• Identify the top 3      potential customer groups for this opportunity and describe their      characteristics and preferences

BUS/475v10

Project Plan

BUS/475 v10

Page 2 of 2

Wk 4 – Apply: Project Plan

Project Title:

Project Objectives:

· List project objective

· List project objective
· List project objective

Operational Step	Responsible Person	Timeline

Example

Project Title: Desert Taco Opportunity

Description: Based on initial feedback from customer surveys, online discussion/social media groups, and SWOT analyses, you’ve determined that there is an opportunity to increase your organization’s customer base through the introduction of desert tacos in your food truck menu.

Project Objectives:

· Identify the top 3 potential customer groups for this opportunity and describe their characteristics and preferences

Operational Step

Responsible Person

Timeline

Review the organization’s customer database to determine potential customer groups

Leo (Market Research Manager)

9/30 (1 week)

Identify the top 3 groups to target based upon volume, brand loyalty, and location

Betty (Director of Marketing)

10/7 (2 weeks)

Survey customers regarding food preferences and potential menu items

Tom (Customer Service Representative)

10/21 (4 weeks)

Share customer feedback with inventory and operational teams

Betty/Tom

10/28 (5 weeks)

Determine the top 5 locations and times to complete a pilot study with your test market.

Operational Step

Responsible Person

Timeline

Review sales data to determine peak sales opportunities by location

Jim (Director of Sales)

9/30 (1 week)

Identify the top 5 locations in which to conduct the desert taco pilot

Jim

10/7 (2 weeks)

Create marketing collateral and social media communications to promote the desert taco pilot

Oliver (Media Relations Manager)

10/21 (4 weeks)

Provide expected volume and product information for the inventory team

Jim

10/7 (2 weeks)

Estimate the required inventory and supply chain needs necessary to support the desert taco pilot

Operational Step

Responsible Person

Timeline

Based on expected customer volume, locations, and times, determine the product inventory required to support the pilot.

Louise (Controller)

10/14 (3 weeks)

Source supply companies and obtain product pricing quotes and delivery timelines.

Louise

10/21 (4 weeks)

Determine shipment and storage needs to support the pilot.

Louise and Ben (Operations Manager)

10/21 (4 weeks)

Purchase product for the pilot and arrange transportation to support the desert taco pilot at the various locations.

Louise

10/28 (5 weeks)

Copyright 2019 by University of Phoenix. All rights reserved.

Copyright 2019 by University of Phoenix. All rights reserved.

7.1 Competition Driven by Innovation

Competition is a process driven by the “perennial gale of creative destruction,” in the words of famed economist Joseph Schumpeter.

5

 The continuous waves of market leadership changes in the TV industry, detailed in the ChapterCase, demonstrate the potency of innovation as a competitive weapon: It can simultaneously create and destroy value. Firms must be able to innovate while also fending off competitors’ imitation attempts. A successful strategy requires both an effective offense and a hard-to-crack defense.

Many

firms have dominated an early wave of innovation only to be challenged and often destroyed by the next wave. As highlighted in the ChapterCase, traditional television networks (ABC, CBS, and NBC) have been struggling to maintain viewers and advertising revenues as cable and satellite providers offered innovative programming. Those same cable and satellite providers now are trying hard to hold on to viewers as more and more people gravitate toward customized content online. To exploit such opportunities, Google acquired YouTube, while Comcast, the largest U.S. cable operator, purchased NBCUniversal.

6

 Comcast’s acquisition helps it integrate delivery services and content, with the goal of establishing itself as a new player in the media industry. In turn, both traditional TV and cable networks are currently under threat from content providers that stream via the internet, such as Netflix, YouTube, and Amazon.

As the adage goes, change is the only constant—and the rate of technological change has accelerated dramatically over the past hundred years. Changing technologies spawn new industries, while others die. This makes innovation a powerful strategic weapon to gain and sustain competitive advantage. 

Exhibit 7.1

 shows how many years it took for different technological innovations to reach 50 percent of the U.S. population (either through ownership or usage). As an example, it took 84 years for half of the U.S. population to own a car, but only 28 years for half the population to own a TV. The pace of the adoption rate of recent innovations continues to accelerate. It took 19 years for the PC to reach 50 percent ownership, but only 6 years for MP3 players to accomplish the same diffusion rate.

EXHIBIT 7.1  Accelerating Speed of Technological Change

Source: Depiction of data from the U.S. Census Bureau, the Consumer Electronics Association, Forbes, and the National Cable and Telecommunications Association.

What factors explain increasingly rapid technological diffusion and adoption? One determinant is that initial innovations such as the car, airplane, telephone, and the use of electricity provided the necessary infrastructure for newer innovations to diffuse more rapidly. Another reason is the emergence of new business models that make innovations more accessible. For example, Dell’s direct-to-consumer distribution system improved access to low-cost PCs, and Walmart’s low-price, high-volume model used its sophisticated IT logistics system to fuel explosive growth. In addition, satellite and cable distribution systems facilitated the ability of mass media such as radio and TV to deliver advertising and information to a wider audience. The speed of technology diffusion has accelerated further with the emergence of the internet, social networking sites, and viral messaging. Amazon continues to drive increased convenience, higher efficiency and lower costs in retailing. The accelerating speed of technological changes has significant implications for the competitive process and firm strategy. We will now take a close look at the innovation process unleashed by technological changes.

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THE INNOVATION PROCESS

LO 7-1

Outline the four-step innovation process from idea to imitation.

Broadly viewed, innovation describes the discovery, development, and transformation of new knowledge in a four-step process captured in the four I’s: idea, invention, innovation, and imitation (see 

Exhibit 7.2

).

7

EXHIBIT 7.2 
 The Four I’s: Idea, Invention, Innovation, and Imitation

The innovation process begins with an idea. The idea is often presented in terms of abstract concepts or as findings derived from basic research. Basic research is conducted to discover new knowledge and is often published in academic journals. This may be done to enhance the fundamental understanding of nature, without any commercial application or benefit in mind. In the long run, however, basic research is often transformed into applied research with commercial applications. For example, wireless communication technology today is built upon the fundamental science breakthroughs Albert Einstein accomplished over 100 years ago in his research on the nature of light.

8

In a next step, 

invention

 describes the transformation of an idea into a new product or process, or the modification and recombination of existing ones. The practical application of basic knowledge in a particular area frequently results in new technology. If an invention is useful, novel, and non-obvious as assessed by the U.S. Patent and Trademark Office, it Page 223can be patented.

9

 A 

patent

 is a form of intellectual property, and gives the inventor exclusive rights to benefit from commercializing a technology for a specified time period in exchange for public disclosure of the underlying idea (see also the discussion on isolating mechanisms in 

Chapter 4

). In the United States, the time period for the right to exclude others from the use of the technology is 20 years from the filing date of a patent application. Exclusive rights often translate into a temporary monopoly position until the patent expires. For instance, many pharmaceutical drugs are patent protected.

Strategically, however, patents are a double-edged sword. On the one hand, patents provide a temporary monopoly as they bestow exclusive rights on the patent owner to use a novel technology for a specific time period. Thus, patents may form the basis for a competitive advantage. Because patents require full disclosure of the underlying technology and know-how so that others can use it freely once the patent protection has expired, many firms find it strategically beneficial not to patent their technology. Instead they use 

trade secrets

, defined as valuable proprietary information that is not in the public domain and where the firm makes every effort to maintain its secrecy. The most famous example of a trade secret is the Coca-Cola recipe, which has been protected for over a century.

10

 The same goes for Ferrero’s Nutella, whose secret recipe is said to be known by even fewer than the handful of people who have access to the Coca-Cola recipe.

11

Avoiding public disclosure and thus making its underlying technology widely known is precisely the reason Netflix does not patent its recommendation algorithm or Google its PageRank algorithm. Netflix has an advantage over competitors because its recommendation algorithm works best; the same goes for Google—its search algorithm is the best available. Disclosing how exactly these algorithms work would nullify their advantage.

Innovation

 concerns the commercialization of an invention.

12

 The successful commercialization of a new product or service allows a firm to extract temporary monopoly profits. As detailed in the ChapterCase, Netflix began its life with a business model innovation, offering unlimited DVD rentals via the internet, without any late fees. However, Netflix gained its early lead by applying big data analytics to its user preferences to not only predict future demand but also to provide highly personalized viewing recommendations. The success of the latter is evident by the fact that movies that were recommended to viewers scored higher than they were scored previously. To sustain a competitive advantage, however, a firm must continuously innovate—that is, it must produce a string of successful new products or services over time. In this spirit, Netflix further developed its business model innovation, moving from online DVD rentals to directly streaming content via the internet. Moreover, it innovated further in creating proprietary content such as House of Cards and Orange Is the New Black.

Page 224

Successful innovators can benefit from a number of 

first-mover advantages

,

13

 including economies of scale as well as experience and learning-curve effects (as discussed in 

Chapter 6

). First movers may also benefit from network effects (see the discussion of Apple and Uber later in this chapter). Moreover, first movers may hold important intellectual property such as critical patents. They may also be able to lock in key suppliers as well as customers through increasing switching costs. For example, users of Microsoft Word might find the switching costs entailed in moving to a different word-processing software prohibitive. Not only would they need to spend many hours learning the new software, but collaborators would also need to have compatible software installed and be familiar with the program to open and revise shared documents.

Google—by offering a free web-based suite of application software such as word-processing (Google Docs), spreadsheet (Google Sheets), and presentation programs (Google Slides)—is attempting to minimize switching costs by leveraging cloud computing—a real-time network of shared computing resources via the internet (Google Drive). Rather than requiring each user to have the appropriate software installed on his or her personal computer, the software is maintained and updated in the cloud. Files are also saved in the cloud, which allows collaboration in real time globally wherever one can access an internet connection.

Innovation need not be high-tech to be a potent competitive weapon, as P&G’s history of innovative product launches such as the Swiffer line of cleaning products shows. P&G uses the razor–razor-blade business model (introduced in 

Chapter 5

), where the consumer purchases the handle at a low price, but must pay a premium for replacement refills and pads over time. As shown in 

Exhibit 7.3

, an innovation needs to be novel, useful, and successfully implemented to help firms gain and sustain a competitive advantage.

EXHIBIT 7.3 
 Innovation: A Novel and Useful Idea That Is Successfully Implemented

The innovation process ends with imitation. If an innovation is successful in the marketplace, competitors will attempt to imitate it. Although Netflix has some 50 million U.S. subscribers, imitators are set to compete its advantage away. Amazon offers its Instant Video service to its estimated 65 million Prime subscribers ($99 a year or $8.25 a month), with selected titles free. In addition, Prime members receive free two-day shipping on Amazon purchases. Hulu Plus ($7.99 a month), a video-on-demand service, has some 9 million subscribers. One advantage Hulu Plus has over Netflix and Amazon is that it typically makes the latest episodes of popular TV shows available the day following broadcast, on Hulu; the shows are often delayed by several months before being offered by Netflix or Amazon. A joint venture of NBCUniversal Television Group (Comcast), Fox Broadcasting (21st Century Fox), and Disney/ABC Television Group (The Walt Disney Co.), Hulu Plus uses advertisements along with its subscription fees as revenue sources. Finally, Google’s YouTube with its more than 1 billion users is evolving into a TV ecosystem, benefiting not only from free content uploaded by its users but also creating original programming. As of 2017, the most subscribed channels were by PewDiePie (57 million) and YouTube Spotlight, its official channel (26 million) used to highlight videos and events such as YouTube Music Awards and YouTube Comedy Week

14

. Google’s business is, of course, ad supported. Only time will tell whether Netflix will be able to sustain its competitive advantage given the imitation attempts by a number.

7.2 Strategic and Social Entrepreneurship

LO 7-2

Apply strategic management concepts to entrepreneurship and innovation.

Entrepreneurship

 describes the process by which change agents (entrepreneurs) undertake economic risk to innovate—to create new products, processes, and sometimes new organizations.

15

 Entrepreneurs innovate by commercializing ideas and inventions.

16

 They seek out or create new business opportunities and then assemble the resources necessary to exploit them.

17

 Indeed, innovation is the competitive weapon entrepreneurs use to exploit opportunities created by change, or to create change themselves, in order to commercialize new products, services, or business models.

18

 If successful, entrepreneurship not only drives the competitive process, but it also creates value for the individual entrepreneurs and society at large.

