Business Strategy Notes Competitive Advantage III1 So far in this course, we have used a Porter-based view of strategy.

Under this view, a business should stake out a position for itself by selecting a target market and then arrange the organizations activities to deliver value to its target customers. For each activity in the firms value chain, the firm must decide how best to carry out the activity. When making those decisions, the firm faces trade-offs between willingness-to-pay and costs. The optimum choice is determined by the preferences of the target customer. As a result, different companies within an industry can sensibly do things differently, because they are pursuing different target markets. However, there are many companies that are very good at what they do; they enjoy a competitive advantage not so much because of the target market they selected, but because they have unique capabilities. Because of this, many strategists (such as Jay Barney) have advanced a resource-based view of strategy. Under this view, a companys competitive advantage comes from having something that competitors do not whether it be a competitive position the firm has staked out, or the capabilities the firm has.

Position Based Competitive Advantages2 In many cases, a firms competitive position can be attributed to a position that it occupies. Some examples are below: o Brand-name: If the firm has a brand-name that is well recognized and generates willingness-to-pay, then that firm clearly has an advantage. Coke and Pepsi, for example, both have significant advantages over rival cola companies because of their brands. o Reputation: A firm may also enjoy a reputation for quality products or for treating customers well. For example, Harry James (Melissa MacEacherns father) is in the business of repairing appliances, and enjoys a reputation for fair dealings with customers. Can you think of other examples? o Geographic: Being physically close to the customer can often be an advantage. For example, UPEI has an advantage in this respect over other universities for students who are from PEI particularly if they prefer going to university near their home. Meanwhile UNB has the geographic advantage for students from the Fredericton area. Wal-Mart has secured this type of advantage in many communities by being the first to set up discount stores in towns that are not large enough to support two discount stores. o Distribution channels: Large firms that sell consumer products usually have better access to retail shelves than their smaller competitors. For example, if Coke or Pepsi introduce a new drink, they can persuade

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By Don Wagner, UPEI, February 6, 2007. This material is drawn from Garth Saloner, Andrea Shepard and Joel Podolny, Strategic Management, John Wiley & Sons, Inc, New York, 2001, pages 43-46.

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retailers to carry their new product more effectively than other companies can. o Networks: Firms can have an advantage if their product is widely used and increases in value the more that other people use it. For example, when choosing between Microsofts Word versus Corrells WordPerfect, most customers choose Word simply because it is easier to share documents with others using that software. Can you think of other examples? o Gatekeepers: Some firms occupy a position that gives it a unique opportunity to influence potential customers. For example, due to the fact that most people use the Windows Operating System, Microsoft enjoys significant advantages in other software markets. In fact, those advantages helped Microsoft secure dominance in word-processing and in webbrowsers. Similarly, Google now has such an advantage. Wal-Mart does as well, given the high traffic it draws. Other examples? Many of the above positions are held by virtue of incumbency. That is, the firm has an advantage by having secured the position at some time in the past. We will address the issue of how durable those advantages are next week.

Capability Based Competitive Advantages3 There are many firms that owe their advantage to their capabilities. For example, Sony has a unique ability to design and efficiently manufacture high-quality compact electronic goods. Apple has a unique ability to develop products that are insanely great in the eyes of many consumers. Here in Charlottetown, Silverorange has a unique capability in designing appealing web-systems that are easily navigated. Do these firms simply have better engineers and programmers, or has strategy played a role in their success? If success were driven simply by doing activities better or more effectively, then the issue of capabilities would merely be an optimization problem; it wouldnt be strategy. The reality is that a firm must be selective over what capabilities it wishes to develop. Just as it is unrealistic to think you can effectively provide a single perfect product for all market segments, it is also unrealistic to think you can develop world-class capabilities in everything. Consequently, a firm should focus on developing capabilities based on how it wants to operate. To have superior capabilities, a firm certainly needs good managers and employees. But good people do not automatically create an effective organization. Even with good people, an organization must deal with two key organizational problems the coordination problem and the incentive problem.

The Coordination Problem One of the main reasons that firms exist at all is to coordinate activities. For example, building a car requires a tremendous amount of coordination, since each part must fit

This material is drawn from Garth Saloner, Andrea Shepard and Joel Podolny, Strategic Management, John Wiley & Sons, Inc, New York, 2001, pages 46-53 and 72-89.

