Evaluate a Company's Resources and Competitiveness

CHAPTER 4 Evaluating a Company’s Resources, Capabilities,
and Competitiveness
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Chapter 3 described how to use the tools of industry and
competitor analysis to assess a company’s external environment
and lay the groundwork for matching a company’s strategy to its
external situation.
Chapter 4 discusses techniques for evaluating a company’s
internal situation, including its collection of resources and
capabilities and the activities it performs along its value chain.
Internal analysis enables managers to determine whether their
strategy is likely to give the company a significant competitive
edge over rival firms. Combining internal and external analyses
facilitates an understanding of how to reposition a firm to take
advantage of new opportunities and to cope with emerging
competitive threats.
© McGraw-Hill Education
Chapter 4–‹#›
Learning Objectives
This chapter will help you understand:
How to evaluate how well a firm’s strategy is working.

How to assess the company’s strengths and weaknesses in light
of market opportunities and external threats.
Why a company’s resources and capabilities are critical in
gaining a competitive edge over rivals.
How value chain activities affect a company’s cost structure and
customer value proposition.
How a comprehensive evaluation of a firm’s competitive
situation can assist managers in making critical decisions about
their next strategic moves.
© McGraw-Hill Education.
In this chapter, the analytic spotlight will be trained on six
questions:
How well is the firm’s present strategy working?
What are the firm’s most important resources and capabilities,
and will they give the firm a lasting competitive advantage over
rival companies?
What are the firm’s strengths and weaknesses in relation to the
market opportunities and external threats?
How do a firm’s value chain activities impact its cost structure
and customer value proposition?
Is the firm competitively stronger or weaker than key rivals?
What strategic issues and problems merit front-burner
managerial attention?
In probing for answers to these questions, five analytic tools—
resource and capability analysis, SWOT analysis, value chain
analysis, benchmarking, and competitive strength assessment—
will be used.
All five are valuable techniques for revealing a firm’s
competitiveness and for helping managers match their strategy
to the firm’s particular circumstances.
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QUESTION 1: How Well Is the Company’s Present Strategy
Working?
The three best indicators of how well a company’s strategy is
working are:
Whether it is achieving its stated financial and strategic
objectives
Whether its financial performance is above the industry average
Whether it is gaining customers and gaining market share
Strategic success in a firm’s present competitive approach
requires asking:
Has the firm been successful actions in attracting customers and
improving its market position?
Has the firm gained a sustainable competitive advantage based
on low product costs or better product offerings?
Is the firm appropriately concentrating its resources on serving
a broad spectrum of customers or a narrow market niche?
Are the firm’s functional strategies in R&D, production,
marketing, finance, human resources, information technology
strengthening its competitive position?
Has the firm been successful in its efforts to establish alliances
with other enterprises?
Persistent shortfalls in meeting its performance targets and
weak marketplace performance relative to rivals are reliable
warning signs that the firm has a weak strategy, suffers from
poor strategy execution, or both.
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FIGURE 4.1 Identifying the Components of a Single-Business
Company’s Strategy
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FIGURE 4.1 Identifying the Components of a Single-Business
Company’s Strategy
Single business strategic action plan components include:
Moves to respond to changing conditions in the macro-
environment or in industry and competitive conditions
Basing competitive advantage on lower costs, better products,
superior service of a market niche or specific buyers
Expanding or narrowing geographic coverage
Partnering to build valuable partnerships and strategic alliances
with other enterprises in the same industry
Key functional strategies of the overall business strategy:
R&D, technology, product design; supply chain management;
production; sales, marketing, and distribution; information
technology; human resources; and finance.
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Specific Indicators of Strategic Success
Sales and earnings growth trends
Company’s overall financial strength
Customer retention rate
Stock price trends
Rate of new customers acquired
Evidence of improvement in internal processes
defect rate, order fulfillment, delivery times, days of inventory,
and employee productivity
Specific indicators of how well a firm’s strategy is working
include:

Trends in the company’s sales and earnings growth.
Trends in the company’s stock price.
The company’s overall financial strength.
The company’s customer retention rate.
The rate at which new customers are acquired.
Evidence of improvement in internal processes such as defect
rate, order fulfillment, delivery times, days of inventory, and
employee productivity.
Strategic Management Principle
Sluggish financial performance and second-rate market
accomplishments almost always signal weak strategy, weak
execution, or both.
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TABLE 4.1 Key Financial Ratios: How to Calculate Them
and What They Mean (1 of 8)Profitability RatiosHow
CalculatedWhat It ShowsGross profit marginSales revenues −
Cost of goods sold
Sales revenuesShows the percentage of revenues available to
cover operating expenses and yield a profit.Operating profit
margin (or return on sales)Sales revenues − Operating expenses
Sales revenues
or
Operating income
Sales revenuesShows the profitability of current operations
without regard to interest charges and income taxes. Earnings
before interest and taxes is known as EBIT in financial and
business accounting.Net profit margin (or net return on
sales)Profits after taxes
Sales revenuesShows after-tax profits per dollar of sales.Total
return on assetsProfits after taxes + Interest
Total assetsA measure of the return on total investment in the
enterprise. Interest is added to after-tax profits to form the
numerator, since total assets are financed by creditors as well as
by stockholders.

The stronger a company’s current overall performance, the more
likely it has a well-conceived, well-executed strategy. The
weaker a company’s financial performance and market standing,
the more its current strategy must be questioned and the more
likely the need for radical changes.
Table 4.1 provides a compilation of the profitability ratios most
commonly used to evaluate a company’s financial performance
and balance sheet strength.
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and What They Mean (2 of 8)Profitability RatiosHow
CalculatedWhat It ShowsNet return on total assets (ROA)Profits
after taxes
Total assets
A measure of the return earned by stockholders on the firm’s
total assets.Return on stockholders’ equity (ROE) Profits after
taxes
Total stockholders’ equityThe return stockholders are earning
on their capital investment in the enterprise. A return in the
12% to 15% range is average.Return on invested capital
(ROIC)—sometimes referred to as return on capital employed
(ROCE)
Profits after taxes
Long-term debt +
Total stockholders’ equityA measure of the return that
shareholders are earning on the monetary capital invested in the
enterprise. A higher return reflects greater bottom-line
effectiveness in the use of long-term capital.

Table 4.1 provides a compilation of the financial profitability
ratios most commonly used to evaluate a company’s financial
performance and balance sheet strength.
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and What They Mean (3 of 8)Liquidity RatiosHow
CalculatedWhat It ShowsCurrent ratio Current assets
Current liabilitiesShows a firm’s ability to pay current
liabilities using assets that can be converted to cash in the near
term. Ratio should be higher than 1.0.Working capitalCurrent
assets − Current liabilitiesThe cash available for a firm’s day-
to-day operations. Larger amounts mean the firm has more
internal funds to (1) pay its current liabilities on a timely basis
and (2) finance inventory expansion, additional accounts
receivable, and a larger base of operations without resorting to
borrowing or raising more equity capital.
Table 4.1 provides a compilation of the assets-to-liabilities
liquidity ratios most commonly used to evaluate a company’s
financial performance and balance sheet strength.
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and What They Mean (4 of 8)Leverage RatiosHow
CalculatedWhat It ShowsTotal debt-to-assets ratio Total debt
Total assets
Measures the extent to which borrowed funds (both short-term
loans and long-term debt) have been used to finance the firm’s
operations. A low ratio is better—a high fraction indicates
overuse of debt and greater risk of bankruptcy.Long-term debt-
to-capital ratio Long-term debt
Long-term debt +
Total stockholders’ equityA measure of creditworthiness and
balance-sheet strength. It indicates the percentage of capital
investment that has been financed by both long-term lenders and
stockholders. A ratio below 0.25 is preferable since the lower
the ratio, the greater the capacity to borrow additional funds.
Debt-to-capital ratios above 0.50 indicate an excessive reliance
on long-term borrowing, lower creditworthiness, and weak
balance- sheet strength.
Table 4.1 provides a compilation of the financial leverage ratios
most commonly used to evaluate a company’s financial
performance and balance sheet strength.
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and What They Mean (5 of 8)Leverage RatiosHow
CalculatedWhat It ShowsDebt-to-equity ratio Total debt
Total stockholders’ equityShows the balance between debt
(funds borrowed, both short term and long term) and the amount
that stockholders have invested in the enterprise. The further
the ratio is below 1.0, the greater the firm’s ability to borrow
additional funds. Ratios above 1.0 put creditors at greater risk,
signal weaker balance sheet strength, and often result in lower
credit ratings.Long-term debt-to-equity ratio Long-term debt
Total stockholders’ equityShows the balance between long-term
debt and stockholders’ equity in the firm’s long-term capital
structure. Low ratios indicate a greater capacity to borrow
additional funds if needed.Times-interest-earned (or coverage)
ratio Operating income
Interest expensesMeasures the ability to pay annual interest
charges. Lenders usually insist on a minimum ratio of 2.0, but
ratios above 3.0 signal increasing creditworthiness.
Table 4.1 provides a compilation of the debt-to-equity leverage
ratios and income-to-expenses coverage ratio most commonly
used to evaluate a company’s financial performance and balance
sheet strength.
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and What They Mean (6 of 8)Activity RatiosHow
CalculatedWhat It ShowsDays of inventory Inventory