Although many new ventures fail, some achieve spectacular success. Examples of successful entrepreneurs are:

·

▪ Reed Hastings, founder of Netflix featured in the ChapterCase. Hastings grew up in Cambridge, Massachusetts. He obtained an undergraduate degree in math and then volunteered for the Peace Corps for two years, teaching high school math in Swaziland (Africa). Next, he pursued a master’s degree in computer science, which brought him to Silicon Valley. Hastings declared his love affair with writing computer code, but emphasized, “The big thing that Stanford did for me was to turn me on to the entrepreneurial model.”

19

 His net worth today is an estimated $1 billion.

·

·
Dr. Dre, rapper, music and movie producer, as well as highly successful serial entrepreneur.
©JC Olivera/Getty Images Entertainment/Getty Images

▪Dr. Dre, featured in 

ChapterCase 4

, a successful rapper, music and movie producer, and serial entrepreneur. Born in Compton, California, Dr. Dre focused on music and entertainment early on during high school, working his first job as a DJ. Dr. Dre’s major breakthrough as a rapper came with the group N.W.A. One of his first business successes as an entrepreneur was Death Row Records, which he founded in 1991. A year later, Dr. Dre’s first solo album, The Chronic, was a huge hit. In 1996, Dr. Dre founded Aftermath Entertainment and signed famed rappers such as 50 Cent and Eminem. Dr. Dre, known for his strong work ethic and attention to detail, expects nothing less than perfection from the people with whom he works. Stories abound that Dr. Dre made famous rappers rerecord songs hundreds of times if he was not satisfied with the outcome. In 2014, Dr. Dre appeared to become the first hip-hop billionaire after Apple acquired Beats Electronics for $3 billion. In 2015, N.W.A’s early success was depicted in the biographical movie Straight Outta Compton, focusing on group members Eazy-E, Ice Cube, and Dr. Dre, who coproduced the film, grossing over $200 million at the box office, with a budget of $45 million.

20

· ▪ Jeff Bezos, the founder of Amazon.com (featured in 

ChapterCase 8

), the world’s largest online retailer. The stepson of a Cuban immigrant, Bezos graduated with a degree in computer science and electrical engineering, before working as a financial analyst on Wall Street. In 1994, after reading that the internet was growing by 2,000 percent a month, he set out to leverage the internet as a new distribution channel. Listing products that could be sold online, he finally settled on books because that retail market was fairly fragmented, with huge inefficiencies in its distribution system. Perhaps even more important, books are a perfect commodity because they are identical regardless of where a consumer buys them. This reduced uncertainty when introducing online shopping to consumers. In 2017 his personal wealth exceeded $80 billion.

21

· ▪ Elon Musk, an engineer and serial entrepreneur with a deep passion to “solve environmental, social, and economic challenges.”

22

 We featured him in his role as leader of Tesla in 

ChapterCase 1

. Musk left his native South Africa at age 17. He went to Canada and then to the United States, where he completed a bachelor’s degree in economics and physics at the University of Pennsylvania. After only two days in a PhD program in Page 226applied physics and material sciences at Stanford University, Musk left graduate school to found Zip2, an online provider of content publishing software for news organizations. Four years later, in 1999, computer maker Compaq acquired Zip2 for $341 million (and was in turn acquired by HP in 2002). Musk moved on to co-found PayPal, an online payment processor. When eBay acquired PayPal for $1.5 billion in 2002, Musk had the financial resources to pursue his passion to use science and engineering to solve social and economic challenges. He is leading three new ventures simultaneously: electric cars with Tesla, renewable energy with SolarCity, and space exploration with SpaceX.

23

 (In 2016, Tesla Motors acquired SolarCity, renaming itself simply Tesla).

·

Entrepreneurs

 are the agents who introduce change into the competitive system. They do this not only by figuring out how to use inventions, but also by introducing new products or services, new production processes, and new forms of organization. Entrepreneurs can introduce change by starting new ventures, such as Reed Hastings with Netflix or Mark Zuckerberg with Facebook. Or they can be found within existing firms, such as A.G. Lafley at Procter & Gamble (P&G), who implemented an open-innovation model (which we’ll discuss in 

Chapter 11

). When innovating within existing companies, change agents are often called intrapreneurs: those pursuing corporate entrepreneurship.

24

Entrepreneurs who drive innovation need just as much skill, commitment, and daring as the inventors who are responsible for the process of invention.

25

 As an example, the engineer Nikola Tesla invented the alternating-current (AC) electric motor and was granted a patent in 1888 by the U.S. Patent and Trademark Office.

26

 Because this breakthrough technology was neglected for much of the 20th century and Nikola Tesla did not receive the recognition he deserved in his lifetime, the entrepreneur Elon Musk is not just commercializing Tesla’s invention but also honoring Tesla with the name of his company, Tesla, which was formed to design and manufacture all-electric automobiles. Tesla launched several all-electric vehicles based on Tesla’s original invention (see 
ChapterCase 1
).

Strategic entrepreneurship

 describes the pursuit of innovation using tools and concepts from strategic management.

27

 We can leverage innovation for competitive advantage by applying a strategic management lens to entrepreneurship. The fundamental question of strategic entrepreneurship, therefore, is how to combine entrepreneurial actions, creating new opportunities or exploiting existing ones with strategic actions taken in the pursuit of competitive advantage.

28

 This can take place within new ventures such as Tesla or within established firms such as Apple. Apple’s continued innovation in mobile devices is an example of strategic entrepreneurship: Apple’s managers use strategic analysis, formulation, and implementation when deciding which new type of mobile device to research and develop, when to launch it, and how to implement the necessary organizational changes to support the product launch. Each new release is an innovation; each is therefore an act of entrepreneurship—planned and executed using strategic management concepts. In 2015, for example, Apple entered the market for computer wearables by introducing the Apple Watch. In 2017, Apple released the 10th-year anniversary model of its original iPhone, introduced in 2007.

Social entrepreneurship

 describes the pursuit of social goals while creating profitable businesses. Social entrepreneurs evaluate the performance of their ventures not only by financial metrics but also by ecological and social contribution (profits, planet, and people). They use a triple-bottom-line approach to assess performance (discussed in 
Chapter 5
). Examples of social entrepreneurship ventures include Teach For America, TOMS Shoes (which gives a pair of shoes to an economically disadvantaged child for every pair of shoes it sells), Better World Books (an online bookstore that uses capitalism to alleviate illiteracy around the word),

29

 and Wikipedia, whose mission is to collect and develop educational information, and make it freely available to any person in the world (see following and 

MiniCase 14

).

Page 227

The founder of Wikipedia, Jimmy Wales, typifies social entrepreneurship.

30

 Raised in Alabama, Wales was educated by his mother and grandmother who ran a nontraditional school. In 1994, he dropped out of a doctoral program in economics at Indiana University to take a job at a stock brokerage firm in Chicago. In the evenings he wrote computer code for fun and built a web browser. During the late 1990s internet boom, Wales was one of the first to grasp the power of an open-source method to provide knowledge on a very large scale. What differentiates Wales from other web entrepreneurs is his idealism: Wikipedia is free for the end user and supports itself solely by donations and not, for example, by online advertising. Wikipedia has 35 million articles in 288 languages, including some 5 million items in English. About 500 million people use Wikipedia each month. Wales’ idealism is a form of social entrepreneurship: His vision is to make the entire repository of human knowledge available to anyone anywhere for free.

Since entrepreneurs and the innovations they unleash frequently create entire new industries, we now turn to a discussion of the industry life cycle to derive implications for competitive strategy.

7.3 Innovation and the Industry Life Cycle

LO 7-3

Describe the competitive implications of different stages in the industry life cycle.

Innovations frequently lead to the birth of new industries. Innovative advances in IT and logistics facilitated the creation of the overnight express delivery industry by FedEx and that of big-box retailing by Walmart. The internet set online retailing in motion, with new companies such as Amazon and eBay taking the lead, and it revolutionized the advertising industry first through Yahoo, and later Google and Facebook. Advances in nanotechnology are revolutionizing many different industries, ranging from medical diagnostics and surgery to lighter and stronger airplane components.

31

Industries tend to follow a predictable 

industry life cycle

: As an industry evolves over time, we can identify five distinct stages: introduction, growth, shakeout, maturity, and decline.

32

 We will illustrate how the type of innovation and resulting strategic implications change at each stage of the life cycle as well as how innovation can initiate and drive a new life cycle.

The number and size of competitors change as the industry life cycle unfolds, and different types of consumers enter the market at each stage. That is, both the supply and demand sides of the market change as the industry ages. Each stage of the industry life cycle requires different competencies for the firm to perform well and to satisfy that stage’s unique customer group. We first introduce the life cycle model before discussing different customer groups in more depth when introducing the crossing-the-chasm concept later in this chapter.

33

Exhibit 7.4

 depicts a typical industry life cycle, focusing on the smartphone industry in emerging and developed economies. In a stylized industry life cycle model, the horizontal axis shows time (in years) and the vertical axis market size. In 
Exhibit 7.4
, however, we are taking a snapshot of the global smartphone industry in the year 2018. This implies that we are joining two different life cycles (one for emerging economies and one for developed economies) in the same exhibit at one point in time.

EXHIBIT 7.4 
 Industry Life Cycle: The Smartphone Industry in Emerging and Developed Economies

The development of most industries follows an S-curve. Initial demand for a new product or service is often slow to take off, then accelerates, before decelerating, and eventually turning to zero, and even becoming negative as a market contracts.

As shown in 
Exhibit 7.4
, in emerging economies such as Argentina, Brazil, China, India, Indonesia, Mexico, and Russia, the smartphone industry is in the growth stage. The market for smartphones in these countries is expected to grow rapidly over the next few years. More and more of the consumers in these countries with very large populations Page 228are expected to upgrade from a simple mobile phone to a smartphone such as the Apple iPhone, Samsung Galaxy, or Xiaomi’s popular Mi6.

In contrast, the market for smartphones is in the maturity stage in 2018 in developed economies such as Australia, Canada, Germany, Japan, South Korea, the United Kingdom, and the United States. This implies that developed economies moved through the prior three stages of the industry life cycle (introductory, growth, and shakeout) some years earlier. Because the smartphone industry is mature in these markets, little or no growth in market size is expected over the next few years because most consumers own smartphones. This implies that any market share gain by one firm comes at the expense of others, as users replace older smartphones with newer models. Competitive intensity is expected to be high.

Each stage of the industry life cycle—introduction, growth, shakeout, maturity, and decline—has different strategic implications for competing firms. We now discuss each stage in detail.

INTRODUCTION STAGE

When an individual inventor or company launches a successful innovation, a new industry may emerge. In this introductory stage, the innovator’s core competency is R&D, which is necessary to creating a product category that will attract customers. This is a capital-intensive process, in which the innovator is investing in designing a unique product, trying new ideas to attract customers, and producing small quantities—all of which contribute to a high price when the product is launched. The initial market size is small, and growth is slow.

In this introductory stage, when barriers to entry tend to be high, generally only a few firms are active in the market. In their competitive struggle for market share, they emphasize unique product features and performance rather than price.

Although there are some benefits to being early in the market (as previously discussed), innovators also may encounter first-mover disadvantages. They must educate potential Page 229customers about the product’s intended benefits, find distribution channels and complementary assets, and continue to perfect the fledgling product. Although a core competency in R&D is necessary to create or enter an industry in the introductory stage, some competency in marketing also is helpful in achieving a successful product launch and market acceptance. Competition can be intense, and early winners are well-positioned to stake out a strong position for the future. As one of the main innovators in software for mobile devices, Google’s Android operating system for smartphones is enjoying a strong market position and substantial lead over competitors.

The strategic objective during the introductory stage is to achieve market acceptance and seed future growth. One way to accomplish these objectives is to initiate and leverage 

network effects

,

34

 the positive effect that one user of a product or service has on the value of that product for other users. Network effects occur when the value of a product or service increases, often exponentially, with the number of users. If successful, network effects propel the industry to the next stage of the life cycle, the growth stage (which we discuss next).

Apple effectively leveraged the network effects generated by numerous complementary software applications (apps) available via iTunes to create a tightly integrated ecosystem of hardware, software, and services, which competitors find hard to crack. The consequence has been a competitive advantage for over a decade, beginning with the introduction of the iPod in 2001 and iTunes in 2003. Apple launched its enormously successful iPhone in the summer of 2007. A year later, it followed up with the Apple App Store, which boasts, for almost anything you might need, “there’s an app for that.” Popular apps allow iPhone users to access their business contacts via LinkedIn, hail a ride via Uber, call colleagues overseas via Skype, check delivery of their Zappos packages shipped via UPS, get the latest news on Twitter, and engage in customer relationship management using Salesforce.com. You can stream music via Pandora, post photos using Instagram, watch Netflix, access Facebook to check on your friends, or video message using Snap.

