This chapter has covered a great deal of ground—I hope that you are not suffering from indigestion.
If you are feeling a little overwhelmed, not to worry: we shall be returning to the themes and issues raised in this chapter in the subsequent chapters of this book.
The key lessons from this chapter are:
◆ Strategy is a key ingredient of success both for individuals and organizations. A sound strategy cannot guarantee success, but it can improve the odds. Successful strategies tend to embody four elements: clear, long-term goals; profound understanding of the external environment; astute appraisal of internal resources and capabilities; and effective implementation.
◆ The above four elements form the primary components of strategy analysis: goals, industry analysis, analysis of resources and capabilities, and strategy implementation through the design of structures and systems.
◆ Strategy is no longer concerned with detailed planning based upon forecasts; it is increasingly about direction, identity, and exploiting the sources of superior profitability.
◆ To describe the strategy of a firm (or any other type of organization) we need to recognize where the firm is competing, how it is competing, and the direction in which it is developing.
◆ Developing a strategy for an organization requires a combination of purpose-led planning (rational design) and a flexible response to changing circumstances (emergence).
◆ The principles and tools of strategic management have been developed primarily for business enterprises; however, they are also applicable to the strategic management of not-for-profit organizations, especially those that inhabit competitive environments.
Our next stage is to delve further into the basic strategy framework shown in Figure 1.2. The elements of this framework—goals and values, the industry environment, resources and capabilities, and structure and systems—are the subjects of the five chapters that form Part II of the book.
We then deploy these tools to analyze the quest for competitive advantages in different industry contexts (Part III), and then in the development of corporate strategy (Part IV). Figure 1.8 shows the framework for the book.
Chapter 1 introduced a framework for strategy analysis that provides the structure for Part II of this book. This chapter has explored the first component of that framework—the goals, values, and performance of the firm.
We have explored in some depth the difficult, and still contentious, issue of the appropriate goals for the firm. While each firm has a specific business purpose, common to all firms is the desire, and the necessity, to create value. How that value is defined and measured distinguishes those who argue that the firms should operate primarily in the interests of owners (shareholders) from those who argue for a stakeholder approach. Our approach is pragmatic: shareholder and stakeholder
interests tend to converge and, where they diverge, the pressure of competition limits the scope for pursuing stakeholder interests at the expense of profit, hence my conclusion that long-run profit—or its equivalent, enterprise value—is appropriate both as an indicator of firm performance and as
a guide to strategy formulation. We explored the relationships between value, profit, and cash flow and saw how the failings of shareholder value maximization resulted more from its misapplication than from any inherent flaw.
The application of financial analysis to the assessment of firm performance is an essential component of strategic analysis. Financial analysis creates a basis for strategy formulation, first, by appraising overall firm performance and, second, by diagnosing the sources of unsatisfactory performance.
Combining financial analysis and strategic analysis allows us to establish performance targets for companies and their business units.
Finally, we looked beyond the limits of our useful, yet simplistic, profit-oriented approach to firm performance and business strategy. We looked, first, at how the principles of corporate social responsibility can be incorporated within a firm’s strategy to enhance its creation of both social and share-holder value. Second, we extended our analysis of value maximization to take account of the fact that strategy creates enterprise value not only by generating profit but also by creating real options.
In Chapter 1 we established that a profound understanding of the competitive environment is a critical ingredient of a successful strategy. Despite the vast number of external influences that affect every business enterprise, our focus is the firm’s industry environment which we analyze in order to evaluate the industry’s profit potential and to identify the sources of competitive advantage.
The centerpiece of our approach is Porter’s five forces of competition framework, which links the structure of an industry to the competitive intensity within it and to the profitability that it realizes.
The Porter framework offers a simple yet powerful organizing framework for identifying the relevant features of an industry’s structure and predicting their implications for competitive behavior.
The primary application for the Porter five forces framework is in predicting how changes in an industry’s structure are likely to affect its profitability. Once we understand the drivers of industry profitability, we can identify strategies through which a firm can improve industry attractiveness and position itself in relation to these different competitive forces.