Cost of goods sold ÷ 365Measures inventory management
efficiency. Fewer days of inventory are better.Inventory
turnoverCost of goods sold InventoryMeasures the number of
inventory turns per year. Higher is better.Average collection
periodAccounts receivable
Total sales ÷ 365
or
Accounts receivable
Average daily salesIndicates the average length of time the firm
must wait after making a sale to receive cash payment. A
shorter collection time is better.
Table 4.1 provides a compilation of the inventory and accounts
receivable collection activity ratios most commonly used to
evaluate a company’s financial performance and balance sheet
strength.
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and What They Mean (7 of 8)Other RatiosHow CalculatedWhat
It ShowsDividend yield on common stockAnnual dividends
per share
Current market price
per shareA measure of the return that shareholders receive in
the form of dividends. A “typical” dividend yield is 2% to 3%.
The dividend yield for fast-growth firms is often below 1%; the
dividend yield for slow-growth firms can run 4% to 5%.Price-

to-earnings (P/E) ratioCurrent market price
per share
Earnings per shareP/E ratios above 20 indicate strong investor
confidence in a firm’s outlook and earnings growth; firms
whose future earnings are at risk or likely to grow slowly
typically have ratios below 12.Dividend payout ratioAnnual
dividends
per share
Earnings per shareIndicates the percentage of after-tax profits
paid out as dividends.
Table 4.1 provides a compilation of dividend yield, price-to-
earnings, and dividend payout ratios most commonly used to
evaluate a company’s financial performance and balance sheet
strength.
Chapter 4–‹#›
and What They Mean (8 of 8)
Copyright ©McGraw-Hill Education. Permission required for
reproduction or display.Other RatiosHow CalculatedWhat It
ShowsInternal cash flowAfter-tax profits + DepreciationA rough
estimate of the cash a firm’s business is generating after
payment of operating expenses, interest, and taxes. Such
amounts can be used for dividend payments or funding capital
expenditures.Free cash flowAfter-tax profits + Depreciation –
Capital expenditures – Dividends
A rough estimate of the cash a firm’s business is generating

after payment of operating expenses, interest, taxes, dividends,
and desirable reinvestments in the business. The larger a firm’s
free cash flow, the greater its ability to internally fund new
strategic initiatives, repay debt, make new acquisitions,
repurchase shares of stock, or increase dividend payments.
Table 4.1 provides a compilation of cash flow ratios most
commonly used to evaluate a company’s financial performance
and balance sheet strength.
Chapter 4–‹#›
QUESTION 2: What Are the Company’s Strengths and
Weaknesses in Relation to the Market Opportunities and
External Threats?
SWOT analysis is a tool for identifying situational reasons
underlying a firm’s performance.
Internal strengths (the basis for strategy)
Internal weaknesses (deficient capabilities)
Market opportunities (strategic objectives)
External threats (strategic defenses)
SWOT can help explain why a strategy is working well (or not)
by taking a close look a company's strengths in relation to its
weaknesses and in relation to the strengths and weaknesses of
competitors. Are the firm’s strengths enough to make up for its
weaknesses? Has the firm’s strategy built on these strengths

and shielded the firm from its weaknesses? Do the firm's
strengths exceed those of its rivals? Similarly, a SWOT
analysis can help determine whether a strategy has been
effective in fending off external threats and positioning the firm
to take advantage of market opportunities.
SWOT analysis is a widely used diagnostic tool popular for its
ease of use, also because it can be used to evaluate the efficacy
of a strategy and as the basis for crafting a strategy from the
outset to determine whether the firm is positioned to pursue new
market opportunities and to defend against emerging threats to
its future well-being.
Connect Activity
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Chapter 4–‹#›
Identifying a Company’s Internal Strengths
A competence is an activity that a firm has learned to perform
with proficiency and at an acceptable cost—a true capability, in
other words.
A core competence is an activity that a firm performs
proficiently and that is also central to its strategy and
competitive success.
A distinctive competence is a competitively important activity
that a firm performs better than its rivals—it represents a
competitively superior internal strength.

A firm’s strengths represent its competitive assets. Basing a
firm’s strategy on its most competitively valuable strengths
gives the firm its best chance for market success. When a
company’s proficiency rises from that of mere ability to
perform an activity to the point of being able to perform it
consistently well and at acceptable cost, it is said to have a
competence—a true capability, in other words. If a firm’s
competence level in some activity domain is superior to that of
its rivals it is known as a distinctive competence. A core
competence is a proficiently performed internal activity that is
central to a firm’s strategy and is typically distinctive as well.
A core competence is a more competitively valuable strength
than a competence because of the activity’s key role in the
firm’s strategy and the contribution it makes to the firm’s
market success and profitability
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Identifying a Company’s Internal Weaknesses
A weakness
Is something a firm lacks or does poorly (in comparison to
others) or a condition that puts it at a competitive disadvantage
in the marketplace
Types of weaknesses
Inferior or unproven skills, expertise, or intellectual capital in
competitively important areas of the business
Deficiencies in physical, organizational, or intangible assets
A firm’s weaknesses are shortcomings that constitute
competitive liabilities, weakness, or competitive deficiency, and
is something a firm lacks or does poorly (in comparison to
others) or a condition that puts it at a competitive disadvantage
in the marketplace. A firm’s internal weaknesses can relate to

(1) inferior or unproven skills, expertise, capabilities, or
intellectual capital in competitively important areas of the
business; (2) deficiencies in competitively important physical,
organizational, or intangible assets.
Chapter 4–‹#›
Identifying a Company’s Market Opportunities
Characteristics of market opportunities
Newly emerging and fast-changing markets may represent
“golden opportunities” but are often hidden in “fog of the
future.”
Opportunities can evolve in mature markets.
Opportunities with market factors aligned with the firm’s
strengths offer the most potential for the firm to gain
competitive advantage.
Depending on the prevailing circumstances, a firm’s
opportunities can be plentiful or scarce, fleeting or lasting, and
can range from wildly attractive to marginally interesting to
unsuitable. A firm is well advised to pass on a particular market
opportunity unless it has or can acquire the competencies
needed to capture it.
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Identifying External Threats
Types of threats
Normal course-of-business
Sudden-death (survival)
Considering threats
Identify threats to the firm’s future prospects
Evaluate strategic actions to be taken to neutralize or lessen

impact
Simply making lists of a firm’s strengths, weaknesses,
opportunities, and threats is not enough. The payoff from
SWOT analysis comes from the conclusions about a firm’s
situation and the implications for strategy improvement that
flow from the four lists.
Chapter 4–‹#›
TABLE 4.2 What to Look for in Identifying a Company’s
Strengths, Weaknesses, Opportunities, and Threats (1 of
4)Strengths and Competitive AssetsWeaknesses and
Competitive DeficienciesAmple financial resources to grow the
businessNo distinctive core competenciesStrong brand-name
image or company reputationLack of attention to customer
needsCost advantages over rivalsWeak balance sheet, too much
debtAttractive customer baseHigher costs than
competitorsProprietary technology, superior technological
skills, important patentsToo narrow a product line relative to
rivalsStrong bargaining power over suppliers or buyersWeak
brand image or reputation
Table 4.2-1 lists many of the things to consider in compiling a
company’s strengths and weaknesses. Sizing up a company’s
complement of strengths and deficiencies is akin to constructing
a strategic balance sheet, where strengths represent competitive
assets and weaknesses represent competitive liabilities. Ideally,
the company’s competitive assets should outweigh its
competitive liabilities by an ample margin.