Even more important is the effect that apps have on the value of an iPhone. Arguably, the explosive growth of the iPhone is due to the fact that the Apple App Store offers the largest selection of apps to its users. By 2017, the App Store offered more than 2 million apps, which had been downloaded more than 130 billion times, earning Apple some $50 billion in revenues. Moreover, Apple argues that users have a better experience because the apps take advantage of the tight integration of hardware and software provided by the iPhone. The availability of apps, in turn, leads to network effects that increase the value of the iPhone for its users. 

Exhibit 7.5

 shows how. Increased value creation, as we know from 
Chapter 6
, is positively related to demand, which in turn increases the installed base, meaning the number of people using an iPhone. As of the spring of 2017, Apple had sold some 80 million iPhone 7 models in just six months. The average selling price of an iPhone was $700; with the latest model (iPhone X) priced at $1,000. As the installed base of iPhone users further increases, this incentivizes software developers to write even more apps. Making apps widely available strengthened Apple’s position in the smartphone industry. Based on positive feedback loops, a virtuous cycle emerges where one factor positively reinforces another. Apple’s ecosystem based on integrated hardware, software, and services providing a superior user experience is hard to crack for competitors.

EXHIBIT 7.5 
 Leveraging Network Effects to Drive Demand: Apple’s iPhone

Page 230

GROWTH STAGE

Market growth accelerates in the growth stage of the industry life cycle (see 
Exhibit 7.4
). After the initial innovation has gained some market acceptance, demand increases rapidly as first-time buyers rush to enter the market, convinced by the proof of concept demonstrated in the introductory stage.

As the size of the market expands, a 

standard

 signals the market’s agreement on a common set of engineering features and design choices.

35

 Standards can emerge from the bottom up through competition in the marketplace or be imposed from the top down by government or other standard-setting agencies such as the Institute of Electrical and Electronics Engineers (IEEE) that develops and sets industrial standards in a broad range of industries, including energy, electric power, biomedical and health care technology, IT, telecommunications, consumer electronics, aerospace, and nanotechnology. 

Strategy

High

light 7.1

 discusses the unfolding standards battle in the automotive industry.

Strategy Highlight 7.1

Standards Battle: Which Automotive Technology Will Win?

In the envisioned future transition away from gasoline-powered cars, Nissan Chairman Carlos Ghosn firmly believes the next technological paradigm will be electric motors. Ghosn calls hybrids a “halfway technology” and suggests they will be a temporary phenomenon at best. A number of start-up companies, including Tesla in the United States and BYD Auto in China, share Ghosn’s belief in this particular future scenario.

One of the biggest impediments to large-scale adoption of electric vehicles, however, remains the lack of appropriate infrastructure: There are few stations where drivers can recharge their car’s battery when necessary. With the range of electric vehicles currently limited to some 200 miles, many consider a lack of recharging stations a serious problem, so called “range anxiety.” High-end Tesla vehicles can achieve 250 miles per charge, while a lower priced Nissan Leaf’s maximum is range is roughly 85 miles. Tesla, Nissan, and other independent charging providers such as ChargePoint, however, are working hard to develop a network of charging stations. By early 2017, Tesla claimed a network of some 800 supercharger stations throughout the United States and was building more stalls at many stations. It also enabled the in-car map to identify how many stalls were open at each station in real time.

The Nissan Leaf, the world’s best-selling electric vehicle.
©VDWI Automotive/Alamy Stock Photo RF

Nissan’s Ghosn believes electric cars will account for up to 10 percent of global auto sales over the next decade. The Swedish car maker Volvo has gone even further by announcing that beginning in 2019 it will no longer produce any cars with internal combustion engines. Rather, all its new vehicles will be fully electric or hybrid. This is a strong strategic commitment by one of the traditional car manufacturers. It is also the first of its kind.

In contrast, Toyota is convinced gasoline-electric hybrids will become the next dominant technology. These different predictions have significant influence on how much money Nissan and Toyota invest in technology and where. Nissan builds one of its fully electric vehicles, the Leaf (an acronym for Leading, Environmentally friendly, Affordable, Family car) at a plant in Smyrna, Tennessee. Toyota is expanding its R&D investments in hybrid technology. Nissan put its money where its mouth is and has spent millions developing its electric-car program since the late 1990s. Since it was introduced in December 2010, the Nissan Leaf has become the best-selling electric vehicle, with more than 250,000 units sold. The most recent Nissan Leaf model has a range of more than 100 miles per charge. In 2017, GM introduced the all-electric Chevy Bolt, with a range of over 200 miles per charge, similar to Tesla’s Model 3.

Toyota, on the other hand, has already sold 10 million of its popular Prius cars since they were introduced in 1997. By 2020, Toyota plans to offer hybrid technology in all its vehicles. Eventually, the investments made by Nissan and Toyota will yield different returns, depending on which predictions prove more accurate.

An alternative outcome is that neither hybrids nor electric cars will become the next paradigm. To add even more uncertainty to the mix, Honda and BMW are betting on cars powered by hydrogen fuel cells. In sum, many alternative technologies are competing to become the winner in setting a new standard for propelling cars. This situation is depicted in 

Exhibit 7.6 

, where the new technologies represent a swarm of new entries vying for dominance. Only time will tell which technology will win this standards battle.

36

EXHIBIT 7.6 
 Automotive Technologies Compete for Industry Dominance

Page 231

Since demand is strong during the growth phase, both efficient and inefficient firms thrive; the rising tide lifts all boats. Moreover, prices begin to fall, often rapidly, as standard business processes are put in place and firms begin to reap economies of scale and learning. Distribution channels are expanded, and complementary assets in the form of products and services become widely available.

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After a standard is established in an industry, the basis of competition tends to move away from product innovations toward process innovations.

38

 

Product innovations

, as the name suggests, are new or recombined knowledge embodied in new products—the jet airplane, electric vehicle, smartphones, and wearable computers. 

Process innovations

 are new ways to produce existing products or to deliver existing services. Process innovations are made possible through advances such as the internet, lean manufacturing, Six Sigma, biotechnology, nanotechnology, and so on.

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Process innovation must not be high-tech to be impactful, however. The invention of the standardized shipping container, for instance, has transformed global trade. By loading goods into uniform containers that could easily be moved between trucks, rail, and ships, significant savings in cost and time were accomplished. Before containerization was invented some 60 years ago, it cost almost $6 to load a ton of (loose) cargo, and theft was rampant. After containerization, the cost for loading a ton of cargo had plummeted to $0.16 and theft all but disappeared (because containers are sealed at the departing factory). Efficiency gains in terms of labor and time were even more impressive. Before containerization, dock labor could move 1.7 tons per hour onto a cargo ship. After containerization, this had jumped to 30 tons per hour. Ports are now able to accommodate much larger ships, and travel time across the oceans has fallen in half. As a consequence, costs for shipping goods across the globe have fallen rapidly. Moreover, containerization enabled optimization of global supply chains and set the stage for subsequent process innovations such as just-in-time (JIT) operations management. Taken together, a set of research studies estimated that containerization alone more than tripled international trade within five years of adopting this critical process innovation.

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Exhibit 7.7 

shows the level of product and process innovation throughout the entire life cycle.

40

 In the introductory stage, the level of product innovation is at a maximum because new features increasing perceived consumer value are critical to gaining traction in the market. In contrast, process innovation is at a minimum in the introductory stage because companies produce only a small number of products, often just prototypes or beta versions. The main concern is to commercialize the invention—that is, to demonstrate that the product works and that a market exists.

EXHIBIT 7.7 
 Product and Process Innovation throughout an Industry Life Cycle

The relative importance, however, reverses over time. Frequently, a standard emerges during the growth stage of the industry life cycle (see the second column, “Growth,” in 

Exhibit 7.7

). At that point, most of the technological and commercial uncertainties about the new product are gone. After the market accepts a new product, and a standard for the new technology has emerged, process innovation rapidly becomes more important than product innovation. As market demand increases, economies of scale kick in: Firms establish and optimize standard business processes through applications of lean manufacturing, Page 233Six Sigma, and so on. As a consequence, product improvements become incremental, while the level of process innovation rises rapidly.

During the growth stage, process innovation ramps up (at increasing marginal returns) as firms attempt to keep up with rapidly rising demand while attempting to bring down costs at the same time. The core competencies for competitive advantage in the growth stage tend to shift toward manufacturing and marketing capabilities. At the same time, the R&D emphasis tends to shift to process innovation for improved efficiency. Competitive rivalry is somewhat muted because the market is growing fast.

Since market demand is robust in this stage and more competitors have entered the market, there tends to be more strategic variety: Some competitors will continue to follow a differentiation strategy, emphasizing unique features, product functionality, and reliability. Other firms employ a cost-leadership strategy in order to offer an acceptable level of value but lower prices to consumers. They realize that lower cost is likely a key success factor in the future, because this will allow the firm to lower prices and attract more consumers into the market. When introduced in the spring of 2010, for example, Apple’s first-generation iPad was priced at $829 for 64GB with a 3G Wi-Fi connection.

41

 Just three years later, in spring 2013, the same model was priced at only one-third of the original price, or $275.

42

 Access to efficient and large-scale manufacturing operations (such as those offered by Foxconn in China, the company that assembles most of Apple’s products) and effective supply chain capabilities are key success factors when market demand increases rapidly. By 2017, Gazelle, an ecommerce company that allows people to sell their electronic devices and to buy pre-certified used ones, offered a mere $15 for a “flawless” first-generation iPad.

The key objective for firms during the growth phase is to stake out a strong strategic position not easily imitated by rivals. In the fast-growing shapewear industry, start-up company Spanx has staked out a strong position. In 1998, Florida State University graduate Sara Blakely decided to cut the feet off her pantyhose to enhance her looks when wearing pants.

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 Soon after she obtained a patent for her body-shaping undergarments, and Spanx began production and retailing of its shapewear in 2000. Sales grew exponentially after Blakely appeared on The Oprah Winfrey Show. By 2017, Spanx had grown to more than 250 employees and sold millions of Spanx “power panties,” with estimated revenues of some $500 million. To stake out a strong position and to preempt competitors, Spanx now offers over 200 products ranging from slimming apparel and swimsuits to bras and activewear. Moreover, it now designs and manufactures body-shaping undergarments for men (“Spanx for Men—Manx”). Spanx products are now available in over 50 countries globally via the internet. Moreover, to strengthen its strategic position and brand image in the United States, Spanx is opening retail stores across the country.

The shapewear industry’s explosive growth—it is expected to reach $6 billion in annual sales by 2022—has attracted several other players: Flexees by Maidenform, BodyWrap, and Miraclesuit, to name a few. They are all attempting to carve out positions in the new industry. Given Spanx’s ability to stake out a strong position during the growth stage of the industry life cycle and the fact that it continues to be a moving target, it might be difficult for competitors to dislodge the company.

Taking the risk paid off for Spanx’s founder: After investing an initial $5,000 into her startup, Blakely became the world’s youngest self-made female billionaire. Blakely was also listed in the Time 100, the annual list of the most influential people in the world.

SHAKEOUT STAGE

Rapid industry growth and expansion cannot go on indefinitely. As the industry moves into the next stage of the industry life cycle, the rate of growth declines (see 
Exhibit 7.4
). Firms begin to compete directly against one another for market share, rather than trying Page 234to capture a share of an increasing pie. As competitive intensity increases, the weaker firms are forced out of the industry. This is the reason this phase of the industry life cycle is called the shakeout stage: Only the strongest competitors survive increasing rivalry as firms begin to cut prices and offer more services, all in an attempt to gain more of a market that grows slowly, if at all. This type of cutthroat competition erodes profitability of all but the most efficient firms in the industry. As a consequence, the industry often consolidates, as the weakest competitors either are acquired by stronger firms or exit through bankruptcy.

The winners in this increasingly competitive environment are often firms that stake out a strong position as cost leaders. Key success factors at this stage are the manufacturing and process engineering capabilities that can be used to drive costs down. The importance of process innovation further increases (albeit at diminishing marginal returns), while the importance of product innovation further declines.