As with most of the tools for strategy analysis that we shall consider in this book, the Porter five forces framework is easy to comprehend. However, real learning about industry analysis and about the Porter framework in particular derives from its application. It is only when we apply the Porter framework to analyzing competition and diagnosing the causes of high or low profitability in an industry that we are forced to confront the complexities and subtleties of the model. A key issue is
identifying the industry within which a firm competes and recognizing its boundaries. By employing the principles of substitutability and relevance, we can delineate meaningful industry boundaries.
Finally, our industry analysis allows us to make a first approach at identifying the sources of competitive advantage through recognizing key success factors in an industry.
I urge you to put the tools of industry analysis to work—not just in your strategic management coursework but also in interpreting everyday business events. The value of the Porter framework is as a practical tool—in helping us to understand the disparities in profitability between industries, whether an industry will sustain its profitability into the future, and which start-up companies have the best potential for making money. Through practical applications, you will also become aware
of the limitations of the Porter framework. In the next chapter we will see how we can extend our analysis of industry and competition.
The purpose of this chapter has been to go beyond the basic analysis of industry structure, competition, and profitability presented in Chapter 3 to consider the dynamics of competitive rivalry and the internal complexities of industries.
In terms of industry and competitive analysis, we have extended our strategy toolkit in several directions:
◆ We have recognized the potential for complementary products to add value and noted the importance of strategies that can exploit this source of value. Such complementary relationships are especially important in industries based upon digital technologies. Here complementarities between hardware and software and between operating systems and applications have given rise to platform-based competition and winner-takes-all markets. We shall explore these competitive dynamics further in Chapter 9.
◆ We have noted the importance of competitive interactions between close rivals and learned a structured approach to analyzing competitors and predicting their behavior. At a more sophisticated theoretical level, we have recognized how game theory offers insights into competition, bargaining, and the design of winning strategies.
◆ We examined the microstructure of industries and markets and the value of segmentation analysis and strategic group analysis in understanding industries at a more detailed level and in selecting an advantageous strategic position within an industry.
We have shifted the focus of our attention from the external environment of the firm to its internal environment. We have observed that internal resources and capabilities offer a sound basis for building strategy. Indeed, when a firm’s external environment is in a state of flux, internal strengths are likely to provide the primary basis upon which it can define its identity and its strategy.
In this chapter we have followed a systematic approach to identifying the resources and capabilities that an organization has access to and then have appraised these resources and capabilities in terms of their potential to offer a sustainable competitive advantage and, ultimately, to generate profit.
Having built a picture of an organization’s key resources and capabilities and having identified areas of strength and weakness, we can then devise strategies through which the organization can exploit its strengths and minimize its vulnerability to its weaknesses. Figure 5.10 summarizes the main stages of our analysis.
In the course of the chapter, we have encountered a number of theoretical concepts and relation-ships; however, the basic issues of resource and capability analysis are intensely practical. At its core, resource and capability analysis asks what is distinctive about a firm in terms of what it can do better than its competitors and what it cannot. This involves not only analysis of balance sheets, employee competencies, and benchmarking data, but also insight into the values, ambitions, and traditions of a company that shape its priorities and identity.
Strategy formulation and strategy implementation are closely interdependent. The formulation of strategy needs to take account of an organization’s capacity for implementation; at the same time, the implementation process inevitably involves creating strategy. If an organization’s strategic management process is to be effective then its strategic planning system must be linked to actions, commitments and their monitoring, and the allocation of resources. Hence, operational plans and capital expenditure budgets are critical components of a firm’s strategic management system.
Strategy implementation involves the entire design of the organization. By understanding the need to reconcile specialization with cooperation and coordination, we are able to appreciate the fundamental principles of organizational design.
Applying these principles, we can determine how best to allocate individuals to organizational units and how to combine these organizational units into broader groupings—in particular the choice between basic organizational forms such as functional, divisional, or matrix organizations.
We have also seen how company’s organizational structures have been changing in recent years, influenced both by the demands of their external environments and the opportunities made available by advances in information and communication technologies.
The chapters that follow will have more to say on the organizational structures and management systems appropriate to different strategies and different business contexts. In the final chapter (Chapter 16) we shall explore some of the new trends and new ideas that are reshaping our thinking about organizational design.
Making money in business requires establishing and sustaining competitive advantage.
