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NotetoReader:Thisdocumentisaroughdraft.Whenweassignvariousarticlesandbookchapters,studentswonderhowtheconceptsrelatetoeachother–academicssometimesdoandsometimesdonotputtheirideasincontextofotherideasinthefield.Weputthisdocumenttogetherinordertopresentrelevantstrategyframeworksandconceptsinawaythatyoucanclearlyseehowtheymightrelatetoeachother—thisdocumentrepresentstheopinionsofitsauthors.StrategyEssentialsismeanttobeaconvenienceforyou…aone­stopshopfortheconceptscoveredinanadvancedstrategycourse.Youareencouragedtoreadtheideasintheiroriginalformaswell…considerthesethe“CliffNotes”(oracheatsheet).Therearestilltyposandneedforrefinement…buttoleratetheflawsandappreciatethesimplicityofhavingtheconceptsallinoneplace.Thisdocumentwillsurelyimproveovertimeinlargepartduetoyourcommentsandsuggestions–keepthemcoming!

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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

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Table of Contents

WHATISSTRATEGY? ..................................................................................................................................................... 4STRATEGYVS.TACTICS................................................................................................................................................... 5INTRODUCTION ............................................................................................................................................................ 6VALUECREATION.......................................................................................................................................................... 8

DefiningWillingness‐to‐Pay .............................................................................................................................. 10ValueCapture ................................................................................................................................................... 15AddedValue ...................................................................................................................................................... 16ValueChain ....................................................................................................................................................... 21

INDUSTRYANALYSIS .................................................................................................................................................... 26Porter’sFiveForcesFramework ........................................................................................................................ 26DisruptiveTechnologies .................................................................................................................................... 31OtherForces...................................................................................................................................................... 32TemplateforAnalysis........................................................................................................................................ 33ResistingCommoditization ............................................................................................................................... 35UnderstandingValueSummary ........................................................................................................................ 40

POSITIONING ............................................................................................................................................................. 42Segmentation.................................................................................................................................................... 42SegmentSelection............................................................................................................................................. 45GenericStrategies ............................................................................................................................................. 45OverallCostLeadership..................................................................................................................................... 46Differentiation................................................................................................................................................... 47Focus ................................................................................................................................................................. 47

PREEMPTIONANDSUSTAINABILITY ................................................................................................................................. 49InvestinginCapitalIntensiveAssets ................................................................................................................. 49SecuringSuperiorScarceResources .................................................................................................................. 50Sustainability..................................................................................................................................................... 53

RESOURCE‐BASEDVIEW .............................................................................................................................................. 61Wealth‐Creating,SustainableCompetitiveAdvantage..................................................................................... 62Resource‐BasedViewvs.PositionalViewoftheFirm ....................................................................................... 69

SHIFTINGPERSPECTIVES:COMPONENTSOFFIRMVALUE .................................................................................................... 69AssetsandCapabilitiesValue............................................................................................................................ 72EmployedResourceValue ................................................................................................................................. 72GovernanceValue ............................................................................................................................................. 73ValuefromACV‐ERV‐GVInteractions ............................................................................................................... 77

FINANCIALMETRICS .................................................................................................................................................... 79FIRMBOUNDARIES...................................................................................................................................................... 82EXTERNALITIESANDCSR.............................................................................................................................................. 95

RemedialCSR .................................................................................................................................................... 96StrategicCSR ................................................................................................................................................... 102

ENCAPSULATIONOFCORECONCEPTS ........................................................................................................................... 108Strategy........................................................................................................................................................... 108Value ............................................................................................................................................................... 109IndustryAnalysis ............................................................................................................................................. 111Positioning ...................................................................................................................................................... 112PreemptionandSustainability ........................................................................................................................ 113Resource‐BasedView ...................................................................................................................................... 114ShiftingPerspectives:ComponentsofFirmValue........................................................................................... 116

GLOSSARY ............................................................................................................................................................... 118REFERENCELIST........................................................................................................................................................ 120

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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]

1Economic 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.

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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

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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.

4SAFE 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.