Assuming an acceptable value proposition, price becomes a more important competitive weapon in the shakeout stage, because product features and performance requirements tend to be well-established. A few firms may be able to implement a blue ocean strategy, combining differentiation and low cost, but given the intensity of competition, many weaker firms are forced to exit. Any firm that does not have a clear strategic profile is likely to not survive the shakeout phase.

MATURITY STAGE

After the shakeout is completed and a few firms remain, the industry enters the maturity stage. During the fourth stage of the industry life cycle, the industry structure morphs into an oligopoly with only a few large firms. Most of the demand was largely satisfied in the shakeout stage. Any additional market demand in the maturity stage is limited. Demand now consists of replacement or repeat purchases. The market has reached its maximum size, and industry growth is likely to be zero or even negative going forward. This decrease in market demand increases competitive intensity within the industry. In the maturity stage, the level of process innovation reaches its maximum as firms attempt to lower cost as much as possible, while the level of incremental product innovation sinks to its minimum (see 
Exhibit 7.7
).

Generally, the firms that survive the shakeout stage tend to be larger and enjoy economies of scale, as the industry consolidated and most excess capacity was removed. The domestic airline industry has been in the maturity stage for a long time. The large number of bankruptcies as well as the wave of mega-mergers, such as those of Delta and Northwest, United and Continental, and American Airlines and US Airways, are a consequence of low or zero growth in a mature market characterized by significant excess capacity.

DECLINE STAGE

Changes in the external environment (such as those discussed in 

Chapter 3

 when presenting the PESTEL framework) often take industries from maturity to decline. In this final stage of the industry life cycle, the size of the market contracts further as demand falls, often rapidly. At this final phase of the industry life cycle, innovation efforts along both product and process dimensions cease (see 
Exhibit 7.7
). If a technological or business model breakthrough emerges that opens up a new industry, however, then this dynamic interplay between product and process innovation starts anew.

If there is any remaining excess industry capacity in the decline stage, this puts strong pressure on prices and can further increase competitive intensity, especially if the industry Page 235has high exit barriers. At this final stage of the industry life cycle, managers generally have four strategic options: exit, harvest, maintain, or consolidate:

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· ▪ Exit. Some firms are forced to exit the industry by bankruptcy or liquidation. The U.S. textile industry has experienced a large number of exits over the last few decades, mainly due to low-cost foreign competition.

· ▪ Harvest. In pursuing a harvest strategy, the firm reduces investments in product support and allocates only a minimum of human and other resources. While several companies such as IBM, Brother, Olivetti, and Nakajima still offer typewriters, they don’t invest much in future innovation. Instead, they are maximizing cash flow from their existing typewriter product line.

· ▪ Maintain. Philip Morris, on the other hand, is following a maintain strategy with its Marlboro brand, continuing to support marketing efforts at a given level despite the fact that U.S. cigarette consumption has been declining.

· ▪ Consolidate. Although market size shrinks in a declining industry, some firms may choose to consolidate the industry by buying rivals. This allows the consolidating firm to stake out a strong position—possibly approaching monopolistic market power, albeit in a declining industry.

Although chewing tobacco is a declining industry, Swedish Match has pursued a number of acquisitions to consolidate its strategic position in the industry. It acquired, among other firms, the Pinkerton Tobacco Co. of Owensboro, Kentucky, maker of the Red Man brand. Red Man is the leading chewing tobacco brand in the United States. Red Man has carved out a strong strategic position built on a superior reputation for a quality product and by past endorsements of Major League Baseball players since 1904. Despite gory product warnings detailing the health risk of chewing tobacco and a federally mandated prohibition on marketing, the Red Man brand has remained not only popular, but also profitable.

The industry life cycle model assumes a more or less smooth transition from one stage to another. This holds true for most continuous innovations that require little or no change in consumer behavior. But not all innovations enjoy such continuity.

CROSSING THE CHASM

LO 7-4

Derive strategic implications of the crossing-the-chasm framework.

In the influential bestseller Crossing the Chasm

45

 Geoffrey Moore documented that many innovators were unable to successfully transition from one stage of the industry life cycle to the next. Based on empirical observations, Moore’s core argument is that each stage of the industry life cycle is dominated by a different customer group. Different customer groups with distinctly different preferences enter the industry at each stage of the industry life cycle. Each customer group responds differently to a technological innovation. This is due to differences in the psychological, demographic, and social attributes observed in each unique customer segment. Moore’s main contribution is that the significant differences between the early customer groups—who enter during the introductory stage of the industry life cycle—and later customers—who enter during the growth stage—can make for a difficult transition between the different parts of the industry life cycle. Such differences between customer groups lead to a big gulf or chasm into which companies and their innovations frequently fall. Only companies that recognize these differences and are able to apply the appropriate competencies at each stage of the industry life cycle will have a chance to transition successfully from stage to stage.

Exhibit 7.8

 shows the 

crossing-the-chasm framework

 and the different customer segments. The industry life cycle model (shown in 
Exhibit 7.4
) follows an S-curve leading Page 236up to 100 percent total market potential that can be reached during the maturity stage. In contrast, the chasm framework breaks down the 100 percent market potential into different customer segments, highlighting the incremental contribution each specific segment can bring into the market. This results in the familiar bell curve. Note the big gulf, or chasm, separating the early adopters from the early and late majority that make up the mass market. Social network sites have followed a pattern similar to that illustrated in 
Exhibit 7.8
. Friendster was unable to cross the big chasm. Myspace was successful with the early majority, but only Facebook went on to succeed with the late majority and laggards. Each stage customer segment, moreover, is also separated by smaller chasms. Both the large competitive chasm and the smaller ones have strategic implications.

EXHIBIT 7.8 
 The Crossing-the-Chasm Framework

Source: Adapted from G.A. Moore (1991), Crossing the Chasm: Marketing and Selling Disruptive Products to Mainstream Customers (New York: HarperCollins), 17.

Both new technology ventures and innovations introduced by established firms have a high failure rate. This can be explained as a failure to successfully cross the chasm from the early users to the mass market because the firm does not recognize that the business strategy needs to be fine-tuned for each customer segment. Formulating a business strategy for each segment guided by the who, what, why, and how questions of competition (Who to serve? What needs to satisfy? Why and how to satisfy them?), introduced in 
Chapter 6
, the firm will find that the core competencies to satisfy each of the different customer segments are quite different. If not recognized and addressed, this will lead to the demise of the innovation as it crashes into the chasm between life cycle stages.

We first introduce each customer group and map it to the respective stage of the industry life cycle. To illustrate, we then apply the chasm framework to an analysis of the mobile phone industry.

TECHNOLOGY ENTHUSIASTS

The customer segment in the introductory stage of the industry life cycle is called technology enthusiasts.

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 The smallest market segment, it makes up some 2.5 percent of total market potential.

Technology enthusiasts

often have an engineering mind-set and pursue new technology proactively. They frequently seek out new products before the products are officially introduced into the market. Technology enthusiasts enjoy using beta versions of products, tinkering with the product’s imperfections and providing (free) feedback and suggestions to companies. For example, many software companies such as Google and Microsoft launch beta versions to accumulate customer feedback to work out bugs before the official launch. Moreover, technology enthusiasts will often pay a premium price to have the latest gadget. The endorsement by technology enthusiasts validates the fact that the new product does in fact work.

A recent example of an innovation that appeals to technology enthusiasts is Google Glass, a mobile computer that is worn like a pair of regular glasses. Instead of a lens, Page 237however, one side displays a small, high-definition computer screen. Google Glass was developed as part of Google’s wild-card program. Technology enthusiasts were eager to get ahold of Google Glass when made available in a beta testing program in 2013.

Google Glass allows the wearer to use the internet and smartphone-like applications via voice commands (e.g., conduct online search, stream video, and so on).
©AP Images/Google/REX

Those interested had to compose a Google+ or Twitter message of 50 words or less explaining why they would be a good choice to test the device and include the hashtag #ifihadglass. Some 150,000 people applied and 8,000 winners were chosen. They were required to attend a Google Glass event and pay $1,500 for the developer version of Google Glass.

Although many industry leaders, including Apple CEO Tim Cook, agree that wearable computers such as the Apple Watch or the Fitbit (a physical activity tracker that is worn on the wrist; data are integrated into an online community and phone app) are important mobile devices, they suggest that there is a large chasm between the current technology for computerized eyeglasses and a successful product for early adopters let alone the mass market.

47

 They seem to be correct, because Google was until now unable to cross the chasm between technology enthusiasts and early adopters, even after spending $10 billion on R&D per year.

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EARLY ADOPTERS

The customers entering the market in the growth stage are early adopters. They make up roughly 13.5 percent of the total market potential.

Early adopters

, as the name suggests, are eager to buy early into a new technology or product concept. Unlike technology enthusiasts, however, their demand is driven by their imagination and creativity rather than by the technology per se. They recognize and appreciate the possibilities the new technology can afford them in their professional and personal lives. Early adopters’ demand is fueled more by intuition and vision rather than technology concerns. These are the people that lined up at Apple Stores in the spring of 2015 when it introduced Apple Watch. Since early adopters are not influenced by standard technological performance metrics but by intuition and imagination (What can this new product do for me or my business?), the firm needs to communicate the product’s potential applications in a more direct way than when it attracted the initial technology enthusiasts. Attracting the early adopters to the new offering is critical to opening any new high-tech market segment.

EARLY MAJORITY

The customers coming into the market in the shakeout stage are called early majority. Their main consideration in deciding whether or not to adopt a new technological innovation is a strong sense of practicality. They are pragmatists and are most concerned with the question of what the new technology can do for them. Before adopting a new product or service, they weigh the benefits and costs carefully. Customers in the early majority are aware that many hyped product introductions will fade away, so they prefer to wait and see how things shake out. They like to observe how early adopters are using the product.

Early majority

customers rely on endorsements by others. They seek out reputable references such as reviews in prominent trade journals or in magazines such as Consumer Reports.

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Because the early majority makes up roughly one-third of the entire market potential, winning them over is critical to the commercial success of the innovation. They are on the cusp of the mass market. Bringing the early majority on board is the key to catching the growth wave of the industry life cycle. Once they decide to enter the market, a herding effect is frequently observed: The early majority enters in large numbers.

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The significant differences in the attitudes toward technology of the early majority when compared to the early adopters signify the wide competitive gulf—the chasm—between these two consumer segments (see 
Exhibit 7.8
). Without adequate demand from the early majority, most innovative products wither away.

Fisker Automotive, a California-based designer and manufacturer of premium plug-in hybrid vehicles, fell into the chasm because it was unable to transition to early adopters, let alone the mass market. Between its founding in 2007 and 2012, Fisker sold some 1,800 of its Karma model, a $100,000 sports car, to technology enthusiasts. It was unable, however, to follow up with a lower-cost model to attract the early adopters into the market. In addition, technology and reliability issues for the Karma could not be overcome. By 2013, Fisker had crashed into the first chasm (between technology enthusiasts and early adopters), filing for bankruptcy. The assets of Fisker Automotive were purchased by Wanxiang, a Chinese auto parts maker.

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Tesla Motors CEO Elon Musk (left) in front of a Tesla Roadster; Fisker Automotive CEO Henrik Fisker (right) in front of a Fisker Karma.
©Misha Gravenor

In contrast, Tesla, the maker of all-electric vehicles introduced in 
ChapterCase 1
 and a fierce rival of Fisker at one time, was able to overcome some of the early chasms. The Tesla Roadster was a proof-of-concept car that demonstrated that electric vehicles could achieve an equal or better performance than the very best gasoline-engine sports cars. The 2,400 Roadsters that Tesla built between 2008 and 2012 were purchased by technology enthusiasts. Next, Tesla successfully launched the Model S, a family sedan, sold to early adopters. The Tesla Model S received a strong endorsement as the 2013 Motor Trend Car of the Year and the highest test scores ever awarded by Consumer Reports. This may help in crossing the chasm to the early majority, because consumers would now feel more comfortable in considering and purchasing a Tesla vehicle. Tesla is hoping to cross the large competitive chasm between early adopters and early majority with its new, lower-priced Model 3.

LATE MAJORITY

The next wave of growth comes from buyers in the late majority entering the market in the maturity stage. Like the early majority, they are a large customer Page 239segment, making up approximately 34 percent of the total market potential. Combined, the early majority and late majority make up the lion’s share of the market potential. Demand coming from just two groups—early and late majority—drives most industry growth and firm profitability.