Identifying opportunities for competitive advantage requires insight into the nature and process of competition within a market. Our analysis of the imperfections of the competitive process takes us back to the resources and capabilities needed to compete in a particular market and conditions under which these are available. Similarly, the isolating mechanisms that sustain competitive advantage are dependent primarily upon the ability of rivals to access the resources and capabilities needed for imitation.
Competitive advantage has two primary dimensions: cost advantage and differentiation advantage. The first of these, cost advantage, is the outcome of seven primary cost
drivers. We showed that by applying these cost drivers and by disaggregating the firm into a value chain of linked activities we can appraise a firm’s cost position relative to competitors and identify opportunities for cost reduction. The principal message of this section is the need to look behind cost accounting data and beyond simplistic approaches to cost efficiency, and to analyze the factors that drive relative unit costs in each of the firm’s activities in a systematic and comprehensive manner.
The appeal of differentiation is that it offers multiple opportunities for competitive advantage with a greater potential for sustainability than does cost advantage. The vast
realm of differentiation opportunity extends beyond marketing and design to encompass all aspects of a firm’s interactions with its customers. Achieving a differentiation advantage requires the firm to match its own capacity for creating uniqueness to the requirements and preferences of customers. The value chain offers firms a useful framework for identifying how they can create value for their customers by combining demand-side and supply-side sources of differentiation.
Finally, the basis of a firm’s competitive advantage has important implications not just for the design of its strategy but for the design of its organizational structure and systems. Typically, companies that are focused on cost leadership design their organizations differently from those that pursue differentiation. However, the implications of competitive strategy for organizational design are complicated by the fact that, for most firms, cost efficiency and differentiation are not mutually exclusive—in today’s
intensely competitive markets, firms have little choice but to pursue both.
A vital task of strategic management is to navigate the crosscurrents of change. But predicting and adapting to change are huge challenges for businesses and their leaders.
The life-cycle model allows us to understand the forces driving industry evolution and to anticipate their impact on industry structure and the basis of competitive advantage.
But, identifying regularities in the patterns of industry evolution is of little use if firms are unable to adapt to these changes. The challenge of adaptation is huge: the presence of organizational inertia means that industry evolution occurs more through the birth of new firms and the death of old ones rather than through adaptation by established firms. Even flexible, innovative companies experience problems in coping with new technologies—especially those that are “competence destroying,” “disruptive,” or embody “architectural innovation.”
Managing change requires managers to operate in two time zones: they must optimize for today while preparing the organization for the future. The concept of the ambidextrous organization is an approach to resolving this dilemma. Other tools for managing strategic change include: creating perceptions of crisis, establishing stretch targets, corporate-wide initiatives, recruiting external managerial talent, dynamic capabilities, and scenario planning.
Whatever approach or tools are adopted to manage change, strategic change requires building new capabilities. To the extent that an organization’s capabilities are a product of its entire history, building new capabilities is a formidable challenge. To understand how organizations build capability we need to understand how resources are integrated into capability—in particular, the role of processes, structure, motivation, and alignment. The complexities of capability development and our limited understanding of how capabilities are built point to the advantages of sequential approaches to developing capabilities.
Ultimately, capability building is about harnessing the knowledge which exists within the organization. For this purpose knowledge management offers considerable potential for increasing the effectiveness of capability development. In addition to specific techniques for identifying, retaining, sharing, and replicating knowledge, the knowledge-based view of the firm offers penetrating insights into the challenges of and potential for the creation and exploitation of knowledge by firms.
In the next two chapters, we discuss strategy formulation and strategy implementation in industries at different stages of their development: emerging industries, which are characterized by rapid change and technology-based competition, and mature industries.
In emerging and technology-based industries, nurturing and exploiting innovation is the fundamental source of competitive advantage and the focus of strategy formulation. Yet the fundamental strategic issues in these industries—the dynamics of competition, the role of the resources and capabilities in establishing competitive advantage, and the design of structures and systems to implement strategy—are ones we have already encountered and require us to apply our basic strategy toolkit.
Yet, the unpredictability and instability of these industries mean that strategic decisions in technology-driven industries have a very special character. The remarkable dynamics of these industries mean that the difference between massive value creation and total failure may be the result of small differences in timing or technological choices.
