Chapter 3: The Internal Organization

Chapter 3
The Internal Organization:
Resources, Capabilities, Core Competencies, and Competitive
Advantages

LEARNING OBJECTIVES

1. Explain why firms need to study and understand their internal organization.
2. Define value and discuss its importance.
3. Describe the differences between tangible and intangible resources.
4. Define capabilities and discuss their development.
5. Describe four criteria used to determine whether resources and capabilities are
core competencies.
6. Explain how firms analyze their value chain for the purpose of determining where
they are able to create value when using their resources, capabilities, and core
competencies.
7. Define outsourcing and discuss reasons for its use.
8. Discuss the importance of identifying internal strengths and weaknesses.
9. Discuss the importance of avoiding core rigidities.

CHAPTER OUTLINE

Opening Case: Data analytics, Large pharmaceutical companies, and core

competencies.
ANALYZING THE INTERNAL ORGANIZATION
The Context of Internal Analysis
Creating Value 
The Challenge of Analyzing the Internal Organization  
Resources, Capabilities, Core Competencies 
Strategic Focus Emphasis on Value Creation through Tangible (Kinder Morgan) and
Intangible (Coca-Cola Inc.) Resources 
Strategic Focus Superdry and its performance problems.
Building Core Competencies
Value Chain Analysis  
Outsourcing
Competencies, Strengths, Weaknesses, and Strategic Decisions  

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LECTURE NOTES

OPENING CASE
Big Pharma: The use of data analytics as a business strategy.

The idea of using data strategically remains somewhat novel in some organizations.
However, the reality of “big data” and “big data analytics” (which is “the process of
examining big data to uncover hidden patterns, unknown correlations and other useful
information that can be used to make better decisions”) is quickly changing this situation.
Large pharmaceutical companies are considering the possibility of trying to develop a
core competence in terms of BDA. Health care reform and the changing landscape of health
care delivery systems throughout the world are influencing these firms to think of
developing BDA as a core competence. Many benefits can accrue to big pharma firms
capable of forming BDA as a core competence including quickly identifying trial
candidates and accelerate their recruitment, developing improved inclusion and exclusion
criteria to use in clinical trials, and uncover unintended uses and indications for products.
In terms of customer functionality, superior products can be provided at a more rapid
pace as a foundation for helping patients live better and healthy lives.

*Note
Numerous firms such as Coca-Cola, McDonald’s, and Subway have implemented
value-creating strategies using their unique resources, capabilities, and core
competencies. In particular, they have developed unique capabilities related to the
management of their brands.
 The ultimate goal of such strategies is for the firms to achieve a sustainable
competitive advantage that will enable them to earn above-average returns.
 To achieve strategic competitiveness and earn above-average returns, firms must
leverage their core competencies to exploit opportunities in the external
environment.
 However, a competitive advantage does not always last, because value-creating
strategies may be successfully imitated or duplicated by competitors.

Several features of the global economy, such as technological changes, can result in the
erosion of the competitive advantage of established competitors. For example, the Internet is
undermining the competitive advantage of brick-and-mortar rivals.

Competitive advantages are often strongly related to the resources firms hold and how they
are managed. Resources are the foundation for strategy and these can generate competitive
advantages leading to wealth creation when they are bundled together uniquely.

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People are an especially critical resource for producing innovation and gaining a competitive
advantage. Even if they are not as critical in some industries, they are necessary for the
development and implementation of firms’ strategies.

The sustainability of a competitive advantage is a function of three factors:

 The obsolescence of a core competence - the basis of value creation - as a result of
environmental changes
 The availability of substitutes for the core competence (or the extent to which competitors
can use different core competencies to overcome value created by the original core
competence)
 The imitability of the core competence (or the abilities of competitors to develop the same
core competence)

To sustain a competitive advantage, firms must manage current core competencies while
simultaneously developing new competencies. In other words, strategists must continuously
make investments that will enhance the value of current competencies while striving to
develop new ones (discussed further in Chapter 5).

This chapter represents the next phase in the strategy development process: what a firm can
do. It is linked to the understanding that managers gain by assessing the external environment
to determine what the firm might do, or to identify opportunities that might be pursued.

*Note
It is important to stress that the outcomes of the external and internal analyses of a
firm's environment must be linked. Analyzing the external environment enables
strategists to identify opportunities that the firm can choose to pursue if it is capable
of doing so. This capability is determined by a careful analysis of the firm's internal
environment, or by determining whether or not it has the resources, capabilities, and
core competencies that will enable it to successfully implement value-creating
strategies that fit with its vision and mission (previously discussed in Chapter 1).

Explain the need for organizations to study and understand

1
their internal organization.