Chapter 4–‹#›
4)Strengths and Competitive Assets (continued)Weaknesses and
Competitive Deficiencies (continued)Superior product
qualityLack of adequate distribution capabilityWide geographic
coverage or strong global distribution capabilityLack of
management depthAlliances or joint ventures that provide
access to valuable technology competencies, or attractive
geographic marketsA plague of internal operating problems or
obsolete facilities
Too much underutilized plan capacity
Table 4.2-2 lists many of the things to consider in compiling a
company’s strengths and weaknesses. Sizing up a company’s
complement of strengths and deficiencies is akin to constructing
a strategic balance sheet, where strengths represent competitive
assets and weaknesses represent competitive liabilities. Ideally,
the company’s competitive assets should outweigh its
competitive liabilities by an ample margin.
Chapter 4–‹#›
4)Market OpportunitiesExternal ThreatsMeet sharply rising
buyer demand for the industry’s productIncreasing intensity of
competitionServe additional customer groups or market
segmentsSlowdowns in market growthExpand into new
geographic marketsLikely entry of potent new
competitionsExpand the company’s product line to meet a
broader range of customer needsGrowing bargaining power of

customers or suppliersEnter new product lines or new
businessesA shift in buyer needs and tastes away from the
industry’s productTake advantage of failing trade barriers in
attractive foreign marketsAdverse demographic changes that
threaten to curtail demand for the industry’s product
Table 4.2-3 displays a sampling of potential threats and market
opportunities. Sizing up a company’s complement of strengths
and deficiencies is akin to constructing a strategic balance
sheet, where strengths represent competitive assets and
weaknesses represent competitive liabilities. Ideally, the
company’s competitive assets should outweigh its competitive
liabilities by an ample margin.
Chapter 4–‹#›
4)Market Opportunities (continued)External Threats
(continued)Take advantage of an adverse change in the fortunes
of rival firmsAdverse economic conditions that threaten critical
suppliers or distributorsAcquire rival firms or companies with
attractive technological expertise or competenciesChanges in
technology—particularly disruptive technology that can
undermine the company’s distinctive competenciesTake
advantage of emerging technological developments to innovate
Enter into alliances or other cooperative venturesRestrictive
foreign trade policies
Costly new regulatory requirements
Tight credit conditions
Rising prices on energy or other key inputs

Table 4.2-4 displays a sampling of potential threats and market
opportunities. Sizing up a company’s complement of strengths
and deficiencies is akin to constructing a strategic balance
sheet, where strengths represent competitive assets and
weaknesses represent competitive liabilities. Ideally, the
company’s competitive assets should outweigh its competitive
liabilities by an ample margin.
Chapter 4–‹#›
What Do SWOT Listings Reveal?
New strategy
SWOT is the foundation for positioning the firm to use its
strengths to seize opportunities and to shore up its competitive
deficiencies to mitigate external threats.
Existing strategy
SWOT insights into the firm’s overall business situation can
translate into recommended strategic actions.
The SWOT analysis process involves more than making four
lists. In crafting a new strategy, it offers a strong foundation
for understanding how to position the firm to build on its
strengths in seizing new business opportunities and how to
mitigate external threats by shoring up its competitive
deficiencies. In assessing the effectiveness of an existing
strategy, it can be used to glean insights regarding the firm's
overall business situation (thus the name Situational Analysis);
and it can help translate these insights into recommended
strategic actions.
Chapter 4–‹#›

FIGURE 4.2 The Steps Involved in SWOT Analysis: Identify
the Four Components of SWOT, Draw Conclusions, Translate
Implications into Strategic Actions
Figure 4.2 shows the steps involved in gleaning insights from
SWOT analysis.
Chapter 4–‹#›
QUESTION 3: What Are the Company’s Most Important
Resources and Capabilities, and Will They Give the Company a
Lasting Competitive Advantage?
Competitive assets
Resources and capabilities
They determine competitiveness and the ability to succeed in
the marketplace.
A firm’s strategy depends on these to develop sustainable
competitive advantage over its rivals.
A firm’s resources and capabilities are its competitive assets
and they determine whether its competitive power in the
marketplace will be impressively strong or disappointingly
weak. Companies with second-rate competitive assets nearly
always are relegated to a trailing position in the industry.
Connect Activity
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Chapter 4–‹#›
Identifying the Company’s
Resources and Capabilities
A resource
A productive input or competitive asset that is owned or
controlled by a firm (e.g., a fleet of oil tankers)
A capability
The capacity of a firm to perform some activity proficiently
(e.g., superior skills in marketing)
A resource is a competitive asset that is owned or controlled by
a firm.
A capability or competence is the capacity of a firm to perform
an internal activity competently through deployment of a firm’s
resources.
A firm’s resources and capabilities represent its competitive
assets and are determinants of its competitiveness and ability to
succeed in the marketplace.
Resource and capability analysis is a powerful tool for sizing up
a firm’s competitive assets and determining if they can support
a sustainable competitive advantage over market rivals.
Chapter 4–‹#›
TABLE 4.3 Types of Company Resources (1 of 2)Tangible
resourcesPhysical resources: land and real estate; manufacturing
plants, equipment, or distribution facilities; the locations of
stores, plants, or distribution centers, including the overall
pattern of their physical locations; ownership of or access rights
to natural resources (such as mineral deposits)Financial
resources: cash and cash equivalents; marketable securities;

other financial assets such as a company’s credit rating and
borrowing capacityTechnological assets: patents, copyrights,
production technology, innovation technologies, technological
processesOrganizational resources: IT and communication
systems (satellites, servers, workstations, etc.); other planning,
coordination, and control systems; the company’s organizational
design and reporting structure
Tangible resources are the most easily identified, because
tangible resources are those that can be touched or quantified
readily. Obviously, they include various types of physical
resources such as manufacturing facilities and mineral
resources, but they also include a company’s financial
resources, technological resources, and organizational resources
such as the company’s communication and control systems.
Technological resources are included among tangible resources,
by convention, even though some types, such as copyrights and
trade secrets, might be more logically categorized as intangible.
Chapter 4–‹#›
TABLE 4.3 Types of Company Resources (2 of 2)
Copyright McGraw-Hill Education. Permission required for
reproduction or display.Intangible resourcesHuman assets and
intellectual capital: the education, experience, knowledge, and
talent of the workforce, cumulative learning, and tacit
knowledge of employees; collective learning embedded in the
organization, the intellectual capital and know-how of
specialized teams and work groups; the knowledge of key
personnel concerning important business functions; managerial
talent and leadership skill; the creativity and innovativeness of
certain personnelBrands, company image, and reputational
assets: brand names, trademarks, product or company image,
buyer loyalty and goodwill; company reputation for quality,

service, and reliability; reputation with suppliers and partners
for fair dealingRelationships: alliances, joint ventures, or
partnerships that provide access to technologies, specialized
know-how, or geographic markets; networks of dealers or
distributors; the trust established with various partnersCompany
culture and incentive system: the norms of behavior, business
principles, and ingrained beliefs within the company; the
attachment of personnel to the company’s ideals; the
compensation system and the motivation level of company
personnel
Intangible resources are harder to discern, but they are often
among the most important of a firm’s competitive assets. They
include various sorts of human assets and intellectual capital
(skills and knowledge), as well as its brands, image, and
reputational assets. While intangible resources have no material
existence on their own, they are often embodied in something
material.
It is important to remember that it is not exactly how a resource
is categorized that matters, rather, that all of the firm’s
different types of resources are included in the inventory.
The real purpose of using categories in identifying a firm’s
resources is to ensure that none of a firm’s resources go
unnoticed when sizing up its competitive assets
Chapter 4–‹#›
Identifying Capabilities
An organizational capability
Is the intangible but observable capacity of a firm to perform a
critical activity proficiently using a related combination (cross-
functional bundle) of its resources
Is knowledge-based, residing in people and in a firm’s

intellectual capital or in its organizational processes and
systems, embodying tacit knowledge
A resource bundle
Is a linked and closely integrated set of competitive assets
centered around one or more cross-functional capabilities
Organizational capabilities are more complex entities than
resources; indeed, they are built up through the use of resources
and draw on some combination of the firm’s resources as they
are exercised.
Two approaches to identifying a firm’s capabilities:
A complete listing of resources the firm has accumulated
considering whether (and to what extent the firm has built up
any related capabilities through their use).
A functional approach that identifies capabilities related to
specific functions that draw on a limited set of resources
involving a single department or organizational unit and cross-
functional capabilities that are multidimensional—they spring
from effective collaboration among people with different types
of expertise working in different organizational units.
Chapter 4–‹#›
Assessing the Competitive Power of a Company’s Resources
and Capabilities
The Total Economic Value produced by a firm is equal to V-C.
It is the difference between the buyer's perceived value (V)
regarding a product or service and what it costs (C) the firm to
produce it.
Competitively superior resources and capabilities are strategic
assets capable of producing a sustainable competitive advantage
with far greater profit potential.

A competitive advantage means that you can produce more
value (V) for the customer than rivals can, or the same value at
lower cost (C). In other words, your V-C is greater than the V-
C of competitors. V-C is what we call the Total Economic Value
produced by a company.
Chapter 4–‹#›
VRIN: Four Tests of a Resource’s
Competitive Power
The VRIN Test for sustainable competitive advantage asks if a
resource or capability is Valuable, Rare, Inimitable, and Non-
substitutable.
V: Is the resource (or capability) competitively valuable?
R: Is it rare—is it something rivals lack?
I: Is it hard to copy (inimitable)?
N: Is it invulnerable to the threat of substitution of different
types of resources and capabilities (non-substitutable)?
The competitive power of a resource or capability is measured
by how many of four specific tests it can pass. These tests are
referred to as the VRIN tests for sustainable competitive
advantage—VRIN is a shorthand reminder standing for
Valuable, Rare, Inimitable, and Nonsubstitutable. The first two
tests determine whether a resource or capability can support a
competitive advantage. The last two determine whether the
competitive advantage can be sustained. Resources can
contribute to a sustainable competitive advantage only when
resource substitutes aren’t on the horizon.

