15
The term “rents” can be used interchangeable with economic profits – returns in excess of all costs including the opportunity cost of
resources such as capital.


 63

output increases constantly, the incremental costs get larger and larger. Second, notice
that our cost curves indicate we have some given level of fixed costs, and we are
adding variable costs to generate more output.

In highly competitive goods markets, firms will choose to produce an output level where
their MC is equal to P to maximize firm profits. Here, the average cost (AC) is below
MC, so the firm generates an economic surplus, which is referred to as a Ricardian rent,
after the British economist David Ricardo. This economic surplus is above all actual
costs and opportunity costs, including the market cost of capital. This surplus results
purely from more efficient cost curves (remember, this firm cannot set prices). However,
the firm is limited in expansion because its superior resource is scarce. Luckily, the
scarcity that limits the firmʼs size also prevents competing firms from replicating its cost
curves and ultimately driving prices down for the entire industry. In the wheat industry,
the scarce resource may be particularly fertile land close to a river, which is limited in
physical size. Or it may be a skilled owner who has limited time to apply harvesting
expertise.

Monopoly Rents. When a firm makes a product that, in the view of consumers, is
differentiated from the products of competing firms, different prices emerge. As product
substitutability drops, firms have increasing control over how they price their goods.
Wheat produces have virtually no control, Coke has some control (because Pepsi is a
partial substitute), but Microsoft has very strong control over pricing of its Windows
operating system. As a result of consumer perceived differences, degrees of price
inelasticity arise, and the firm begins to face a downward-sloping demand curve. In this
scenario, firms select to produce quantities where the market clears at prices well above
MC, and in turn AC. Since monopolistic firms can enjoy a gap between AC and P, they
generate economic surplus above their actual costs and opportunity costs, including the
market cost of capital.

Examples. Typically, we consider Ricardian rents a supply side phenomenon, and we

consider monopoly rents a demand side phenomenon. Ricardian rents result from
superior production efficiency, while monopoly rents result from differentiated products
that have no good substitutes. In both cases, the ability to earn the rent ultimately
derives from the existence of valuable resources that a firm possesses but competitors
do not. A firm can have both Ricardian and monopoly rents.

Steel is one of the most competitive product markets because buyers of steel can
purchase identical grades of steel from a variety of different producers, with little care for
the specific producer. However, steel is labor intensive, and firms located near cheaper
labor supplies face lower costs. The Brazilian steel firm Usiminas is one such firm, and
has historically been one of the lowest cost producers in the world. Usiminas generates
Ricardian rents when it sells steel on the world market at world prices.

Webkins are a particularly differentiated product due to brand image. Other small stuffed
animals are not perceived by small children to be comparable to Webkins, so the


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demand for Webkins is downward sloping. The maker of Webkins therefore limits output
to keep prices above average costs. This difference gives rise to monopoly rents
because the maker of Webkins faces very similar production costs as other stuffed
animal makers.

Ex Post Limits to Competition

The second condition for a firm to enjoy a wealth-creating, sustainable competitive

advantage based on superior resources is the presence of ex post limits to competition.
These limits are barriers that ensure resource heterogeneity is preserved over time.
Without ex post limits to competition, other firms would clone the high performance
firmʼs resources and drive down profit margins in the industry. The Pet Rock industry is
a well-known case of no ex post limits. Though initially extremely profitable, imitators
broke into the industry and brutal competition quickly brought down prices. Ex post limits
to competition are typically driven by imperfect imitability and imperfect substitutability.

Imperfect Imitability. “Isolating mechanisms” are factors that prevent firms from
replicating other firmsʼ superior economic rents. Isolating mechanisms can prevent
imitation of resources that allow low-cost efficiency, or prevent imitation of resources
that allow differentiated end products for consumers. Common examples of isolating
mechanisms include:

• Exclusive legal franchises: these prevent overlap of market segments

• Patents and trademarks: rival firms cannot free-ride on intellectual property
• Channel crowding: rival firms cannot gain access to needed distribution channels
• Causal ambiguity: unobservable trade secrets are lowering costs
• Experience curves: resources in an industry may have to be developed over time
• Buyer switching costs: even perfect imitations do not draw away consumers

Imperfect Substitutability. Imperfect substitutability is the inability of would-be rivals to

acquire resources that are good substitutes for the superior resources possessed by the
firm. Whereas imperfect imitability limits direct imitation or cloning, imperfect
substitutability limits firms from creating resources that substitute for or neutralize
economically powerful resources.

In practice the distinction between imperfect imitability and imperfect substitutability is a

matter of degree rather than kind. To offer a rough distinction, the inability of potential
rivals to replicate Akamaiʼs algorithms for detecting Internet congestion is imperfect
imitability, while the inability to develop alternative technologies for high-speed Internet
connections is imperfect substitutability.

Imperfect Mobility

The third condition necessary for the firm to have a sustainable competitive advantage
is imperfect mobility. Imperfect mobility means either (i) the resource cannot be bought
and sold in the marketplace (there is no market for resources such as “corporate


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culture” or “reputation”), or (ii) the resource is more productive for one firm than others (it
is “co-specialized”).

Perfect Mobility. We start by considering an example of a perfectly mobile resource.

Suppose that there is a CEO named Fred, and Fred is not like other CEOs. He is so
talented, the firm that currently employs Fred, call it Firm A, earns an economic rent.
Fred is perfectly mobile if Fredʼs superlative skills relative to other CEOs are not firm
specific; Fred would be an equally extraordinary manager at any firm in the industry.

Firm Aʼs rivals will compete to lure Fred away from his current employer by offering Fred
a higher salary, and Fredʼs salary will be bid up to the point that he receives the full
value of his additional productivity relative to ordinary, run-of-the-mill CEOs. If the going
market rate for run-of-the-mill CEOs is $1 million a year, and Fredʼs skills can add an
extra $2 million in profitability to the firm that employs him, then competition among
firms for Fredʼs services will drive his salary to $3 million a year. Fred gets a salary
premium equal to his extra value, while the firm ends up employing Fred will have the
same profits as other firms because it must pay a premium in return for the added value
that Fredʼs skills create. Even though Fred is an extra-productive resource, the firm that
possesses this resource is unable to secure a competitive advantage over other firms
because Fred is perfectly mobile.

Co-specialized Resources. Co-specialized resources are those that are more productive
when used together—collective productivity would be sacrificed if these assets were
separated. Unlike an asset such as “corporate culture” Fred can buy and sell his labor
freely in the market. Suppose however that Fred has been working his magic at Firm A
creating rents, but he is unable to bring rents to other firms in the industry because
Fredʼs skills perfectly complement the other top managers. Now, Firm A will not
necessarily have to compensate Fred for his full added value to the firm. The co-
specialized resources cannot capture their individually superior production because the
bundle is difficult to buy and sell in the market. Fred cannot capture his full value even
though he is free and willing to move to another firm. Likely, Fred and Firm A will split
the economic rent, based on bilateral negotiations.

Owning Mobile Resources. Unlike labor, firms can own many resources that are openly
traded in the market. We can hypothesize an oil firm, BesankOil,16 which owns an
especially productive tract of oil reserves. The firm discovered these reserves and thus
controls how they are used. Because of their extra-productivity, these oil reserves allow
BesankOil to extract oil from the ground at a cost less than the production costs of rival
firms.

The owners of BesankOil will earn a Ricardian rent, similar to the farmer with the fertile
land. If the resource is mobile, then the company can sell the tracts to rival firms who
would attain the same low-cost production as BesankOil. It appears that BesankOil has

























































16
This fictitious company is named after a mentor of mine at the Kellogg School of Management, Professor David Besanko.


 66

a sustainable competitive advantage even though its resource is not immobile.
However, recognizing the full opportunity costs of BesankOil resolves this apparent
contradiction.

Even though BesankOil is more profitable than competing oil producers, a correct
accounting of BesankOilʼs economic rent should take into account the opportunity cost it
incurs by not selling the asset to the second-highest valuing user. In this case, the cash
flows that the second-highest valuing user gets from the oil tracts are (by hypothesis)
exactly the same as the cash flows received by BesankOil. This means that the
opportunity cost incurred by BesankOil from not selling the superior resource just offsets
the extra value that the resource creates. We could also consider BesankOil as two
separate value chains: tract exploration and oil extraction. BesankOilʼs competitive
advantage lies in exploration (perhaps due to skill, perhaps luck), but its extraction
operation is merely industry average.

Ex Ante Limits to Competition

The final condition necessary for the firm to create a wealth-enhancing sustainable
competitive advantage is limited competition to acquire the resources in the first place.
The firm must be able to acquire the resources that underpin its competitive advantage
at below-market rates. To illustrate the importance of ex ante limits to competition, we
consider the fable recounted in David Friedmanʼs book, Price Theory (1990):

Suppose there is a certain valley into which a rail line can be built. Further
suppose that whoever builds the rail line first will have a monopoly; it will
never pay to build a second rail line into the valley. To simplify the
discussion, we assume that the interest rate is zero, so we can ignore
complications associated with discounting receipts and expenditures to a
common date. Assume that if the rail line is built in 1900, the total profit
that the railroad will eventually collect [over all its years of operation] will
be $20 million. If the railroad is built before 1900, it will lose $1 million a
year until 1900, because until then, not enough people will live in the
valley for their business to support the cost of maintaining the rail line.
Lastly, suppose that all of these facts are widely known in 1870.

I, knowing these facts, propose to build the railroad in 1900. I am

forestalled by someone who plans to build in 1899; $19 million is better
than nothing, which is all he will get if he waits for me to build first.
Someone willing to build still earlier forestalls him. The railroad is built in
1880—and the building receives nothing above the normal return on his
capital for building it (p. 384).

In this fable, the race to acquire the valuable resource—the monopoly on rail
transportation in the valley—competes away the economic profits that result from the
monopoly. The present value of the cost of acquiring the monopoly franchise (20 years


 67

of $1 million a year losses between 1880 and 1900) exactly offsets the present value of
the cash flows from possessing the monopoly franchise. Now, if we were to look at this
market in 1903 or 1907, we would say that that the incumbent railroad has a sustainable
competitive advantage in this particular market. But, due to ex ante competition, the cost
of acquiring this advantage meant that, on balance, the advantage created no net
wealth for the owners of the railroad.

The key factor limiting ex ante competition is imperfect information, that the value-
creating potential of the resource is not widely appreciated. One of the most famous
examples of the implications of limited ex ante competition occurred in 1891 when Asa
G. Chandler purchased the secret formula for Coca Cola (called Merchandise 7X) from
the inventor, Atlanta druggist Dr. John Styth Pemberton, for $2,300. When Chandlerʼs
sons sold the company in 1916, they received $25 million. For the Chandler family, this
represented a rate of return of 45 percent per year, each year for a quarter of a century!

Conclusion

Recall that Peterafʼs central goal of the resource-based view is to explain where wealth-
creating, sustainable competitive advantages come from.

The first necessary condition for wealth-creating, sustainable competitive advantage is

resource heterogeneity. If a firm does not have a unique bundle of resources, it would
be no different from rivals in its industry, and it therefore could not outperform them.
Without a portfolio of superior resources, a firm cannot have a competitive advantage.

The second necessary condition for wealth-creating, sustainable competitive advantage

is ex post limits to competition. Without ex post limits, the resources that underpin the
firmʼs competitive advantage could be imitated or substituted for. In the absence of ex
post limits, the firm could not enjoy a sustainable competitive advantage.

The third necessary condition for wealth-creating, sustainable competitive advantage is

imperfect mobility. In the absence of imperfect mobility, the firm would not profit from its
possession of superior resources. The extra profit gained from possessing the superior
resource is offset by the premium that it needs to pay to the owner of the resource in
order to keep the resource from moving to other competing firms. Without imperfect
mobility (e.g., with perfect mobility) a firm that possesses the superior resource would
not outperform its competitors and would thus not have a competitive advantage.

The final necessary condition for wealth creating, sustainable competitive advantage is
ex ante limits to competition. Without ex ante limits to competition, firms compete up the
cost to acquire the resource in the first place. Firmʼs that incurs up-front costs to acquire
superior resources do not have wealth-creating sustainable competitive advantage.


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Resource-Based View vs. Positional View of the Firm

As an explanation of competitive advantage, the RBV can be contrasted with another

important perspective in strategy, the positional view of the firm, also called the activity-
systems view by Pankaj Ghemawat and Jan Rivkin (1998). The positional view is best
summarized in the reading by Michael Porter, What is Strategy. The positional view
emphasizes the idea that competitive advantage arises from the ability of a firm to
create a unique competitive position in the market in which it competes. These unique
positions are created based on the different activities performed by rivals. The firmʼs
competitive advantage is sustained, according to the positional view of strategy, when
there are barriers that make it difficult or undesirable for other firms to replicate the
firmʼs position. These barriers might be barriers to entry at the industry level, economies
of scale that create room for only one firm to occupy the position the firm has staked out
in the market, or the complexity involved in executing an integrated system of activities.

Relative to the resource-based view of the firm, the positional view has a product market
orientation—competitive advantage through the creation, domination, and preservation
of a unique position in the firmʼs product market. The resource-based view has a
resource market orientation—competitive advantage through imperfections in resource
markets that give a firm a privileged access to certain valuable resources. Another way
to draw the distinction is that the positional view emphasizes the things you do, while
the resource-based view emphasizes the things you have.

A final distinction is that the positional view emphasizes the importance of unique and
valuable competitive positions as a source of competitive advantage, but the resource-
based view emphasizes that competitive positions do not exist in the abstract, and
instead positions are contingent on the firm possessing certain resources. For example,
the RBV would concede that Southwest has a great competitive position, but would add
that its greatness is contingent on Southwestʼs resources. Meanwhile, the positional
view would emphasize that unique and valuable resources do not exist in the abstract,
because resources are only great if the firm can build activity systems and competitive
positions that are different and better than competing firms.