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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.

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BuyerSurplus

FirmSurplus

WTP: Buyers Willingness-to-Pay Per Unit

C: Unit Production Cost

P: Unit Price of Good or Service

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Quantity/Market Share

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 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.

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ProducerSurplus

BuyerSurplus

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

C: Cost of Inputs(our conjectures)Organizational slack – sameOperational choices – sameTechnology choices—same Optimality of firm boundaries – improved so costs decrease.

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

(We might conclude):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.

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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.

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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 6For numerical examples of the WTP concept, see Creating Competitive Advantage, by Pankaj Ghemawat and Jan W. Rivkin.

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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.

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BuyerSurplus

FirmSurplus

WTP: Buyers Willingness-to-Pay

C: Cost of Inputs

P’: Price of Goods or Services

P

Price Increase

Loss of Market Share

INTITIAL MARKET SHARE

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Some firms can premium priceand capture value from buyers

BIG PRICE HIKE LOSES LITTLE MARKET SHARE

BuyerSurplus

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C

P’P

Gain of Market Share

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Price Cut

INITIAL MARKET SHARE

Other firms can underprice and capture value from competitors

MODEST PRICE CUT GAINS CONSIDERABLE MARKET SHARE

Figure 2 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.

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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.

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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:

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Methods to Enhance Willingness to Pay

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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.

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(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.

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WILLINGNESS TO PAYCOST PRICE

CORPORATE OVERHEAD ACTIVITIESFUNCTIONAL ACTIVITIES

MARGINS

OUTBOUND LOGISTICS

WTPCOST PRICE

TECHNOLOGY DEVELOPMENT

WTPCOST PRICE

OPERATIONS

WTPCOST PRICE

WTPCOST PRICE

INPUT PROCUREMENT

HUMAN RESOURCES

WTPCOST PRICE

WTPCOST PRICE

MARKETING & SALES

AFTER-SALES SERVICES

WTPCOST PRICE

WTPCOST PRICE

FIRM INFRASTRUCTURE

INBOUND LOGISTICS

WTPCOST PRICE

FIG 4: VALUE CHAIN / ACTIVITY ANALYSIS

©EFM Design LLC

A firm’s activities are divided into two areas

Every individual activity has some contribution to customer’s WTP and firm’s cost

Activities sum to the firm’s total WTP & cost

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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

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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.

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RESTAURANT

NATURAL GAS

ETHANE

STYRENE

POLYSTYRENE

CARTONS

EACH INDUSTRY HAS ITS OWN VALUE CHAIN

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

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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).

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Buyer Power

Pressure from Substitute Industries

FIG. 6: PORTER’S FIVE FORCES

Pressure from Entrants

Supp

lier

Pow

erB

uyer Pow

er

©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

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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.

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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.

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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

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t*t0 TIME

Demand for Performance

Disruptive Technology

Sustaining Technology

PERFORMANCE

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.

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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

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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.

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35

FACTORS AFFECTING BUYER POWER

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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,

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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.

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QUANTITY

Demand for Performance

Competition among firms making PCsresults in a movement DOWN the demand curve for PCs Quantity increases and price decreases

PRIC

E

QUANTITY

QUANTITY

Demand for Microprocessors

The movement DOWN the demand curvefor PC’s results in a SHIFT RIGHTWARDfor the demand curve for microproccessors

PRIC

E

Demand for Microprocessors

Figure 8

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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

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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

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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,

11This 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).

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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

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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

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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.

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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 Resources

Organizational Requirements

Risks

Sustained access to capital investment

Tight cost control Technology change may nullify past investments

Process engineering Frequent detailed control reports

Low cost learning by newcomers through imitation or investment

Intense labor supervision Structured organization and responsibilities

Inability to see required product or marketing change

Products designed for ease in manufacture

Incentives based on strict quantitative targets

Cost inflation which narrows profit margin

Low cost distribution

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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 Resources

Organizational Requirements

Risks

Strong creative and marketing insights

Strong coordination among R&D, product development, and marketing

If cost difference grows, consumers may sacrifice features for savings

Product engineering and basic research skills

Subjective measurement of incentives with qualitative focus

Buyersʼ need for differentiation may fall as they become sophisticated

Corporate reputation for quality or technology leadership

Amenities to attract highly skilled labor, scientists, or marketers

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

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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?)