ANALYZING THE INTERNAL ORGANIZATION

The Context of Internal Analysis

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In the global economy, traditional factors such as labor costs, access to financial resources
and raw materials, and protected or regulated markets continue to be sources of competitive
advantage, but to a lesser degree (mostly because the advantages created by these more
traditional sources can be overcome by competitors through an international strategy and by
the flow of resources throughout the global economy).

Increasingly, those analyzing their firm’s internal environment should use a global mind-set
(i.e., the ability to study an internal environment in ways that are not dependent on the
assumptions of a single country, culture, or context).

Analysis of the firm’s internal environment requires that evaluators examine the firm’s
portfolio of resources and the bundles of heterogeneous resources and capabilities managers
have created. Understanding how to leverage the firm’s unique bundle of resources and
capabilities is a key outcome decision makers seek when analyzing the internal environment.

*Note
It might be appropriate at this point in the discussion to be reminded of the primary
differences between the I/O and resource-based models. The I/O model presumes that
resources and capabilities are distributed homogeneously among firms and freely
move between them; the primary determining factor is how firms react to changes in
the external environment. The resource-based model presumes a heterogeneous
distribution of resources and capabilities and assumes that they do not move freely
between firms.

By using or exploiting their core competencies, firms are in a position to develop and
perform value-creating strategies better than their competitors or to create and perform value-
creating strategies that competitors either are unable or unwilling to imitate.

*Note
Value represents a concept of the relationship between a product's features (such as
quality) and its price relative to those offered by competitors. As will be discussed in
Chapter 4, value can be provided by low cost, high differentiation of product features,
or a combination of low cost and differentiated features.

Figure Note
Relationships between the components of an internal strategic analysis - resources,
capabilities, and core competencies - and a sustainable competitive advantage and
strategic competitiveness are illustrated in Figure 3.1. This is a very helpful figure as
it ties together much of the material in the chapter.

FIGURE 3.1

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Components of Internal Analysis Leading to Competitive Advantage and Strategic

Competitiveness

As illustrated in Figure 3.1:

 A firm's tangible and intangible resources (for example, its facilities and corporate culture,
respectively) represent sources of capabilities
 These capabilities (teams or bundles of resources) represent sources of core competencies
 When exploited and nurtured (and valuable, costly to imitate, rare, and non-substitutable),
core competencies are potential sources of competitive advantage
 If a firm is able to use its core competencies to achieve a competitive advantage, it will
achieve strategic competitiveness and earn above-average returns so long as competitors
are unable or unwilling to imitate them successfully

*Note
The importance of a firm's internal characteristics - represented by its resources and
capabilities - highlights a shift in the priorities and prescriptions of strategic
management research. The field has evolved or developed from a position that
understanding industry characteristics and then positioning the firm to take advantage
of industry characteristics relative to competitors was of primary importance to
recognizing that it is a firm's resources and capabilities (which represent sources of
core competencies) that should serve as the foundation for firm strategy. This shift
recognizes that industry attractiveness is not dependent only on industry
characteristics. Industry attractiveness is ultimately determined by both industry
characteristics (which can be translated into opportunities and threats) or what a firm
might do and its internal strengths (its resources, capabilities, and core competencies)
which determine what a firm is capable of doing to take advantage of (or exploit)
external opportunities.

2 Define value and discuss its importance.

CREATING VALUE

Some thoughts on “value”:

 Firms create value by exploiting core competencies and meeting the standards of global
competition.
 Value is measured by the product’s performance and by its attributes for which customers
are willing to pay.

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 Firms must provide value to customers that is superior to the value provided by
competitors in order to create a competitive advantage.
 Customers perceive higher value in global rather than domestic-only brands.
 Firms create value by innovatively bundling and leveraging their resources and
capabilities.
 Ultimately, value is the foundation for earning above-average profits.
 Core competencies, combined with product-market positions, are the most important
sources of advantage.
 The core competencies of a firm, in addition to analysis of its general, industry, and
competitor environments, should drive its selection of strategies.

The Challenge of Analyzing the Internal Organization

Correctly identifying, developing, deploying, and protecting firm resources, capabilities, and
core competencies requires managers to make difficult decisions. In part, these challenges are
a result of characteristics of both the internal and external environments of the firm. This
challenge is multiplied because of three conditions that characterize important strategic
decisions - uncertainty, complexity, and intraorganizational conflict.

Figure Note: Suggest that students refer to Figure 3.2 during your discussion of the
three conditions that characterize important strategic decisions.

FIGURE 3.2
Conditions Affecting Managerial Decisions about Resources, Capabilities, and Core
Competencies

The conditions or decision characteristics presented in Figure 3.2 are:

 Uncertainty regarding the assessment of the general and industry environments,
assessments, and predictability of competitive actions, and customer preferences.
Strategic leaders need to be aware of how biases affect decisions about how to cope with
uncertainty and how to manage resources and capabilities to form core competencies.
 Complexity regarding the nature of any interrelatedness of the causes of change in the
environment and how the environments are perceived, especially regarding decisions as to
which of the firm’s resources and capabilities might serve as the foundation for
competitive advantage.
 Intraorganizational conflicts among managers making decisions about which core
competencies are to be nurtured and about how the nurturing should take place.