Shifting Perspectives: Components of Firm Value

Up to now we have mainly focused on techniques for describing how firms create and
capture value. Here we want to ask a related, but different question: Why is the
enterprise itself more valuable than the cumulative value of its resources and
investments? Another way to state the question is, when it comes to the firm, why is the
whole worth more than the sum of the parts? In cases where the firm is worth less than
the sum of the parts, we ultimately expect the firm to be disassembled to unlock the
value of the components. However, most firms are valuable above and beyond their
component parts. In other words, firms enjoy “synergy”17 among their constituent parts.

























































17
A synergy suggests that the interaction among two or more components of the firm produces combined value in excess of the sum of the
value of the components would have produced if they operated separately.


 69

Consider a football franchise has constituent parts – a coach, team players, the team
“system,” the stadium, the brand. It is a reasonable conjecture that if we extract a
component from one franchise and replace it with a component taken from another
franchise, there would be some affect -- the new component would interact favorably or
unfavorably with the other component parts of the franchise. Understanding the precise
nature of the interaction among component parts of an enterprise is of fundamental
importance.

Below we will describe three sources or components of firm value that can be used to
describe the total value of an enterprise, and explain how the interaction among these
components gives rise to synergy. Describing the value of the firm in this way is, in
some respects, redundant to describing the firmʼs position. However, understanding and
evaluating the components of a firmʼs value is highly complementary to positioning
analysis. When we describe a firmʼs position, we describe:
• Characteristics of the firmʼs output
• The segment of customers the firm serves
• The suppliers with whom the firm transacts
• The locations the firmʼs activities span

This description of the firm is more informative and insightful if it is framed relative to the
firmʼs direct competitors. The position the firm “owns,” by virtue of the firm having
invested in a value chain constructed to serve that position, can be valued in monetary
terms. In our discussion, we suggest that the value of the firm goes beyond the value of
the firmʼs market position.

Here we think of the firm as being comprised of three components:

1. The value of the firmʼs assets and capabilities (essentially the added value of
the firmʼs position as described above). Here we will refer to this component as
asset and capability value (ACV). Assets and capabilities are the cumulative
physical and nonphysical investments made by the organization. Again, this is
essentially the value of the firmʼs market position. Assets and capabilities are
quite literally what the firm is doing, for whom, with whom, and where. ACV is
the value of these cumulative investments.
2. The added value of the resources the firm employs but does not own. Here we
mainly refer to the firmʼs human capital. While we sometimes pay attention to
the nature of the human capital a firm employs when we describe its position, it
is unusual to pay close attention to the factors that we will elaborate on here. We
refer to this component as employed resource value (ERV). ERV is the added
value of the resources used, or employed, but not owned by the firm.
3. The added value of the firmʼs internal governance and incentive structure. We
refer to this component as governance value (GV). GV refers to the added value
of structuring the organization such that the players actions are transparent and
aligned in the interest of the firmʼs capital owners.

We believe the framework presented here is in line with how investors should and often


 70

do think about the value of a firm. A firm enters a market and operates and by doing so,
chooses a market position (eventually this is becomes the ACV component). The firm
employs a set of well-suited resources necessary to operate in its market position
(leading to ERV), and sets up a structure of governing those resources (GV). In sum,
the particulars of the firmʼs choices of how to operate, its execution choices, combine
with the firmʼs position and give rise to the three components of value. The three
components interact with each other and with market forces, as shown in Figure 16,
thereby increasing or decreasing the total value of the firm as well as the relative shares
of the three components.

g
on ts
A m nen
ACV n o
io p
ct Com
r a
te e
In hre
T

GV
ACV
Industry Forces

ERV


 71

Assets and Capabilities Value

Consider an enterprise with all of its current non-owned inputs (such as human capital)
replaced with the next best alternatives. The value of the enterprise, stripped of its non-
owned resources and then replaced with the next best set of resources is the ACV of
the firm. ACV is derived from assets and capabilities owned by the firmʼs
shareholders or capital owners. ACV is essentially the monetary value of the
firmʼs position. This is the portion of the firmʼs value that cannot be expropriated away
from the firmʼs owners (or shareholders). Itʼs the component of value that is ownable.
Examples of assets and capabilities are location, premises, brand, contacts with buyers
and suppliers, patents, and documented organizational know-how (related to
manufacturing, administering, etc.). These assets and capabilities can be acquired
instantly or developed over time. ACV can be sold to other firms as itʼs the “turn-key”
portion of the firm (meaning anyone can “turn the key” and derive this value).

Employed Resource Value

ERV is the incremental value to the firm that results from superior matching of employed
resources such as human capital to its ACV. Our discussion here draws on insights
from the resource based view of the firm presented above. The resource-based view
suggests that co-specialization between particular resources and the whole rest of the
firm was critical if the firm was to have the leverage (or bargaining power) over the value
produced by the resources. If a resource is equally productive at all firms, then the
resourceʼs value fully reflects that fact. On the other hand, if the resource is more
productive when employed by a particular firm, then the resource is worth less to
another firm. A superior choice of employed resources results in “synergies” with the
firmʼs ACV relative to using the next best set of resources and these synergies are the
ERV component of firm value. To retain some of the value generated by non-owned
resources, such as human capital, it is necessary that the firmʼs ACV be complementary
(that is, generates synergies or co-specialized) the with firmʼs employed resources. If
the firmʼs ACV does not enhance the productivity of the ERV, then the resources are
likely to capture their full value as compensation as their outside options are fully
credible.

Consider an individual who is a very gifted artist and cartoonist. Technological inputs, a
group of creative peers, a process to manage the output of an animated film, and other
sorts of assets and capabilities would likely enhance this individualʼs productivity.
Likewise, assets and capabilities for animated filmmaking are enhanced by particularly
well match human inputs. ERV is the value due to superior matching of particular
resource inputs to particular ACV. For some service firms, say law firms, ERV value can
be a high fraction of overall firm value. On the other hand, for a firm with a particularly
strong brand and a lot of additional ACV, ERV might be a small fraction of firm value.
Arguably, the value of Coca-Cola would be quite nearly fully preserved even if all human
capital were replaced with the next best alternative group of employees.


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Governance Value

GV is incremental value to the firm that results from properly incentivizing employed
resources to generate additional ACV. Again, it is easiest to consider the case of human
capital. Every day, scientists, marketers, and distributors. come to work and they are
essentially asked to drive the ACV value of the firm. The more successful these people
are in their job functions, the more value the shareholders derive. Governance is about
putting in place infrastructure and incentive structures that motivate the production of
ACV. Motivating the production of ACV is the central challenge facing organizations.

To understand how profound and central the challenge of encouraging is, letʼs develop
an example. Consider an individual who is a programmer for Microsoft. Suppose this
individual comes up with an idea that would enhance the operating system and increase
the value of the firm by, say, $50 million. While $50 million is trivial relative to the market
value of Microsoft, a number of individuals developing these ideas continually is
essentially what drives the ongoing value of the firm. Nothing is more fundamental to the
value of the firm than a set of human capital driven to increase the ACV of the firm.
Herein lies the issue—once ACV is developed, it is owned by the firm. ACV cannot be
taken by an individual to another firm—the firm can sell it, but human capital cannot take
ACV away (what human capital can take from the firm is called ERV). Hence, human
capital cannot threaten to move its past contributions to another firm—it can only
threaten to take future ideas—the value of past ideas is embedded in the firm.

When human capital creates ACV, that human capital certainly appreciates how much
effort was undertaken. When considering the production of ACV, it is reasonable for that
human capital to wonder “whatʼs in it for me?” Governance is the answer to this
question. Good governance displays transparency, consistency, equity, and overall
good sense and, thereby, informs human capital before the effort is undertaken “what is
in it for them.” While we cannot describe one-size fits all good governance, we can
discuss two types of governance paradigms observed.

Consider that firms fall along a continuum. At one end of the spectrum are firms that are
primarily made up of ERV. An example of such a firm is one that produces movie
scripts—without the script writers, the firm wouldnʼt be worth much. At the other end of
the spectrum are firms whose value is entirely ACV value—replacing non-owned
resources entirely with the next best set would not change the value of the firm at all.
We doubt the value of Cameron Cookware (a firm that makes cookware for the stove
top and microwave) would change much of its human capital were switched out. Most
firms fall between these two extremes—but all firms are closer to one of these two
types. GE is one such “in-between” firm—but likely more ACV than ERV (although this
varies by business unit).


 73

Governance in ACV Firms

Reputedly, General Electric (GE) has structured its organization so it drives human
capital to increase the value of the firm. The incentive to increase the value of the firm
are derived from some combination of the following: the employees financial rewards
are correlated with their contribution to firm profits, the employees contribution of firm
value over time increases their inside options (chances of promotion), as well as their
outside options. The reason this is the case is that GE has an external reputation for
empowering managers and enabling them to acquire strong management skills in the
process. The employed resources must get some, but not all, of the value they create.
In considering GE and several other ACV firms that have reputations for sound
governance we can observe a commonality. Good governance for an ACV value firm
entails a correlation between the human capitalʼs contribution of ACV value and
an improvement in that human capitalʼs value. This can be accomplished in a
number of ways. For example, firms might give individuals stock options. If the individual
contributes ACV and the firmʼs value appreciates, so does the value of the individualʼs
options. We imagine this would work well in the context of a small firm where the
individualʼs wealth changed appreciably with the value of the firm. However, we can also
appreciate the limits of this approach at a large and mature company. How much of the
firm can employee number 36,781 own?!

But there is an alternative way to increase the value of human capital beyond increasing
the value of the human capitalʼs stock holdings. The firm can promote on the basis of
ACV contributions. Promotions enable individuals to enjoy more leverage for every hour
they work—promotions mean more access to the firmʼs productive assets (plants and
people). With more leverage the individual can be more productive and financially and
professionally rewarded. Here, though, the limitation is firm growth—firms can only
promote as long as they are growing. As the firmʼs growth slows, it becomes
challenging to find a true promotion opportunity, even for worthy individuals.
Furthermore, mature firms perceive even more of a need to produce ACV. If the firm
cannot use options or promotions, how might the firm motivate the production of ACV?

Again, there is an alternative way to increase the value of human capital beyond stock
options or promotions within the organization. The firm can increase the human capitalʼs
external visibility. With higher external visibility, the human capital finds its opportunities
greatly enhanced in exchange for its contribution of ACV to a particular organization. GE
is known for imparting generally desirable skills and know-how to its managers, as well
as for encouraging movement from GE to other organizations. Opportunity to segue-
way out of the organization can be as motivating as opportunity to move up in a given
organization. While being in the U.S. armed forces may not be financially rewarding in
and of itself, rapid promotion within the armed services is externally visible and opens
up opportunities in the private sector. Many nonprofit organizations maintain a
reputation for high standards so that quality human capital is attracted and then
rewarded with outside options.


 74

Again, there is no one-size fits all governance model for ACV type firms. However, all
good governance of ACV firms shares the idea that the value of the human capital
appreciates with the ACV value of the firm. If the human capital owns a stake in the firm,
then the human capitalʼs wealth increases along with its contribution of ACV. If the
human capital is promoted within the organization for its ACV contribution, then the
value that human capital derives from its job increases through increased leverage. If
the human capital is rewarded with outside options for its ACV contribution, than the
value the human capital derives throughout his/her career increases. While the human
capital does not directly own its ACV contribution (by the very nature of ACV, the firm
owns it), good governance suggests the human capital ultimately derives value
correlated with its ACV contribution. Good governance also allows for value to be of
both monetary and nonmonetary nature.

The form, intention, and overall nature of governance is not radically different for ERV
firms, but there are important distinctions. One important distinction is the underlying
“problem” the governance needs to address. In the case of ACV firms, the employee
cannot credibly threaten to take the ACV away from the firm. This is a twin-edged
sword, as they say (good news and bad news). While itʼs good for the firm that its ACV
cannot be stolen by human capital, the absence of leverage to threaten the firm can
under-motivate the employee to produce ACV. Hence, the “problem” the governance of
an ACV firm is addressing is “under-motivation.” The firm is committing in advance to a
set of rewards that it will bestow upon the human capital after the ACV is produced.

The firm will reward the human capital after the ACV is produced and securely owned
by the firm—that is, the firm promises to reward the human capital at the point where
the human capital is not empowered enough to demand the reward. At the beginning of
this document we included the following in our definition of strategy: “A wise firm that
uses its advantage judiciously will be able to sustain its position in the value chain.”
Good governance of an ACV firm is an example of a “judicious” use of power. If firms
continually back out on their promises, they end up with a lot of slack effort from human
capital.

Governance in ERV Firms

ERV firms face a situation very different from ACV firms. The human capital can
threaten to take the value away from the firm—in fact, each time the human capital
leaves the building, the value of the firm, technically, goes with that human capital. To
retain the value, the firm must retain the human capital. However, the trick is to retain
value without paying that value out in wages to human capital. Some of the value has to
be retained by the firm to deliver a return to invested capital. In the case of ERV
governance, the question is how to maintain a balance of power between the firm and
the human capital. In fact, the question is what is the firm if all or most of the value
resides with the human capital?


 75

The first insight of governance of ERV firms is that the firm must invest in assets that
complement and enhance the productivity of the human capital. If the “pie” is larger for
talent at firm A relative to firm B, than the best human capital will be attracted to and
retained by firm A. Governance must focus on what assets, capabilities, and
infrastructure to supply to talented human capital to enhance its productivity. In other
words, the ERV firm needs ACV in order to retain some of the value. ACV is critical as
without it, the human capital shops itself around to the highest bidder. The ultimate
employer of the human capital simply passes ERV through as wages. Consulting firms,
law firms, creative agencies have to determine what assets and capabilities can be firm-
owned and available to the talent so the talent wants to associate with particular firms.