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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

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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.

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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.

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least important

most important

Information Gaps & Complexity

cumulative experience on a learning curve

product performance track records & reputation

installed base in a network market

WILL ADVANTAGE BE UNDERMINED BY SH I F T S IN TECHNOLOGY OR CUS T OMER PR IOR I T I ES?

path dependance

“black magic”

social complexity

WILL THEY PREVENT US FROM REPL IC AT ING OUR SUCCESS FORMUL A AS WE GROW?

need to imitate on numerous dimensions

Information Gaps & Complexity

market big enough to support

just one efficient-scale firm

WILL ADVANTAGE BE UNDERMINED AS MARKET GROW S?

trade secrets

superior locations

human talent

WILL THEY RETA IN ECONOMIC POWER? GATEWAY S T O PROF I TABLE GROW TH?

intellectual property

brand names

Information Gaps & Complexity

trade secrets

superior locations

human talent

WHAT DO YOU DO WHEN THEY EXP IRE? WOR TH MORE T O O THER F IRMS?

intellectual property

brand names

Increasing ReturnsAdvantages

Information Gaps& Complexity

Economies of Scale, Market Size, & Sunk Cost

One-of-a-KindStrategic Assets

Legal Barriers

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

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)

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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

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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.

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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.

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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

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INSTALLED BASE - MARKET SHARE AT START OF YEAR 1

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Unstable Equilibrium

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.

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

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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.

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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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OUTPUT (UNITS PER YEAR)

P = MC AT THIS LEVEL OF OUTPUT

RICARDIAN RENT

$ P

ER

UN

IT

MC AC

AC*=$3

P*=$6

(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.

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.

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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.

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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

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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.

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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

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Indust

ry F

orc

es

Inte

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ion A

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Three

Com

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ACV

ACV

GV

ERV

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.

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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).

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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.

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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?

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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.

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Vf

Vg

Va

Vk

GV: With good systems for incentivizing resources, the firm’s value is additionally enhanced.

ERV:By utilizing human resources that are complementary to the firm’s assetsthe firm’s value is addtionally enhanced.

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.

TOTAL VALUE OF THE FIRM

V PLUS THE ERV OF THE FIRMA

V PLUS THE ACV OF THE FIRMK

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.

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Table 6: Issues for the Long term Value of the Firm

Long Run Nature of the Firm Form of Preemption ERV is Critical Mostly ACV

Investing in Capital Intensive Assets

• Quality of firmʼs ACV • Technologies that

depreciate or leap frog ACV stock

• Divisibility of investments

• Pricing Power • Extent of HR co-

specialization • Scalability • Governance: and

reducing reliance on specific HR

Ex. Disney animation, Goldman Sachs

• 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

Securing Superior Scarce Resources

• Ex ante limits on competition

• Substitution and imitation

• Scalability • Marketing and demand

realization • Expropriation

Ex. Law firm of “Star and Star”

• 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

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

(1-tax rate) X(Sales - COGS)

Sales

(SG & A)Sales

WACCCapitalSales

X= X (Market Share) X (Market Size)

NOPAT: Net Operating Profit After TaxWAAC: Weighed Average Cost of CapitalV: VolumeCOGS: Cost of Good SoldSG&A: Selling General & Administrative

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.

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.