Members of the early and late majority are also quite similar in their attitudes toward new technology. The late majority shares all the concerns of the early majority. But there are also important differences. Although members of the early majority are confident in their ability to master the new technology, the late majority is not. They prefer to wait until standards have emerged and are firmly entrenched, so that uncertainty is much reduced. The late majority also prefers to buy from well-established firms with a strong brand image rather than from unknown new ventures.

LAGGARDS

Finally, laggards are the last consumer segment to come into the market, entering in the declining stage of the industry life cycle. These are customers who adopt a new product only if it is absolutely necessary, such as first-time cell phone adopters in the United States today. These customers generally don’t want new technology, either for personal or economic reasons. Given their reluctance to adopt new technology, they are generally not considered worth pursuing. 

Laggards

make up no more than 16 percent of the total market potential. Their demand is far too small to compensate for reduced demand from the early and late majority (jointly almost 70 percent of total market demand), who are moving on to different products and services.

CROSSING THE CHASM: APPLICATION TO THE MOBILE PHONE INDUSTRY

Let’s apply the crossing-the-chasm framework to one specific industry. In this model, the transition from stage to stage in the industry life cycle is characterized by different competitive chasms that open up because of important differences between customer groups. Although the large chasm between early adopters and the early majority is the main cause of demise for technological innovations, other smaller mini-chasms open between each stage.

Exhibit 7.9

 shows the application of the chasm model to the mobile phone industry. The first victim was Motorola’s Iridium, an ill-fated satellite-based telephone system.

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 Development began in 1992 after the spouse of a Motorola engineer complained about being unable to get any data or voice access to check on clients while vacationing Page 240on a remote island. Motorola’s solution was to launch 66 satellites into low orbit to provide global voice and data coverage. In late 1998, Motorola began offering its satellite phone service, charging $5,000 per handset (which was almost too heavy to carry around) and up to $14 per minute for calls.

52

 Problems in consumer adoption beyond the few technology enthusiasts became rapidly apparent. The Iridium phone could not be used inside buildings or in cars. Rather, to receive a satellite signal, the phone needed an unobstructed line of sight to a satellite. Iridium crashed into the first chasm, never moving beyond technology enthusiasts (see 
Exhibit 7.9
). For Motorola, it was a billion-dollar blunder. Iridium was soon displaced by cell phones that relied on Earth-based networks of radio towers. The global satellite telephone industry never moved beyond the introductory stage of the industry life cycle.

EXHIBIT 7.9 
 Crossing the Chasm: The Mobile Phone Industry

The first Treo, a fully functioning smartphone combining voice and data capabilities, was released in 2002 by Handspring. The Treo fell into the main chasm that arises between early adopters and the early majority (see 
Exhibit 7.9
). Technical problems, combined with a lack of apps and an overly rigid contract with Sprint as its sole service provider, prevented the Treo from gaining traction in the market beyond early adopters. For these reasons, the Treo was not an attractive product for the early majority, who rejected it. This caused the Treo to plunge into the chasm. Just a year later, Handspring was folded into Palm, which in turn was acquired by HP for $1 billion in 2010.

53

 HP shut down Palm in 2011 and wrote off the acquisition.

54

BlackBerry (formerly known as Research in Motion or RIM)

55

 introduced its first fully functioning smartphone in 2000. It was a huge success—especially with two key consumer segments. First, corporate IT managers were early adopters. They became product champions for the BlackBerry smartphone because of its encrypted security software and its reliability in always staying connected to a company’s network. This allowed users to receive e-mail and other data in real time, anywhere in the world where wireless service was provided. Second, corporate executives were the early majority pulling the BlackBerry smartphone over the chasm because it allowed 24/7 access to data and voice. BlackBerry was able to create a beachhead to cross the chasm between the technology enthusiasts and early adopters on one side and the early majority on the other.

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 BlackBerry’s managers identified the needs of not only early adopters (e.g., IT managers) but also the early majority (e.g., executives), who pulled the BlackBerry over the chasm. By 2005, the BlackBerry had become a corporate executive status symbol. As a consequence of capturing the first three stages of the industry life cycle, between 2002 and 2007, BlackBerry enjoyed no less than 30 percent year-over-year revenue growth as well as double-digit growth in other financial performance metrics such as return on equity. BlackBerry enjoyed a temporary competitive advantage.

In 2007, BlackBerry’s dominance over the smartphone market began to erode quickly. The main reason was Apple’s introduction of the iPhone. Although technology enthusiasts and early adopters argue that the iPhone is an inferior product to the BlackBerry based on technological criteria, the iPhone enticed not only the early majority, but also the late majority to enter the market. For the late majority, encrypted software security was much less important than having fun with a device that allowed users to surf the web, take pictures, play games, and send and receive e-mail. Moreover, the Apple iTunes Store soon provided thousands of apps for basically any kind of service. While the BlackBerry couldn’t cross the gulf between the early and the late majority, Apple’s iPhone captured the mass market rapidly. Moreover, consumers began to bring their personal iPhone to work, which forced corporate IT departments to expand their services beyond the BlackBerry. Apple rode the wave of this success to capture each market segment. Likewise, Samsung with its Galaxy line of phones, having successfully imitated the look-and-feel of an Page 241iPhone (as discussed in 
Chapter 4
), is enjoying similar success across the different market segments.

This brief application of the chasm framework to the mobile phone industry shows its usefulness. It provides insightful explanations of why some companies failed, while others succeeded—and thus goes at the core of strategy management.

In summary, 

Exhibit 7.10 

details the features and strategic implications of the entire industry life cycle at each stage.

EXHIBIT 7.10
 Features and Strategic Implications of the Industry Life Cycle

High

Moderate

Few, if any

Non-price competition

Price

Differentiation

Life Cycle Stages
Introduction	Growth	Shakeout	Maturity	Decline
Core Competency	R&D, some marketing	R&D, some manufacturing, marketing	Manufacturing, process engineering	Manufacturing, process engineering, marketing	Manufacturing, process engineering, marketing, service
Type and Level of Innovation	Product innovation at a maximum; process innovation at a minimum	Product innovation decreasing; process innovation increasing	After emergence of standard: product innovation decreasing rapidly; process innovation increasing rapidly	Product innovation at a minimum; process innovation at a maximum	Product & process innovation ceased
Market Growth	Slow		High	Moderate and slowing down	None to moderate	Negative
Market Size	Small		Moderate	Large	Largest	Small to moderate
	Price	Falling	Low	Low to high
Number of Competitors		Few, if any	Many	Fewer	Moderate, but large
Mode of Competition		Non-price competition	Shifting from non-price to price competition	Price or non-price competition
Type of Buyers	Technology enthusiasts	Early adopters	Early majority	Late majority	Laggards
Business-Level Strategy		Differentiation	Differentiation, or integration strategy	Cost-leadership or integration strategy	Cost-leadership, differentiation, or integration strategy
Strategic Objective	Achieving market acceptance	Staking out a strong strategic position; generating “deep pockets”	Surviving by drawing on “deep pockets”	Maintaining strong strategic position	Exit, harvest, maintain, or consolidate

A word of caution is in order, however: Although the industry life cycle is a useful framework to guide strategic choice, industries do not necessarily evolve through these stages. Moreover, innovations can emerge at any stage of the industry life cycle, which in turn can initiate a new cycle. Industries can also be rejuvenated, often in the declining stage.

Although the industry life cycle is a useful tool, it does not explain everything about changes in industries. Some industries may never go through the entire life cycle, while others are continually renewed through innovation. Be aware, too, that other external factors that can be captured in the PESTEL framework (introduced in 
Chapter 3
) such as fads Page 242in fashion, changes in demographics, or deregulation can affect the dynamics of industry life cycles at any stage.

It is also important to note that innovations that failed initially can sometimes get a second chance in a new industry or for a new application. When introduced in the early 1990s as an early wireless telephone system, Iridium’s use never went beyond that by technology enthusiasts. After Motorola’s failure, the technology was spun out as a standalone venture called Iridium Communications. As of 2017, it looks like Iridium’s satellite-based communications system will get another chance of becoming a true breakthrough innovation.

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 Rather than in an application in the end-consumer market, this time Iridium is considered for global deployment by airspace authorities to allow real-time tracking of airplanes wherever they may be. The issue of being able to track airplanes around the globe at all times came to the fore in 2014, when Malaysia Airlines Flight 370 with 239 people on board disappeared without a trace, and authorities were unable to locate the airplane.

For the last few decades, air controllers had to rely on ground-based radar to direct planes and to triangulate their positions. A major problem with any ground-based system is that it only works over land or near the shore, but not over oceans, which cover more than 70 percent of the Earth’s surface. Moreover, radar does not work in mountain ranges. Oceans and mountain terrain, therefore, are currently dead zones where air traffic controllers are unable to track airplanes.

Iridium’s technology is now used as a space-based flight tracking system. In 2017, Elon Musk’s SpaceX launched the first set of 10 satellites (out of a total of 66 needed) into space to begin constructing a space-based air traffic control system. Such a system affords air traffic controllers full visibility of and real-time flight information from any airplane over both water and land. It also allows pilots more flexibility in changing routes to avoid bad weather and turbulence, thus increasing passenger convenience, saving fuel, and reducing greenhouse-gas emissions. In addition, the new technology, called Aireon, would allow planes to fly closer together (15 miles apart instead of the now customary 80 miles), allowing for more air traffic on efficient routes. A research study by an independent body predicts that global deployment of Aireon would also lead to a substantial improvement in air safety.

Providing the next-generation air traffic control technology and services is a huge business opportunity for Iridium Communications. National air traffic control agencies will be the main customers to deploy the new Aireon technology. This goes to show that a second chance of success for an innovation may arise, even after the timing and application of an initial technology were off.

7.4 Types of Innovation

LO 7-5

Categorize different types of innovations in the markets-and-technology framework.

Because of the importance of innovation in shaping competitive dynamics and as a critical component in formulating business strategy, we now turn to a discussion of different types of innovation and the strategic implications of each. We need to know, in particular, along which dimensions we should assess innovations. This will allow us to formulate a business strategy that can leverage innovation for competitive advantage.

One insightful way to categorize innovations is to measure their degree of newness in terms of technology and markets.

58

 Here, technology refers to the methods and materials used to achieve a commercial objective.

59

 For example, Amazon integrates different types of technologies (hardware, software, big data analytics, cloud computing, logistics, and so on) to provide not only the largest selection of retail goods online, but also an array of services and mobile devices (e.g., Alexa, a digital personal assistant; Page 243Kindle tablets; Prime; cloud-computing services; and so on). We also want to understand the market for an innovation—e.g., whether an innovation is introduced into a new or an existing market—because an invention turns into an innovation only when it is successfully commercialized.

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 Measuring an innovation along these dimensions gives us the 

markets-and-technology framework

 depicted in 

Exhibit 7.11 

. Along the horizontal axis, we ask whether the innovation builds on existing technologies or creates a new one. On the vertical axis, we ask whether the innovation is targeted toward existing or new markets. Four types of innovations emerge: incremental, radical, architectural, and disruptive innovations. As indicated by the color coding in 

Exhibit 7.11

, each diagonal forms a pair: incremental versus radical innovation and architectural versus disruptive innovation.

EXHIBIT 7.11 
 Types of Innovation: Combining Markets and Technologies

INCREMENTAL VS. RADICAL INNOVATION

Although radical breakthroughs such as smartphones and magnetic resonance imaging (MRI) radiology capture most of our attention, the vast majority of innovations are actually incremental ones. An 

incremental innovation

 squarely builds on an established knowledge base and steadily improves an existing product or service offering.

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 It targets existing markets using existing technology.

On the other hand, 

radical innovation

 draws on novel methods or materials, is derived either from an entirely different knowledge base or from a recombination of existing knowledge bases with a new stream of knowledge. It targets new markets by using new technologies.

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 Well-known examples of radical innovations include the introduction of the mass-produced automobile (the Ford Model T), the X-ray, the airplane, and more recently biotechnology breakthroughs such as genetic engineering and the decoding of the human genome.

Many firms get their start by successfully commercializing radical innovations, some of which, such as the jet-powered airplane, even give birth to new industries. Although the British firm de Havilland first commercialized the jet-powered passenger airplane, Boeing was the company that rode this radical innovation to industry dominance. More recently, Boeing’s leadership has been contested by Airbus; each company has approximately half the market. This stalemate is now being challenged by aircraft manufacturers such as Bombardier of Canada and Embraer of Brazil, which are moving up-market by building larger luxury jets that are competing with some of the smaller airplane models offered by Boeing and Airbus.