In addition to ACV, the structure of pay matters. Often, ERV firms are structured as
partnerships. One begins as one of the “minions”—underlings who get low hourly
wages, long hours, grueling work, but lots of learning. Talent and diligence are rewarded
with promotions. Promotions have two related upsides. One is that with promotion, the
human capital gets their own minions—each hour the human capital works is now more
productive and hence more financially and professionally rewarding (like promotions in
the ACV firm). Once promoted to a high level, the human capital gets a seat at the table
where the division of the firmʼs profits is decided. Talented minions ultimately stay in
order to move up this pyramid of pay and power. It should be clear that a critical
governance tool of most ERV firms is an army of minions.

A cheap and productive base is critical to the financial success of those individuals
higher up on the pyramid. It stands to reason that one of two things must be true about
the minions:
• They overestimate their chances of success. They would not accept such a bad
deal for one or two years if they realized their servitude delivered a low
probability of success.
• They realize that their odds of promotion at the organization are low, but the
grueling work positions them for many good outside options. Other employer are
attracted to individuals who held position such as these because of how much
the individual learned or because the individual signals they are a hard worker for
having held this job.

It is also possible that rather than providing minions, the ERV firm provides advanced
technologies. Pixar offers its creative types unfathomable technology. Again, this is
retaining ERV through ownership of ACV. Minions are somewhere in between.


 76






 fV GV:
TOTAL VALUE OF THE FIRM


 With good systems for incentivizing resources,


 the firm’s value is additionally enhanced.




 g V A V PLUS THE ERV OF THE FIRM

 ERV:
By utilizing human resources that are complementary to the firm’s assets

 the firm’s value is addtionally enhanced.




 a V K V PLUS THE ACV OF THE FIRM

 ACV:
The firm’s activities added incremental value over the initial capital invested.

 These activities produced assets such as brand, patents, processes,
institutionalized know-how etc.






kV BOOK VALUE OF THE FIRM’S ASSETS







Value from ACV-ERV-GV Interactions

While we can consider the three components in isolation, there are important
interactions among them. First, superior ACV tends to attract superior ERV because
good matching levers up the value of human capital (though much is captured in
wages). Furthermore, ERV is maximized by good GV, because the matches themselves
are dependent on incentive systems. Finally, GV reinforces ACV, because good
structure motivates those actions that nourish the firmʼs position in superior resources.

At a point in time the firm is made up of three components that you can think of as slices
of the pie. A firmʼs total value is dependent on each component, as shown in Figure 17.
Imagine that fruitful interactions among the three components grow the pie—and firm
choices and market conditions can grow or shrink the pie. As shown in Table 6, ACV
and ERV based firms can use different forms for strategic preemption.


 77

Table 6: Issues for the Long term Value of the Firm
Form of Preemption Long Run Nature of the Firm
ERV is Critical
• Quality of firmʼs ACV
• Technologies that
depreciate or leap frog
Investing in Capital ACV stock
Intensive Assets • Divisibility of
investments
• Pricing Power
• Extent of HR co-
specialization
• Scalability
• Governance: and
reducing reliance on
specific HR
Ex. Disney animation, Goldman
Sachs
• Ex ante limits on
competition
• Substitution and
Securing Superior imitation
Scarce Resources • Scalability
• Marketing and demand
realization
• Expropriation
Ex. Law firm of “Star and Star”


Mostly ACV
• Quality of firmʼs ACV
• Technologies that depreciate or leap
frog ACV stock
• Divisibility of investments
• Pricing Power
• Demand growth potential
• Reducing consonance of firmʼs
offering
• Governance: motivating HR to make
ACV investments
Ex. Pepsi Co., Mittal Steel
• Technologies that depreciate or leap
frog ACV stock
• Divisibility of investments
• Pricing power
• Demand growth potential
• Governance: motivating HR to make
ACV investments
Ex. Google, Microsoft
78

Financial Metrics

When we are working toward a deep understanding of how firms create, capture, and
sustain value, we have to look at the firmʼs financial performance. Different types of
advantages have “financial footprints.” That is, particular advantages show up in
identifiable ways in the firmʼs financials. Any identified competitive advantage must be
reflected in financial metrics, shown in Figure 18.

Economic Profit = NOPAT - (WACC x Capital) = V x (P-C) WHERE C INCLUDES THE COST OF CAPITAL

(Sales - COGS) (SG & A) Capital

= (1-tax rate) X WACC X X (Market Share) X (Market Size)
Sales Sales Sales

NOPAT: Net Operating Profit After Tax

WAAC: Weighed Average Cost of Capital
V: Volume
COGS: Cost of Good Sold
SG&A: Selling General & Administrative

A firmʼs strategy must be measurable via its financial footprint. If a firm believes it
enjoys high return because of its cumulative brand equity, evidence of that belief should
be reflected in its gross margins. If the firm claims to have efficacious management
processes, it should be evident in its selling, general and administrative expenses
(SG&A) as a percent of sales ratio. Whatever advantage the firm claims to enjoy over its
rival, should be evidenced in one or more of its financial metrics of performance shown
in Figure 19.


 79

 Superior Economic Profit

Higher Gross Margin Lower SG&A to Sales Ratio Lower Capital to Sales Ratio Superior Economic Profit

Efficencies in Marketing Superior Management

Cost of Goods Sold (COGS) or Administration of Working Capital WTP Advantage
Advantage
Price Premium Higher Volumes Efficiencient Use of Lower Prices Due to
Due to WTP Advantage Fixed Assets Cost Advantage
Ability to Dominate a
Niche Competitors
Cannot Serve


 80



COGS/Revenue
(without operating lease adjustment)

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

49.6% 46.0% 53.4% 57.3% 59.2%

SG&A/Revenue
representative metrics.

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

Adjusted EBITA Margin 22.3% 21.4% 23.3% 20.0% 19.7%
(without operating lease adjustment)

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 R&D Expense/Revenue

20.1% 22.1% 16.2% 16.1% 13.7%
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
n/a n/a n/a n/a n/a

Deprecation/Revenue

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

Pretax Return on Invested Capital 8.0% 8.0% 10.5% 7.1% 6.5%

(without operating lease adjustment)

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

15.6% 19.5% 20.8% 17.1% 12.6%
Average Net PP&E/Revenue

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

133.6% 114.9% 75.8% 93.1% 109.3%

Capitalized Op. Lease/Revenue

Higher Gross Margin
(without operating lease adjustment)
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Capital Turnover
(Revenue/Average Invested Capital) n/a n/a n/a n/a n/a
11.8% 17.4% 27.1% 15.2% 19.9%
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
Average Working Capital/Revenue
0.77 0.88 1.28 1.06 0.92

Dec-03 Dec-04 Dec-05 Dec-06 Dec-07

11.0% 9.2% 7.8% 9.6% 8.8%

Average Net Other Assets/Revenue

Operating Tax Rate
(without operating lease adjustment)
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
-15.5% -10.7% -5.5% -8.5% -9.9%
24.2% 11.2% -30.7% 11.2% -57.7%
analysis above, the ROIC tree allows for a firmʼs strategy to be disaggregated into
Invested Capital Tree, shown below in Figure 20. As in the economic profit derived

A complementary approach to understanding the financial footprint is the Return on

81

Given the objective is to generate economic profits, the ROIC tree is focused on the
activities underlying the firms performance. This analysis allows for comparability to
other firms and therefore a way for management to benchmark their strategy relative to
another firm.

Performance Management

It clearly follows if we can disaggregate financial performance and strategy into

quantifiable and clear measures then we should be able to orient the entire company
towards creating value. Over the years firms such as GE have developed systems
around economic profit that aim to resource allocation, and in particular employee
actions, in such a way as to create value. While this makes sense, the reality is these
programs have not always worked in practice. The challenge for a company is to strike
a balance between long-term and short-term objectives, and, planning and
implementation. The key is taking these metrics and shaping behavior and resource
utilization in a way to have value creation become a part of the very DNA of the firm.

The classic problem faced by economic profit-based performance measurement is that

a company must ensure the long-term health of the firm. Peculiarly, the day-to-day
measurement of strategy can in fact distract from long-term performance. As shown in
the ROIC tree, there needs to be a translation of what drives value into metrics. These
may be coupled with milestones that may provide targets that are tied to less
quantifiable strategic actions. For example, if M&A is a part of the firmʼs strategy to
expand the firmʼs boundaries, then in addition to simple measures such as revenue
growth or cost savings, milestones may be developed to recognize the progress on the
closing of a transaction.

Because the firm is focused on generating economic profits today any system must
have enough flexibility to encompass long-term performance. For example, an approach
would be to focus the performance measurement depending on the role and level within
an organization. If this system were to be utilized by UPS or FedEx, the delivery level
would be focused on number of deliveries, cost per deliveries, average time required per
delivery. At a regional or country level the focus is not just on cost control, but also
customer satisfaction, productivity developments, and capital budgeting decisions.
Finally, at the corporate level the board would be focused on not just the underlying
drivers of economic profit created on a business unit level but also possible milestones
such as progress in entering new markets, or progress by competitors in entering your
markets.

Firm Boundaries

The term “firm boundaries” refers to the choices of activities and distinct businesses
undertaken by an enterprise. Strategy has no finish line. Firms must continually judge if
their plans for value creation, value capture, and preemption are in line with market
dynamics. Evaluating the boundaries of the firm is a critical part of the continual process


 82

of setting the firmʼs strategy. Strategic decisions that set a firmʼs boundaries focus on
the gap between the value of the whole firm and the value of its parts. Firms should
integrate activities with synergies, and outsource activities without synergies. A firmʼs
boundaries will affect the extent to which the firm creates value, as well as the extent to
which the firm can sustainably capture value.

Firm boundaries can typically be extended in the following directions:

• Vertical: Decisions about vertical boundaries concern which steps in the vertical
chain to conduct in-house and which to outsource. When Pepsi bought bottlers, it
was a vertical move (forward integration). When Pepsi bought restaurants, there
was a vertical dimension—the fountain business was forward integration.
Campbellʼs backward integrated into can making—that is, Campbellʼs entered the
business of being its own supplier.
• Horizontal: Decisions about horizontal boundaries mainly pertain to increasing
scale in a given business. The firm increases the quantity of its output, and/or the
volume of consumers. This may refer to adding varieties, but not to adding
products. The distinction between horizontal growth and concentric diversification
is not definitive (meaning the difference can be a very thin line).
• Concentric Diversification: A diversified firm is one that operates in one or more
different markets. Operating in highly related or concentric markets means the
outputs are related on either or both the production and consumption side.
Pepsiʼs beverage business and its snack food business share some common
inputs (print and media advertising) and many of the same distribution channels.
Hence, many would consider Pepsi and Frito-Lay to be an example of concentric
diversification.
• Conglomerate Diversification: A diversified firm is one that operates in one or
more different markets. Operating in markets that are neither related in
production nor consumption is called conglomeration.
• Geographic Expansion: Here the firm enters a new geography and leverages its
operating expertise and/or its product mix.

With each boundary decision, three groups of synergies may exist, shown in Table 7
and Table 8, and detailed below:

1. Coordination: Reducing transaction costs

• Vertically related production facilities working together to coordinate product
flows (e.g., paper mill located adjacent to a pulp mill)
• Winery experimenting with grape growing to better match criteria for the wine
being produced and demanded

2. Leveraging Power: Using size as a source of power over suppliers and buyers
• Cross Selling (Cost)—sell multiple products through common promotions,
channels, and/or sales force (sell a service contract with appliance sale;
merchandise offers in credit card statements; coupons for chips with soda).
• Increasing concentration may reduce rivalry; generating more market power and


 83

 higher prices. But the firm needs to consider:
o Can my firm grow large enough relative to the market to have an effect?
o Will too many of the benefits spillover to my competition?
• Manufacturer-owned distribution—use manufacturer owned distribution channels
to influence market prices and as a source of information on competitors and end
customers. Note: if also sell to independent channels—potential channel conflict
and negative synergy. Some potential customers may eschew doing the
business with the firm to avoid being a source of profits for a competitor.

3. Sharing Assets: Reducing costs through economies of scale or scope

• Plants that are capable of producing end products for multiple businesses (i.e.,
auto assembly plants producing cars and small SUVs on the same line)
• A manufacturer produces components that are used in a variety of different
products (i.e., diesel engines used in generators and earth moving equipment)
• A firm undertakes an R&D project on an enabling technology that benefits
multiple businesses (GE: breakthroughs in material sciences benefit medical
devices, appliances, jet engines, gas turbines)

It is important to note that some analysts believe that managers may have motivation to
expand the firm boundaries aside from creating shareholder wealth through the
exploitation of synergies. Expanding boundaries is often self-serving to managers by
way of:
• Raising their profile and compensation
• Diversifying their job risk

Table 7: Synergies

Horizontal Vertical Diversification

• Expanding into new
Coordination • Reduce negotiations • R&D
geographies
• Timing and size of • Innovation
production batches • Marketing
• Input attributes • Promotions

Leveraging • Over input suppliers • Over input suppliers • Over input suppliers
Power • Over customers • Over customers
• Strategic presence in
multiple markets
Sharing • Corporate overhead • Corporate overhead • Corporate overhead
Assets • Equipment • Capital budgeting
• Knowledge across
business units


 84

Firms often try to manage risk by managing their boundaries. These firms may manage
boundaries organically, or through merger and acquisition activity in the market. Often,
synergies do not materialize in the expected magnitude. And too often, overlooked
challenges arise to the detriment of optimistic managers.