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*Note
The descriptions of uncertainty, complexity, and intraorganizational conflict (see
below) expand on the material presented in the text. This should help you explain
these concepts in greater depth, if you should choose to do so.

Uncertainty is present because of the inherent difficulty in identifying, assessing, and

predicting changes and trends in characteristics of the external environment. Among these
characteristics are correctly predicting the extent, direction, and timing of changes in the
general environment, such as those resulting from societal values, political and economic
conditions, customer preferences, and emerging technologies from other industries (and how
they might ultimately affect the firm).

Complexity is increased because of the uncertain nature of interrelationships among the

characteristics of the external environment and the related challenge regarding how to assess
the effects of changes in one set of characteristics on other characteristics. The issue becomes
more complex when managers must relate the complex external environment to their
assessment of the firm's internal environment and thus affects decisions regarding the firm's
resources, capabilities, and core competencies, and their relationship to opportunities in the
external environment that can be exploited successfully to achieve a competitive advantage.

Intra-organizational conflicts often develop as a result of uncertainty and complexity. When

managers make decisions regarding the identification of the firm's capabilities and choose to
nurture them (with resources) to develop core competencies that can be exploited to achieve
a competitive advantage, they must make these important decisions without absolute
certainty that the decision is correct. And, such decisions may result in changes or shifts in
power and interrelationships among individuals and groups within the firm. When this
occurs, there may be conflict as those who are affected adversely - or perceive that they will
be so affected - may resist these changes. In some cases, managers faced with decisions that
may have unpleasant consequences or are uncomfortable often experience denial, an
unconscious coping mechanism used to block out and not initiate major changes that may
have some pain associated with them.

Thus, managers that must make decisions under conditions of uncertainty, complexity, and
intraorganizational conflict must exercise judgment, a capacity for making a successful
decision in a timely manner when no correct model is available or when relevant data are
unreliable or incomplete.

When exercising judgment, decision makers often take intelligent risks. In the current
competitive landscape, executive judgment can be a particularly important source of
competitive advantage. One reason is that over time, effective judgment allows a firm to

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build a strong reputation and retain the loyalty of stakeholders whose support is linked to
above-average returns.

Significant changes in the value-creating potential of a firm’s resources and capabilities can
occur in a rapidly changing global economy. Because these changes affect a company’s
power and social structure, inertia or resistance to change may surface. Even though these
reactions may happen, decision makers should not deny the changes needed to assure the
firm’s strategic competitiveness. By denying the need for change, difficult experiences can
be avoided in the short run.

3 Describe the differences between tangible and intangible resources.

RESOURCES, CAPABILITIES, AND CORE COMPETENCIES

This section develops the background and relationships among resources, capabilities, and
core competencies that represent potential sources on which a firm can build the foundation
for a competitive advantage.

Resources

Resources represent inputs into a firm's production process, such as capital equipment, the
skills of individual employees, brand names, financial resources, and talented managers.

By themselves - or individually - resources generally will not enable a firm to achieve a

competitive advantage. They must be combined or integrated with other firm resources to
establish a capability. When these capabilities are identified and nurtured, they can result in
core competencies, which may lead to a competitive advantage. A firm's resources can be
classified either as tangible or intangible.

STRATEGIC FOCUS
Emphasis on Value Creation through Tangible (Kinder Morgan) and Intangible
(Coca-Cola Inc.) Resources

The Strategic Focus profiles two companies, Kinder Morgan and Coca-Cola, and
describes some of the ways in which they have used resources to create value for
customers. Kinder-Morgan’s focus is on tangible resources – pipe and pipeline networks,
storage terminals, liquid transportation assets, and financial assets (derived from creative
tax approaches to earnings distributions and cash). Coca-Cola has a number of both
tangible and intangible resources that it uses to create value. Intangible resources include

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a strong brand (based on well-managed image from marketing capabilities) that spans its
product line. Tangible resources include financial capabilities and massive storage tanks
that support its growing juice business and its advanced distribution system.

*Note
The point should be obvious that competitive advantage can be achieved through
a number of different means.

Tangible Resources

Tangible resources are assets that can be seen or quantified, such as a firm's physical assets
(e.g., its plant and equipment). Tangible resources are classified in one of four ways, as
illustrated in Table 3.1.