Chapter 4–‹#›
Social Complexity and Causal Ambiguity
Two factors that inhibit the ability of rivals to imitate a firm’s
most valuable resources and capabilities.
Social complexity refers to factors in a firm’s culture, the
interpersonal relationships among managers or R&D teams, its
trust-based relations with customers or suppliers that contribute
to its competitive advantage.
Causal ambiguity about the how the firm uses its resources and
relationships puts competitors at a loss in understanding how to
imitate these complex resources.
Social complexity and causal ambiguity are two factors that
inhibit the ability of rivals to imitate a firm’s most valuable
resources and capabilities. Causal ambiguity makes it very hard
to figure out how a complex resource contributes to competitive
advantage and, therefore, exactly what to imitate.
Chapter 4–‹#›
Managing Resources and Capabilities Dynamically
Threats to resources and capabilities
Rivals develop better substitutes over time.
Current capabilities decay from benign neglect.
Disruptive changes in the competitive environment.
Manage capabilities dynamically
Attend to the ongoing modification of existing competitive
assets.
Take advantage of opportunities to develop totally new kinds of
capabilities.

Rivals that are initially unable to replicate a key resource may
develop better and better substitutes over time. Resources and
capabilities can depreciate like other assets if they are managed
with benign neglect. Disruptive changes in technology,
customer preferences, distribution channels, or other
competitive factors can also destroy the value of key strategic
assets. Rivals that are initially unable to replicate a key
resource may develop better and better substitutes over time.
Resources and capabilities can depreciate like other assets if
they are managed with benign neglect. Disruptive changes in
technology, customer preferences, distribution channels, or
other competitive factors can also destroy the value of key
strategic assets.
Chapter 4–‹#›
The Role of Dynamic Capabilities
To sustain its competitiveness and help drive improvements in
its performance, a firm requires a dynamically evolving
portfolio of resources and capabilities.
A dynamic capability is the ongoing capacity of a firm to
modify its existing resources and capabilities or create new
ones.
Improve on existing resources and capabilities incrementally.
Add new resources and capabilities to the firm’s competitive
asset portfolio.
Companies that know the importance of recalibrating and
upgrading their most valuable resources and capabilities ensure
that these activities are done on a continual basis. By
incorporating these activities into their routine managerial

functions, they gain the experience necessary to be able to do
them consistently well. At that point, their ability to freshen and
renew their competitive assets becomes a capability in itself—a
dynamic capability.
Chapter 4–‹#›
QUESTION 4: How Do Value Chain Activities Impact a
Company’s Cost Structure and Its Customer Value Proposition?
Signs of a firm’s competitive strength
Its prices and costs are in line with rivals.
Its customer-value proposition is competitive and cost effective.
Its bundled capabilities are yielding a sustainable competitive
advantage.
The higher a firm’s costs are above those of close rivals, the
more competitively vulnerable it becomes. Conversely, the
greater the amount of customer value that a firm can offer
profitably relative to close rivals, the less competitively
vulnerable the firm becomes.
Chapter 4–‹#›
The Concept of a Company Value Chain
The value chain
Identifies the primary activities and related support activities
that create customer value
Identifies the inner workings of the firm's customer value
proposition and business model
Permits a deep look at the firm’s cost structure and its ability to
profitably offer low prices
Reveals the emphasis that a firm places on activities that

enhance differentiation and support higher prices
Every firm’s business consists of a collection of activities
undertaken in the course of producing, marketing, delivering,
and supporting its product or service.
All the various activities that a firm performs internally
combine to form a value chain—so called because the
underlying intent of a firm’s activities is
ultimately to create value for buyers.
Chapter 4–‹#›
FIGURE 4.3 A Representative Company Value Chain
Source: Based on the discussion in Michael E. Porter,
Competitive Advantage (New York: Free Press, 1985), pp. 37-
43.
As shown in Figure 4.3, a company’s value chain consists of
two broad categories of activities: the primary activities
foremost in creating value for customers and the requisite
support activities that facilitate and enhance the performance of
the primary activities. The kinds of primary and secondary
activities that constitute a company’s value chain vary
according to the specifics of a company’s business; hence, the
listing of the primary and support activities in Figure 4.3 is
illustrative rather than definitive.
Chapter 4–‹#›

Comparing Value Chains of Rival Companies
Value chain analysis
Facilitates a comparison, activity-by-activity, of how
effectively and efficiently a firm delivers value to its customers,
relative to its competitors
The value chain analysis process
Segregates a firm’s operations into different types of primary
and secondary activities to identify major components of its
internal cost structure
Uses activity-based costing to evaluate activities
Same for significant competitors
Value chain analysis facilitates a comparison of how rivals,
activity by activity, deliver value to customers. Even rivals in
the same industry may differ significantly in terms of the
activities they perform. How each activity is performed may
affect a company’s relative cost position as well as its capacity
for differentiation. Thus, even a simple comparison of how the
activities of rivals’ value chains differ can reveal competitive
differences.
Chapter 4–‹#›
The Value Chain System
An industry value chain includes
Internal value chain
Value chains of upstream industry suppliers
Value chains of forward channel intermediaries
Effects of the industry value chain
Costs and profit margins of suppliers and channel partners can
affect prices to end consumers.
Activities of channel partners can affect industry sales volumes
and customer satisfaction.

A company’s value chain is embedded in a larger system of
activities that includes the value chains of its suppliers and the
value chains of whatever wholesale distributors and retailers it
utilizes in getting its product or service to end users. This value
chain system (sometimes called a vertical chain) has
implications that extend far beyond the company’s costs.
A firm’s cost competitiveness depends not only on the costs of
internally performed activities (its own value chain) but also on
costs in the value chains of its suppliers and distribution
channel allies.
Chapter 4–‹#›
FIGURE 4.4 A Representative Value Chain System
Source: Based in part on the single-industry value chain display
in Michael E. Porter, Competitive Advantage (New York: Free
Press, 1985), p. 35.
A typical value chain system that incorporates the value chains
of suppliers and forward-channel allies (if any) is shown in
Figure 4.4. As was the case with company value chains, the
specific activities constituting value chain systems vary
significantly from industry to industry.
Chapter 4–‹#›

Illustration Capsule 4.1 The Value Chain for Boll & Branch
Source: Adapted from Christina Brinkley, “What Goes into the
Price of Luxury Sheets?” The Wall Street Journal, March 29,
2014,
www.wsj.com/articles/SB1000014240527023037254045794619
53672838672 (accessed February 16, 2016).
Illustration Capsule 4.1 shows representative costs for various
external and internal value chain activities performed by Boll &
Branch, a maker of luxury linens and bedding sold directly to
consumers online.
Chapter 4–‹#›
The Value Chain for Boll & Branch
Which activities in the value chain are primary activities?
Which are secondary activities?
Which activities are linked to the value chain for the entire
industry?
Where in the industry activity chain could Boll & Branch
possibly reduce cost(s) without reducing its competitive
strength?
A company’s primary and secondary activities identify the
major components of its internal cost structure. The combined
costs of all the various primary and support activities
constituting a company’s value chain define its internal cost

structure. Evaluating a company’s internal and external cost-
competitiveness involves using what accountants call activity-
based costing to determine the costs of performing each value
chain activity.
Chapter 4–‹#›
Benchmarking: Assessing the Cost and Effectiveness of Value
Chain Activities
Benchmarking
Involves improving internal activities based on learning from
other companies’ “best practices”
Assesses whether the cost competitiveness and effectiveness of
a company’s value chain activities are in line with its
competitors’ activities
Sources of benchmarking information
Market data reports from consulting companies and market
analysts, publications of industry trade groups and government
agencies, and customers
Visits to benchmark firms
Benchmarking is a potent tool for improving a firm’s own
internal activities that is based on learning how firms perform
them and borrowing their “best practices.” The comparison is
often made between companies in the same industry, but
benchmarking can also involve comparing how activities are
done by companies in other industries.
Benchmarking the costs of a firm's activities against those of
rivals provides hard evidence of whether the firm is cost-
competitive.

Chapter 4–‹#›
Illustration Capsule 4.2 Benchmarking in the Solar Industry
What benchmarks does the solar industry use in comparing costs
among industry competitors?
How has SunPower responded to the continued downward
pricing pressure in the industry?
Why is the collection of competitive intelligence to accurately
benchmark delivered costs of such importance in the solar
industry?
As competition grows, benchmarking plays an increasingly
critical role in assessing a solar company’s relative costs and
price positioning compared to other firms. This is often
measured using the all-in installation and production costs per
kilowatt hour generated by a solar asset, called the “Levelized
Cost of Energy” (LCOE). Kilowatt hours are the units of
electricity that are sold to consumers.
SunPower’s quarterly earnings calls highlighted efforts to
compete on benchmark prices by simplifying its company
structure; divesting from non-core assets; and diversifying
beyond the low-cost, large-scale utility solar market and into
residential and commercial solar – where it could compete more
easily on price.
For solar to play a major role in U.S. power generation, costs
must keep falling. As solar companies race towards lower costs,
benchmarking will continue to be a core strategic tool in
determining pricing and market positioning.
Connect Activity
Consider adding a File Attachment assignment requiring the
student to develop a graphic showing the elements of Delivered
Cost in the Cement Industry and CEMEX in particular. Have the

student include details on the costs of each element relative to
industry averages as well as a discussion of how the analysis
informs competitive advantage. You can post instructions for
the student within the assignment and collect their attachments
for grading.
Chapter 4–‹#›
Strategic Options for Remedying a Cost or Value Disadvantage
Areas in the total value chain system assess ways to improve
efficiency and effectiveness.
Internal activity segments
Suppliers’ part of the value chain system
Forward-channel portion of the value chain system
There are three main areas in a company’s total value chain
system where company managers can try to improve its
efficiency and effectiveness in delivering customer value: (1) a
company’s own internal activities, (2) suppliers’ part of the
value chain system, and (3) the forward-channel portion of the
value chain system.
Chapter 4–‹#›
Improving Internally Performed
Value Chain Activities
Implement best practices throughout the firm, particularly for
high-value activities.
Redesign products, components and activities to facilitate
speedier and more economical manufacture or assembly.
Relocate high-cost activities to external value chains to be
performed more cheaply by vendors or contractors.