Table 8: Challenges

Horizontal Vertical Diversification

Coordination • Low total product • Loss of market • Transfer pricing

demand pressures reduces culture emerges
• Culture clash discipline for in • Businesses are less
house production related than hoped
Leveraging • Buyers and • In house activities • Over input suppliers
Power suppliers resist may compete with • Over customers
pressures, learn to partners, draining • Strategic presence in
respond goodwill multiple markets

Sharing • Firms overestimate • Costs rise as firm • Corporate overhead

Assets fit, and infrastructure loses ability to • Knowledge across
becomes strained specialize business units

Growth Through Acquisition18

I. The Impetus to Grow

Mckinsey studied the 100 largest companies in the U.S between 1994 – 2004 (two
economic cycles) across two dimensions: Total returns to shareholders (TRS) and
growth. They found that growth matters both to company survival and to long-term
survival. Companies that exhibited growth rates lower than the GDP in the first
economic cycle were five times more likely to disappear altogether than companies that
grew rapidly in the first cycle; companies with above-average revenue in the first cycle
were more likely to exhibit above-average TRS in the next cycle. In short,
the “grow or go” philosophy is hardwired into the fabric of modern corporations. 19
That said, the “undisciplined pursuit of more” is supposed to be characteristic of
companies in decline.20

II. Types of Growth

There are two types of growth: organic growth and inorganic growth. Organic growth
can be broken down into two components: growth of the specific segments that the

























































18
Stern MBA Class of 2009 Vikram Bhaskaran prepared this M&A section of Strategy Essentials under the supervision of
Professor Sonia Marciano
19 “The Granularity of Growth,” Patrick Viguerie, Sven Smit, Mehrdad Baghai
20 “How the Mighty Fall,” Jim Collins


 85

company operates in (portfolio momentum) and the companyʼs relative market share
performance (the difference between company growth rates and relevant segment
growth rates). Inorganic growth is typically synonymous with M&A. Mckinsey studied
416 companies between 1999 and 2006 and found that the average large company in
their dataset grew at 10.1 percent per year over the period. As seen below, most of this
growth can be explained by portfolio momentum and M&A.

Breakdown of CAGR 1999-2006

3.96%


30.69%
 PorIolio
Momentum


M&A


65.35%
 Share
Gain


Source: Mckinsey granular growth database

III. Growth through M&A

Mergers and acquisitions are arguably the most popular and influential form of
discretionary business investment and, as we have seen earlier, are integral to growth.
The following diagram summarizes M&A deal flow across the last 10 years. M&A
activity takes place in waves and has historically been correlated with market growth or
decline. 2007 was a record year for M&A both in terms of deal value and total number of
global deals.


 86

Global M&A deal volume (in $trillions), 1998-2008

4.8


3.8

3.3
 3.4

3.2

2.9

2.3

2

1.7

1.3
 1.4


98
 99
 00
 01
 02
 03
 04
 05
 06
 07
 08


Source: Dealogic

IV. Rationale behind M&A

From an economic standpoint, mergers can be horizontal, vertical or conglomerate.

Horizontal mergers involve firms operating in similar businesses (e.g. Chevron, Texaco).
Vertical mergers occur in different stages of production operations (e.g. AOL, Time
Warner) and conglomerate mergers where firms are in different business activities
(Tycoʼs acquisitions). 21

While the type of merger definitely dictates the specific rationale for M&A, the most
commonly used term that encapsulates the rationale for M&A is Synergy. Broadly
speaking, the term is used to refer to strategic, operational and financial benefits that
arise when a firm partakes in M&A; where the value of the combined firms is greater
than the sum of the value of both firms individually. More simply, it is the increase in
competitiveness and resulting cash flows beyond what the two companies are expected
to accomplish independently.

When acquirers pay a premium for a business they have to both meet the performance
targets that the markets already expects and the even higher targets implied by the
acquisition premiums. Expected growth and future profitability are already embedded in
the share price of both businesses – adding synergy means creating value that not only
does not yet exist but is not yet expected. 22 Below is an exhaustive list of articulated
reasons for why companies partake in M&A activity through the lens of strategic,
operational and financial synergies.

























































21 “Mergers and Acquisitions,” J. Fred Weston, Samuel C. Weaver
22 “The Synergy Trap,” Sirower


 87

Strategic Synergies

• Access to capabilities/know-how: Companies that want to compete more

effectively in an existing market might lack certain capabilities to do so and might
acquire another firm with the requisite set of capabilities; allowing the acquiring
firm to “leapfrog” the process of internal capability building. This is an especially
common stated rationale in R&D intensive and technology-centric businesses.
• Access to new markets: A firm might want to enter a new product /geographic
market by acquiring another firm operating in that market.
• Access to customers: A firm might acquire another firm based on the
attractiveness and revenue generating potential of the target firmʼs customer
base. A firm might do this to cross-sell new products to this customer base or
improve on the existing customer value proposition.
• Diversification: Conventional wisdom states that it is better for shareholders to
diversify risk. However, corporate executives oftentimes state diversification of
unsystematic risk as a strategic imperative that drives M&A activity. A company
that merges to diversify may acquire another company in a seemingly unrelated
industry in order to reduce the impact of a particular industry's performance on its
profitability.
• Elimination of competition: Tempered by the regulatory constraints of
monopoly rules, many M&A deals allow the acquirer to eliminate future
competition (increasing barriers to entry for an incumbent player) and gain a
larger market share by acquiring a smaller competitor.

Operational Synergies

• Economies of scale: Economies of scale refer to the reduction in unit cost

achieved by producing a large volume of a product. In the context of M&A the
larger combined firm has the ability to reduce operating costs by gaining scale in
areas such as production. 23
• Economies of scope: Economies of scope typically refer to demand-side
efficiencies where combined firms are able to better utilize distribution channels
and marketing efforts. Industry consolidation can also force companies to merge
and take advantage of economies of scale/scope in order to survive and compete
profitably -- as was the case with pharmaceutical companies.24
• Economics of vertical integration: When a firm purchases up or down the
value chain, it might be able to reduce its reliance on customers or suppliers
thereby increasing market power. 25


























































23 “Intelligent M&A, “ Scott Moeller, Christopher Bra
24 ibid
25
“Mergers and acquisitions,” Kevin K. Boeh, Paul W. Beamish


 88

Financial Synergies

• Optimizing capital structure. The cost of capital may be lowered and debt
capacity may be increased if a combined firm is able to avail of lower borrowing
rates. Other financial synergies might include better cash management, lease
terms, management of working capital etc. 26
• Tax Advantages: Past losses of an acquired subsidiary can be used to minimize
present profits of the parent company and thus lower tax bills. Thus, firms have a
reason to buy firms that have accumulated tax losses. However, the Federal
government has instituted numerous restrictions regarding tax-loss mergers and
their popularity is on the decline.27

Research on M&A also focuses on the psychology of mergers where the unit of analysis
is not the firm but the individual managers that drive M&A activity. Research suggests
that manager hubris, empire building, status, power and remuneration are some of the
underlying reasons for M&. 28 Because it is impossible to diversify human capital risk at
the manager level, this school of thought also suggests that managers diversify their
own risk by growing their organizations through M&A.

V. M&A and Value Creation/Destruction: Evidence of Post Merger Profitability

• In their research, Professors Healy, Palepu, and Ruback (1992) find that, on
average, operating cash flows of merged companies drop from their pre-merger
level.
• They also find that merged companies experience improvements in asset
productivity, leading to higher cash flows relative to their peers.
• Hence, non-merging firms experience stronger declines in operating cash flows.

It is fair to say that the history of mergers over the past century suggests that:
• Expected (or announced) synergies tend to be less than “real” potential synergies
• Realized synergies tend to be less than “real” potential synergies
• Mergers may not be the optimal way to achieve advanced in shareholder wealth

Depending on the source, acquiring firms fail to capture value 50 % – 75% of the time
while target companies get about 15%-25% of the premium on the pre-existing value of
the firm. Failure is typically gleaned by comparing stock prices before and after
acquisition announcements and by compiling anecdotal evidence from business
executives during the process. While there is no real consensus between practitioners,
consultants, academics and business executives about the exact percentage of failures,


























































26
“Valuation for M&A,” Frank C. Evans, David M. Bishop
27
ibid
28

 “M & A,” Jeffrey C. Hooke


 89

there is some consensus about the root causes behind M&A Failure. Two schools of
failure analysis exist. There is empirical performance literature that focuses onexplaining
the variance in acquiring firm performance based on the premium paid and the post-
merger integration literature that (largely anecdotal) that explains potential problems
with integration.

• Premium School. Acquisition premiums can be as high as 100% of the market

value. 29 In this school of thought it is believed that the premiums companies pay
to acquire other companies are systematically overstated and therefore set up
acquisitions to fail. The takeover premium here is defined as the amount the
acquiring firm pays for an acquisition that is above the pre-acquisition price of the
target. In this worldview, the larger the premium paid for an acquisition, the worse
the subsequent returns for the acquiring firms.30
• Post-Merger Integration School. Most surveys of corporate executives tend to
highlight post-merger integration as the dominant source of deal error. A survey
of M&A Executives conducted by the Corporate Strategy Board showed that 60%
of surveyed corporate development executives rank integration as the single
place of value leakage. The main argument made is that the strategic intent of
the acquisition is lost in integration and that integration synergies are harder to
realize than expected. Within this school of thought, analysts view clashing
corporate cultures as one of the most significant obstacles to post-merger
integration. In fact, a cottage industry has emerged to help companies navigate
the rough terrain of cultural integration. A Watson Wyatt study found that cultural
incompatibility is consistently rated as the greatest barrier to successful
integration but research on cultural factors are least likely to be an aspect of due
diligence. 31 However, according to Wharton M&A expert Sikora, Culture
integration is certainly important," he says, "but it's always the excuse when
something doesn't work out." 32

VI. Integration Approaches

Seasoned acquirers develop “integration playbooks” which outline specific set of

processes, people and resources required at every stage integration However,
conceptually, it is useful to think of integration in terms of strategic interdependence and
organizational autonomy.33 More simply, the sources of value capture combined with the
degree of autonomy required to capture the value will determine the size and scope of
the integration efforts.


























































29
“The Synergy Trap,” Sirower
30
ibid
31

“Mergers and Acquisitions from A-Z,” Andrew Sherman
32
http://knowledge.wharton.upenn.edu/printer_friendly.cfm?articleid=1137
33 “
Managing Acquisitions: Creating Value Through Corporate Renewal ,” David B. Jemison, Philippe C. Haspeslagh


 90

Strategic Interdependence

The degree of strategic interdependence is driven by expected value creation across a

range of areas:

• Resource Sharing: Value created by combining the companies at the operating

level

• Functional Skills Transfer: Value created by moving people or sharing

information, know-how and knowledge.

• General Management Skill Transfer: Value created through improved insight,

coordination and control.

• Combination benefits: Value created by leveraging cash resources, excess

capacity, borrowing capacity, added purchasing power or greater market power.

Organizational Autonomy
The degree of autonomy that the acquirer gives the new target firm can be determined
by asking three simple questions: Is autonomy integral to preserving the strategic
capability bought? If so, how much autonomy should be allowed? In which areas is
autonomy important?

Depending on where companies fall on both axes, four types of integration approaches
emerge:
Need
for
strategic
interdependence



Low










































High


Low
 
 


 Preservation
 Symbiosis



Need
for
 

autonomy

 









































 

High
 Holding

 Absorption





 91

 1. Absorption. The acquirer subsumes the acquirer into its existing structure. This
typically happens when a large firm acquires a smaller competitor to gain scale.
This approach is positively related to the acquirer buying tangible or intangible
resources which are non-people dependent.34
2. Preservation. The target firm is run as a discrete entity. Thus is common when
the strategic rationale for acquisition is diversification.
3. Symbiosis. This is the most common type of acquisition where management
must ensure simultaneous boundary preservation and boundary permeability.
This approach is positively related to the acquirer buying intangible resources
that are people dependent.
4. Holding. Here the intention is not to integrate and value is created by financial
transfers, risk sharing or general management capability.

VII. Integration Challenges

The single most cited problem during integration is cultural incompatibility. Surprisingly,
cultural issues are rarely factored in when deciding to acquire another company.
Cultural challenges manifest themselves in the following areas:

Leadership
One companyʼs executives may favor a command-and-control style, whereas leaders at
another organization may prefer a more hands-off approach. Every companyʼs
leadership style can seem unique. Senior leaders have different motivational styles
and the resulting friction often creates additional risks. Companies that ignore cultural
issues as they relate to leadership styles sometimes destroying much
of the mergerʼs potential value in the process.

Governance
Effective corporate governance must encompass the way decisions are made in each
part of the company and across organizational boundaries. This includes the work of
such governing bodies as program management steering committees, councils that
oversee the work of support functions, corporate governance boards and even new
product development committees. Integrations issues are compounded by competing
governance structures.

Communication
Communication, is critical during a merger given the inherent uncertainties on the part of
employees and customers. However, communication styles vary widely among
companies, and what has worked for one may not work for another. Attitudes about


























































34
“Strategic capabilities and knowledge transfer within and between organization,” Arturo Capasso, Giovanni Battista Dagnino,
Andrea Lanza


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confidentiality, preferences for formal versus informal channels and the frequency of
communications may all come into play. With employees in particular, insufficient or
inconsistent guidance on such key issues as organizational restructuring, customer
relations and changes in financial policies can create unnecessary business risk.

Business Processes
Different companies have significantly different ways of developing, updating and
enforcing core business processes which must be understood and respected during the
integration phase. Changes in the way companies handle these tasks require strong
leadership, supported by careful and frequent communications to verify that employees,
customers and vendors understand and accept them. If changes in core business
processes and process interdependencies are not deliberately and systematically
thought through during the integration planning phase, organizations risk internal
breakdowns in the quality of products and services and may provide incorrect or
untimely data to customers, suppliers and service providers.