TABLE 3.1
Tangible Resources

A firm's tangible resources generally can be placed into one of four categories:
 Financial resources, such as borrowing capacity
 Organizational resources, such as its formal reporting structure and systems
 Physical resources, such as location
 Technological resources, such as patents and trademarks

*Note
One statement made in the chapter deserves special attention. Paraphrased slightly,
the authors declare that the value of tangible resources is constrained because they are
difficult to leverage: it is hard to derive more business or additional value from a
tangible resource. For example, an airplane is a tangible resource or asset, but it can
only be used on one route at a time, and it is equally impossible to put the same crew
on five different routes at the same time. This is also true for the financial investment
made in the airplane, but intangible assets such as a new innovation in manufacturing
processes can be applied to many assembly lines. These dynamics are considered
next.

Intangible Resources

A firm's intangible resources may be less visible, but they are no less important. In fact, they
may be more important as a source of core competencies. Intangible resources range from
innovation resources, such as knowledge, trust, and organizational routines, to the firm's

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people-dependent or subjective resources of know-how, networks, organizational culture, to

the firm's reputation for its goods and services and the way it interacts with others (such as
employees, suppliers, or customers).

*Note
It is interesting to note that tangible resources may be less valuable today than they
were in the past. To support this conclusion, economist John Kendrick has found that
intangible assets have contributed increasingly to US economic growth since the early
1900s. The ratio of intangible business capital to tangible business capital in 1929
was 30 percent to 70 percent, but that ratio was 63 percent to 37 percent in 1990.

Table Note
Three classifications of intangible resources are presented in Table 3.2.

TABLE 3.2
Intangible Resources

A firm's intangible resources can be classified as:

 Human resources, such as knowledge, trust, and managerial capabilities
 Innovation resources, such as scientific capabilities and capacity to innovate
 Reputational resources, such as the firm's reputation with customers or suppliers

Because tangible resources are those that can be seen (such as plants), touched (such as
equipment), documented (such as contracts with suppliers of raw materials), or quantified
(such as the value of a specific asset), they generally do not, by themselves, represent
capabilities that serve as sources of core competencies. However, they still have value and
will contribute to the development of capabilities and core competencies.

*Note
Resources are the source of firm capabilities, capabilities are the source of core
competencies, and core competencies are the foundation for achieving a competitive
advantage and strategic competitiveness.

Because they cannot be quantified, touched, or seen, and are more difficult to explain,
intangible resources are more likely to be sources of sustainable competitive advantage.
And, if they also are difficult for competitors to identify and/or understand, they also may
represent the most likely source(s) of a firm's capabilities, core competencies, and sustained
competitive advantage.

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The Value of Brands: A Mini-Lecture

One intangible resource that may enable a firm to create a reputation and serve as a
source of competitive advantage is a brand name. Specifically, what a brand name
communicates to customers about the performance characteristics or attributes of a
firm's product(s) represents a direct link to a firm's reputation with its customers.

When the brand name communicates positive characteristics of a product (for

example, superior performance, high quality, or superior value), consumers will tend
to purchase the brand name product rather than similar products offered by competing
firms. Thus, it is important that companies with strong brand names nurture the core
competencies that provide the brand name with value and continually communicate
that value through consistent advertising messages.

When a firm has a brand name that serves as a foundation for competitive advantage,
the firm often will try to leverage the power of that brand name. Using an example in
the chapter, Harley-Davidson's name now adorns a limited edition Barbie doll, a
popular restaurant in New York City, and a line of L’Oreal cologne. Moreover,
Harley-Davidson Motorclothes generates over $100 million in revenue for the firm
each year, and the Harley brand adorns many clothing items, from black leather
jackets to fashions for tots.

The value of a brand name can be lessened or reduced by competitive actions that the
firm either does not recognize or to which it fails to respond. In the consumer goods
segment, national brands are under attack by private label store brands. And some
appear to be losing the battle as customer preferences are shifting toward private labels
that may be perceived as providing more value than the national brands. In many
cases, national brands have reacted to such threats by cutting prices.

However, cost-cutting is not the only strategy that can be used to safeguard a brand.
 For companies whose brand names are expected to thrive and continue to provide a
competitive advantage (such as Nike or Hanes), their challenge is to nurture and
exploit the resources, capabilities, and core competencies that are the source of
competitive advantage.
 For companies whose brands are under fire (such as Marlboro or Budweiser), the
challenge is to re-establish the value of the brand. They must reconfigure their
existing bundle of resources, capabilities, and core competencies to renew them as
sources of competitive advantage.
 For companies whose brands are troubled, because the brands are no longer a

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source of competitive advantage, the challenge is even greater: they must identify
and develop new bundles of resources and capabilities and nurture them to establish
a new source of competitive advantage.
 Firms also may choose to package their brand as a way to differentiate themselves
from competitors, as Century 21 Real Estate has done by using technology to make
its offices virtual home stores by offering many discounted home services,
including cable service, appliances, insurance, and mortgages.
 Other firms (e.g., Procter & Gamble, General Motors, and Philip Morris) support
their brand-name products through heavy advertising expenditures.