Reallocate resources to activities that address buyers’ most
important purchase criteria.
Adopt productivity-enhancing, cost-saving technological
improvements that spur innovation, improve design, and
enhance creativity.
Strategic approaches to reducing internally performed value
chain activity costs that will improve a firm’s cost-
competitiveness by:
Implementing best practices throughout the firm, particularly
for high-cost activities.
Redesigning the product and/or some of its components to
eliminate high-cost components or facilitate speedier and more
economical manufacture or assembly.
Relocating high-cost activities (such as manufacturing) to
geographic areas where they can be performed more cheaply or
outsource activities to lower-cost vendors or contractors.
Adopting technologies that spur innovation, improve design,
and enhance creativity.
Chapter 4–‹#›
Improving Supplier-Related
Value Chain Activities
Pressure suppliers for lower prices.
Switch to lower-priced substitute inputs.
Collaborate closely with suppliers to identify mutual cost-
saving opportunities.
Work with suppliers to enhance the firm’s differentiation.
Select and retain suppliers who meet higher-quality standards.
Coordinate with suppliers to enhance design or other features
desired by customers.
Provide incentives to suppliers to meet higher-quality standards,

and assist suppliers in their efforts to improve.
Supplier-related cost disadvantages can be attacked by
pressuring suppliers for lower prices, switching to lower-priced
substitute inputs, and collaborating closely with suppliers to
identify mutual cost-saving opportunities.
A firm can enhance its customer value proposition through its
supplier relationship by selecting and retaining suppliers that
meet higher-quality standards, providing quality-based
incentives to suppliers, and integrating suppliers into the design
process.
Chapter 4–‹#›
Improving Value Chain Activities of
Distribution Partners
Achieving cost-based competitiveness
Pressure forward-channel allies to reduce their costs and
markups.
Collaborate with forward-channel allies to identify win-win
opportunities to reduce costs.
Change to a more economical distribution strategy, including
switching to cheaper distribution channels.
Any of three means can be used to achieve better cost-
competitiveness in the forward portion of the industry value
chain:
Pressure distributors, dealers, and other forward-channel allies
to reduce their costs and markups.
Collaborate with forward channel intermediaries to identify

win–win opportunities to reduce costs
Change to a more economical distribution strategy, including
switching to cheaper distribution channels (selling direct via the
Internet) or integrating forward into company-owned retail
outlets.
Chapter 4–‹#›
Enhancing Differentiation Through Activities at the Forward
End of the Value Chain System
Engage in cooperative advertising and promotions with forward-
channel allies.
Use exclusive arrangements with downstream sellers or other
mechanisms that increase their incentives to enhance delivered
customer value.
Create and enforce standards for downstream activities and
assist in training channel partners in business practices.
The means to enhancing differentiation through activities at the
forward end of the value chain system include (1) engaging in
cooperative advertising and promotions
with forward allies (dealers, distributors, retailers, etc.), (2)
creating exclusive arrangements with downstream sellers or
utilizing other mechanisms that increase their incentives to
enhance delivered customer value, and (3) creating and
enforcing standards for downstream activities and assisting in
training channel partners in business practices.
Performing value chain activities with capabilities that permit
the firm to either outmatch rivals on differentiation or beat them
on costs will give the firm a competitive advantage.
Chapter 4–‹#›

Translating Proficient Performance of Value Chain Activities
into Competitive AdvantageOption 1: Beat rivals by creating
more customer value from value chain activities, for a
differentiation-based competitive advantage1. Managers decide
to perform value chain activities in ways that drive
improvements in quality, features, performance, and other
differentiation-enhancing aspects.2. Competencies gradually
emerge in performing value chain activities that drive
improvements in quality, features, and performance.3.
Company proficiency in performing some of these
differentiation-enhancing activities rises to the level of a core
competence.4. Company proficiency in performing the core
competence continues to build and evolves into a distinctive
competence.5. Company gains a competitive advantage based
on superior differentiation capabilities.
A company that does a first-rate job of managing its activities
of its value chain relative to competitors stands a good chance
of profiting from its competitive advantage. A company’s
external value-creating activities in its value can offer a
Chapter 4–‹#›
Translating Proficient Value Chain Activity Performance into
Competitive AdvantageOption 2: Beat rivals by conducting
value chain activities more efficiently, for a cost-based
competitive advantage1. Company managers decide to perform
value chain activities in the most cost-efficient manner.2.
Competencies gradually emerge in driving down the cost
of value chain activities (such as production, inventory
management, etc.).3. Company capabilities in performing

certain value chain activities more efficiently rise to the level of
a core competence.4. Company proficiency in performing
the core competence continues to build and evolves into a
distinctive competence.5. Company gains a competitive
advantage based on superior differentiation capabilities.
A company that does a first-rate job of managing its activities
of its value chain relative to competitors stands a good chance
of profiting from its competitive advantage. A company’s
external value-creating activities in its value can offer a
Chapter 4–‹#›
QUESTION 5: Is the Company Competitively Stronger or
Weaker Than Key Rivals?
Assessing overall competitive strength
How does the firm rank relative to competitors on each of the
important factors that determine market success?
Does the firm have a net competitive advantage or disadvantage
versus major competitors?
Using resource analysis, value chain analysis, and
benchmarking to determine a company’s competitiveness on
value and cost is necessary but not sufficient. A more
comprehensive assessment needs to be made of the firm’s
overall competitive strength. The answers to two questions are
of particular interest: First, how does the
firm rank relative to competitors on each of the important
factors that determine market success? Second, all things

considered, does the firm have a net competitive advantage or
disadvantage versus major competitors?
Strategic Management Principles
High-weighted competitive strength ratings signal a strong
competitive position and possession of competitive advantage;
low ratings signal a weak position and competitive
disadvantage.
Chapter 4–‹#›
Steps in the Competitive Strength
Assessment Process
Make a list of the industry’s key success factors and measures
of competitive strength or weakness.
Assign weights to each competitive strength measure based on
its perceived importance.
Score competitors on each competitive strength measure and
multiply by each measure by its corresponding weight.
Sum the weighted strength ratings on each factor to get an
overall measure of competitive strength for each firm.
Use overall strength ratings to draw conclusions about the
firm’s net competitive advantage or disadvantage and to take
specific note of areas of strength and weakness.
Step 1. Make a list of the industry’s key success factors and
other telling measures of competitive strength or weakness (6 to
10 measures usually suffice).
Step 2. Assign weights to each competitive strength measure
based on its perceived importance. (The sum of the weights for
each measure must add up to 1.)
Step 3. Calculate weighted strength ratings by scoring each
competitor on each strength measure (using a 1-to-10 rating
scale, where 1 is very weak and 10 is very strong) and

multiplying the assigned rating by the assigned weight.
Step 4. Sum the weighted strength ratings on each factor to
get an overall measure of competitive strength for each
company being rated.
Step 5. Use the overall strength ratings to draw conclusions
about the size and extent of the company’s net competitive
advantage or disadvantage and to take specific note of areas of
strength and weakness.
Chapter 4–‹#›
TABLE 4.4 A Representative
Weighted Competitive Strength Assessment
Table 4.4 provides an example of competitive strength
assessment in which a hypothetical firm (ABC Company)
competes against two rivals. In the example, relative cost is the
most telling measure of competitive strength, and the other
strength measures are of lesser importance. The firm with the
highest rating on a given measure has an implied competitive
edge on that measure, with the size of its edge reflected in the
difference between its weighted rating and rivals’ weighted
ratings.
The overall competitive strength scores indicate how all the
different strength measures add up—whether the firm is at a net
overall competitive advantage or disadvantage against each
rival. The higher a firm’s overall weighted strength rating, the
stronger its overall competitiveness versus rivals.
Chapter 4–‹#›
Strategic Implications of a Competitive