Performance Management Systems

Differences in the way the acquiring and target companies evaluate and reward
employee performance are important and, if overlooked, can lead to morale issues,
undesired turnover, inconsistent performance and a decline in overall employee
productivity. Thus, merger integration plans should include efforts to harmonize
performance metrics and compensation systems where possible, while explaining
important differences when necessary. Newly merged companies must help employees
understand that their different recognition and reward systems are fair, even if not
always uniform across the organization. 35

VIII. Successful Acquirers

While failure is hard to study objectively, there are companies where M&A expertise and
excellence has become a competitive advantage in its own right. A couple of key factors
that characterize successful acquirers include:

1. Timing. According to Bain & Company analysis of more than 24,000 transactions
between 1996 and 2006, acquisitions completed during and right after the recession
from 2001 to 2002 generated almost triple the excess returns of acquisitions made
during the preceding boom. ("Excess returns" is defined as shareholder returns from
four weeks before to four weeks after the deal, compared with peers.) This finding held
true regardless of industry or the size of the deal. Moreover, companies that acquire in
bad times as well as in good outperform boom-time buyers over the long run. 36
Mckinsey says that of the potential strategic moves companies can take to grow in a
downturn—divest, acquire, invest to gain share—an effective acquisition strategy
(defined as growth through M&A at a rate higher than that of 75 percent of a companyʼs


























































35 “Avoiding post-merger blues,” Bearingpoint, 2008
36
Thomspson Datastream, Thompson Financial, Bain Analysis


 93

peers) created significant value for shareholders. During an upturn, on the other hand,
divestments created slightly more value than acquisitions did.37

2. Treatment of Acquisition as a Competency. Successful acquirers such as GE and

Pepsi, approach M&A as if it is a process such as supply chain management and not as
a one time event. They codify their learnings across each acquisition and have a
systematic and well articulated “M&A Playbook.”

3. Proactive vs. Reactive Acquisitions. For successful acquirers, acquisitions are not
seen as a stand-alone strategy but instead a tool to fill strategic holes (such as
diversifying an asset profile or expanding a geographic footprint) that can't be filled as
efficiently on an organic basis. The connection between successful acquirers and their
adherence to an overarching strategy is also borne out by the fact that none of them
acquired companies for defensive purposes — that is, to block a competitor. For these
companies, it would seem, M&A strategy is proactive rather than reactive.38

4. Early Involvement of Business Units. Oftentimes, business unit executives (who

are charged with integration) are not involved in the due-diligence phase of the
acquisition. M&A teams that identify synergy opportunities without significant
participation by the relevant business units can engender resentment and bring about
charges that the team is setting unattainable targets. Many rewarded acquirers
therefore say that having business units lead the entire process for a bolt-on acquisition
can dramatically improve estimates of synergies — and the likelihood of capturing
them.39

Mergers and Acquisitions—A sensible strategic choice or lazy management?

Mergers and acquisitions (M&A) have long been a part of our corporate life. In the post
war period the rise and fall of conglomerates and the recent period of private equity
have witnessed a new flurry of dealmaking. M&A has actively been encouraged as a
healthy manifestation of the free market economy. If our careers have not been touched
by M&A to date, it is inevitable that we will be affected by M&A in the future.

As discussed above, M&A is pursued with the intent of expanding the firm boundaries.
For a firm whose objective is to create economic profits first and foremost, M&A often
arises because of a companyʼs belief that organic growth is either too expensive or not
sufficiently fast enough.

The costs to complete a transaction and the likelihood of any synergies are important. It
is also critical to understand the market dynamics. For example, we should ask
questions such as: How important is this new market? What is the current cycle in this
market and how do asset prices compare to historic values? If I donʼt enter organically

























































37
“M&A Strategies in a Down Market,” Mckinsey Quarterly, 2008
38
“Growing through Acquisitions,” BCG, 204
39
“Habits of Busiest Acquirers,” Mckinsey Quarterly


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what will my competition do? Can I create value from this transaction? What is the
maximum I can pay and what are the likely synergies?

Alternative to Mergers and Acquisitions

When organic growth is a challenge, value can be created from options other than M&A.
Joint-ventures and alliances have been created by companies as ways to create a
position in a market. These structures are usually legally complex, but also can be
valuable where a deal is either too expensive or where delaying in order to gain more
information is valuable.

Externalities and CSR

This section was prepared with significant insight and assistance from Scott Osman (NYU Stern EMBA
2009), Francine Blei (NYU Stern EMBA 2010) and Amad Shaikh (Wharton EMBA 2010)

Why is CSR part of a strategy course?

“Corporate responsibility” has many different interpretations. Loosely the term embraces
ethical and fair business practices, attending to a safe workplace, gender blind, and
embracing diversity. More broad connotations include philanthropic endeavors
supported by the corporation and its employees. However, strategic corporate
responsibility brings the term to a heightened level of “doing good and doing well”.
Generally, it is fair to ask “What is the obligation of business to the society in which it
operates?” Ultimately, every activity in the value chain will affect social factors in the
locations where the company operates. While these impacts can be positive or
negative, CSR is concerned with the negative spillovers. Overall, enterprise makes
significant net positive contributions to society by way of the production of output valued
by consumers that is in excess of the costs of inputs sacrificed in production. Some
producers are “added value” producers—they produce output that is perceived to be
superior to some or all consumers or they produce their output more efficiently than do
other producers.

Although firms benefit society (without firms there would be no prosperity), the
underlying motivation is still monetary profits, not altruism. Frequently, firms can
enhance profits by “shifting costs” to society—for example, a more polluting process
might come at a lower cost. Alternatively, shifting from a labor intensive to a capital
intensive process could increase margins, but will also generate unemployment. Firms
can also enhance profitability by engaging in behavior that amounts to expropriation –
for example the “hidden fees” of cellular or banking services. The externalities of firms
engaging in profit maximizing affects the firmʼs net contribution, as well as its public
perception. Perception could impact WTP (boycotts) as well as future operating costs
(firm ultimately diminishes its operating context or regulators impose constraints).
Hence, considerations of how to reduce externalities and manage the perception of the
firmʼs activities are related to firm strategy.


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Why should firms be concerned with CSR when their net contribution to society is
positive?

While society benefits from profitable enterprise, the firmʼs net benefit to society does
not necessarily increase directly with profits. Economists would argue that some
production decisions are not “first-best”—society loses more than the firm gains in
profits as a result of some choices. This is certainly plausible when the firm engages in
fraudulent, deceptive, or outright incompetent behavior. Few would disagree that firms
should be constrained from engaging in value destruction. The more challenging
discussion is about what to do in the case of activities that generate profits while also
producing smaller but, nonetheless, palpable externalities. In the age of internet and
instant communication, corporations find themselves dealing with an increasingly well
informed public. Public scrutiny often means that corporations that cause externalities
face the risk of social feedback, which hurts financial performance. Firms engage in
CSR to address that social feedback. Some of this CSR attempts to directly mitigate the
harm done by the firm (“junk food” maker reduces its fat content), or offset the harm by
contributing something positive (“junk food” maker supports athletic programs). These
examples of “remedial” CSR tend to increase the firmʼs operating costs (sometimes a
little, sometimes a lot). Particularly intriguing CSR, referred to below as “strategic,” is
that which both enhances society as well as firm profits.

Figure 21

As firm grows Social externalities

and matures, Firm faces Firm creates a
CAUSE
confound firm’s boycotts and CSR agenda to
maximizing profits EFFECT
brand or public government action address feedback
entails cost cutting perception
vigilance

Remedial CSR

Milton Friedman is often credited for making the most incisive case that the obligation of
firms is to focus exclusively on profits. In a 1970 essay in The New York Times
Magazine Friedman wrote:
That is why, in my book Capitalism and Freedom, I have called it [social
responsibility] a “fundamentally subversive doctrine” in a free society, and
have said that in such a society, “there is one and only one social
responsibility of business—to use its resources and engage in activities
designed to increase its profits so long as it stays within the rules of the
game, which is to say, engages in open and free competition without
deception or fraud.”


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Would Friedman suggest that remedial CSR was “fundamentally subversive” or a
means to defend profits by preserving/enhancing the firmʼs reputation? In the quote,
Friedman clearly disavows profitable but fraudulent, deceptive and, by extension,
blatantly incompetent enterprise. He also disavows corporate philanthropy—
management giving at its own discretion. What about the case of a firm operating within
the “rules of the game” but at the same time imposing externalities on society? It is fair
to suggest that Friedman would be supportive of CSR as long as shareholders were
among the beneficiaries in the long run.

The position taken here is that CSR at the expense of shareholder wealth is a slippery
slope. To what performance metric would we hold management accountable if
management is charged with serving the whole of society? That said, the principle that
shareholders be among the beneficiaries of CSR hardly diminishes the challenge of
developing a CSR agenda. Managers donʼt have a parallel universe against which they
can measure shareholder wealth derived from various levels and approaches to CSR.
Does erring on the side of caution mean that management be vigilant in protecting the
firmʼs reputation and exposure to future liability? Or, as many interpret Friedman, does
caution mean that management err on the side of spending shareholder wealth
sparingly so it can fight vague and ambiguous threats that loom somewhere in the
future? Is CSR akin to “tilting at windmills”?

In general, firms are increasing their attention to CSR. The current mood is that the
vague and ambiguous threats posed by the firmʼs own externalities on the firmʼs
reputation and ultimate liability are not windmills. Companies now perceive more of an
obligation to not only “stay within the rules of the game,” but to take remedial action to
balance harms they create. Oil companies clean up their oil spills, and chemical
companies that harm the public health make contributions to medical research efforts (in
addition to satisfying legal claims). On the other hand, the rules themselves have
become increasingly blurred and complex. In order to remain competitive, many
corporations have been shifting production abroad to benefit from lower cost labor.
Many cheap labor markets have arguably lax labor regulations and subject workers to
standards the firmsʼ home markets would not tolerate. Firms themselves are often
directly involved with setting, or lobbying for, the very rules and regulations that govern
their activities. Staying within the rules when the rules are unpalatable and/or influenced
by the firms themselves will hardly deflect accusations of corporate irresponsibility.

The choice firms currently face (cheap labor to remain competitive vs. operations which
subject the firm to peril in the long-run) has been a driver of CSR activism. CSR
responds to factors such as the internet (increased odds of detection) and taste shifts
(more constituents express concern), combined with profit enhancing choices (like
outsourcing)—opening firms up to accusations of negative externalities. Firms find
themselves being vigorously blamed by citizens, governments, and social activists for
causing a number of negative externalities:


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 • Structural unemployment caused by laid-off workers with industry-specific skills
• Lowly paid workers who become reliant on socially financed assistance
• Traffic congestion caused by heavy usage of public roads

Organized groups can exert influence through exclusion, such as boycotting products
from the “offending” firm. In recent times, companies have been held responsible for a
widening range of issues, and activists have become more sophisticated in generating
awareness and mobilizing action through the media. Furthermore, governments have
employed a wide range of responses, from regulation and restriction, to industry-specific
taxes, and, in extreme cases, privatization.

Remedial CSR agendas fall along a spectrum between topical appeasement and
substantive redress. Appeasement measures may include publicity campaigns,
sponsorship of community events, philanthropic contributions, or encouraging
employees to donate time or their own money. Appeasement is distinct from “pure
philanthropy” as the basis is some return to shareholders. However, not much attention
has been historically paid to whether or not this premise is correct. Furthermore,
companies may not want to offset the potential efficacy of these activities by appearing
self-serving. Measuring returns on CSR would subject the firm to accusations that its
motives were disingenuous. Unfortunately, without direct ties to financial metrics,
appeasement may often fall outside of the scope of pure profit-maximization. On the
other hand, the dollars devoted to these activities tend not to be big enough to provoke
much of Friedmanʼs (ghostʼs) ire. But as constituents and feedback mechanisms have
become more sophisticated, “token-bribe-charity” initiatives by firms often fail to deflect
criticism. In sum, appeasement doesnʼt hurt much but it doesnʼt, in all likelihood, help
much either.

In the middle of the remedial CSR spectrum are programs that are, in fact, remedial,
such as selling environmentally friendly products in addition to traditional products
(e.g.,automobiles). The benefit of moving towards the middle and higher end of the
remedial CSR spectrum is that measurement is often not as confounded. It is
reasonable and straightforward for a firm to measure the profitability of a product
offering. This CSR qualifies as “remedial” (rather than “strategic,” which is discussed
below) if it reduces profits but raises the firms profile as a “concerned producer” and,
thereby, preserves the firmʼs reputation and, what some call, its “license to operate.”
Furthermore, in the course of participating in a market for “socially responsible”
products, the firm can point out and ponder the customerʼs own propensity to express
concerns about social issues while making purchases that suggest otherwise.

On the substantive end of the spectrum are solidly remedial activities. Here firms
address problems directly, for example, by installing filters that reduce the polluting
effects of smoke-stacks. It is possible that the firmʼs costs and the negative externality
decline together, but this outcome is not the norm. Solidly remedial CSR is likely to raise


 98

the firmʼs costs. The return to shareholders comes in the form of reducing the firmʼs
future liability and/or preserving or enhancing its reputation. As information technology
reduces the frictions of mobilizing social movements, firms are increasingly forced to
move towards substantive redress. Sometimes companies deal with mediating
organizations that monitor, rank, and report social performance. These organizations act
as information verification bodies (like the auditing function of accounting firms) that
allow private self-regulation. Once firms embrace CSR it is difficult to “put the genie
back in the bottle.” These activities are, at the least, a tacit admission of guilt.