Note: It is important to remember that resources - both tangible and intangible -

represent the primary sources that enable a firm to establish capabilities, the capacity
for a set or bundle of unique resources to perform a task or activity integratively. In
other words, individual resources alone, while they may have value, will contribute to
the development of capabilities only when they are put together in unique
combinations to provide the foundation for core competencies and the establishment
of competitive advantage. Examples include a firm’s information-based tangible
resources (Table 3.1) and/or its intangible resources (Table 3.2).

4 Define capabilities and discuss their development.

Capabilities

As implied in the definition, a firm’s capabilities represent its capacity to integrate individual
firm resources to achieve a desired objective, though this ability does not emerge overnight.

Capabilities develop over time as a result of complex interactions that take advantage of the
interrelationships between a firm’s tangible and intangible resources that are based on the
development, transmission, and exchange or sharing of information and knowledge as carried
out by the firm’s employees (its human capital).

A firm’s ability to achieve a competitive advantage is thus reflected in its knowledge base
and the ability of its human capital to successfully exploit firm capabilities. Thus, human
capital is of significant value in the firm’s ability to develop capabilities and core
competencies to achieve strategic competitiveness.

*Note

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As discussed in the chapter, the strategic value of resources is increased when they
are integrated or combined. Unique combinations of the firm’s tangible and intangible
resources can be molded into capabilities - what the firm can do when it deploys
teams of resources working together.

The knowledge possessed by the firm’s human capital may be one of the most significant
sources of a firm’s competitive advantage because it represents everything that the firm has
learned, and thus everything that it knows about successfully linking or bundling sets of
individual resources to develop capabilities as a foundation for developing core competencies
and, ultimately, to achieve a competitive advantage.

*Note
A number of firms have gone so far as to hire a Chief Learning Officer (CLO) to find
ways for the organization to acquire, internalize, and share knowledge in
competitively relevant ways. Managing knowledge is critical since enterprises view
this as their primary source of competitive advantage and believe it should be used in
ways that will create value for customers.

Establishing and nurturing the skills and abilities of the workforce is of critical importance to
a firm’s ability not only to establish, but to sustain a competitive advantage by acquiring new
knowledge and developing new skills that will enhance existing capabilities and core
competencies, as well as aid in the development of new ones.

*Note
Firms use a variety of methods to nurture the value of their human capital. For
example, Microsoft contends its best asset is the intellectual potential of its
employees. To support the trend, the firm strives to hire people who are more talented
than the current set of employees in hopes of defending and extending the domain of
its intellectual property. It is not uncommon for prospective employees to be asked
questions like, “Why are manhole covers round?” (The answer: A round cover cannot
fall into the hole no matter which way it is turned.) Such questions may seem silly,
but the goal is to identify people with powerful reasoning skills, and thus
(conceivably) the capacity to generate outstanding software solutions.

Firms also have functional area capabilities they have nurtured and are now considered as
core competencies. As a result, these core competencies provide the foundation for the firm’s
competitive advantage.

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Table Note: Table 3.3 illustrates the value-creating potential of functional areas for a
broad array of firms in a variety of industries. Rather than going over the table item
by item, students should be asked to discuss why a particular firm’s capabilities serve
as a source of competitive advantage. In other words, involve students in a discussion
of why one firm’s functional activity is being performed better than that of its
competitors. For example, ask students to compare and contrast the marketing
approaches of Procter & Gamble and Polo Ralph Lauren Company or the
manufacturing capabilities of Komatsu and Sony.

TABLE 3.3
Examples of Firms’ Capabilities

Table 3.3 provides examples of functional areas, capabilities, and firm examples across a
variety of industries. It indicates that a number of functional area capabilities have the
potential to serve as the foundation for a firm’s competitive advantage.

STRATEGIC FOCUS
Strengthening the Superdry Brand

British-based SuperGroup is the owner of Superdry and its carefully branded product
lines. The Superdry brand is at the heart of the business. The brand is targeted to
discerning customers who seek to purchase “stylish clothing that is uniquely designed
and well made.” Superdry is dealing with recent performance issues. In addition to upper-
management turnover, analysts believe SuperGroup expanded too quickly, without the
supporting infrastructure. Ask students to discuss how changes in management style
affect changes in the decision-making process. Ask students to discuss the changes that
were made to the Superdry brand including marketing approaches and adding product
lines.

Describe four criteria used to determine whether resources and

5
capabilities are core competencies.

Core Competencies

Once a firm has identified its resources and capabilities, it is ready to identify its core
competencies, the resources and capabilities that are a source of competitive advantage for
the firm over its competitors. Core competencies emerge over time through an organizational
process of accumulating and learning how to deploy different resources and capabilities. As
the capacity to take action, core competencies are the “crown jewels of a company,” the

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activities the company performs especially well compared with competitors and through
which the firm adds unique value to its goods or services over a long period.