Strength Assessment
The higher a firm’s overall weighted strength rating, the
stronger its overall competitiveness versus rivals.
The rating score indicates the total net competitive advantage
for a firm relative to other firms.
Firms with high competitive strength scores are targets for
benchmarking.
The ratings show how a firm compares against rivals, factor by
factor (or capability by capability).
Strength scores can be useful in deciding what strategic moves
to make.
A company’s competitive strength scores pinpoint its strengths
and weaknesses against rivals and point directly to the kinds of
offensive and defensive actions it can use to exploit its
competitive strengths and reduce its competitive vulnerabilities.
A competitively astute company should utilize the strength
scores in deciding what strategic moves to make. When a
company has important competitive strengths in areas where one
or more rivals are weak, it makes sense to consider offensive
moves to exploit rivals’ competitive weaknesses. When a
company has important competitive weaknesses in areas where
one or more rivals are strong, it makes sense to consider
defensive moves to curtail its vulnerability.
Chapter 4–‹#›
QUESTION 6: What Strategic Issues and Problems Merit Front-
Burner Managerial Attention?
Which and how serious are the strategic issues that managers
must address—and resolve—for the firm to be more financially
and competitively successful in the years ahead.
A good strategy must contain ways to deal with all the strategic

issues and obstacles that stand in the way of the firm’s financial
and competitive success in the years ahead.
The final and most important analytic step is to zero in on
exactly what strategic issues company managers need to
address—and resolve—for the firm to be more financially and
competitively successful in the years ahead. This step involves
drawing on the results of both industry analysis and the
evaluations of the company’s internal situation.
The task here is to get a clear fix on exactly what strategic and
competitive challenges confront the company, which of the
company’s competitive shortcomings need fixing,
and what specific problems merit company managers’ front-
burner attention. Pinpointing the specific issues that
management needs to address sets the agenda for deciding what
actions to take next to improve the company’s performance and
business outlook.
Chapter 4–‹#›
Strategic Priority “How To” Issues
How to meet challenges of new foreign competitors
How to combat the price discounting of rivals
How to both reduce high costs and prepare for price reductions
How to sustain growth as buyer demand slows
How to adapt to the changing demographics of the firm’s
customer base
Compiling a “priority list” of problems creates an agenda of
strategic issues that merit prompt managerial attention.

Compiling a list of problems and roadblocks creates a strategic
agenda of problems that merit prompt managerial attention. A
good strategy must contain ways to deal with all the strategic
issues and obstacles that stand in the way of the company’s
financial and competitive success in the years ahead.
Chapter 4–‹#›
Strategic Priority “Should We” Issues
Expand rapidly or cautiously into foreign markets?
Reposition the firm to move to a different strategic group?
Counter increasing buyer interest in substitute products?
Expand the firm’s product line?
Correct the firm’s competitive deficiencies by acquiring a rival
firm with the missing strengths?
Pinpointing the specific issues that management needs to
address sets the agenda for deciding what actions to take next to
improve the company’s performance and business outlook.
Chapter 4–‹#›
APPENDIX: IMAGE DESCRIPTIONS FOR UNSIGHTED
STUDENTS
Chapter 4–‹#›

Appendix 1 Figure 4.1 Identifying the Components of a Single-
Business Company’s Strategy, Text Alternative
Single business strategic action plan components include:
Moves to respond to changing conditions in the macro-
environment or in industry and competitive conditions
Initiatives to build competitive advantage based on:
Lower costs and prices relative to rivals?
A better product or service (design, features, quality, wider
selection, etc.)?
Superior ability to service a market niche or specific group of
buyers?
Efforts to expand or narrow geographic coverage
Efforts to build competitively valuable partnerships and
strategic alliances with other enterprises within its industry
Key functional strategies of the overall business strategy:
R&D, technology, product design; supply chain management;
production; sales, marketing, and distribution; information
technology; human resources; and finance.
Return to slide containing original image.
Chapter 4–‹#›
Appendix 2 Figure 4.2 The Steps Involved in SWOT Analysis:
Identify the Four Components of SWOT, Draw Conclusions,
Translate Implications into Strategic Actions, Text Alternative
What can be gleaned from the SWOT listings?
The first two steps of SWOT analysis are:
Identify company strengths and competitive assets.
Identify company weaknesses and competitive deficiencies.
These two steps lead to conclusions concerning the company’s

overall business situation. This includes determining what are
the underlying reasons for the success (or lack of success) of
the company’s strategy. It also includes what the attractive and
unattractive aspects of the company’s situation are.
The last two steps of SWOT analysis are:
Identify market opportunities.
Identify external threats.
These two steps reveal implications for improving company
strategy. This includes using company strengths as the
foundation for the company’s strategy; shoring up weaknesses
that are interfering with the success of the strategy; pursuing
those market opportunities best suited to company strengths;
correcting weaknesses that impair pursuit of important market
opportunities; repair weaknesses that heighten vulnerability of
external threats; and using company strengths to lessen the
impact of important external threats.
Chapter 4–‹#›
Appendix 3 Figure 4.3 A Representative Company Value Chain,
Text Alternative
Primary activities and costs of a company's value chain are:
Supply chain management
Operations
Distribution
Sales and marketing service
Profit margin
These primary activities and costs are supported by the
following
Product R&D

Technology
Systems development
Human resource management
General administration
Chapter 4–‹#›
Appendix 4 Figure 4.4 A Representative Value Chain
System, Text Alternative
A representative value chain system shows the following
Supplier-related value chains: activities, costs, and margins of
suppliers
A firm's own value chain: internally performed activities, costs,
and margins
Forward-channel value chains: (1) activities, costs, and margins
of forward-channel allies and strategic partners and (2) buyer or
end-user value chains
Chapter 4–‹#›
Appendix 5 Illustration Capsule 4.1 The Value Chain for Boll &
Branch, Text Alternative
The cost of goods, including the raw cotton; the spinning,
weaving, and dyeing; cutting, sewing, and finishing; the
transportation of the material, and the factory fee is $68.46.

The inspection fees, ocean freight/insurance, import duties,
warehouse/packing, packaging, customer shipping, and
promotions/donations total $154.38.
Boll & Branch’s markup is about 60%.
Boll & Branch’s retail price is $250.00, resulting in a gross
margin of $95.62.
Chapter 4–‹#›
Appendix 6 Table 4.4 A Representative Weighted Competitive
Strength AssessmentRating scale: 1 equals very weak, 10 equals
very strong
ABC CO.ABC CO.RIVAL 1RIVAL 1RIVAL 2RIVAL 2Key
success factor/strength measureImportance weightStrength
RatingWeighted ScoreStrength RatingWeighted scoreStrength
RatingWeighted ScoreQuality/product
performance0.1080.8050.5010.10Reputation/image0.1080.8070.
7010.10Manufacturing
capability0.1020.20101.0050.50Technological
skills0.05100.5010.0530.15Dealer network/ distribution
capability0.0590.4540.2050.25New product innovation
capability0.0590.4540.2050.25Financial
resources0.1050.50101.0030.30Relative cost
position0.3051.50103.0010.30Customer servicer
capabilities0.1550.7571.0510.15Sum of importance
weights1.00000000Overall weighted00ABC Co = 5.950Rival 1
= 7.700Rival 2 = 2.10

Chapter 4–‹#›
Concepts
and Cases
22e
Thompson
Peteraf
Gamble
Strickland
T h e Q u e s t f o r C o m p e t i t i v e A d v a n t a g e
STRATEGY
Crafting & Executing
CHAPTER 3 Evaluating a Company’s External Environment
©alice-photo/Shutterstock.com
©McGraw-Hill Education. All rights reserved. Authorized only
for instructor use in the classroom. No reproduction or further
distribution permitted without the prior written consent of
McGraw-Hill Education.

Copyright © McGraw-Hill Education. Permission required for
Chapter 3 presents the concepts and analytical tools for
assessing a company’s external environment. Attention centers
on the competitive arena in which a company operates, together
with the technological, societal, regulatory, or demographic
influences in the macro-environment that are acting to reshape
the company’s future market arena.
3–1
Learning Objectives
This Chapter Will Help You Understand:
How to recognize the factors in a company’s broad macro-
environment that may have strategic significance.
How to use analytic tools to diagnose the competitive
conditions in a company’s industry.
How to map the market positions of key groups of industry
rivals.
How to determine whether an industry’s outlook presents a
company with sufficiently attractive opportunities for growth
and profitability.
This chapter presents the concepts and analytical tools for
zeroing in on a single-business company’s external
environment.
3–2
FIGURE 3.1 From Analyzing the Company’s Situation to
Choosing a Strategy

Chapter 3 External Environment
Chapter 4 Internal Environment
As depicted in Figure 3.1, strategic thinking begins with an
appraisal of the company’s external and internal environments
(as a basis for deciding on a long-term direction and developing
a strategic vision), moves toward an evaluation of the most
promising alternative strategies and business models, and
culminates in choosing a specific strategy.
3–3
Analyzing the Company's Macro-Environment
PESTEL Analysis
Focuses on principal components of strategic significance in the
macro-environment
Political factors
Economic conditions (local to worldwide)
Sociocultural forces
Technological factors
Environmental factors (the natural environment)
Legal and regulatory conditions
The macro-environment encompasses the broad environmental
context in which a company’s industry is situated that includes
strategically relevant components over which the firm has no
direct control.