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with the other parts. It is difficult to imagine that individual people each in business for themselves, and pricing their work in an open market, would be able to actually construct a car. There needs to be some centralized planning. Yet, coordination is a skill that frequently is executed poorly. The more complicated the task, and the more people involved, the harder it is to coordinate activities. There are many, many kinds of coordination problems, such as plant layouts and the delegation of responsibilities. Here, I highlight three particular problems: o Balancing gains from specialization and gains from integration: Many firms gain efficiencies by having their employees specialize in their tasks. The auto assembly line may well be the epitome of specialization. A person does the same thing repeatedly and ought to get very good at it. However, too much specialization prevents individuals from appreciating how their activities fit in with the firms other activities. Perhaps this problem might not matter for individuals inserting screws into an engine block, but many professionals do need to grasp the big picture to properly carry out their own activities. One example comes from my experiences as a tax accountant a professional giving tax advice needs to understand the business implications of any recommendations he/she makes. o How to design a decision-making process: When groups face a decision, group-members often disagree on how best to proceed. A firm must therefore have a system in place that designates who makes the decisions. In large organizations (and even in many small ones), no single person can actually make all the decisions. Consequently, firms must have some system in place that designates what kinds of decisions are assigned to each individual. Firms will differ on how much authority is delegated from senior management to middle management or line staff. At the organizations where you have worked, does senior management reserve for itself most decision-making authority, or does it allow others to make important decisions? Is your employers approach effective? What are the advantages of delegating down? Why would anyone not delegate authority? o How information flows: In large firms, no one person can know everything there is to know about the company. But to make effective decisions it is important that decision-makers get the information they need to make a sensible decision. Consequently, firms must coordinate information flow. In your workplace(s), do decision-makers get the information they need? If not, why not? It is important to note that solutions to coordination problems involve tradeoffs. There are advantages and disadvantages to specialization. There are advantages and disadvantages to centralized decision-making. How the company handles these issues depends heavily on how the firm has chosen to compete. We will see, for example, that Southwest Airlines has made decisions on these issues specifically as a consequence of (and a part of) its strategy.

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The Incentive Problem The other main organizational challenge is the incentive problem. Firms must deal with the reality that employees objectives are not perfectly aligned with the firms objectives. Employees may seek many things that are at odds with the firms objectives. Employees tend to pursue higher earnings, extra perks, prestige and power. For example, Michelins advertising agencies have tried to drop the chubby Michelin Man in favour of more creative ideas (that might bring recognition to the advertising agency). However, the chubby Michelin Man is very recognizable and may very well sell tires more effectively than an award-winning new advertising approach. Similarly, the motivation behind corporate takeovers is often suspect. Senior management ought to maximize the wealth of shareholders, but some takeovers appear to be motivated by a desire to expand the managements sphere of power. Incentive problems occur not only at the individual level, but at the subunit level as well. For example, a sales division may seek to optimize sales by selling at prices that do not optimize profits.

Making the Organization Effective We will address the following tools for affecting organizational effectiveness: o Organizational structure o Incentives o Methods and routines o Culture

Organizational Structure Organizational structure refers to how the firm is divided into units and subunits, the lines of authority and accountability, and the links between the various subunits. Organizational structure primarily addresses the coordination problem, but it also affects the incentive problem because this structure affects how managers are held accountable. Links between subunits can be formal or informal.

Formal Structures - Let us begin with the formal, hierarchal structure. The organizational structure has an enormous effect on the nature of coordination within a firm. Cooperation and coordination will almost always be strongest within an operating unit rather than across operating units. Consequently, the choice of an organization structure should consider where cooperation and coordination are most important to the firms objectives. - There are three basic forms of organization a functional organization, a product-line organization (a.k.a. a divisional organization), and a geographic organization. In addition, there are two main variations the matrix organizational structure and hybrid structures.

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Functional Structure - Functional structures divide the company into functions such as production, marketing, finance, R&D, etc. The structure looks as follows: CEO

VP Production

VP Marketing

VP Finance

VP Human Res

VP R&D

Under this structure, divisions cannot be treated as profit centres.

Product Structure - A product structure divides the company into product groups. For example, a food producer might divide its business as follows: CEO

VP Dairy

VP Produce

VP Canned Goods

VP Meat

VP Confection

Under this structure, product line divisions can be treated as profit centres. Divisions would then typically be subdivided further by function. For example, the dairy division might have subdivisions such as dairy production, dairy marketing, dairy finance, dairy R&D. What are some of the advantages of this structure over the functional structure? What are some of the disadvantages?

Geographical Structure - A geographical structure divides the company into geographical areas. For example, a company could be subdivided as follows:

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CEO

VP Canada

VP U.S.

VP Europe

VP Asia

VP Latin America

The company could then be subdivided further. For example, the European division might be subdivided into specific countries in which the company operates. These divisions would then be subdivided further along functional or product lines. Geographical divisions can be treated as profit centres.