*Note
Remember, resources and capabilities serve as the foundation on which firms
formulate and implement value-creating strategies so that the firm can achieve
strategic competitiveness and earn above-average returns. However, if a firm has a
deficiency in some of its resources, it may not be able to achieve strategic
competitiveness. For example, insufficient financial resources may prevent a firm
from implementing the processes or integrating the activities required to add superior
value by limiting its ability to hire workers with the necessary skills or to invest in the
capital assets (facilities and equipment) that are needed.

Thus, firms not only are challenged to scan the external environment to identify
opportunities that can be exploited, but also to have an in-depth understanding of their
resources and capabilities. This enables the firm to develop strategies to exploit
external opportunities while it also avoids competing in areas where the firm's
resources and capabilities are inadequate.

Not all of a firm’s resources and capabilities are strategic assets - that is, assets that have
competitive value and the potential to serve as a source of competitive advantage. Some
resources and capabilities may result in incompetence, because they represent competitive
areas in which the firm is weak compared to competitors. Thus, some resources or
capabilities may stifle or prevent the development of a core competence.

When the firm's resources and capabilities result in a core competence, the firm will be able
to produce goods or services with features and characteristics that are valued by customers.
This implies that firms can implement value-creating strategies only when its capabilities and
resources can be combined to form core competencies.
The question is asked: “How many core competencies are required for a competitive
advantage?” McKinsey & Company recommends that firms identify 3 or 4 competencies
around which to frame their strategic actions.

BUILDING CORE COMPETENCIES

This section discusses two conceptual tools/frameworks firms can use to identify competitive
advantages:
 Four criteria determine which of the firm’s resources and capabilities are core
competencies.

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 Value chain analysis, a tool for determining which value-creating competencies should be
maintained, upgraded, and developed and which should be outsourced.

Four Criteria for Sustainable Competitive Advantage

Four criteria should be used to determine whether or not a firm’s capabilities are core
competencies and can be a source of competitive advantage.

Table Note
Table 3.4 describes the four criteria for determining strategic capabilities. These
criteria are discussed in more detail following the table.

TABLE 3.4
The Four Criteria of Sustainable Strategic Capabilities

Before they can be sources of competitive advantage, capabilities must be:

 valuable  rare  costly-to-imitate  nonsubstitutable

It is important to understand that a firm’s capabilities must meet all four of the criteria noted
earlier before they can be core competencies and enable the firm to achieve a sustainable
competitive advantage.

However, a short-term competitive advantage is available when firm capabilities are

valuable, rare, and non-substitutable. The length of time that a firm possessing such
capabilities can expect to sustain a competitive advantage depends on how long it takes for
competitors to successfully imitate the value-creating activity or process, or reproduce valued
features or characteristics of the product or service.

Thus, the ability to sustain a competitive advantage is dependent on firm capabilities being
valuable, rare, non-substitutable, and costly to imitate.

Valuable

Capabilities that are valuable help a firm exploit opportunities and/or neutralize threats in the
external environment. Valuable capabilities allow a firm to develop and implement strategies
that create customer value.

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Rare

Capabilities are rare when they are possessed by few, if any, current or potential competitors.
If many firms have the same capabilities, the same value-creating strategies will be selected.
As a result, none of the firms will be able to achieve a sustainable competitive advantage. A
competitive advantage will be achieved by firms that develop and exploit capabilities that are
different from those held by other firms.

Costly to Imitate

Capabilities are costly to imitate when other firms are unable to develop them except at a cost
disadvantage relative to firms that already have them. This usually is a result of one or a
combination of three conditions:

1. Unique historical conditions can make duplication of capabilities costly. For example,
establishing facilities in a key location that can preempt competition when no other locations
have similar value-related characteristics or developing a unique organizational culture in the
early stages of the organization's life may not be cheap to duplicate by firms that are
developing theirs at a different time.

A unique culture may not only serve as a source of competitive advantage, but also can be a
source of competitive disadvantage. The latter may be the case when a firm's culture
prevents it from recognizing or successfully adapting to changes in a turbulent environment.

*Note
This may explain why such companies as IBM and General Motors, whose cultures
developed early in each company's history - and during relatively calm or stable
environments - were able to rely on formal controls and multiple approvals of
strategies and be successful. However, their respective cultures, grounded in rigidity
and bureaucracy, may have prevented them from successfully adapting to rapid
environmental change in a fast-paced global environment.

2. Causal ambiguity also may prevent competitors from perfectly imitating a competency if
the link between a firm's capabilities and core competencies is not identified or understood.
Competitors may not be able to identify or determine how a firm uses its competencies to
achieve a sustainable competitive advantage.

3. Social complexity means that a firm's capabilities are the product of complex social
phenomena such as interpersonal relationships within the firm (e.g., how managers and
subordinates at Hewlett-Packard work with each other) or a firm’s reputation with its
customers and suppliers.