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A predictable pattern of innovation is that firms (often new ventures) use radical innovation to create a temporary competitive advantage. They then follow up with a string of incremental innovations to sustain that initial lead. Gillette is a prime example for this pattern of strategic innovation. In 1903, entrepreneur King C. Gillette invented and began selling the safety razor with a disposable blade. This radical innovation launched the Gillette Co. (now a brand of Procter & Gamble). To sustain its competitive advantage, Gillette not only made sure that its razors were inexpensive and widely available by introducing the “razor and razor blade” business model, but also continually improved its blades. In a classic example of a string of incremental innovations, Gillette kept adding an additional blade with each new version of its razor until the number had gone from one to six! Though this innovation strategy seems predictable, it worked. Gillette’s newest razor, the Fusion ProGlide with Flexball technology, a razor handle that features a swiveling ball hinge, costs $11.49 (and $12.59 for a battery-operated one) per razor! 

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Dollar Shave Club is disrupting Gillette’s business model based on incremental innovation. As a result, Gillette’s market share in the $15 billion wet shaving industry has declined from some 70 percent (in 2010) to below 60 percent (by 2017).

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The Gillette example, nonetheless, shows how radical innovation created a competitive advantage that the company can sustain through follow-up incremental innovation. Such an outcome is not a foregone conclusion, though. In some instances, the innovator is outcompeted by second movers that quickly introduce a similar incremental innovation to continuously improve their own offering. For example, although CNN was the pioneer in 24-hour cable news, today Fox News is the most watched cable news network in the United States (although the entire industry is in decline as viewers now stream much more content directly via mobile devices, as discussed in 

ChapterCase 7

 about Netflix). Once firms have achieved market acceptance of a breakthrough innovation, they tend to follow up with incremental rather than radical innovations. Over time, these companies morph into industry incumbents. Future radical innovations are generally introduced by new entrepreneurial ventures. Why is this so? The reasons concern economic incentives, organizational inertia, and the firm’s embeddedness in an innovation ecosystem.

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ECONOMIC INCENTIVES

Economists highlight the role of incentives in strategic choice. Once an innovator has become an established incumbent firm (such as Google has today), it has strong incentives to defend its strategic position and market power. An emphasis on incremental innovations strengthens the incumbent firm’s position and thus maintains high entry barriers. A focus on incremental innovation is particularly attractive once an industry standard has emerged and technological uncertainty is reduced. Moreover, many markets where network effects are important (such as online search), turn into 

winner-take-all markets

, where the market leader captures almost all of the market share. As a near monopolist, the winner in these types of markets is able to extract a significant amount of the value created. In the United States, Google handles some 65 percent of all online queries, while it handles more than 90 percent in Europe. As a result, the incumbent firm uses incremental innovation to extend the time it can extract profits based on a favorable industry structure (see the discussion in 
Chapter 3
). Any potential radical innovation threatens the incumbent firm’s dominant position.

The incentives for entrepreneurial ventures, however, are just the opposite. Successfully commercializing a radical innovation is frequently the only option to enter an industry protected by high entry barriers. One of the first biotech firms, Amgen, used newly discovered drugs based on genetic engineering to overcome entry barriers to the pharmaceutical Page 245industry, in which incumbents had enjoyed notoriously high profits for several decades. Because of differential economic incentives, incumbents often push forward with incremental innovations, while new entrants focus on radical innovations.

ORGANIZATIONAL INERTIA

From an organizational perspective, as firms become established and grow, they rely more heavily on formalized business processes and structures. In some cases, the firm may experience organizational inertia—resistance to changes in the status quo. Incumbent firms, therefore, tend to favor incremental innovations that reinforce the existing organizational structure and power distribution while avoiding radical innovation that could disturb the existing power distribution. Take, for instance, power distribution between different functional areas, such as R&D and marketing. New entrants, however, do not have formal organizational structures and processes, giving them more freedom to launch an initial breakthrough. We discuss the link between organizational structure and firm strategy in depth in 
Chapter 11
.

INNOVATION ECOSYSTEM

A final reason incumbent firms tend to be a source of incremental rather than radical innovations is that they become embedded in an 

innovation ecosystem

: a network of suppliers, buyers, complementors, and so on.

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 They no longer make independent decisions but must consider the ramifications on other parties in their innovation ecosystem. Continuous incremental innovations reinforce this network and keep all its members happy, while radical innovations disrupt it. Again, new entrants don’t have to worry about preexisting innovation ecosystems, since they will be building theirs around the radical innovation they are bringing to a new market.

ARCHITECTURAL VS. DISRUPTIVE INNOVATION

Firms can also innovate by leveraging existing technologies into new markets. Doing so generally requires them to reconfigure the components of a technology, meaning they alter the overall architecture of the product.

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 An 

architectural innovation

, therefore, is a new product in which known components, based on existing technologies, are reconfigured in a novel way to create new markets.

As a radical innovator commercializing the xerography invention, Xerox was long the most dominant copier company worldwide.

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 It produced high-volume, high-quality, and high-priced copying machines that it leased to its customers through a service agreement. Although these machines were ideal for the high end of the market such as Fortune 100 companies, Xerox ignored small and medium-sized businesses. By applying an architectural innovation, the Japanese entry Canon was able to redesign the copier so that it didn’t need professional service—reliability was built directly into the machine, and the user could replace parts such as the cartridge. This allowed Canon to apply the razor–razor-blade business model (introduced in 
Chapter 5
), charging relatively low prices for its copiers but adding a steep markup to its cartridges. Xerox had not envisioned the possibility that the components of the copying machine could be put together in an altogether different way that was more user-friendly. More importantly, Canon addressed a need in a specific consumer segment—small and medium-sized businesses and individual departments or offices in large companies—that Xerox neglected.

Finally, a 

disruptive innovation

 leverages new technologies to attack existing markets. It invades an existing market from the bottom up, as shown in 

Exhibit 7.12

.

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 The dashed lines represent different market segments, from Segment 1 at the low end to Segment 4 at the high end. Low-end market segments are generally associated with low profit margins, Page 246while high-end market segments often have high profit margins. As first demonstrated by Clayton Christensen, the dynamic process of disruptive innovation begins when a firm, frequently a startup, introduces a new product or process based on a new technology to meet existing customer needs. To be a disruptive force, however, this new technology has to have additional characteristics:

EXHIBIT 7.12 
 Disruptive Innovation: Riding the Technology Trajectory to Invade Different Market Segments from the Bottom Up

1. It begins as a low-cost solution to an existing problem.

2. Initially, its performance is inferior to the existing technology, but its rate of technological improvement over time is faster than the rate of performance increases required by different market segments. In 
Exhibit 7.12
, the solid upward curved line captures the new technology’s trajectory, or rate of improvement over time.

The following examples illustrate disruptive innovations:

· ▪ Japanese carmakers successfully followed a strategy of disruptive innovation by first introducing small fuel-efficient cars and then leveraging their low-cost and high-quality advantages into high-end luxury segments, captured by brands such as Lexus, Infiniti, and Acura. More recently, the South Korean carmakers Kia and Hyundai have followed a similar strategy.

· ▪ Digital photography improved enough over time to provide higher-definition pictures. As a result, it has been able to replace film photography, even in most professional applications.

· ▪ Laptop computers disrupted desktop computers; now tablets and larger-screen smartphones are disrupting laptops.

· ▪ Educational organizations such as Coursera and Udacity are disrupting traditional universities by offering massive open online courses (MOOCs), using the web to provide large-scale, interactive online courses with open access.

One factor favoring the success of disruptive innovation is that it relies on a stealth attack: It invades the market from the bottom up, by first capturing the low end. Many times, incumbent firms fail to defend (and sometimes are even happy to cede) the low end of the market, because it is frequently a low-margin business. Google, for example, is using its mobile operating system, Android, as a beachhead to challenge Microsoft’s dominance in the personal computer industry, where 90 percent of machines run Windows.

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 Google’s Page 247Android, in contrast, is optimized to run on mobile devices, the fastest-growing segment in computing. To appeal to users who spend most of their time on the web accessing e-mail and other online applications, for instance, it is designed to start in a few seconds. Moreover, Google provides Android free of charge.

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 In contrast to Microsoft’s proprietary Windows operating system, Android is open-source software, accessible to anyone for further development and refinement. Google’s Android holds an 85 percent market share in mobile operating systems, while Apple’s iOS has 12 percent, and the remaining 3 percent is held by Microsoft’s Windows.

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Another factor favoring the success of disruptive innovation is that incumbent firms often are slow to change. Incumbent firms tend to listen closely to their current customers and respond by continuing to invest in the existing technology and in incremental changes to the existing products. When a newer technology matures and proves to be a better solution, those same customers will switch. At that time, however, the incumbent firm does not yet have a competitive product ready that is based on the disruptive technology. Although customer-oriented visions are more likely to guard against firm obsolescence than product-oriented ones (see 

Chapter 2

), they are no guarantee that a firm can hold out in the face of disruptive innovation. One of the counterintuitive findings that Clayton Christensen unearthed in his studies is that it can hurt incumbents to listen too closely to their existing customers. Apple is famous for not soliciting customer feedback because it believes it knows what customers need before they even realize it.

Netflix, featured in the 

ChapterCase

, disrupted the television industry from the bottom up (as shown in 
Exhibit 7.12
) with its online streaming video-on-demand service. Netflix’s streaming service differentiated itself from cable television by making strategic trade-offs. By initially focusing on older “rerun TV” (such as Breaking Bad) and not including local content or exorbitant expensive live sport events, Netflix was able to price its subscription service considerably lower than cable bundles. Netflix improved the viewing experience by allowing users to watch shows and movies without commercial breaks and on-demand, thus enhancing perceived consumer value. By switching quickly from sending DVDs via postal mail to online streaming, Netflix was able to ride the upward-sloping technology trajectory (shown in 
Exhibit 7.12
) to invade the media industry from the bottom up, all the way to providing premium original content such as House of Cards. Netflix’s pivot to online streaming was aided by increased technology diffusion (see 
Exhibit 7.1
) as more and more Americans adopted broadband internet connections in the early 2000s.

HOW TO RESPOND TO DISRUPTIVE INNOVATION?

Many incumbents tend to dismiss the threat by startups that rely on disruptive innovation because initially their product or service offerings are considered low end and too niche-focused. As late as 2010 (the year Blockbuster filed for bankruptcy), the CEO of Time Warner, one of the incumbent media companies to be disrupted by Netflix, did not take it seriously. When asked about the online streaming service as a potential competitor, he ridiculed the threat as equivalent to the likelihood of the Albanian army taking over the entire world.

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 It is critical to have an effective response to disruptive innovation.

Although the examples in the previous section show that disruptive innovations are a serious threat for incumbent firms, some have devised strategic initiatives to counter them:

1. Continue to innovate in order to stay ahead of the competition. A moving target is much harder to hit than one that is standing still and resting on existing (innovation) laurels. Amazon is an example of a company that has continuously morphed through innovation,

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 from a simple online book retailer to the largest ecommerce company, and now to include stores on the ground in the grocery sector. It also offers a personalized digital assistant (Alexa), consumer electronics (Kindle tablets), cloud computing, Page 248and content streaming, among other many other offerings (see 
ChapterCase 8
). Netflix continued to innovate by pivoting to online streaming and away from sending DVDs through the mail.

2. Guard against disruptive innovation by protecting the low end of the market (Segment 1 in 
Exhibit 7.12
) by introducing low-cost innovations to preempt stealth competitors. Intel introduced the Celeron chip, a stripped-down, budget version of its Pentium chip, to prevent low-cost entry into its market space. More recently, Intel followed up with the Atom chip, a new processor that is inexpensive and consumes little battery power, to power low-cost mobile devices.

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 Nonetheless, Intel also listened too closely to its existing personal computer customers such as Dell, HP, Lenovo, and so on, and allowed ARM Holdings, a British semiconductor design company (that supplies its technology to Apple, Samsung, HTC, and others) to take the lead in providing high-performing, low-power-consuming processors for smartphones and other mobile devices.

3. Disrupt yourself, rather than wait for others to disrupt you. A firm may develop products specifically for emerging markets such as China and India, and then introduce these innovations into developed markets such as the United States, Japan, or the European Union. This process is called 

reverse innovation

,

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 and allows a firm to disrupt itself. 