Matrix Structure - A matrix structure uses two (or even three) of the above structures at the same time. - So, for example, there might be VPs of production, marketing, finance, R&D, Eastern Canadian operations, Central Canada operations and Western Canada operations. The manager in charge of production in Eastern Canada would report to BOTH the VP of production and the VP of Eastern Canada operations. CEO VP Production VP Marketing VP Finance Manager Fin. East VP HR

VP E. Canada

Manager Prodn East

Manager Mkg East

Manager HR East

VP Central Canada

Manager Prodn Cen

Manager Mkg Cen

Manager Fin. Cent

Manager HR Central

VP W. Canada -

Manager Prodn West

Manager Mkg West

Manager Fin. West

Manager HR West

The Boston Consulting Group devised this structure and persuaded many large corporations (such as Dutch Royal Shell) to adopt it. The structure was designed to promote communication and co-ordination across more than one dimension.

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Many companies have since abandoned this structure, especially when facing increased competition. Why do you think they did that?

Hybrid Structure - Many companies use some combination of the above structures. For example, it might generally use a geographical structure EXCEPT that the R&D and finance functions are not placed under the geographical divisions. - An example is as follows: CEO

VP Canada

VP U.S.

VP Europe

VP Finance

VP R&D

Informal Networks - The above structures are the official lines of responsibility. Cooperation between two employees (or business units) normally works best when both employees (or units) have the same supervisor. Why? - However, informal networks may make it possible for business units to work well together despite the fact that the units are far apart in the formal structure. - What can a company do to foster informal networks? Designing Incentives If you talk about change but dont change the reward and recognition system, nothing changes Paul Allaire, former CEO, Xerox Corporation If you want people motivated to do a good job, give them a good job to do. Frederick Herzberg Shareholders and senior managers cannot simply tell their subordinates what to do and then check whether they did it. Oftentimes, they need to structure their compensation schemes and reward systems to induce the desired behaviour.

Financial Incentives - Part of the compensation of many managers and some employees is performance based. Common examples include sales commissions for salespeople, stock options for managers, and profit-sharing schemes for employees. - What are some of the advantages and disadvantages of stock options?

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In some cases, a manager of a division will be compensated based on the profitability of his/her division. What are the advantages or disadvantages of this type of remuneration? Managers of functional areas (which are not profit centres) will often be remunerated based on some measurable statistics. As indicated above, sales managers may be compensated based on sales volume, R&D managers may receive compensation based on patents or successful products, etc. What are the disadvantages of these methods of incentive pay? There is a fundamental tension between incentives based on corporate-wide profits, and incentives based on the individuals personal measurable success. Incentives based on corporate-wide profits tend to promote co-operation amongst employees, but have little power on employees who believe their own actions do not significantly affect the firms profits. On the other hand, incentives based on the individuals personal measurable success will much more powerfully affect the individuals behaviour, but may interfere with cooperation. For example, a salesperson may be unwilling to help another salespersons important customer if that help involves sacrificing his/her own commissions.

Non-Financial Incentives - What are some effective non-financial incentives? Improving Methods and Routines Some ways of doing an activity are more efficient than others. Even if incentives worked perfectly, one cannot count on employees figuring out the most efficient ways of doing things. Firms can improve routines within their firms in a number of ways. o Time and motion studies: These have a long history. As we saw in the Airborne case, some firms continue to utilize these studies. Time and motion studies can only work for repetitive, documentable tasks. o More often, skills are learned on the job. New employees learn the routines from the experienced ones. How might a firm foster this type of learning within an organization? o Benchmarking is another useful way to discover better methods.

Corporate Culture Employees are also influenced by corporate culture. Many firms have a very pronounced philosophy of how they operate. Certain cultural traits are desirable in virtually all firms. These include: o A culture of ethical behaviour: Of course, moral behaviour is desirable for its own sake, but why is it important to the business to have a culture of ethical behaviour? o A culture of co-operation: Many large organizations are plagued by office politics where managers interfere with progress in an effort to protect their own power within the organization. o A spirit of high performance.

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Nevertheless, not all firms should have the same culture. Some aspects of culture are strategy-dependent. A conservative culture may suit a firm in a mature industry or an industry where mistakes can devastate the firm. A frugal culture may suit a firm pursuing a cost-leadership strategy, but not a firm using a premium product strategy. For example, Wal-Mart seeks to promote a culture that is people-friendly and that celebrates cheapness. Hewlett Packard seeks to promote cooperation between divisions by building a culture around The HP Way. How can management influence corporate culture?