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Nonsubstitutable

A firm's capabilities are nonsubstitutable when they do not have strategic equivalents. Firm
resources are strategically equivalent when each can be separately exploited to implement the
same strategies. If capabilities are invisible, it is even more difficult for competitors to
identify viable substitutes. Examples of capabilities that can be difficult to identify or to find
suitable substitutes include firm-specific knowledge and trust-based working relationships.

Table Note
Table 3.5 summarizes the relationship between the characteristics of firm capabilities,
sustainability of competitive advantage, and performance implications. Rather than
repeating the table in a lecture, students should be advised to refer to it as needed.

TABLE 3.5
Outcomes from Combinations of the Criteria for Sustainable Competitive Advantage

Highlights from Table 3.5 are:

 Resources and capabilities that are neither valuable, rare, costly to imitate, nor
nonsubstitutable mean that the firm will be at a competitive disadvantage and will earn
below-average returns.
 Resources and capabilities that are valuable, but are neither rare nor costly to imitate and
may or may not be nonsubstitutable mean that the firm can achieve competitive parity and
earn average returns.
 Resources and capabilities that are both valuable and rare, but are not costly to imitate and
may or may not be nonsubstitutable, may enable the firm to achieve a temporary
competitive advantage and will earn above-average to average returns.
 Resources and capabilities that are valuable, rare, costly to imitate, and nonsubstitutable
will enable the firm to achieve a sustainable competitive disadvantage and earn above-
average returns.

Explain how value-chain analysis is used to identify and

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evaluate resources and capabilities.

Value Chain Analysis

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A framework that firms can use to identify and evaluate the ways in which their resources
and capabilities can add value is value chain analysis. This framework is useful because it
enables firms to understand which parts of their operations or activities create value by
segmenting the value chain into primary and secondary activities as illustrated in Figure 3.3.

Figure Note
Students should refer to Figure 3.3 and Tables 3.6 and 3.7 during your explanation of
the value chain concept. Tables 3.6 and 3.7 develop the criteria for examining the
value-creating potential of the firm's primary and secondary activities, respectively,
after these terms are introduced in Figure 3.3.

FIGURE 3.3
A Model of the Value Chain

Figure 3.3 illustrates how the value-creating activities performed by the firm can be
separated into value chain activities and support functions.

Value chain activities represent traditional line activities such as supply chain management,
operations, distribution, marketing, and follow-up service.

Support functions are represented by a firm's staff activities and include its financial
infrastructure, human resource management practices, and management information systems
activities.

FIGURE 3.4
Creating Value Through Value Chain Activities

Figure 3.4 illustrates the link between the value chain activities and customer value. All areas
of the value chain can help firms deliver value to customers.

Supply-chain management consists of activities including sourcing, procurement,

conversion, and logistics management that are necessary for the firm to receive raw
materials and convert them into final products.

Operations consist of activities necessary to efficiently change raw materials into

finished products. Developing employees’ work schedules, designing production
processes and physical layout of the operations’ facilities, determining production
capacity needs, and selecting and maintaining production equipment are examples of
specific operations activities.

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Distribution consists of activities related to getting the final product to the customer.
Efficiently handling customers’ orders, choosing the optimal delivery channel, and
working with the finance support function to arrange for customers’ payments for
delivered goods are examples of these activities.

Marketing (including sales) consists of activities taken for the purpose of segmenting
target customers on the basis of their unique needs, satisfying customers’ needs, retaining
customers, and locating additional customers. Advertising campaigns, developing and
managing product brands, determining appropriate pricing strategies, and training and
supporting a sales force are specific examples of these activities.

Follow-up service consists of activities taken to increase a product’s value for customers.
Surveys to receive feedback about the customer’s satisfaction, offering technical support
after the sale, and fully complying with a product’s warranty are examples of these
activities.

FIGURE 3.5
Creating Value Through Support Functions

Figure 3.5 illustrates the link between the support functions a company performs and
customer value. All support functions can help firms deliver value to customers.

Finance consists of activities associated with effectively acquiring and managing

financial resources. Securing adequate financial capital, investing in organizational
functions in ways that will support the firm’s efforts to produce and distribute its products
in the short- and long-term, and managing relationships with those providing financial
capital to the firm are specific examples of these activities.

Human Resource consists of activities associated with managing the firm’s human
capital. Selecting, training, retaining, and compensating human resources in ways that
create a capability and hopefully a core competence are specific examples of these
activities.

Management Information Systems consist of activities taken to obtain and manage

information and knowledge throughout the firm. Identifying and utilizing sophisticated
technologies, determining optimal ways to collect and distribute knowledge, and linking
relevant information and knowledge to organizational functions are activities associated
with this support function.