Strategy Highlight 7.2

 describes how GE Healthcare invented and commercialized a disruptive innovation in China that is now entering the U.S. market, riding the steep technology trajectory of disruptive innovation shown in 
Exhibit 7.12
.

Strategy Highlight 7.2

GE’s Innovation Mantra: Disrupt Yourself!

GE Healthcare is a leader in diagnostic devices. Realizing that the likelihood of disruptive innovation increases over time, GE decided to disrupt itself. A high-end ultrasound machine found in cutting-edge research hospitals in the United States or Europe costs $250,000. There is not a large market for these high-end, high-price products in developing countries. Given their large populations, however, these countries have a strong medical need for ultrasound devices.

GE’s Vscan is a wireless ultrasound device priced around $5,000.
©VCG/Getty Images News/ Getty Images

In 2002, a GE team in China, through a bottom-up strategic initiative, developed an inexpensive, portable ultrasound device, combining laptop technology with a probe and sophisticated imaging software. This lightweight device (11 pounds) was first used in rural China. In spring 2009, GE unveiled the new medical device under the name Venue 40 in the United States, at a price of less than $30,000. There was also high demand from many American general practitioners, who could not otherwise afford the $250,000 needed to procure a high-end machine (that weighed about 400 pounds). In the fall of 2009, then GE Chairman and CEO Jeff Immelt unveiled the Vscan, an even smaller device that looks like a cross between an early iPod and a flip phone. This wireless ultrasound device is priced around $5,000. GE views the Vscan as the “stethoscope of the 21st century,” which a primary care doctor can hang around her neck when visiting with patients.

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7.5 Platform Strategy

LO 7-6

Explain why and how platform businesses can outperform pipeline businesses.

Up to this point in our discussion of strategy and competitive advantage, we focused mainly on businesses that operate at one or more stages of the linear value chain (introduced in 
Chapter 4
).

A firm’s value chain captures the internal activities a firm engages in, beginning with raw materials and ending with retailing and after-sales service and support. The value chain represents a linear view of a firm’s business activities. As such, this traditional system of horizontal business organization has been described as a pipeline, because it captures a linear transformation with producers at one end and consumers at the other. Take BlackBerry as an example of a business using a linear pipeline approach based on a step-by-step arrangement for creating and transferring value. This Canadian ex-leader in smartphones conducted internal R&D, designed the phones, then manufactured them (often in company-owned plants), and finally retailed them in partner stores such as AT&T or Verizon, which offered wireless services and after-sales support.

THE PLATFORM VS. PIPELINE BUSINESS MODELS

Read the examples below, and try to figure out how these businesses’ operations differ from the traditional pipeline structure described earlier.

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· Valued at $70 billion in 2017, the ride-hailing service Uber was launched less than 10 years earlier in a single city, San Francisco. Uber is not only disrupting the traditional taxi and limousine business in hundreds of cities around the globe, but also reshaping the transportation and logistics industries, without owning a single car. In the future, Uber might deploy a fleet of driverless cars; it is currently testing autonomous vehicles.

· Reaching close to 2 billion people (out of a total of 7 billion on Earth), Facebook is where people get their news, watch videos, listen to music, and share photos. Garnering some $30 billion in annual advertising revenues in 2016, Facebook has become one of the largest media companies in the world, without producing a single piece of content.

· China-based ecommerce firm Alibaba is the largest web portal that offers online retailing as well as business-to-business services on a scale that dwarfs Amazon.com and eBay combined. On its Taobao site (similar to eBay), Alibaba offers more than 1 billion products, making it the world’s largest retailer without owning a single item of inventory. When going public in 2014 by listing on the New York Stock Exchange (NYSE), Alibaba was the world’s largest initial public offering (IPO), valued at $25 billion. Not even three years later, by early 2017, Alibaba was valued at some $260 billion, making it one of the most valuable technology companies in the world.

What do Uber, Facebook, and Alibaba have in common? They are not organized as traditional linear pipelines, but instead as a 

platform businesses

. The five most valuable companies globally (Apple, Alphabet, Microsoft, Amazon, and Facebook) all run platform business models. ExxonMobil, running a traditional linear business model from raw materials (fossil fuels) to distribution (of refined petroleum products) and long the most valuable company in the world, had fallen to number six by 2016.

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 Based on the 2016 book Platform Revolution by Parker, Van Alstyne, and Choudary, platforms can be defined along three dimensions:

1. A platform is a business that enables value-creating interactions between external producers and consumers.

2. Page 250The platform’s overarching purpose is to consummate matches among users and facilitate the exchange of goods, services, or social currency, thereby enabling value creation for all participants.

3. The platform provides an infrastructure for these interactions and sets governance conditions for them.

The business phenomenon of platforms, however, is not a new one. Platforms, often also called multi-sided markets, have been around for millennia. The town squares in ancient cities were marketplaces where sellers and buyers would meet under a set of governing rules determined by the owner or operator (such as what type of wares could be offered, when the marketplace was open for business, which vendor would get what stand on the square, etc.). The credit card, often hailed has the most important innovation in the financial sector over the last few decades,

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 provides a more recent example of a multi-sided market. Credit cards facilitate more frictionless transactions between vendors and customers because the vendor is guaranteed payment by the bank that issues the credit card, and customers using credit cards can easily transact online without the need to carry cash in the physical world. In addition, credit card users can buy goods or services on credit based on their promise of repaying the bank.

In the digital age, platforms are business model innovations that use technology (such as the internet, cloud computing, etc.) to connect organizations, resources, information, and people in an interactive ecosystem where value-generating transactions (such as hailing a ride on Uber, catching up on news on Facebook, or connecting a Chinese supplier to a U.S. retailer via Alibaba) can be created and exchanged. Effective use of technology allows platform firms to drastically reduce the barriers of time and space: Information is available in real time across the globe, and market exchanges can take place effectively across vast distances (i.e., China to the United States) or even in small geographic spaces (such as Tinder, a location-based dating service).

THE PLATFORM ECOSYSTEM

To formulate an effective platform strategy, a first step is to understand the roles of the players within any 

platform ecosystem

 (see 

Exhibit 7.13

). From a value chain perspective, producers create or make available a product or service that consumers use. The owner of the platform controls the platform IP address and controls who may participate and in what ways. The providers offer the interfaces for the platform, enabling its accessibility online.

EXHIBIT 7.13  The Players in a Platform Ecosystem

SOURCE: Adapted from Van Alystyn, M., Parker. G. G., and Choudary, S. P. (2016, Apr.) “Pipelines, Platforms, and the New Rules of Strategy,” Harvard Business Review.

The players in the ecosystem typically fill one or more of the four roles but may rapidly shift from one role to another. For example, a producer may decide to purchase the platform to become an owner, or an owner may use the platform as a producer. Producer and consumer can also switch, for example, as when a passenger (consumer) who uses Uber for transportation decides to become an Uber driver (producer). This is an example of so-called side switching.

ADVANTAGES OF THE PLATFORM BUSINESS MODEL

Platform businesses tend to frequently outperform pipeline businesses, because of the following advantages:

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1. Platforms scale more efficiently than pipelines by eliminating gatekeepers. Platform businesses leveraging digital technology can also grow much faster—that is, they scale efficiently—because platforms create value by orchestrating resources that reside in the ecosystem. The platform business does not own or control these resources, facilitating rapid and often exponential growth.

In contrast, pipelines tend to be inefficient in managing the flow of information from producer to consumer. When hiring a professional services firm such as consultants or Page 251lawyers, the buyer has to purchase a bundle of services offered by the firm, for example, retaining a consulting team for a specific engagement. This team of consultants contains both senior and junior consultants, as well as administrative support staff. The client is unable to access the services of only one or two senior partners but not the rest of the team, where inexperienced junior associates are also billed at a high rate to the client. Platforms such as Upwork unbundle professional services by making available precisely defined individual services while eliminating the need to purchase a bundle of services as required by gatekeepers in old-line pipelines.

2. Platforms unlock new sources of value creation and supply. Consider how upstart Airbnb (featured in 

ChapterCase 3

) disrupted the hotel industry. To grow, traditional competitors such as Marriott or Hilton would need to add additional rooms to their existing stock. To add new hotel room inventory to their chains, they would need to find suitable real estate, develop and build a new hotel, furnish all the rooms, and hire and train staff to run the new hotel. This often takes years, not to mention the multimillion-dollar upfront investments required and the risks involved.

In contrast, Airbnb faces no such constraints because it does not own any real estate, nor does it manage any hotels. Just like Marriott or Hilton, however, it uses sophisticated pricing and booking systems to allow guests to find a large variety of rooms pretty much anywhere in the world to suit their needs. As a digital platform, Airbnb allows any person to offer rooms directly to pretty much any consumer that is looking for accommodation online. Airbnb makes money by taking a cut on every rental through its platform. Given that Airbnb is a mere digital platform, it can grow much faster than old-line pipeline businesses such as Marriott. Airbnb’s inventory is basically unlimited as long as it can sign up new users with spare rooms to rent, combined with very little if any cost to adding inventory to its existing online offerings. Unlike traditional hotel chains, Airbnb’s growth is not limited by capital, hotel staff, or ownership of real estate. In 2017, Airbnb offered over 2 million listings worldwide for rent.

3. Platforms benefit from community feedback. Feedback loops from consumers back to the producers allow platforms to fine-tune their offerings and to benefit from big data Page 252analytics. TripAdvisor, a travel website, derives significant value from the large amount of quality reviews (including pictures) by its users of hotels, restaurants, and so on. This enables TripAdvisor to consummate more effective matches between hotels and guests via its website, thus creating more value for all participants. It also allows TripAdvisor to capture a percentage of each successful transaction in the process.

Netflix also collects large amounts of data about users’ viewing habits and preferences across the world. This allows Netflix to not only make effective recommendations on what to watch next, but also affords a more effective resource allocation process when making content investments. Before even producing a single episode of House of Cards, for example, Netflix knew that its audience would watch this series. Netflix has continued following the data, which allows the market to shape new content.

NETWORK EFFECTS

For platform businesses to succeed, however, it is critical to benefit from positive network effects. We provided a brief introduction of network effects earlier when discussing how to gain a foothold for an innovation in a newly emerging industry during the introduction stage of the industry life cycle. We now take a closer look at the role of network effects in platforms, including feedback loops that can initiate virtuous growth cycles leading to platform leadership.

Netflix.

Consider how the video-streaming service Netflix (featured in the 
ChapterCase
) leverages network effects for competitive advantage. Netflix’s business model is to grow its global user base as large as possible and then to monetize it via monthly subscription fees. It does not offer any ads. The established customer base in the old-line DVD rental business gave Netflix a head start when entering into the new business of online streaming. Moreover, the cost to Netflix of establishing a large library of streaming content is more or less fixed, but the per unit cost falls drastically as more users join. Moreover, the marginal cost of streaming content to additional users is also extremely low (it is not quite zero because Netflix pays for some delivery of content either by establishing servers hosting content in geographic proximity of users, or paying online service providers for faster content streaming).

As Netflix acquires additional streaming content, it increases the value of its subscription service to customers, resulting in more people signing up. With more customers, Netflix could then afford to provide more and higher-quality content, further increasing the value of the subscription to its users. This created a virtuous cycle that increased the value of a Netflix subscription as more subscribers signed up (see 

Exhibit 7.14

).

EXHIBIT 7.14 Netflix Business Model: Leveraging Network Effects to Drive Demand

Growing its user base is critical for Netflix to sustain its competitive advantage. Netflix has been hugely successful in attracting new users: In 2017 it had some 100 million subscribers worldwide. Yet, while providing a large selection of high-quality streaming content is a necessity of the Netflix business model, this element can and has been easily duplicated by others such as Amazon, Hulu, and premium services on Google’s YouTube. To lock in its large installed base of users, however, Netflix has begun producing and distributing original content such as the hugely popular shows House of Cards and Orange Is the New Black. To sustain its competitive advantage going forward, Netflix needs to rely on its core competencies, including its proprietary recommendation Page 253engine, data-driven content investments, and network infrastructure management.

Uber.

The feedback loop in network effects becomes even more apparent when taking a closer look at Uber’s business model. Like many platforms, Uber performs a classic matching service. In this case, it allows riders to find drivers and drivers to find riders. Uber’s deep pockets, thanks to successful rounds of fund-raising, allow the startup to lose money on each ride in order to initiate a positive feedback loop. Uber provides incentives for drivers to sign up (such as extending credit so that potential drivers can purchase vehicles) and also charges lower than market rates for its rides. As more and more drivers sign up in each city and thus coverage density rises accordingly, the service becomes more convenient. This drives more demand for its services as more riders choose Uber, which in turn brings in more drivers. This positive feedback loop is shown in 

Exhibit 7.15

.

