Chapter Three Internal Analysis: Distinctive Competencies, Competitive Advantage, and Profitability

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 2 “In preparing for battle I have always found that plans are useless, but planning is indispensable.” - Dwight D. Eisenhower © RoyaltyFree/ Stockdisc/ Getty Images

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 3  The firm’s resources and capabilities  Distinctive competencies Internal Analysis The purpose of internal analysis is to pinpoint the strengths and weaknesses of the organization. It includes assessments of: Building and sustaining a competitive advantage requires a company to achieve superior: Efficiency Quality Innovations Responsiveness to customers

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 4 Internal Analysis: Strengths and Weaknesses Internal analysis, along with the external analysis of the company’s environment, gives managers the information to choose the strategies and business model to attain a sustained competitive advantage. Strengths Assets that boost profitability Weaknesses Liabilities that depress profitability

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 5 Competitive Advantage  Competitive Advantage A firm’s profitability is greater than the average profitability for all firms in its industry.  Sustained Competitive Advantage A firm maintains above average and superior profitability and profit growth for a number of years.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 6 Strategy, Resources, Capabilities, and Competencies Figure 3.1

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 7 Competitive Advantage, Value Creation, and Profitability 1.Value or utility the customer gets from owning the product 2.Price that a company charges for its products 3.Costs of creating that product  Consumer surplus is the “excess” utility a consumer captures beyond the price paid Basic Principle: the more utility that consumers get from a company’s products or services, the more pricing options the company has. How profitable a company becomes depends on three basic factors:

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 8 Value Creation per Unit Figure 3.2

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 9 Value Creation and Pricing Options There is a dynamic relationship among utility, pricing, demand, and costs. Figure 3.3

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 10 Comparing Toyota and General Motors Superior value creation requires that the gap between perceived utility (U) and costs of production (C) be greater than that obtained by competitors. Figure 3.4

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 11 The Value Chain A company is a chain of activities for transforming inputs into outputs that customers value – including the primary and support activities. Figure 3.5

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 12 Building Blocks of Competitive Advantage Figure 3.6

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 13 Efficiency  Measured by the quantity of inputs it takes to produce a given output: Efficiency = Outputs / Inputs  Productivity leads to greater efficiency and lower costs: Employee productivity Capital productivity Superior efficiency helps a company attain a competitive advantage through a lower cost structure.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 14 Quality Superior quality = customer perception of greater value in a product’s attributes Form, features, performance, durability, reliability, style, design  Quality products are goods and services that are: Reliable and Differentiated by attributes that customers perceive to have higher value  A perception of quality allows a firm to differentiate its products in the eyes of its customers.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 15 A Quality Map for Automobiles When customers evaluate the quality of a product, they commonly measure it against two kinds of attributes: 1. Quality as Excellence 2. Quality as Reliability Figure 3.7

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 16 Innovation Innovation is the act of creating new products or new processes Product innovation »Creates products that customers perceive as more valuable and »Increases the company’s pricing options Process innovation »Creates value by lowering production costs Successful innovation can be a major source of competitive advantage – by giving a company something unique.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 17 Customer Responsiveness  Enhanced customer responsiveness: Customer response time, design, service, after-sales service and support Superior responsiveness to customers differentiates a company’s products and services and leads to brand loyalty and premium pricing. Identifying and satisfying customers’ needs – better than the competitors do.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 18 Analyzing Competitive Advantage and Profitability  Competitive Advantage When a company’s profitability is greater than the average of all other companies in the same industry that compete for the same customers  Benchmarking Comparing company performance against that of competitors and the company’s historic performance  Measures of Profitability Return On Invested Capital (ROIC) Net profit Net income after tax Capital invested Equity + Debt to creditors Net Profit = Total revenues – Total costs = ROIC =

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 19 Definitions of Basic Accounting Terms Table 3.1

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 20 Drivers of Profitability (ROIC) Figure 3.9

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 21 Ways to Increase ROIC Increase Company’s Return on Sales  Increase sales revenue more than costs  Reduce cost of goods sold  Reduce spending on SG&A Sales, Marketing, General & Administrative Expenses  Reduce R&D expenses Research & Development Increase Capital Turnover  Reduce the amount of working capital Inventory, Accounts Receivable, Payables  Reduce the amount of fixed capital PPE - Property, Plant & Equipment      

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 22 The Durability of Competitive Advantage 1. Barriers to Imitation Making it difficult to copy a company’s distinctive competencies 2. Capability of Competitors Strategic commitment Absorptive capacity 3. Industry Dynamism Ability of an industry to change rapidly The durability of a company’s competitive advantage over its competitors depends on: Competitors are also seeking to develop distinctive competencies that will give them a competitive edge.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 23 Why Companies Fail  Inertia Companies find it difficult to change their strategies and structures  Prior Strategic Commitments Limit a company’s ability to imitate and cause competitive disadvantage  The Icarus Paradox A company can become so specialized and inner-directed based on past success that it loses sight of market realities Categories of rising and falling companies: Craftsmen Builders Pioneers Salespeople When a company loses its competitive advantage, its profitability falls below that of the industry.  It loses the ability to attract and generate resources.  Profit margins and invested capital shrink rapidly.

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 24 Avoiding Failure: Sustaining Competitive Advantage 1.Focus on the Building Blocks of Competitive Advantage Develop distinctive competencies and superior performance in:  Efficiency  Quality  Innovation  Responsiveness to Customers 2.Institute Continuous Improvement and Learning 3.Track Best Practice and Use Benchmarking 4.Overcome Inertia Luck may play a role in success, so always exploit a lucky break - but remember: “The harder I work, the luckier I seem to get.” J P Morgan

Copyright © Houghton Mifflin Company. All rights reserved. 3 | 25 “Developing a sound and healthy organization requires understanding the environment as much as understanding the organization.” - Gary Hamel © RoyaltyFree/ Stockdisc/ Getty Images