APPENDIX SOME INTERESTING WTP/COST TRADEOFF DECISIONS (to discuss if time permits) Three Extra Inches at TWA In 1993, TWA was in deep trouble. The company was undergoing a Chapter 11 reorganization, employee morale was low, and consumers rated TWA as Americas worst airline. At this point Bob Cozzi, Senior VP Marketing, decided to remove 10-40 seats per plane and space out the remaining seats to give each economy class passenger an extra three inches of legroom. The airline spent $1 million to physically rearrange the seats, and $9 million to promote the changes. The move was enormously successful. Within 6 months, the airline catapulted to the top position in consumer ratings. Employee morale rose. (Why would extra legroom for passengers improve employee morale?) Average revenue per seat rose by 30%. The change in strategy increased willingness-to-pay substantially but increased costs only slightly. The extra leg-room affected willingness-to-pay to a large degree. Only six months after rearranging the seats TWA was rated the best airline, even though consumers still rated the airline below average in all major categories other than seating comfort. Willingness-to-pay is a tricky concept to understand in the airline industry because many of the passengers are business travelers, who do not pay for their own tickets. When a business sends an employee on a trip, several parties influence the buying decision. o Company policy: Senior management sets policies designed to keep down the cost of employee air travel. For example, most companies will not pay for first class or business class tickets (except for the most senior managers). Some firms specify which airlines should be flown. (Why would a firm impose that type of restriction?) Company policy might also require its employees to choose the lowest-cost flight, but that stipulation can be difficult to enforce because the cheapest flights may be very inconvenient (e.g. red-eye flights). o Passenger: The passenger has his/her own preferences and usually tries to exert some influence on which flight he/she will take. The passenger

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typically will try to optimize convenience and comfort. He/she may also prefer an airline with a frequent-flyer plan. o Executive Assistant: The actual booking is often done by a secretary or executive assistant, who has an interest in finding a comfortable arrangement for his/her boss.4 If corporate customers have a policy that their managers must take the lowest-cost fare, how does willingness-to-pay enter into the decision to choose one flight versus a competitors flight? The AIRLINES COST of having fewer seats on a plane depends enormously on whether the planes would otherwise be filled to capacity. If the flights are not full, the cost of having fewer seats is zero. If the flights are full, the cost equals the foregone revenues from fare-paying passengers. Most of TWAs flights were not full, so the change in strategy had a relatively low cost. Was TWAs change in seating space bad for its competitors?

Frequent Flyer Programs The airline has long been a tough industry even before the 9/11 terrorist attacks. Most of the time, the industry seems to be plagued by over-capacity. Before the introduction of frequent flyer programs, customers had low switching costs, making it hard for airlines to avoid price competition. In fact, shortly before the introduction of frequent flyer programs, several discount airlines had entered the industry. (Freddie Laker operated a discount airline between the U.S. and London, England, and People Express operated cheap flights within the U.S.) The frequent flyer program created switching costs, and thereby gave the industry some more scope to capture value. A good way to think about the economics of the frequent flyer program is to think about the costs of the program and its effect on willingness-to-pay. Aside from the costs of administering the program (i.e. record keeping, etc), the cost of the program is minimal. The program obligates the airline to carry some passengers for free occasionally. The cost of doing so depends once again on whether the free trip displaces a fare-paying trip. If it does not, the cost is approximately $25 the cost of snacks and some extra fuel. If the free trip does displace a fare-paying trip, the cost is the foregone fare. There are two ways that the free trip could displace a fare-paying trip. 1. The passenger flying on points might have made the trip even if he/she had to pay for it. However, in the absence of the frequent-flyer program the passenger would not necessarily have purchased the ticket from the same airline. Thus, the expected cost of giving a free trip to someone who would otherwise have paid to fly to that destination is:

It is possible that flights booked through an executive assistant tend to be more expensive than those booked directly by the passenger, because (1) the executive assistant is typically not responsible for meeting a budget and may pay less attention to cost than the passenger himself/herself, and (2) the executive assistant is normally given a time range during which the flight must occur, and will tend to stay within that time frame rather than entertaining cheaper flights at slightly less convenient times.

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(fare that would otherwise have applied for the flight) TIMES (probability the same airline would have been chosen for that trip) 2. The seat might otherwise have been sold to another passenger. Frequent-flyer programs have stipulations designed to avoid this possibility. Generally, only a limited number of seats are available to passengers cashing in their points. In addition, airlines will not allow points to be used on flights scheduled at peak periods. The airlines could make the frequent-flyer programs even more appealing to customers by allowing customers to sell their points to other people. Why doesnt some airline do that? The program clearly increases customers willingness-to-pay, particularly if the customer already has accumulated some points on the particular airlines plan. Note also that the program targets customers who typically have a high willingness to pay business travelers who fly frequently. The program may be less effective in cases where a passenger accumulates points on several airlines at the same time, or where the passenger has just cashed in his/her points. To counter that problem, most frequent flyer programs have some elite flyer programs that give additional perks to people who fly very frequently. American Airlines was the first airline to introduce a frequent flyer program, but the other major US airlines introduced their own programs within months. AAs innovation was very easy to imitate. Does this mean that American Airlines should not have introduced the program in the first place?

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