We observe a good deal of variance among managers in terms of their perception of

what it means to have a “conservative” CSR policy; managers answer the question, “do
we err on the side of preserving the firmʼs reputation or the firmʼs return on capital?”
quite differently. While doing nothing is off the table, so should be “tilting at windmills.”
The firm devoting resources to remedial CSR needs to be cognizant of “crowding out”
higher return projects and/or raising its costs of operating thereby weakening the firmʼs
competitive position. Firms increasingly face global competitors, many of whom are not
under pressure to be socially responsible. The “cognitive dissonance” of customers is a
perpetual problem—consumers indicate concerns but are not willing to “vote with their
dollars.”

Challenges aside, experience suggests that remedial CSR matters disproportionately to

the largest or most high profile firms in a given industry. Wal-Mart, for example, faces
tremendous scrutiny for labor practices that are not uncommon in the retail industry.
They claim “Weʼre not the only ones,” or “Itʼs right for our customers,” but liability is
thrust on them nonetheless. When the future segment leader is early in its life cycle,
remedial CSR issues are tabled because future liability is uncertain. But when the firm
has matured, not only is growing more difficult, but externalities are more recognized, so
the firm faces higher risks of social feedback.

A survey of many corporate websites reveals that numerous companies devote a

section on “Corporate Responsibility”, yet the content varied greatly, ranging from:
Supply Chain Code of Conduct, Work conditions – safety, nondiscriminatory practices,
benefits, perquisite, Environment/Sustainability, Climate Change/Carbon Footprint,
and/or Community-oriented efforts. Several companies have a Corporate Responsibility
Reporting section integrated into their annual reports, and some companies have a
separate Division of Corporate Responsibility. However, it was surprising that many of
the above topics related to legally required policies, not altruistic or particularly strategic
policies. Strategies to maintain a “Context Focused” CSR profile include Marriott
Corporation and Cisco Systems, both of which provide a student trainee program which
potentially can feed the company with new employees already oriented to their work
standard, enabling the corporation to extract benefit from its outlays. While companies
define themselves by “socially responsible” behavior as the backbone of their company
– examples are Tomʼs Shoes, Ben and Jerryʼs Whole Foods, Patagonia, Starbucks, The
Body Shop, others seem to introduce programs reactively, as damage control against
negative publicity (e.g. outsourcing to countries having cheaper labor +/- substandard


 99

working conditions, pollution, oil spills, etc.), in an effort to garner good will and
attract/maintain a consumer base. This “Crisis Prevention” is a more a form of damage
control. “Cause-related Marketing” is popular however it sustainability other than
providing a veil of “social correctness” is unclear. And in fact, consumers could be better
served to donate directly to these causes and receive their own tax benefit from doing
so.

Nonetheless, many firms pride themselves in maintaining a proper social image. The
Corporate Responsibility Officer Organization (CRO) publishes an annual “Best
Corporate Citizens List”, which, for some companies, provides a “seal of approval. It
appears, however, that there is a blurry line between ethical corporate governance,
corporate social responsibility, and strategic corporate responsibility. Intrinsic to the
company one expects diversity, safety, etc. With globalization, the expectation is that
these business practices will be universal, thus not taking advantage of developing
countriesʼ labor force and economies. In fact, with increased access to internet and “real
time” events, negative exposure can quickly reverse a companyʼs successes.


 100

Figure 22: Links with Social Factors

FUNCTIONAL ACTIVITIES CORPORATE OVERHEAD ACTIVITIES

• Transporation Impacts
(congestion) INBOUND LOGISTICS

• Financial • Process Pollution

Reporting Practices • Process Recycling
• Government FIRM INFRASTRUCTURE OPERATIONS • Energy Use
Lobbying Practices • Hazardous Materals

• Product Safety
• Product Recycling
• Product Disposal • Packaging Disposal
HUMAN RESOURCES OUTBOUND LOGISTICS • Energy Use
• University Relationships
• Ethical Research Practices
(animal testing, genetic modification)

• Marketing practices • Education, Job Training

(e.g. to children) • Working Conditions
• Marketing practices MARKETING & SALES TECHNOLOGY DEVELOPMENT • Hiring Diversity
(e.g. to poor) • Healthcare
• Privacy

• Procurement Practices
• Disposal of Obsolete Products • Supply Chain Issues
• Handling of Consumables INPUT PROCUREMENT (Child Labor, Conflict, Diamonds)
AFTER-SALES SERVICES
(motor oil, printing ink)

MARGINS


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Strategic CSR

While remedial CSR is concerned with defending shareholder value, strategic CSR
wonders about the possibility of the firm engaging in investments that have clear social
benefits while also producing positives returns to capital. We began this section
asserting that the net contribution of enterprise to society is positive. What is different
here? The key difference is the overtly “socially positive” aspect of the investment.
Without a doubt, firms and customers in western economies are expressing interest in
businesses whose outputs produce clear social benefits, while not “crowding out” or
coming at the expense of businesses devoted to maximizing shareholder wealth.

Strategic CSR is the essence of the often-used phrase “doing well by doing good.”
Highly visible examples include Ben and Jerryʼs, Patagonia, and Seventh Generation.
Some household name companies, such as SC Johnson and DuPont, have also made
firm-wide decisions that social enterprise is worthwhile for them. In terms of the case for
strategic CSR, efforts can reap financial dividends through the effect of this CSR on
employees, consumers, investors, and governments. Motivations for strategic CSR
investments will range considerably. Some companies will start from the premise that
they are socially-bound to make CSR investments, and then ask themselves how to
garner value from those investments. Others simply have a broad view of profit-
maximization, and examine CSR activities just like any other—measuring the bottom
line. Regardless, companies increasingly measure financial returns of CSR activities.

John Mackey (CEO of Whole Foods), in “Putting Customers Ahead of Investors”, a

point-counterpoint to Friedman, stated “the enlightened corporation should try to create
value for all of its constituencies. From an investor's perspective, the purpose of the
business is to maximize profits. But that's not the purpose for other stakeholders--for
customers, employees, suppliers, and the community. Each of those groups will define
the purpose of the business in terms of its own needs and desires, and each
perspective is valid and legitimate. . . . “the most successful businesses put the
customer first, ahead of the investors. In the profit-centered business, customer
happiness is merely a means to an end: maximizing profits. In the customer-centered
business, customer happiness is an end in itself, and will be pursued with greater
interest, passion, and empathy than the profit-centered business is capable of.”


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Several corporations have soundly demonstrated that in addition to “bottom line”
targets, it is possible to creatively incorporate which do not undermine the companyʼs
value. In fact, recent data suggests that at least for certain segments of the population,
consumer choices are influenced by the philosophies endorsed by the corporation.
Furthermore, some companies (e.g. Whole Foods) have shown that corporate
philanthropy can be good for business – an example is setting aside five days
throughout the year where the store donates 5% of total sales to philanthropy – up front
publicity of these events “usually brings hundreds of new or lapsed customers into our
stores, many of whom then become regular shoppers”

According to the KPMG International Survey of Corporate Responsibility Reporting

2008, “75% of the largest 250 companies worldwide have a corporate responsibility
strategy that includes defined objectives, nearly 2/3 of G250 companies engage with
their stakeholders in a structured way, up from 33 percent in 2005, and >50% of the
worldʼs largest 250 companies publicly disclose new business growth opportunities
and/or the financial value of corporate responsibility.”

Portnoy40 and others review motivations behind firms that “rebrand to get even more
mileage from their beyond compliance endeavors” CSR. He states that CSR may be
initiated to attract customers (e.g. emphasizing safe working conditions, environmentally
sound, safe, and/or “politically correct” product sourcing), to encourage employee loyalty
and goodwill, to attract investors, and to promote Community goodwill. However,
Whitehead, in a survey of CSR practices, concludes that the definition of CSR is not
uniform, and that “consistent and systematic criteria for evaluating corporate
performance must be applied, a requirement that is undermined by the adoption of
differing definitions of CSR and the use of alternative terms such as CR.” Other authors
(e.g. Maak) discuss “Corporate Integrity vs. Corporate Responsibility”, suggest an
underlying framework of ʻʻ7 Csʼʼ of integrity: commitment, conduct, content, context,
consistency, coherence, and continuity as the underpinnings of true CSR.

Employees

Employees are aware of a corporationʼs social impact. Companies that make CSR
investments can increase the morale in their workforce, generating returns by (1)
serving as non-financial forms of compensation, (2) increasing retention and thereby
reducing overall training costs, and (3) increasing labor productivity.

There is evidence that employees are aware/interested in the contributions to society

made by the company they work for. According to studies, over 85% of employees
expect their company to make a positive contribution [citation??]. Over 60% of new
employees consider this in the choosing the company they would work for [citation??].
In a study from a major business school, graduating MBA students were willing to


























































40

Portnoy, PR. The (Not So) New Corporate Social Responsibility: An Empirical Perspective. Review of Environmental
Economics and Policy. 2008
2(2):261‐275.


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accept a 10% lower salary if the company was noted for its good work [citation??]. The
quality of a companyʼs CSR activity is perceived by employees as contributing to a
positive work experience, can be a factor in better relationships between employees,
and is a consideration in retention. In the best of these circumstances, the result is
increased productivity and loyalty from the employees, which results in lower costs and
higher profits for the company.

Consumers

Consumers may also be aware of a corporationʼs social impact. Companies can

increase returns by (1) generating brand loyalty, increase willingness-to-pay, and
enabling premium pricing, and (2) accessing new previously underserved markets.

While there is insufficient hard data to support the financial returns of CSR, certain
consumer segments (most prominently college age) do exert willingness to pay for
products from companies sharing their political or social viewpoints. One sees
publications purporting “CSR Doesnʼt Pay” - “Part of the reason why CSR does not
necessarily pay is that only a handful or consumers know or care about the
environmental or social records of more than a handful of firms. "Ethical" products are a
niche market: Virtually all goods and services continue to be purchased on the basis of
price, convenience and quality.”41 On the other hand, others report that through certain
CRSR (e.g. “green”) initiatives, companies are either saving money or the changes are
“cost-neutral”.42

The concept of a “contribution” on the part of a company in the mind of the consumer is
very broadly defined here, spanning from the promise to make a contribution to a charity
based on a purchase, to products created with a “good” pedigree. A box of cereal
emblazoned with a pink ribbon, or a statement that a contribution of some amount will
be made to a charity by a retailer for an in store purchase are examples of the former;
fair trade harvested coffee beans or dishtowels made from fair trade cotton, would be
examples of the latter. In the case of the contribution, it is generally understood by
companies that these are incentives to increase consumer willingness to choose the
product, or to make a purchase. In the case of fair trade coffee, the consumer is willing
to pay considerably more for the product to encourage and reward the good intentions
of the company.

The most exciting, hardest to predict, and dramatic impact of CSR efforts may come
from new business opportunities. There is a growing catalog of examples where
sustainability efforts end up saving the company money, which then results in a
significant bottom-line impact. One dramatic example of this is what is called Bottom of
the Pyramid (BoP), where companies explore ways to serve the underserved market of
the worldʼs exceptionally poor. The BoP program by Unilever reached 110 million rural


























































41
Vogel, D. Corporate Social Responsibility: CSR Doesn't Pay. David Vogel Forbes.com. 10/06/08.
42
Skapinker , M. Why corporate responsibility is a survivor. www.ft.com. April 20 2009.


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Indians since it began in 2002. Awareness of germs increased by 30% and soap use
increased among 79% of parents and among 93% of children in the areas targeted. As
a result, soap consumption increased by 15%. Unilever discovered that it could create a
dramatic health impact on the lives of millions of people by teaching them about
cleanliness and making soap products available at affordable costs. The company is not
only profiting from this activity, it is building brand in a new market because improved
sanitary conditions provide a key link in lifting people out of poverty.

Investors

Investors too are aware of a corporationʼs social impact. Companies that make CSR
investments can increase firm value by increasing the investor base, lowering the firmʼs
cost-of-capital.

Numerous “sustainability” indices exist within stock markets around the world.
Increasingly and with the help of such indices, foundations representing enormous
amounts of invested capital are committing themselves to mission-related investing. In
fact, the Rockefeller Foundation provides consulting practices to other organizations
who want to deploy their investing resources in ways that further organizational goals.

As of 2007, about one out of every nine dollars under professional management in the
United States can be attributed to socially responsible investing—that represents 11
percent of the $25.1 trillion in total assets under management tracked in Nelson
Informationʼs Directory of Investment Managers. This suggests that socially responsible
investing can have an impact, albeit small, on a firmʼs cost-of-capital.

Governments

Finally, governments are responsive to the wider publicʼs view of various companiesʼ
social impacts. While this often manifests itself at the industry level, firms can (jointly if
necessary) make CSR investments to reduce “public enemy” status, thereby increasing
access to the political process and reducing the likelihood of reactive regulation or
taxes. In recent years, oil companies and defense contractors have gone to great
lengths to win public trust. Given that these firms face unique industry-specific
government oversight, they regularly make public appeals to enhance their good name.

Closing Thoughts

It is feasible for many firms to discover that social responsibility is not just a cost center,
but also can be aligned with managementʼs fiduciary obligation of driving shareholder
returns. There are substantial challenges to developing an effective and appropriate
CSR agenda. Many of these challenges were discussed above:
• What should guide managementʼs philosophy of what “conservative” CSR
means?
• What are the looming threats of under-investing in CSR?
• What principles enable management to navigate trade-offs among constituents?


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 • What metrics of CSR efficacy are accurate?

These are some of the challenges faced by proponents of CSR. Additionally, consumers
say they want corporations to behave responsibility, but have not shown consistent
willingness to “vote with their dollars.” This consumer behavior might be indicative of the
failure of firms to effectively produce, distribute, and market the “CSR attributes” of their
output. Unquestionably, CSR is a different attribute than most firms are experienced in
selling. Firms will have to face the significant challenge of developing new value chains
to make the production and distribution of CSR more cost effective as well as
transparent to consumers, government, and social activists.