The speed and unpredictability of change in these markets means that sound strategic decision making can never guarantee success. Yet, managing effectively amidst such uncertainty is only possible with a strategy based upon understanding technological change and its implications for competitive advantage.
In this chapter I have distilled what we have learned in recent decades—about strategies to successfully manage innovation and technological change. The key lessons learned relate to:
◆ how the value created by innovation is shared among the different players in a market, including the roles of intellectual property, tacitness and complexity of the technology, lead time, and complementary resources;
◆ the design of innovation strategies, including whether to be an early mover or a follower; whether to exploit an innovation through licensing, an alliance, a joint venture, or internal development; and how to manage risk;
◆ competing for standards and platform leadership in markets subject to network externalities;
◆ how to implement strategies for innovation, including organizing to stimulate creativity, access innovation from outside, and developing new products.
Many of the themes we have dealt with—such as appropriating value from innovation and reconciling creativity with commercial discipline—are general issues in the strategic management of technology. Ultimately, however, the design and implementation of strategies in industries where innovation is a key success factor requires strategy to be closely tailored to the characteristics of technology, market demand, and industry structure. BCG’s list of the world’s most innovative companies includes among its top ten Apple, Samsung, Amazon, Toyota, and Facebook. While all these companies have been highly successful in using innovation to build competitive advantage, the strategies each has deployed have been closely tailored to their individual circumstances.
Mature industries present challenging environments for the formulation and implementation of business strategies. Competition—price competition in particular—is usually strong, and competitive advantage is often difficult to build and sustain: cost advantages are vulnerable to imitation; differentiation opportunities are limited by the trend to standardization.
Stable positions of competitive advantage in mature industries are traditionally associated with cost advantage from economies of scale or experience, with selecting the most attractive market segments and customers to serve, with creating differentiation advantage, and with pursuing technological and strategic innovation.
Implementing these strategies, especially those associated with rigorous cost efficiency, typically requires management systems based upon standardized processes and relentless performance management. However, as mature industries become increasingly complex and turbulent, so the pursuit of cost efficiency needs to be matched with flexibility, responsiveness, and innovation.
Companies such as Walmart, Coca-Cola, McDonald’s, Hyundai and UPS show remarkable capacity to reconcile vigorous cost efficiency with adaptability.
Declining industries present special challenges to companies: typically, they are associated with intense competition and low margins. However, such environments also present profitable opportunities for those firms that can orchestrate orderly decline from a position of leadership, establish a niche, or generate cash from harvesting assets.
The size and scope of firms reflects the relative efficiencies of markets and firms in organizing production. Over the past 200 years, the trend has been for firms to grow in size and scope as a result of technology and advances in management, causing the administrative costs of firms to fall relative to the transaction costs of markets.
In relation to vertical integration, the transaction costs of markets relative to the administrative costs of firms determine whether a vertically integrated firm is more efficient than specialist firms linked by market contracts. By considering the factors which determine the transaction costs of markets and the administrative costs of firms, we can determine whether a particular activity should be internalized within the firm or outsourced.
The dominant trend of the past three decades is for firms to outsource more and more of their activities and in the process become more vertically specialized. The dominant consideration has been to concentrate upon those activities where the firm possesses distinctive capabilities. However, this trend has involved the replacement of vertical integration, not by arm’s-length market contracts but by collaborative arrangements which combine the specialization benefits of outsourcing with the coordination and knowledge-sharing benefits of vertical integration.
In subsequent chapters we shall return to issues of vertical integration. In the next chapter we shall consider the offshoring phenomenon: firms seeking the optimal international location for different value chain activities. In Chapter 15 we shall look more closely at alliances—the collaborative relationships between firms that have become so typical of modern supply chains.