Analysis of the impact of these factors is often referred to as
PESTEL analysis, an acronym that serves as a reminder of the
six components involved (Political, Economic, Sociocultural,
Technological, Environmental, Legal/Regulatory).
3–4
FIGURE 3.2 The Components
of a Company’s Macro-Environment
Figure 3.2, The Components of a Company’s Macro-
environment identifies the arenas within an organization’s
macro-environment.
3–5
Assessing the Company’s Industry and Competitive
Environment
Thinking strategically about the competitive environment
requires managers to use some well validated concepts and
analytical tools.
Five forces framework
The value net
Driving forces
Strategic groups
Competitor analysis
Key success factors

Thinking strategically about a company’s industry and
competitive environment entails using some well-validated
concepts and analytic tools. These include the five forces
framework, the value net, driving forces, strategic groups,
competitor analysis, and key success factors. Proper use of
these analytic tools can provide managers with the
understanding needed to craft a strategy that fits the company’s
situation within their industry environment. The remainder of
this chapter is devoted to describing how managers can use
these tools to inform and improve their strategic choices.
3–6
The Five Forces Framework
The five competitive forces
Competition from rival sellers
Competition from potential new entrants
Competition from producers of substitute products
Supplier bargaining power
Customer bargaining power
The character and strength of the competitive forces operating
in an industry are never the same from one industry to another.
The most powerful and widely used tool for diagnosing the
principal competitive pressures in a market is the five forces
framework.
3–7
FIGURE 3.3 The Five Forces Model of Competition:

A Key Analytical Tool
Sources: Adapted from M.E. Porter, “How Competitive Forces
Shape Strategy,” Harvard Business Review 57, no. 2 (1979),
pp.137-145; M.E. Porter, “The Five Competitive Forces That
Shape Strategy,” Harvard Business Review 86, no 1 (2008), pp.
80-86.
This five forces framework, depicted in Figure 3.3, holds that
competitive pressures on companies within an industry come
from five sources. These include (1) competition from rival
sellers, (2) competition from competition from producers of
substitute products, (3) potential new entrants, (4) supplier
bargaining power, and (5) customer bargaining power.
3–8
Using the Five-forces Model of Competition
STEP 1: For each of the five forces, identify the different
parties involved, along with the specific factors that bring about
competitive pressures.
STEP 2: Evaluate how strong the pressures stemming from
each of the five forces are (strong, moderate, or weak).
STEP 3: Determine whether the five forces, overall, are
supportive of high industry profitability.
Using the five forces model to determine the nature and strength
of competitive pressures in a given industry involves three

steps:
∙ Step 1: For each of the five forces, identify the different
parties involved, along with the specific factors that bring about
competitive pressures.
∙ Step 2: Evaluate how strong the pressures stemming from each
of the five forces are (strong, moderate, or weak).
∙ Step 3: Determine whether the five forces, overall, are
supportive of high industry profitability.
3–9
Competitive Pressures That Increase Rivalry among Competing
Sellers
Buyer demand is growing slowly or declining.
It is becoming less costly for buyers to switch brands.
Industry products are becoming less differentiated.
There is unused production capacity, or products have high
fixed costs or high storage costs.
The number of competitors is increasing, or they are becoming
more equal in size and competitive strength.
The diversity of competitors is increasing.
High exit barriers keep firms from exiting the industry.
The strongest of the five competitive forces is often the rivalry
for buyer patronage among competing sellers of a product or
service. The intensity of rivalry among competing sellers within
an industry depends on several identifiable factors.
3–10
FIGURE 3.4 Factors Affecting the Strength of Rivalry

Figure 3.4 summarizes these factors affecting rivalry in the
industry, identifying those that intensify or weaken rivalry
among direct competitors in an industry.
3–11
Competitive Pressures Associated with the Threat of New
Entrants
Entry threat considerations
Expected defensive reactions of incumbent firms
Strength of barriers to entry
Attractiveness of a particular market’s growth
in demand and profit potential
Capabilities and resources of potential entrants
Entry of existing competitors into market segments
in which they have no current presence
New entrants into an industry threaten the position of rival
firms since they will compete fiercely for market share, add to
the number of industry rivals, and add to the industry’s
production capacity in the process.
3–12
Market Entry Barriers Facing New Entrants
Sizable economies of scale in production, distribution,
advertising, or other activities

Hard-to-replicate learning curve and industry relationship cost
advantages of incumbents
Strong brand preferences and high customer loyalty
Patents and other intellectual property protection
Strong “network effects” in customer demand
High capital requirements
Building distributor and/or dealer networks and securing
adequate space on retailers’ shelves
Restrictive regulatory and trade policies
The strength of the threat of entry is governed to a large degree
by the height of the industry's entry barriers. High barriers
reduce the threat of potential entry, whereas low barriers enable
easier entry.
Whether an industry’s entry barriers ought to be considered
high or low depends on the resources and capabilities possessed
by the pool of potential entrants. High entry barriers and weak
entry threats today do not always translate into high entry
barriers and weak entry threats tomorrow.
3–13
FIGURE 3.5 Factors Affecting the Threat of Entry
Figure 3.5 summarizes the factors that cause the overall
competitive pressure from potential entrants to be strong or

weak. An analysis of these factors can help managers determine
whether the threat of entry into their industry is high or low.
3–14
Competitive Pressures from the Sellers of Substitute Products
Substitute products considerations
Readily available and attractively priced?
Comparable or better in terms of quality, performance, and
other relevant attributes?
Offer lower switching costs to buyers?
Indicators of substitutes’ competitive strength
Increasing rate of growth in sales of substitutes
Substitute producers adding new output capacity
Increasing profitability of substitute producers
Companies in one industry are vulnerable to competitive
pressure from the actions of companies in a closely adjoining
industry whenever buyers view the products of the two
industries as good substitutes.
3–15
FIGURE 3.6 Factors Affecting Competition from
Substitute Products

Figure 3.6 depicts three factors that determine whether the
competitive pressures from substitute products are strong or
weak. Competitive pressures are stronger when:
Good substitutes are readily available and attractively priced.
Buyers view the substitutes as comparable or better in terms of
quality. performance, and other relevant attributes.
The costs that buyers incur in switching to the substitutes are
low.
3–16
Competitive Pressures Stemming from Supplier Bargaining
Power
Supplier bargaining power depends on:
Strength of demand for and availability of suppliers’ products.
Whether suppliers provide a differentiated input that enhances
the performance of the industry’s product.
Industry members’ costs for switching among suppliers.
Size and number of suppliers relative to industry members.
Possibility of backward integration into suppliers’ industry.
Fraction of the cost of the supplier’s product relative to the
total cost of the industry’s product.
Availability of good substitutes for suppliers’ products.
Whether industry members are major customers of suppliers.
Whether the suppliers of industry members represent a weak or
strong competitive force depends on the degree to which
suppliers have sufficient bargaining power to influence the
terms and conditions of supply in their favor. Suppliers with
strong bargaining power are a source of competitive pressure
because of their ability to charge industry members higher
prices, pass costs on to them, and limit their opportunities to
find better deals.

3–17
FIGURE 3.7 Factors Affecting the Bargaining Power of
Suppliers
Figure 3.7 shows a variety of factors that determine the strength
of suppliers’ bargaining power.
3–18
Competitive Pressures Stemming from Buyer Bargaining Power
and Price Sensitivity
Buyer bargaining power considerations
Strength of buyers’ demand for sellers’ products
Degree to which industry goods are differentiated
Buyers’ costs for switching to competing sellers or substitutes
Number and size of buyers relative to number of sellers
Threat of buyers’ integration into sellers’ industry
Buyers’ knowledge of products, costs and pricing
Buyers’ discretion in delaying purchases
Buyers’ price sensitivity due to low profits, size of purchase,
and consequences of purchase
Product quality not at issue price is primary concern
Whether buyers can exert strong competitive pressures on
industry members depends on (1) the degree to which buyers

have bargaining power, and (2) the extent to which buyers are
price-sensitive. Buyers with strong bargaining power can limit
industry profitability by demanding price concessions, better
payment terms, or additional features and services that increase
industry members’ costs. Buyer price sensitivity limits the
profit potential of industry members by restricting the ability of
sellers to raise prices without losing revenue due to lost sales.
3–19
FIGURE 3.8 Factors Affecting the Bargaining Power of
Buyers
Figure 3.8 summarizes the factors determining the strength of
buyer power in an industry. Note that the first five factors are
the mirror image of those determining the bargaining power of
suppliers.
3–20
Is the Collective Strength of the Five Competitive Forces
Conducive to Good Profitability?
Answers to three questions are needed:
Is the state of competition in the industry stronger than normal?
Can industry firms expect to earn decent profits given
prevailing competitive forces?
Are some of the competitive forces sufficiently powerful to
undermine industry profitability?
Even one powerful competitive force may be enough to make
the industry unattractive in terms of its profit potential.