Potential Examples of CSR

I am interested in your thoughts about the NPV of the following CSR initiatives. Which
would you advocate and why?

1. Your firm operates its largest plant in town X: CSR in your organization is
focused on impact of the plant on the constituents of X. Firm works to
minimize environmental impact. Firm also is strategic in choosing local
organizations to sponsor and support to maximize the purchase of “goodwill”.
2. Firm perceives an “empathy” correlation between its target and a particular
cause (“cause marketing” such as Avon and breast cancer): Firmʼs CSR
takes the form of “matching” – customer makes a sale and firm contributes
some share of proceeds to the cause.
3. Firm seeks to drive WTP and C directly while addressing a social concern: A
clothing company wants to invest in a process to convert recycled materials
into textiles. They believe the resulting textile would be in the cost zone of
their current costs. They also believe that the resulting product will be more
durable (as well as have other positive product attributes, with a few
limitations – but a net better textile).


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 Application to the SAFE case:

As SAFE gets larger and larger, and offers more lucrative salaries, police-officers start leaving the line of duty
for a “less-dangerous” and more lucrative job at SAFE. Eventually enough police officers leave, that the local paper runs a story with the
Police Chief bemoaning how he is losing good officers to SAFE and he is unable to keep up with the attrition. The reporter then makes the
sensationalist leap that the city is becoming less safe because of this large corporation, quipping that it is ironically called SAFE.

In other words, SAFE’s growth has led to an unintended consequence, an externality that threatens the company’s future growth and
reputation.

Remedial CSR: Under this remedy-driven mode, SAFE is caught completely off-guard by the news. While SAFE is a solid contributor to the
local United Way, that fact didn’t make it into the reporter’s story. When the news hit, SAFE’s CEO rushes to make amends by announcing
that it is going to be making a significant contribution towards the construction of the new police station. The CEO also freezes all police
hiring, essentially putting at stake the company’s growth and reputation, which is largely dependent on hiring security professionals from
within the police force. Furthermore, depending on how long the public’s ire lasts, this freeze could become permanently disabling to SAFE.

What if SAFE had done it differently? Here comes “Strategic CSR”…

(One year before story would have otherwise hit): Under this proactive mode, SAFE decides to seek CSR strategies that provide a return on
its social investments. SAFE’s CEO recognizes that SAFE’s growth is causing a drain on the police force. Before the situation worsens, the
CEO meets the Police Chief and engages in integrative bargaining to arrive at win-win solutions* that will help alleviate the drain on police as
well as help SAFE. They both agree that SAFE should fund a new department at the local technical college that will have SAFE-scholarships to
encourage police recruitment and training. SAFE sees the ROI as follows:
1. New ties are created with the Police Chief, preempting any “bad blood” as officers leave SAFE. No “juicy” quotes from the Chief for a
news reporter against SAFE!
2. SAFE gets a commitment from the Chief that as part of the curriculum, it will have its own security staff (ex police officers themselves)
do some of the training. In the process, SAFE’s own employees get retrained, saving resources and costs for continuous training.
3. SAFE establishes good-will with new recruits, who will have a natural affinity to SAFE for future work opportunities, even as they may
have more choices if and when new entrants enter the SAFE-type business model.

*By “win-win” we mean that the firm does not sacrifice profits to make society better off. The firm can sell the socially beneficial product for
a profit.


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Encapsulation of Core Concepts
This section was prepared with significant input and assistance from Amad Shaikh (Wharton EMBA Student
Graduating in 2010)

Strategy

To think strategically is to think about long-term goals and objectives: what do you want
to be when you grow up. What will be the enterpriseʼs “it”? Strategy is means the
enterprise creates value (drives a wedge between costs and customer valuation of the
output), captures value (drives a wedge between revenues and costs), and sustains
value (earns profits long enough to monetize ALL costs). It is important that the
strategist demarcate strategy from tactics, because not doing so can lead to a situation
where neither tactics nor strategy is effective.

Strategy is not the same as Tactics

“Strategy without tactics is the slowest route to victory. Tactics without strategy is the
noise before defeat.” [Sun Tzu]

Letʼs suppose that you are interested in starting a pizza parlor. Youʼll have to decide
what kind of pizza parlor you want to have: the parlor that sells (a) the cheapest pizza in
town through innovative means of cheap production and maximizing profitability on
volume OR (b) deluxe “custom” pizza, using imported and highest-quality ingredients
with the goal of maximizing profit with premium pricing. This is strategy. Tactics, on the
other hand, will be the means and ways that you will achieve your strategy: the
machines that you will use, the type of labor you will hire, your choice of suppliers, etc.

Economic Profits

Before you decide to open that pizza parlor and sink the required capital, you would
contrast the returns you expect from the pizza parlor to other potential uses of that
capital available to you. If you entered a market that is perfectly competitive, for
example, you put your shop in a strip mall with three other pizza shops and you all sell
exactly the same type of pizza, then you can be quite sure that you will earn what
economists call the “competitive return”—a return equal to the opportunity costs of the
capital, which is the return based on the risk of pizza shop in that strip. In other words,
your economic profit (accounting profit i.e. cash profit, less opportunity cost) will be zero.
Strategy will revolve around how you can make more money on your pizza than your
competitors (better quality pizza or lower cost of production compared to the
competitors), and sustaining it.


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Value

Letʼs assume that you went ahead and jumped into the pizza business. The consumer is
willing to pay a certain amount for your pizza (call it “WTP” or willingness to pay),
depending on some generic factors such as size, number of toppings, etc., but the
consumerʼs WTP also depends on attributes of quality and taste and delivery options.
Are you preparing your own dough, are you using high quality ingredients, etc.?

Then there is YOUR cost (call it “C”) in making those pizzas; costs ranging from fixed
costs to operating costs, all of which will vary with your choice of production methods
(capital and labor inputs), raw-materials, etc. C includes the opportunity cost of the
capital—that is, C includes the appropriate risk adjusted return for the capital you tied up
in the business.

Since your WTP has to be greater than C for you to be in a viable business, you are
creating value that is equal to WTP−C, which we refer as to the “wedge.” Youʼll set your
pizza price (call it “P”) somewhere in this wedge. Thus, WTP−P is the consumerʼs
surplus (because he is willing to pay more than the price), and P−C is your producerʼs
surplus or your margin. Multiply P−C by volume and you get profit. Where you set P
depends on many market factors. The goal of strategy is to convert a portion of this
wedge into your profits, and sustain it over some period of time.

Value Capture vs. Value Addition

Letʼs think of WTP−C as a pie. WTP−P is the consumerʼs piece of the pie, P−C is the
firmʼs piece—this is a measure of how much of the value created the firm is capturing. If
the pizza is distinctly good, the firm may be able to raise price and increase value
capture. Although the firm will likely lose some customers, with such distinctly good
pizza, the firm will retain most of its customers. Earning more on each customer
retained will more than offset the revenues lost by losing some customers. The more
distinctly good the pizza is, the more of the value created the firm could capture.
Economists would say that firms can capture more when the firm faces a low price
elasticity (low price sensitivity—which is, in this case, is a result of the pizza being
distinctly good, thereby discouraging most of the firmʼs customers from using price as
the primary driver of their decision to purchase). Firms that make output that some
consumers determine is better can capture more of the value they create by raising
price. Superior firms capture more of the value created (buyer surplus shrinks when
firmʼs raise price—WTP is the same, WTP−P shrinks).

In contrast, if your pizza is about as good as the othersʼ, and you can gain many more
customers by dropping price a little bit (high price elasticity/high price sensitivity—since
pizzas are about the same, price is critical to the decision to purchase process), then by
lowering price below competitors, you could gain share at the expense of your
competitors. Here lowering price below competitors is the approach to value. A price


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war does not alter value creation. A price war increases buyer surplus (same WTP,
lower price). A price war also redistributes market share among firms (at least in the
short run). However, total value created is unchanged (in the short run, at least).

As opposed to “value capture,” you can engage in “value addition.” Letʼs consider the
“industry pie”—if competitors each work to cater to a segment of customers and work to
offer their segment “distinctly” delicious pizza—the industry value creation pie grows.
The growth in value created is primarily driven by the higher WTP of each pizza buyer
getting just what they want. Furthermore, each competitor has a “lock” on their particular
segment by giving that segment pizza that is more satiating (to that segment) than the
other competitorsʼ offerings.

To reinforce this intuition, letʼs say that you could improve the pizzaʼs taste such that the
consumer is willing to pay an additional $2, while it costs you only an additional $1 to
make that happen. Theoretically, you could earn an additional $1. The consumer is still
getting the same WTP−P (both WTP & P went up by $2), but your piece of the pie just
got bigger (P went up by $2, but C only went up by $1)!

Value might also be created by eliminating product features. In this scenario you could
choose to remove that special imported topping (saving yourself, say $2), because
customers were willing to pay only $1 for it (so you were over-serving them). Now you
could lower price by $1. Customers will keep their piece of the pie same (both WTP and
P went down by $1) but since you made the pie bigger, you keep more value (P went
down by $1, but C went down by $2)!

How can you increase WTP in the market? You could make the product better (as we
did in our pizza example). You could bundle complementary products (add a 2-liter coke
bottle with the pizza to make ordering easier), you could reduce buyer purchase cost
(deliver the pizza free of charge), or you could improve the reputation or image (through
experiential results—more sustainable or through aggressive/creative marketing).

Value Chain and Vertical Chain

Firms that assemble ingredients into a pizza are involved in many activities—the value
chain. There are the functional or “primary activities” (rolling the dough) and there are
also corporate activities—infrastructure activities or
support activities such as HR, IT, purchasing, etc.
Together, these activities lead to the final sales of
the goods.

By breaking the entire value chain into discrete

activities, we can analyze what each activity
contributes in making the product or improving its
attributes (WTP) and what each activity costs (C).
The sum of the WTPs and the Cs of all the pieces is


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equal to the overall WTP and overall C for the product. This analysis can help uncover
whether the WTP contribution of each activity is optimized for the cost it incurs. In other
words, the last drop of cost put into the product should be less than what it contributes
to increasing the productʼs WTP (marginal cost < marginal improvement in WTP). So, if
we analyze the pizza delivery activity (an “outbound logistics” activity in Porterʼs Value
Chain—see Figure above), and find out that it is costing $2/pizza to provide this service,
while it is only adding $1.50/pizza to the productʼs WTP, then we would conclude that it
is better to shut the delivery service down, reduce the price by $1.50 (not losing any
customers) and save $0.50/pizza. Or perhaps the reverse was true, and that adding
delivery service (if you didnʼt offer it) would increase WTP more than it would cost,
leading you to add service. We could analyze each piece of the value chain similarly
and determine the cost vs. WTP-benefit for each.

Step back a bit and think of the pizza business, not just the parlor, but the entire “vertical
chain,” from the wheat farm, to the flour production, to the dough production, to the
pizza process, to the delivery process, and to the marketing and customer process. In
fact, many industries are involved in the production of a pizza. Here we realize what
happens in the industries we buy from and sell to impact our business (our ability to add
and capture value) in significant ways. Industry analysis helps us organize our thoughts
about the opportunities and constraints due to adjacent industries (as well as firms in
our industry).

Industry Analysis

You have decided to offer “custom-special” pizza, which combines the best of imported
ingredients, is completely organic, in addition to being low-fat. You feel that you will
provide an offering that is unparalleled in the market. Great taste, great ingredients, and
non-fattening—you have reached the nirvana in pizzas! You jump into the business,
advertise heavily, and sure enough the customers start coming in droves. You are
hardly able to keep up with demand, and you
keep adding employees in an attempt to maintain
the high standards you set for your business. But
late into your second year of booming business,
you start seeing your margins thin out. You sit
down and start to account for what is happening
and it doesnʼt take you long to realize that the
Porterʼs 5 forces have you squarely cornered.

Only a few months ago, the supplier of your

olives, the most popular ingredient on your pizza,
started increasing prices quite drastically. You
looked around for alternatives, but none could
match the freshness and superiority of this one huge supplier. There was little you could
do about this “bargaining power of suppliers,” and you expected this olive-supplier to
keep squeezing harder. You also realized that while you had started out at $25 per


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medium pizza, you were already down to $20, as customers were literally demanding
lower prices or they would switch, and some did. For those who enjoyed your pizza
weekly, this was starting to become “high cost, low stakes” for them, and you just
couldnʼt lose these regular customers; you were giving in to the “bargaining power of the
buyers.” You also remembered that another pizza shop had opened up several blocks
away, and it too was serving “premium” pizza, but at a lower price. It was also getting
the olives from “your” supplier, and the supplier was more than happy to see both of you
competing—lowering pizza prices, increasing volume, and ultimately increasing his
sales of olives. You didnʼt think your loyal customers would leave you, but when one
customer brought you a slice of the other placeʼs pizza, and it tasted almost as good as
yours, it worried you a little due to the “threats of new entrants.”

And as you thought things couldnʼt have gotten worse, right across your parlor, another
threat, the “threat of substitute products” was looming—a new “Pita-Stop,” marketing
organic, fresh ingredients in a pita bread, instead of a pizza was about to open up. All
these forces were making your “premium pizza” into a commodity-like item, pushing you
towards price-based competition, the exact scenario you wanted to avoid by going
premium, instead of cheap. It was too late now, and that night after you went home and
slept, you had a nightmare in which you saw Dr. Porter describing zero economic profits
to you.