Moving from a national to an international business environment represents a quantum leap in complexity. In an international environment, a firm’s potential for competitive advantage is determined not just by its own resources and capabilities but also by the conditions of the national environment in which it operates: including input prices, exchange rates, and institutional and cultural factors. the extent to which a firm is positioned across multiple national markets also influences its economic power.
our approach in this chapter has been to simplify the complexities of international strategy by applying the same basic tools of strategy analysis that we developed in earlier chapters. For example, to determine whether a firm should enter an overseas market, our focus has been on the profit implications of such an entry. this requires an analysis of (a) the attractiveness of the overseas market using the familiar tools of industry analysis and (b) the potential of the firm to establish competitive advantage in that overseas market, which depends on the firm’s ability to transfer its resources and capabilities to the new location and their effectiveness in conferring competitive advantage.
However, establishing the potential for a firm to create value from internationalization is only a beginning. Subsequent analysis needs to design an international strategy: do we enter an overseas market by exporting, licensing, or direct investment? If the latter, should we set up a wholly owned subsidiary or a joint venture? once the strategy has been established, a suitable organizational structure needs to be designed.
that so many companies that have been outstandingly successful in their home market have failed so miserably in their overseas expansion demonstrates the complexity of international management. In some cases, companies have failed to recognize that the resources and capabilities that underpinned their competitive advantage in their home market could not be readily transferred or replicated in overseas markets. In others, the problems were in designing the structures and systems that could effectively implement the international strategy.
As the lessons of success and failure from international business become recognized and distilled into better theories and analytical frameworks, so we advance our understanding of how to design and implement strategies for competing globally. we are at the stage where we recognize the issues and the key determinants of competitive advantage in an international environment. However, there is much that we do not fully understand. Designing strategies and organizational structures that can reconcile critical tradeoffs between global scale economies versus local differentiation, decentralized learning and innovation versus worldwide diffusion and replication, and localized flexibilities versus international standardization remains a key challenge for senior managers.
Diversification is like sex: its attractions are obvious, often irresistible, yet the experience is often disappointing. For top management, it is a minefield. The diversification experiences of large corporations are littered with expensive mistakes: Exxon’s attempt to build Exxon Office Systems as a rival to Xerox and IBM; Vivendi’s diversification from water and environmental services into media, entertainment, and telecoms; Royal Bank of Scotland’s quest to transform itself from a retail bank into a financial services giant. Despite so many costly failures, the urge to diversify continues to captivate senior managers. Part of the problem is the divergence between managerial and shareholder goals.
While diversification has offered meager rewards to shareholders, it is the fastest route to building vast corporate empires. A further problem is hubris. A company’s success in one line of business tends to result in the top management team becoming overly confident of its ability to achieve similar success in other businesses.
Nevertheless, for companies to survive and prosper over the long term, they must change; inevitably, this involves redefining the businesses in which they operate. The world’s two largest IT companies—IBM and Hewlett-Packard—are both over six decades old. Their longevity is based on their ability to adapt their product lines to changing market opportunities. Essentially, they have applied existing capabilities to developing new products, which have provided new growth trajectories.
Similarly with most other long-established companies: for 3M, Canon, Samsung, and DuPont, diversification has been central to the process of evolution. In most cases, this diversification was not a major discontinuity but an initial incremental step in which existing resources and capabilities were deployed to exploit a perceived opportunity.
If companies are to use diversification as part of their long-term adaptation and avoid the many errors that corporate executives have made in the past then better strategic analysis of diversification decisions is essential. The objectives of diversification need to be clear and explicit. Shareholder value creation has provided a demanding and illuminating criterion with which to appraise investment in new business opportunities. Rigorous analysis also counters the tendency for diversification to be a diversion—corporate escapism resulting from the unwillingness of top management to come to terms with difficult conditions within the core business.
The analytic tools at our disposal for evaluating diversification decisions have developed greatly in recent years. In the late 1980s, diversification decisions were based on vague concepts of synergy that involved identifying linkages between different industries. We are now able to be much more precise about the need for economies of scope in resources and capabilities and the economies of internalization that are prerequisites for diversification to create shareholder value. Recognizing the role of these economies of internalization has directed attention to the role of top management capabilities and effective corporate management systems in determining the success of diversification.
While corporate strategies in the form of vertical integration, multinational expansion, and diversification have the potential to create value, ultimately, their success in doing so depends upon the effectiveness with which corporate strategy is implemented. This in turn depends upon the role of the corporate headquarters in managing companies that comprise multiple business units. We have identified four principal types of activity through which corporate management creates value within these companies:
◆ Managing the business portfolio: deciding which businesses and geographical markets the company should serve and allocating resources among these different businesses and markets.