Assessing whether each of the five competitive forces gives rise
to strong, moderate, or weak competitive pressures sets the
stage for evaluating whether, overall, the strength of the five
forces is conducive to good profitability. Are any of the
competitive forces sufficiently powerful to undermine industry
profitability? Can industry firms reasonably expect to earn
decent profits considering the prevailing competitive forces?
The strongest of the five forces determines the extent of the
downward pressure on an industry’s profitability. Having more
than one strong force means that an industry has multiple
competitive challenges with which to cope.
3–21
Matching Company Strategy to
Competitive Conditions
Effectively matching a firm’s business strategy to prevailing
competitive conditions has two aspects:
Pursuing avenues that shield the firm from as many competitive
pressures as possible
Initiating actions calculated to shift competitive forces in the
firm’s favor by altering underlying factors driving the five
forces
Working through the five forces model step by step aids
strategy-makers in assessing whether the intensity of

competition allows good profitability and promotes sound
strategic thinking about how to better match company strategy
to the specific competitive character of the marketplace.
A company’s strategy is strengthened when it provides some
insulation from competitive pressures, shifts the competitive
battle in the company’s favor, and positions firms to take
advantage of attractive growth opportunities.
3–22
Complementors and the Value Net
How the value net differs from the five forces
Focuses on the interactions of industry participants with a
particular (focal) company
Defines the category of competitors to include the focal firm’s
direct competitors, industry rivals, the sellers of substitute
products, and potential entrants
Introduces a new category of industry participant—
complementors—producers of products that enhance the value
of the focal firm’s products when they are used together
Not all interactions among industry participants are necessarily
competitive in nature. Some have the potential to be
cooperative, as the value net framework demonstrates. Like the
five forces framework, the value net includes an analysis of
buyers, suppliers, and substitutors. But it differs from the five
forces framework in several important ways.
3–23
FIGURE 3.9 The Value Net

Figure 3.9 depicts the value net used in an analysis of buyers,
suppliers, and substitutors.
Complementors are the producers of complementary products,
which are products that enhance the value of the focal firm’s
products when they are used together.
3–24
Industry Dynamics and the Forces Driving Change
Driving forces analysis has three steps.
Identifying what the driving forces are
Assessing whether the drivers of change are
acting to make the industry more or less attractive
Determining what strategy changes are needed to prepare for the
impact of the driving forces
Driving forces are the major underlying causes of change in
industry and competitive conditions. Driving forces analysis has
three steps: (1) identifying what the driving forces are; (2)
assessing whether the drivers of change are acting to make the
industry more or less attractive; and (3) determining what
strategy changes are needed to prepare for the impact of the
driving forces.
3–25

Identifying the Forces Driving Industry Change
Changes in the long-term industry growth rate
Increasing globalization
Emerging new Internet capabilities and applications
Shifts in buyer demographics
Technological change and manufacturing process innovation
Product and marketing innovation
Entry or exit of major firms
Diffusion of technical know-how across firms and countries
Changes in cost and efficiency
Reductions in uncertainty and business risk
Regulatory influences and government policy changes
Changing societal concerns, attitudes, and lifestyles
The most important part of driving forces analysis is to
determine whether the collective impact of the driving forces
will increase or decrease market demand, make competition
more or less intense, and lead to higher or lower industry
profitability.
The real payoff of driving-forces analysis is to help managers
understand what strategy changes are needed to prepare for the
impacts of the driving forces
3–26
Assessing the Impact of the Factors Driving Industry Change
Are the driving forces, on balance, acting to cause demand for
the industry’s product to increase or decrease?
Is the collective impact of the driving forces making
competition more or less intense?
Will the combined impacts of the driving forces lead to higher
or lower industry profitability?

The second step in driving forces analysis is to determine
whether the prevailing change drivers are acting to make the
industry environment more or less attractive. Three questions
need to be answered:
Are the driving forces, on balance, acting to cause demand for
the industry’s product to increase or decrease?
Is the collective impact of the driving forces making
competition more or less intense?
Will the combined impacts of the driving forces lead to higher
or lower industry profitability?
Getting a handle on the collective impact of the driving forces
requires looking at the likely effects of each factor separately,
since the driving forces may not all be pushing change in the
same direction.
3–27
Adjusting Strategy to Prepare for the Impacts of Driving Forces
What strategy adjustments will be needed
to deal with the impacts of the driving forces?
What adjustments must be made immediately?
What actions currently being taken should be halted or
abandoned?
What can we do now to prepare for adjustments we anticipate
making in the future?
The third step in the strategic analysis of industry dynamics—
where the real payoff for strategy making comes—is for

managers to draw some conclusions about what strategy
adjustments will be needed to deal with the impacts of the
driving forces. But taking the “right” kinds of actions to prepare
for the industry and competitive changes being wrought by the
driving forces first requires accurate diagnosis of the forces
driving industry change and the impacts these forces will have
on both the industry environment and the company’s business.
3–28
Strategic Group Analysis
Strategic group
Consists of those industry members with similar competitive
approaches and positions in the market
Having comparable product-line breadth
Emphasizing the same distribution channels
Depending on identical technological approaches
Offering the same product attributes to buyers
Offering similar services and technical assistance
Within an industry, companies commonly sell in different
price/quality ranges, appeal to different types of buyers, have
different geographic coverage, and so on. Some are more
attractively positioned than others. Understanding which
companies are strongly positioned and which are weakly
positioned is an integral part of analyzing an industry’s
competitive structure. The best technique for revealing the
market positions of industry competitors is strategic group
mapping.
3–29

Using Strategic Group Maps to Assess the Market Positions of
Key Competitors
Constructing a strategic group map
Identify the competitive characteristics that delineate strategic
approaches used in the industry.
Plot the firms on a two-variable map using pairs of competitive
characteristics.
Assign firms occupying about the same map location to the
same strategic group.
Draw circles around each strategic group, making the circles
proportional to the size of the group’s share of total industry
sales revenues.
A strategic group is a cluster of industry rivals that have similar
competitive approaches and market positions.
Strategic group mapping is a technique for displaying the
different market or competitive positions that rival firms occupy
in the industry.
Evaluating strategy options entails examining what strategic
groups exist, identifying the companies within each group, and
determining if a competitive “white space” exists where
industry competitors can create and capture new demand.
3–30
Typical Variables Used in
Creating Group Maps
Price and quality range (high, medium, low)
Geographic coverage (local, regional, national, global)
Product-line breadth (wide, narrow)
Degree of service offered (no frills, limited, full)

Distribution channels (retail, wholesale, Internet, multiple)
Degree of vertical integration (none, partial, full)
Degree of diversification into other industries (none, some,
considerable)
3–31
Guidelines for Creating Group Maps
Variables selected as map axes should not be highly correlated.
Variables should reflect important (sizable) differences among
rival approaches.
Variables may be quantitative, continuous, discrete, or defined
in terms of distinct classes and combinations.
Drawing group circles proportional to the combined sales of
firms in each group will reflect the relative sizes of each
strategic group.
Drawing maps using different pairs of variables will show the
different competitive positioning relationships present in the
industry’s structure.
Two variables selected as axes for the map should not be highly
correlated; if they are, the circles on the map will fall along a
diagonal and reveal nothing more about the relative positions of
competitors than would be revealed by comparing the rivals on
just one of the variables.
Strategic group maps reveal which firms are close competitors
and which are distant competitors.

3–32
Illustration Capsule 3.1 Comparative Market Positions of
Selected Companies in the Casual Dining Industry: A Strategic
Group Map Example
Footnote: Circles are drawn roughly proportional to the sizes of
the chains, based on revenues.
Illustration Capsule 3.1 shows a two-dimensional group
mapping diagram for the U.S. casual dining industry.
3–33
Examining the Comparative Market Positions of Strategic
Groups in the Casual Dining Industry
Which strategic group is located in the least favorable market
position? Which group is in the most favorable position?
Which strategic group is likely to experience increased
intragroup competition?
Which groups are most threatened by the likely strategic moves
of members of nearby strategic groups?
Strategic group maps using different pairs of variable can be
drawn to give different exposures to the competitive positioning
relationships present in the industry’s structure—there is not

necessarily one best map for portraying how competing firms
are positioned.
3–34
The Value of Strategic Group Maps
Maps are useful in identifying which industry members are
close rivals and which are distant rivals.
Not all map positions are equally attractive
Prevailing competitive pressures from the industry’s five forces
may cause the profit potential of different strategic groups to
vary.
Industry driving forces may favor some strategic groups and
hurt others.
Some strategic groups are more favorably positioned than others
because they confront weaker competitive forces or because
they are more favorably impacted by industry driving forces.
Part of strategic group map analysis always entails drawing
conclusions about where on the map is the “best” place to be
and why. Which firms/strategic groups are destined to prosper
because of their positions? Which firms/strategic groups seem
destined to struggle? What accounts for why some parts of the
map are better than others?
3–35
Competitor Analysis
Competitive intelligence
Information about rivals that is useful in anticipating their next
strategic moves
Signals of the likelihood of strategic moves

Evaluate a Company's Resources and Competitiveness

Evaluate a Company's Resources and Competitiveness

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