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Using the value chain framework enables managers to study the firm’s resources and
capabilities in relationship to the primary and support activities performed to design,
manufacture, and distribute products, and to assess them relative to competitors’ capabilities.
For these activities to be sources of competitive advantage, a firm must be able to:
 Perform primary or support activities in a manner superior to the ways that competitors
perform them
 Perform a primary or support activity that no competitor is able to perform to create
superior value for customers and achieve a competitive advantage

This implies that, given that individual firms comprise unique or heterogeneous bundles of
activities, reconfiguring the value chain - or re-bundling resources and capabilities - may
enable a firm to develop unique value-creating activities.

The managerial challenge is that the value-creation process is difficult and there is no one
best way to assess a firm’s primary and support activities or to evaluate the value-creating
potential of those activities either within the firm or relative to competitors, because of
incomplete or ambiguous data.

By being objective, managers may be able to use the value chain framework to identify new,
unique ways to combine resources and capabilities to create value that are difficult for
competitors to recognize, understand, or imitate. The longer a firm is able to keep
competitors “in the dark” as to how resources and capabilities have been combined to create
value, the longer a firm will be able to sustain a competitive advantage.

Firms can use outsourcing as an alternative to identify primary or support activities for which
its resources and capabilities are not core competencies and do not enable the firm to add
superior value and achieve competitive advantage.

7 Define outsourcing and discuss the reasons for its use.

OUTSOURCING

Outsourcing describes a firm's decision to purchase a value-creating activity from an

external supplier. Outsourcing has become important - and may become more important in
the future - for two reasons:
 There are limits to the abilities of firms to possess all of the bundles of resources and
capabilities that are required to achieve superior performance (relative to competitors) in
all its primary and support activities.

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 With limited resources and capabilities, firms can increase their ability to develop
resources and capabilities to form core competencies and achieve competitive advantage
by nurturing a few core competencies.

Firms engaging in outsourcing can increase their flexibility, mitigate risks, and reduce their
capital investment.

*Note
When outsourcing, a firm seeks the greatest value. In other words, a company wants
to outsource only to firms possessing a core competence in terms of performing the
primary or support activity that is being outsourced.

Other research suggests that outsourcing does not work effectively without extensive internal
capabilities to coordinate external sourcing as well as core competencies.

To ensure that the appropriate primary and support activities are outsourced, four skills are
essential for managers involved in outsourcing programs:
 Strategic thinking – understanding whether/how outsourcing creates competitive
advantage within the company
 Deal making – ability to secure rights from external providers that can be fully used by
internal managers
 Partnership governance – ability to oversee and govern appropriately the relationship with
the company to which the services were outsourced
 Change management – because outsourcing can significantly change how an organization
operates, managers administering these programs must also be able to manage that change,
including resolving employee resistance that accompanies any significant change effort

*Note
Outsourcing can take several forms, depending on a firm's strategic objectives.
Examples of outsourcing strategies that, while different, enable outsourcing firms to
achieve their strategic objectives while changing the face of college campuses
include:
 Universities and colleges outsourcing the management of college bookstores to
Follett College Stores and Barnes & Noble
 Food Service management companies such as ARA and Marriott licensing with
Burger King to establish national chain restaurants on college campuses
 Colleges in the US contracting with private firms to manage or build on-campus
housing

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Discuss the importance of identifying internal strengths and

8, 9
weaknesses; Discuss the importance of avoiding core rigidities.

COMPETENCIES, STRENGTHS, WEAKNESSES, AND STRATEGIC DECISIONS

Tools such as outsourcing help the firm focus on its core competencies as the source of its
competitive advantages. However, evidence shows that the value-creating ability of core
competencies should never be taken for granted. Moreover, the ability of a core competence
to be a permanent competitive advantage can’t be assumed.

All core competencies have the potential to become core rigidities. As Leslie Wexner, CEO
of The Limited, Inc., says: “Success doesn’t beget success. Success begets failure because
the more that you know a thing works, the less likely you are to think that it won’t work.
When you’ve had a long string of victories, it’s harder to foresee your own vulnerabilities.”
Thus, each competence is a strength and a weakness - a strength because it is the source of
competitive advantage and, hence, strategic competitiveness, and a weakness because, if
emphasized when it is no longer competitively relevant, it can sow the seeds of
organizational inertia.

Events occurring in the firm’s external environment create conditions through which core
competencies can become core rigidities, generate inertia, and stifle innovation. According to
one observer, “Often the flip side, the dark side, of core capabilities is revealed due to
external events when new competitors figure out a better way to serve the firm’s customers,
when new technologies emerge, or when political or social events shift the ground
underneath.”

In the final analysis, changes in the external environment do not cause core competencies to
become core rigidities; rather, strategic myopia and inflexibility on the part of managers are
the cause. Thus, nurturing existing competencies must be balanced by efforts to encourage
the development of new competencies.

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