Subject Code: FM CBMEC 2

Course Description: Strategic Management

CHAPTER 3:
INTERNAL ANALYSIS: STRENGTHS, WEAKNESSES, AND COMPETITIVE ADVANTAGE

The Disney brothers chose to compete in a difficult industry. Their studio survived and eventually flourished in spite
of a harsh industry environment and intense competition. The film industry featured several large studios such as Metro
Goldwyn Mayer (MGM) and United Artists. These industry powerhouses had access to the best actors and writers, and they
had distribution networks to ensure that their films played in theaters across the United States. Competition in the industry
was fierce—the industry produced more than 800 films a year throughout the 1920s.

The Disney story, from a strategic perspective, captures the essence and power of a firm’s internal abilities—the
resources and capabilities that can create and sustain a competitive advantage.

THE VALUE CHAIN

The value chain, or the steps in the process it takes to transform raw inputs into finished outputs. Developed by
Michael Porter, the value chain is a way to depict and evaluate the activities a company performs. It discusses production
process that a firm uses to acquire and import raw materials, transform them into valuable outputs, and put them in the hands
of customers. There is also four administrative elements—firm infrastructure, human resource management, technology
development, and procurement—that span all of the firm’s economic activities. Porter’s value chain not only provides a
framework to describe the activities a company performs; it also can help to identify which activities represent the firm’s
competitive strengths and weaknesses.

The value chain helps managers identify areas in which a firm has an absolute strength but provides no guidance
about strength relative to competitors. So, the value chain can be used to answer the important question, “What is a firm good
at?” However, it can’t be used to answer the critical question, “What is the firm better at than relevant competitors?” The firm
must define a set of concepts—resources, capabilities, and priorities—to help in understanding the sources of a firm’s
strengths.

THE RESOURCE-BASED VIEW

Resources, capabilities, and priorities can be thought of as answers to basic questions that firms face. Resources
are what a firm employs to create value and competitive advantage. Capabilities represent how firms do things—the
processes they use. Priorities explain why firms allocate critical resources to achieve key objectives.

Resources

Resources provide the answer to the question, “What creates the firm’s strengths?” One definition states that,
“resources include all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc. controlled by
a firm that enables the firm to conceive of and implement strategies that improve its efficiency and effectiveness.” This
definition clearly identifies what could be a resource, but its scope makes it difficult to identify and limit what types of things
count as a resource. Resources are the “what” of competitive advantage.

Most resources are, or could be, counted and quantified on a firm’s balance sheet as assets. Accountants classify
resources as tangible or intangible assets. Tangible resources are those with physical presence, such as land, factories,
machinery, equipment, or cash. Intangible resources are economically valuable assets that “do not have physical presence,”
and include brands, licenses patents, knowledge, and reputation.

Four categories of resources are important contributors to competitive advantage:

1. Physical resources, such as plant or equipment

Capabilities

Capabilities are processes that the firm has developed to coordinate human activity in order to achieve specific
goals. Capabilities represent the “how” of competitive advantage. Competitive advantage relies on a strong set of operating
capabilities. A firm’s advantage becomes stronger if it develops dynamic capabilities, processes that are designed to
continuously expand existing resources or to improve or modify operating capabilities. Dynamic capabilities are practiced and
refined over time and through repetition. For example, Procter & Gamble (P&G) has many brand resources, such as Crest,
Tide, Pampers, Pantene, and Febreeze. But it also has been through the process of creating a new brand many times.
Through repetition, P&G has refined its capability to create new brands to the point that it now has a dynamic capability that
can help it expand its existing brand resources with new additions, such as the Olay Pro-X skin cleaning system.

Dynamic capabilities can help firms modify and evolve processes to keep pace with environmental changes such as
new competitors, shifting demographics, or emerging technologies. They can also enable firms to incorporate learning into
their processes.