◆ Managing linkages among businesses: exploiting opportunities for sharing resources and transferring capabilities comprises multiple activities ranging from the centralized provision of functions to best practices transfer. The key is to ensure that the potential gains from exploiting such economies of scope are not outweighed by the costs of managing the added complexity.
◆ Managing individual businesses: increasing the performance of individual businesses by enhancing the quality of their decision making, installing better managers, and creating incentives that drive superior performance.
◆ Managing change and development: although multibusinesses have the key advantage of not being captives of a single industry, exploiting this advantage means the processes, structures, and attitudes that foster new initiatives and create a willingness to let go of the past.
Finally, there is the contentious and perplexing issue of corporate governance. While broad agreement exists over the goal of corporate governance—ensuring that companies pursue long-term value maximization while taking account of the interest of multiple stakeholders—putting in place a system that achieves this goal remains elusive. Establishing corporate systems that are invulnerable to self-serving managers, short-term orientated shareholders, human greed and stupidity, and bureaucratic inertia represents a design challenge that is unlikely to be realized.
Mergers and acquisitions can be useful tools of several types of strategy: for acquiring particular resources and capabilities, for reinforcing a firm’s position within an industry, and for achieving diversification or horizontal expansion.
However, despite the plausibility of most of the stated goals that underlie mergers and acquisitions, most fail to achieve these goals. Empirical research shows that the gains flow primarily to the shareholders of the acquired companies.
These disappointing outcomes may reflect the tendency for mergers and acquisitions to be motivated by the desire for growth rather than for profitability. The pursuit of growth through merger is sometimes reinforced by CEO hubris, producing a succession of acquisitions that will ultimately lead to the company failing or restructuring.
A second factor in the poor performance consequences of many mergers are the unforeseen difficulties of post-merger integration. However, the diversity of mergers and their outcomes makes it very difficult to generalize about the types of merger or the approaches to integration that are associated with success.
Strategic alliances take many forms. In common is the desire to exploit complementarities between the resources and capabilities of different companies. Like mergers and acquisitions, and like relationships between individuals, they have varying degrees of success. Unlike mergers and acquisitions, the consequences of failure are usually less costly. As the business environment becomes more complex and more turbulent, the advantages of strategic alliances both in offering flexibility and in reconciling specialization with the ability to integrate a broad array of resources and capabilities become increasingly apparent.
The dynamism and unpredictability of today’s business environment presents difficult challenges for business leaders responsible for formulating and implementing their companies’ strategies. Not least, businesses need to compete at a higher level along a broader front.
In responding to these challenges, business leaders are supported by two developments. The first comprises emerging concepts and theories that offer both insight and the basis for new management tools. Key developments include complexity theory, the principles of self-organization, real option analysis, organizational identity, network analysis, and new thinking concerning innovation, knowledge management, and leadership.
A second area is the innovation and learning that results from adaptation and experimentation by companies. Long-established companies such as IBM and P&G have embraced open innovation; technology-based companies such as Google, W. L. Gore, Microsoft, and Facebook have introduced radically new approaches to project management, human resource management, and strategy formulation. In emerging-market countries we observe novel approaches to government involvement in business (China), new initiatives in managing integration in multibusiness corporations (Samsung), new approaches to managing ambidexterity (Infosys), and new forms of employee
engagement (Haier).
At the same time, it is important not to overemphasize either the obsolescence of existing principles or the need for radically new approaches to strategic management. Many of the features of today’s business environment are extensions of well-established trends rather than fundamental discontinuities. Certainly our strategy analysis will need to be adapted and augmented in order to take account of new circumstances; however, the basic tools of analysis—industry analysis, resource and capability analysis, the applications of economies of scope to corporate strategy decisions—remain relevant and robust. One of the most important lessons to draw from the major corporate failures that have scarred the 21st century— from Enron and WorldCom to Royal Bank of Scotland and Eastman Kodak—has been the realization that the rigorous application of the tools of strategy analysis outlined in this book might have helped these firms to avoid their misdirected odysseys.