There are ways that you could have resisted some of this “commoditization” pressure.
You could have franchised several branches of your “premium pizza” parlors all around
the city, and “crowded out” entrants and substitutes, so that there was no room for a
new entrant to come in. Once you controlled all premium food real estate in the city, the
buyers wouldnʼt have had much choice, and you may not have had to reduce prices as
much. You could also have made an alliance with all the major buyers of olives from this
one olive supplier, so that you can exert your own “buyer pressure” on this supplier. And
as far as substitutes, you could simply start offering “premium pita sandwiches” too, so
that you may have been able to preempt the pita substitute. Even if the pita cannibalized
some of your pizza, at least the profits from both went into the same pocket—yours!

Positioning

Positioning involves segmenting an industry to find a defensible position in that

segment. Firms are actively positioning when they configure their value chain to
neutralize industry constraints and exploit industry opportunities. Porter describes three
generic strategies that are responses to these conditions: cost leadership,
differentiation, and focus. Weʼll start with the “differentiation” generic strategy, which
your “premium” pizza parlor plan reflects. In this strategy, “firms that offer distinct
products [your organic, low-fat, high-quality pizza] will likely be able to receive premium
prices from at least some customers. The inherent trade-off of a differentiation strategy
is market share for margin [as you had expected with your $25 medium-pizza price].
With a differentiation strategy, while firms may not reach as many customers, they can


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charge higher prices if they locate a meaningful segment with a higher desire for their
good.”

The other strategy you could have employed is “cost leadership.” This would have been
the case, if suppose, you had invested in new, innovative ovens that you yourself
helped invent, which consumes half the energy of generic pizza ovens, as well as
“packaging” pieces and “topping” pieces, which meant that only one employee had to
program in the size and toppings for the pizza, and the pizza would come out in a box!
This way you needed half the employees that a regular pizza parlor would need, and
you could offer pizza at a lower price than anyone else, and at the competitive market
pricing, you were coming ahead with the highest margin. You heard Porter, “To qualify
as the low-cost producer with a sustainable cost advantage, the source of a firmʼs low-
cost position must not be available to rivals.”

Finally, you could have chosen a strategy where you only catered your premium pizza
to exclusive “high-end” parties. With this “Focus Strategy,” you chose to serve a specific
clientele, saving retailing costs, while taking care of the folks who would most likely pay
for your premium pizza anyway. As opposed to your current “differentiation strategy”
that identifies underserved product categories and varieties, a “focus strategy” identifies
underserved segments of customers.

Preemption and Sustainability

We already discussed the kind of preemption that you may be able to engage with your
pizza business. A firm can “own” (sustain) some position (operate without competitors
encroaching), when the cost, risk, complexity a potential entrant would face is sufficient
to discourage entry. Firms can make choices that raise barriers to entry. Strategies for
preemption generally fall between two general forms of preemption: capital-intensive
assets and securing superior scarce resources—to be clear, these forms of preemption
are NOT mutually exclusive.

For a truly capital-intensive preemption strategy, we have to move beyond pizza parlors,
and consider industries that are highly capital-intensive. For instance, Reliance built a
gigantic oil refinery in India processing nearly 42 million gallons per day of oil. This one
refinery is essentially able to supply most of the product need in a significant region of
India. Even though Reliance may not run this refinery at full capacity all the time, by
investing in so much excess capacity, it has essentially preempted any other refineries
that may have wanted to set up shop in the region. Sometimes, investments can be
staged; sometimes they have to be all upfront. In order to be truly successful, the
capacity must meet or exceed demand conditions for the near long-term, and be
confident that no cheaper substitutes show up in the arena. We can apply this intuition
to pizza parlors…if you want to “own” the pizza market in a particular strip mall, a
preemptive choice would be to build enough capacity to satisfy all the demand for pizza
that strip mall faces.


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Another form of preemption is to secure scarce and superior inputs that are not widely
available to other producers. For instance, back to our pizza example, if the olives were
truly the specialty hall-mark of your pizza, and if there was only one or two producers of
these olives, then you could either backward integrate and take over the olive producer,
or contract with the producer to make you the only pizza parlor that it supplies its olives
too. This way you are preventing this “scarce” resource from being available to others.
Warren Buffet talked about moats to connote both the form of preemption and their
degrees of sustainability. These moats ranged, in increasing strength: (1) legal barriers
(such as patents) (2) one-of-a-kind strategic assets, like trade secrets, (3) sunk costs
and economies of scale, like the refinery we just talked about, (4) information gaps and
path-dependency, like Cokeʼs brand image that depends on a rich and varied history,
and so many social associations that it is nearly impossible to replicate, and finally the
highest of moats, (5) increasing returns advantages.

Increasing returns or early-mover advantages come from a variety of effects: (1)

experience effects, which relates to increasingly lower variable costs as the company
becomes “experienced” in producing it, as captured by the “learning curve,” (2) network
effects, which relate to a situation where each user of a good or service impacts the
value of it for someone else as in the example of email. The more people use email, the
more valuable this service is to each user. Social networking sites, such as Facebook,
also benefit/need the network effect to be truly successful, (3) buyer uncertainty and
reputation, which relates to building product reputation through experience and
customersʼ unwillingness to switch due to it (customers like your pizza so much that the
other pizza parlor, even when advertising the same attributes as your pizzaʼs, would still
have to charge less in order to overcome customers experiences with your pizza), and
finally (4) buyer switching costs, which relate to costs that buyers would have to face in
order to switch. For instance, a certain product may require training that costs a certain
amount. Once that training cost has been sunk, switching to a competing product would
have to make up for the cost of retraining on the new product.

Resource-Based View

The RBV examines how firms can enjoy sustainable returns as a result of resources
employed. So, while the positional view emphasizes the things you do, the RBV
emphasizes the things you have. Thus, the positional view has a product market
orientation—competitive advantage through the creation, domination, and preservation
of a unique position in the firmʼs product market. The resource-based view has a
resource market orientation—competitive advantage through imperfections in resource
markets that give a firm a privileged access to certain valuable resources.

RBV starts with the assumption that firms are endowed with inherently different bundles
of resources, such as brand names, locations, distribution channels, or even quality
control processes, corporate cultures, etc., that similarly create value. It is by owning
these unique resources that other firms do not possess and cannot acquire, and by
matching these resources to economically relevant environments, that a firm gains


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competitive advantage. There are four foundations of for a wealth-creating, sustainable
competitive advantage: (1) Resources Heterogeneity, (2) Ex Post Limits to Competition,
(3) Imperfect Mobility, and (4) Ex Ante Limits to Competition.

Under “Resources Heterogeneity,” firms have different bundles of resources that they
use to produce and sell their products. Firms with superior resources are able to either
(a) produce at a lower cost (C) than other firms in the industry, earning “Ricardian
Rents” and/or (b) produce superior output (WTP) at the same cost, earning “Monopoly
Rents.” As an example of Ricardian rents, consider a wheat-farmer who has a
particularly fertile piece of land (perhaps next to the river). His cost of production would
be lower due to the resources he owns (the land), and thus while he cannot affect the
market price of wheat, he can earn more than other farmers due to his lower “C.” As an
example of Monopoly rents, consider Microsoft, which can produce much higher WTP
(and can demand high prices), than other companies in its peer industry because of the
unique resources it owns. Back to our pizza parlor example, remember the unique
pizza-oven (patented by your company) that operates at half the cost relative to other
ovens. If you had this, you would own a unique resource that helps you gain Ricardian
rents.

Under “Ex Post Limits,” firms have to have barriers that ensure that resource
heterogeneity is preserved. So, your pizza-oven innovation should have a foolproof
patent on it such that other pizza parlors are unable to duplicate your resource
superiority (imperfect imitability). Furthermore, you hope that the other parlors donʼt
come up with a way to achieve the same lower costs through another different type of
production innovation (imperfect substitutability).

Under “Imperfect Mobility,” the goal is that other firms cannot buy your unique/superior
resource in the marketplace or that the resource is more productive for you than your
competitors (co-specialization). Letʼs say you hired the best manager in the pizza world
who excelled in customer service and in reducing labor turnover. While he may be worth
a lot to you, some other parlor could offer him higher salary and if you really want to
keep him, you may also raise the ante. Eventually, his “price” may be bid up to the point
that he has extracted everything extra that he was worth. Thus, this manager represents
the opposite of “imperfect mobility.” On the other hand, if this manager was so good
BECAUSE he could run your special oven better than anyone else, then he is worth that
much partly because of that oven. So, his value is partly from co-specialization, and
thus other firms will not be able to pay him enough to extract the incremental value he is
worth (because only you own the oven).

“Ex Ante Limits” relate to a firm buying the resources that it needed to create its
competitive advantage at a below-market price. This can only happen when there is
imperfect market information. Only if the firm pays a lower cost for resources than the
present value of its future cash flows that these resources are expected to create, is the
firm ahead in creating real wealth.


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Shifting Perspectives: Components of Firm Value

While creating and capturing value are essential in strategy, we also have to look at a
related question: why is the whole (of the enterprise) worth more than its parts? If this
wasnʼt the case, then the enterprise would be dismantled to unlock componentsʼ value.
However, most firms enjoy “intrinsic synergy” among their constituent parts. Here we
think of the firm as being comprised of 3 parts:

(1) ACV (Asset and Capabilities Value): portion of value that is “ownable” and
sellable, derived from assets and capabilities owned by the firmʼs shareholders or
capital owners; essentially the monetary value of the firmʼs position. Examples:
location, brands, patents, etc.
(2) ERV (Employed Resource Value): portion of value that firm employs but doesnʼt
own, mainly the human capital. Remember our discussion of co-specialization
under “imperfect mobility.” When the human capital is complementary to the
firmʼs ACV, then this co-specialization results in synergies that makes the two
resources more valuable than their sum of their separate values. So, in order for
ERV to increase the firmʼs value, it has to be co-specialized otherwise the ERV
will likely capture its full value as compensation (i.e. other firms will bid up its
price since it will be equally productive at other firms).
(3) GV (Governance Value): portion of value that comes from structuring the
organization such that the playersʼ actions are transparent and aligned with the
interest of the firmʼs capital owners. Governance is about putting in place the
appropriate infrastructure and incentive structure that motivates the production of
ACV. When considering the production of ACV, it is reasonable for that human
capital to wonder “whatʼs in it for me?” Governance is the answer to this question.
Good governance displays transparency, consistency, equity, and overall good
sense and, thereby, informs human capital before the effort is undertaken “whatʼs
in it for them.”


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Good GV in ACV firms entails the idea that value of the human capital should
appreciate with the ACV value of the firm. This could include performance-based stock
options, promotions, though both are limited by the firmʼs growth. Another way is to
open up “external” options for employees, by increasing their external visibility. In this
way, a firm is able to use the worldwide market of opportunities to enhance its own
employeesʼ motivation. GV in an ERV firm is a little different and involves a focus on co-
specialization such that the ERVʼs full value can only be retained at this firm. Also the
pay structure matters, many times with structures where entry-level “minions” get low
wages, long hours, but lots of opportunity to learn. They are motivated to work because
either they will move up and get their own “minions” eventually, or that they will learn so
much that they will have solid external opportunities.

While we can consider the three components in isolation, there are important
interactions among them. First, superior ACV tends to attract superior ERV, because
good matching levers up the value of human capital (though much is captured in
wages). Furthermore, ERV is maximized by good GV, because the matches themselves
are dependent on incentive systems. Finally, GV reinforces ACV, because good
structure motivates those actions that nourish the firmʼs position in superior resources.
In our pizza parlor case, ACV would be the location, special ovenʼs patent, brand-name
that builds over time. ERV would be our super-duper manager who can operate that
special oven better than anyone in the market, but whose value would be no better than
a regular manager without that oven. In other words, the oven needs the manager, and
the manager needs the oven. GV would refer to how well you, as the owner, incentivize
the manager to keep producing more and more out of the ACV that is available. Is he
incentivized appropriately to find innovative ways to reduce delivery costs, for which he
is ultimately rewarded for and expects that reward?


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Glossary

• Assets and Capabilities Value (ACV): Value generated from superior tangible and
intangible inputs that “ownable”. If the firm was sold, ACV would go to the new
owner.
• Commoditization: When consumers shop primarily by finding the lowest price.
• Cost Leadership: Reducing C with minimal effects on WTP.
• Differentiator: Raising WTP with minimal effects on C.
• Employed Resource Value: Value generated from good matching of resources
(mainly human) to the ACV of the firm.
• Ex Ante Limits: Often, superior resources command price premiums and this
presents a challenge to firms. Ultimately, acquiring a superior resource at a price
low enough to leave a residual economic rent requires some market friction – that is,
to pass ex ante limits, there must be some market friction.
• Ex Post Limits: Often, competitors can substitute other resources or can create new
resources that are as valuable as the firm in questionʼs resources – this is a failure of
ex post limits.
• Expropriation: Forcing a firm to accept prices at or below its average costs.
• Five Forces: The industry forces that drive firms to become rivals.
• Governance Value: Value generated from incentives that align human capital with
financial capital.
• Increasing Returns Market: Markets with economies (in C or WTP) that improve with
share.
• Mobility: The ability of inputs to be used as productively by competitor firms. Mobility
suggests that the “resource” (generally human) can take (make mobile) his/her
productivity – thereby creating the ability to extract the value in wages.
• Positioning: Choosing a set of activities for value creation that neutralize industry
constraints while exploiting industry opportunities.
• Preemption: Limiting a firmʼs competitors from duplicating that firmʼs position.
• Resource Based View: The view that superior returns lie in superior resources.


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• Resource Heterogeneity: That resource inputs vary across firms.
• Segmentation: Dividing a market based on product or customer attributes.
• Added Value: Increasing firm surplus by increasing the gap between WTP and C.
• Value Capture: Increasing firm surplus by adjusting P.
• Value Chain: The taxonomy of all a firmʼs activities.
• Value Creation: Generating a gap between WTP and C.


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