Companies with strong dynamic capabilities have a more secure foundation for competitive advantage than those
without them, for two reasons. First, dynamic capabilities entail complex connections and coordination among different
internal units within the firm. For example, finding the optimal site for a restaurant requires input from marketing about demo-
graphic information and target customer segments; the corporate counsel about sales contracts and local regulations; and
real estate professionals skilled at identifying, negotiating, and closing on properties. These strong coordination processes
contribute to the competitive advantage of good restaurant locations.

Second, dynamic capabilities take time to develop and require significant learning. Processes or routines represent
deeply engrained habits of behavior that take years for companies to perfect. As firms and their managers master the ongoing
process of learning and adjusting in the face of competitor, customer, or market changes, they develop a formidable set of
dynamic capabilities.

CREATING A SUSTAINABLE COMPETITIVE ADVANTAGE: THE VRIO MODEL OF SUSTAINABILITY

Competitive advantages arise when resources or capabilities possess two attributes: Value and rarity. Two other
principles determine the durability, or sustainability, of competitive advantage: Inimitability, the characteristics that make a
resource or capability difficult to imitate, and an organization’s ability to exploit profit returns generated by its unique and
valuable resources. Together, these four characteristics—value, rarity, inimitability, and organization to exploit profits—are
often abbreviated as VRIO.

Value

Value denotes worth for customers. A resource creates value if its contributions allow a company to produce a
product or service that is of worth to end users. Products or services have value when they create direct pleasure,
satisfaction, or happiness for the end user, or when they create indirect opportunities for users to experience pleasure and
satisfaction. Users won’t pay for products or services unless they create value in their lives. In fact, a fundamental premise of
our economic system holds that the price someone will pay for a good depends on the value that good produces. The higher
the value, the higher the price that buyers are willing to pay.

Rarity

To be rare is to be uncommon, or not available to other competitors. Unique is often used as a synonym for rare.
Rare or unique resources create competitive advantage through a basic principle of economics—scarcity. When products or
services are scarce, users are often willing to pay a higher price for them than they would if the same products or services
were more commonly available, leading to higher company profits.

Inimitability

Inimitability is the extent to which competitors cannot easily reproduce a product by employing equal, or equivalent,
sources of value in their own products and services.

Path Dependence. Path dependence means that the process through which a resource or capability came into being
may make it difficult for competitors to imitate. Path dependence helps to block imitation when resources or
capabilities follow a sequential development path—for example, when previous investments enable later ones, or
when significant learning underlies the resource or capability.

Tacit Knowledge. For many processes, the actions needed to imitate the sequence can be codified, or written down,
and easily learned by others. Such easy-to-codify-and-learn knowledge is referred to as explicit knowledge. Tacit
knowledge is just the opposite. Many valuable skills and processes can’t be learned easily, if they can be learned at
all. These skills are difficult, maybe even impossible, to learn, teach, or coach, because they are based on tacit
knowledge. Tacit knowledge is sticky, or immobile, and difficult to imitate by competitors.
 Causal Ambiguity. Causality refers to the notion that one thing causes another: A leads to B. Sometimes, however,
the causal relationship is unclear or ambiguous, and the relation- ship between variable A and outcome B is difficult
to disentangle.

Complexity. Resources, capabilities, and priorities become difficult for competitors to imitate when they span the
organization or contain many interrelated elements and exhibit substantial complexity.

Time Compression Diseconomies. Diseconomies happen when an action increases, rather than decreases, cost and
inefficiency. Timing is crucial in the development or deployment of many resources, capabilities, or priorities and can
become a diseconomy in many cases.

Network Effects and First-Mover Advantages. Network effects represent a specific form of a first-mover advantage.
First movers establish a number of advantages. In addition to customers, they can lock up other resources such as
locations, patents, or scarce raw material inputs. They can also establish long-term contracts with customers and set
industry standards that favor their products. These actions make it difficult for rivals to profitably imitate the first
mover.

Organized to Exploit

A firm may employ valuable, rare, and difficult-to-imitate resources and yet still lack a sustainable competitive
advantage because the firm may not be organized to exploit or have the contracts and systems in place to capture the profits
that resources create.