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Superior Economic Profit

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

Cost of Goods Sold (COGS) Advantage

Price Premium Due to WTP Advantage

Efficencies in Marketingor Administration

Higher Volumes

Superior Management of Working Capital

Efficiencient Use ofFixed Assets

WTP Advantage

Lower Prices Due toCost Advantage

Ability to Dominate aNiche Competitors Cannot Serve

81High

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Mar

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just

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Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

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11.8

%17

.4%

27.1

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.2%

19.9

%

Pret

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(with

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Dec

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15.6

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Dec

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24.2

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7%

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argin

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Dec

-03

Dec

-04

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20.1

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16.2

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13.7

%

Cap

ital T

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(Rev

enue

/Ave

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sted

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ital)

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

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0.77

0.88

1.28

1.06

0.92

CO

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Dec

-03

Dec

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-05

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-06

Dec

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49.6

%46

.0%

53.4

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.3%

59.2

%

SG&A

/Rev

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Dec

-03

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-04

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-05

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-06

Dec

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22.3

%21

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23.3

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19.7

%

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/Rev

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Dec

-03

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n/a

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Dep

reca

tion/

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nue

Dec

-03

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Dec

-06

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-07

8.0%

8.0%

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%7.

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age

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Dec

-03

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133.

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-06

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-15.

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A complementary approach to understanding the financial footprint is the Return on Invested Capital Tree, shown below in Figure 20. As in the economic profit derived analysis above, the ROIC tree allows for a firmʼs strategy to be disaggregated into representative metrics.

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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

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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

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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

Coordination • Expanding into new geographies • Reduce negotiations

• Timing and size of production batches

• Input attributes

• R&D • Innovation • Marketing • Promotions

Leveraging Power

• Over input suppliers • Over customers

• Over input suppliers • Over input suppliers • Over customers • Strategic presence in

multiple markets

Sharing Assets

• Corporate overhead • Equipment

• Corporate overhead • Capital budgeting

• Corporate overhead • Knowledge across

business units

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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 demand

• Culture clash

• Loss of market pressures reduces discipline for in house production

• Transfer pricing culture emerges

• Businesses are less related than hoped

Leveraging Power

• Buyers and suppliers resist pressures, learn to respond

• In house activities may compete with partners, draining goodwill

• Over input suppliers • Over customers • Strategic presence in

multiple markets

Sharing Assets

• Firms overestimate fit, and infrastructure becomes strained

• Costs rise as firm loses ability to specialize

• Corporate overhead • Knowledge across

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

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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

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.

65.35%

30.69%

3.96%

PorIolioMomentum

M&A

ShareGain

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

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

2.3

3.2 3.3

1.71.3 1.4

2

2.9

3.8

4.8

3.4

98 99 00 01 02 03 04 05 06 07 08

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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

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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

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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

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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:

Preservation

Symbiosis

Holding

Absorption

LowHigh

LowHigh

Needforstrategicinterdependence

Needforautonomy

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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

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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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As firm growsand matures, maximizing profitsentails cost cuttingvigilance

Social externalitiesconfound firm’sbrand or publicperception

Firm faces boycotts and government action

CAUSE EFFECT

Firm creates a CSR agenda to address feedback

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 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

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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

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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.

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MARGINS

• Process Pollution• Process Recycling• Energy Use• Hazardous Materals

• Packaging Disposal• Energy Use

• Education, Job Training• Working Conditions• Hiring Diversity• Healthcare

• Procurement Practices• Supply Chain Issues(Child Labor, Conflict, Diamonds)

CORPORATE OVERHEAD ACTIVITIESFUNCTIONAL ACTIVITIES

TECHNOLOGY DEVELOPMENT

OPERATIONS

INPUT PROCUREMENT

HUMAN RESOURCES

FIRM INFRASTRUCTURE

OUTBOUND LOGISTICS

INBOUND LOGISTICS

MARKETING & SALES

AFTER-SALES SERVICES

• Product Safety• Product Recycling• Product Disposal• University Relationships• Ethical Research Practices(animal testing, genetic modification)

• Transporation Impacts(congestion)

• Financial Reporting Practices• Government Lobbying Practices

• Marketing practices(e.g. to children)

• Marketing practices(e.g. to poor)• Privacy

• Disposal of Obsolete Products• Handling of Consumables(motor oil, printing ink)

Figure 22: Links with Social Factors

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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

40Portnoy, PR. The (Not So) New Corporate Social Responsibility: An Empirical Perspective. Review of Environmental

Economics and Policy. 20082(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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