EXHIBIT 7.15 
 Uber’s Business Model: Leveraging Network Effects to Increase Demand

With more and more drivers on the Uber platform, both wait time for rides as well as driver downtime falls. Less downtime implies that a driver can complete more rides in a given time while making the same amount of money, even if Uber should lower its fares. Lower fares and less wait time, in turn, bring in more riders on the platform, and so on. This additional feedback loop is shown in 

Exhibit 7.16

.

This feedback loop also explains the much hated “surge pricing” that Uber employs. It is based on dynamic pricing for its services depending on demand. For example, during the early hours of each New Year, demand for rides far outstrips supply. To entice more drivers to work during this time, Uber has to pay them more. Higher pay will bring more drivers onto the platform. Some users complain about surge pricing, but it allows Uber to match supply and demand in a dynamic fashion. As surge pricing kicks in, fewer people will demand rides, eventually bringing supply and demand back into an equilibrium (see 
Exhibit 7.16
).

EXHIBIT 7.16 
 Uber’s Network Effects with Feedback Loop

The ability of a platform to evince and manage positive network effects is critical to producing value for each participant, and it allows it to gain and sustain a competitive advantage. In contrast, negative network effects describe the situation where more and more users exit a platform and the value that each remaining user receives from the platform declines. The social network Myspace experienced negative network effects as more and more users abandoned it for Facebook. One reason was that Myspace attempted to maximize ad revenues per user too early in its existence, while Facebook first focused on building a social media platform that allowed for the best possible user experience before starting to monetize its user base through selling ads.

7.6 Implications for Strategic Leaders

Innovation drives the competitive process. An effective innovation strategy is critical in formulating a business strategy that provides the firm with a competitive advantage. Successful innovation affords firms a temporary monopoly, with corresponding monopoly pricing power. Fast Company named Amazon, Google, Uber, Apple, and Snap as the top five of its 2017 Most Innovative Companies.

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 Continuous innovation fuels the success of these companies.

Entrepreneurs are the agents that introduce change into the competitive system. They do this not only by figuring out how to use inventions, but also by introducing new products or services, new production processes, and new forms of organization. Entrepreneurs frequently start new ventures, but they may also be found in existing firms.

The industry life cycle model and the crossing-the-chasm framework have critical implications for how you manage innovation. To overcome the chasm, you need to formulate a business strategy guided by the who, what, why, and how questions of competition (
Chapter 6
) to ensure you meet the distinctly different customer needs inherent along the industry life cycle. You also must be mindful that to do so, you need to bring different competencies and capabilities to bear at different stages of the industry life cycle.

It is also useful to categorize innovations along their degree of newness in terms of technology and markets. Each diagonal pair—incremental versus radical innovation and architectural versus disruptive innovation—has different strategic implications.

Moving from the traditional pipeline business to a platform business model implies three important shifts in strategy focus:

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1. From resource control to resource orchestration.

2. From internal optimization to external interactions.

3. From customer value to ecosystem value.

The focus in platform strategy, therefore, shifts from traditional concepts of resource control, industry structure, and firm strategic position to creating and facilitating more or less frictionless market exchanges.

In conclusion, in this and the previous chapter, we discussed how firms can use business-level strategy—differentiation, cost leadership, blue ocean, and innovation—to gain and sustain competitive advantage. We now turn our attention to corporate-level strategy to help us understand how executives make decisions about where to compete (in terms of products and services offered, integration along the value chain, and geography) and how to execute it through strategic alliances as well as mergers and acquisitions. A thorough understanding of business and corporate strategy is necessary to formulate and sustain a winning strategy.

CHAPTERCASE 7 
 Consider This…

THE IMPACT OF NETFLIX’S mega-success House of Cards in reshaping the TV industry cannot be underestimated. The American political TV drama starring Kevin Spacey and Robin Wright was an innovation that fundamentally changed the existing business model of TV viewing on three fronts.

1. Delivery. House of Cards was the first time that a major original TV drama was streamed online and thus bypassed the established ecosystem of networks and cable operators.

2. Access. House of Cards created the phenomenon of binge watching because it allowed Netflix subscribers Page 255to view many or all episodes in one sitting, without any advertising interruptions. As of 2017, spending an estimated $200 million, Netflix produced five seasons for a total of 65 episodes each roughly 45 to 60 minutes long.

3. Management. House of Cards was the first time original programming had been developed based on Netflix’s proprietary data algorithms and not by more traditional methods. When executive producer David Fincher and actor Kevin Spacey brought the proposed show to Netflix, the company approved the project without a pilot or any test-marketing. “Netflix was the only network that said, ‘We believe in you,’” recalls Spacey. “‘We’ve run our data and it tells us that our audience would watch this series. We don’t need you to do a pilot. How many [episodes] do you wanna do?’”

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The success of House of Cards created a huge buzz, attracted millions of new subscribers to Netflix, and helped its stock climb to new highs.

©A-Pix Entertainment/Photofest

Despite riding high, there are some serious challenges for CEO Reed Hastings and Netflix on the horizon. First is the issue of how to ensure that Netflix users have a seamless, uninterrupted viewing experience, without buffering (and seeing the “spinning wheels”). Recall that Netflix is responsible for more than one-third of all downstream internet traffic in the United States during peak hours. For a long time, Netflix has been a strong supporter of net neutrality, with the goal of preventing internet service providers (ISPs) such as Comcast from slowing content or blocking access to certain websites. Conceivably, Comcast may have an incentive to slow Netflix’s content and favor its own NBC content.

To work around the net neutrality rules, ISPs have begun imposing “data caps” on their customers. Once users exceed their data cap, additional data usage incurs added fees. Another ISP practice that concerns Hastings is “zero-rating,” an arrangement where the ISP does not count traffic from preferred data providers such as their own content toward customers’ data caps. These are the reasons Netflix—after refusing to do so for a long time—has begun to pay ISPs directly to ensure a smoother streaming experience for its users. Rather than going through the public internet, in exchange for payment, Netflix is able to hook its servers directly to Comcast’s broadband network. Given its precedent, Netflix is likely to strike similar deals with other ISPs, such as AT&T and Verizon, that control access to Netflix customers.

The second issue for Hastings is how to create sustained future growth. The domestic market seems to be maturing, so growth has to come from international expansion. Some 49 million (or about half of) Netflix subscribers reside outside the United States. To drive future growth, Netflix is rapidly expanding its services internationally from 60 countries in 2016 to 190 countries. Netflix is still noticeably absent from China, a market where Hastings commented that Netflix is still, “in the relationship building phase.”

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 One of the issues Netflix will face is potential censoring of its content; House of Cards has not only explicit content in terms of nudity and violence, but also features a corrupt Chinese businessman meddling in U.S. politics. Moreover, problems with a lack of available titles and few places with broadband internet connections hamper Netflix’s international growth.

Questions

1. Netflix started to pay ISPs to ensure fast and seamless access to its end users.

a. Does this violate net neutrality (the rule that internet service providers should treat all data equally, and not charge differentially by user, content, site, etc.)? Why or why not?

b. Do you favor net neutrality? Explain why or why not?

c. How do ISPs use “zero-rating” of data to circumvent net neutrality rules? Is this legal? Is this ethical? Explain.

d. As ISPs will extract more fees from Netflix, the company continues to invest heavily in its proprietary “Open Connect” network, which allows Netflix to connect its servers directly to those of ISPs (via peering). Since most users upgrade their internet connections to faster broadband in order to watch video, are the incentives of broadband providers aligned with Netflix, or will the broadband providers continue to extract significant value from this industry? Apply a five forces analysis.

2. Netflix growth in the United States seems to be maturing. What other services can Netflix offer that might increase demand in the United States?

3. International expansion appears to be a major growth opportunity for Netflix. Elaborate on the challenges Netflix faces going beyond the U.S. market.

a. Do you think it is a good idea to rapidly expand to 190 countries in one fell swoop, or should Netflix follow a more gradual international expansion?

b. What are some of the challenges Netflix is likely to encounter internationally? What can Netflix do to address these? Explain.

This chapter discussed various aspects of innovation and entrepreneurship as a business-level strategy, as summarized by the following learning objectives and related take-away concepts.

LO 7-1 / Outline the four-step innovation process from idea to imitation.

· ▪ Innovation describes the discovery and development of new knowledge in a four-step process captured in the four I’s: idea, invention, innovation, and imitation.

· ▪ The innovation process begins with an idea.

· ▪ An invention describes the transformation of an idea into a new product or process, or the modification and recombination of existing ones.

· ▪ Innovation concerns the commercialization of an invention by entrepreneurs (within existing companies or new ventures).

· ▪ If an innovation is successful in the marketplace, competitors will attempt to imitate it.

LO 7-2 / Apply strategic management concepts to entrepreneurship and innovation.

· ▪ Entrepreneurship describes the process by which change agents undertake economic risk to innovate—to create new products, processes, and sometimes new organizations.

· ▪ Strategic entrepreneurship describes the pursuit of innovation using tools and concepts from strategic management.

· ▪ Social entrepreneurship describes the pursuit of social goals by using entrepreneurship. Social entrepreneurs use a triple-bottom-line approach to assess performance.

LO 7-3 / Describe the competitive implications of different stages in the industry life cycle.

· ▪ Innovations frequently lead to the birth of new industries.

· ▪ Industries generally follow a predictable industry life cycle, with five distinct stages: introduction, growth, shakeout, maturity, and decline.

· ▪ 
Exhibit 7.10 
details features and strategic implications of the industry life cycle

LO 7-4 / Derive strategic implications of the crossing-the-chasm framework.

· ▪ The core argument of the crossing-the-chasm framework is that each stage of the industry life cycle is dominated by a different customer group, which responds differently to a new technological innovation.

· ▪ There exists a significant difference between the customer groups that enter early during the introductory stage of the industry life cycle and customers that enter later during the growth stage.

· ▪ This distinct difference between customer groups leads to a big gulf or chasm, which companies and their innovations frequently fall into.

· ▪ To overcome the chasm, managers need to formulate a business strategy guided by the who, what, why, and how questions of competition.

LO 7-5 / Categorize different types of innovations in the markets-and-technology framework.

· ▪ Four types of innovation emerge when applying the existing versus new dimensions of technology and markets: incremental, radical, architectural, and disruptive innovations (see 
Exhibit 7.11
).

· ▪ An incremental innovation squarely builds on an established knowledge base and steadily improves an existing product or service offering (existing market/existing technology).

· ▪ A radical innovation draws on novel methods or materials and is derived either from an entirely different knowledge base or from the recombination of the existing knowledge base with a new stream of knowledge (new market/new technology).

· ▪ An architectural innovation is an embodied new product in which known components, based on existing technologies, are reconfigured in a novel way to attack new markets (new market/existing technology).

· ▪ A disruptive innovation is an innovation that leverages new technologies to attack existing markets from the bottom up (existing market/new technology).

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LO 7-6 / Explain why and how platform businesses can outperform pipeline businesses.

· ▪ Platform businesses scale more efficiently than pipeline businesses by eliminating gatekeepers and leveraging digital technology. Pipeline businesses rely on gatekeepers to manage the flow of value from end to end of the pipeline. Platform businesses leverage technology to provide real-time feedback.

· ▪ Platforms unlock new sources of value creation and supply. Thus they escape the limits faced by a pipeline company working within an existing industry based on physical assets.

· ▪ Platforms benefit from community feedback. Feedback loops from consumers back to the producers allow platforms to fine-tune their offerings and to benefit from big data analytics.

7.1 Competition Driven by Innovation

Competition is a process driven by the “perennial gale of creative destruction,” in the words of famed economist Joseph Schumpeter.

5

 The continuous waves of market leadership changes in the TV industry, detailed in the ChapterCase, demonstrate the potency of innovation as a competitive weapon: It can simultaneously create and destroy value. Firms must be able to innovate while also fending off competitors’ imitation attempts. A successful strategy requires both an effective offense and a hard-to-crack defense.

Many

firms have dominated an early wave of innovation only to be challenged and often destroyed by the next wave. As highlighted in the ChapterCase, traditional television networks (ABC, CBS, and NBC) have been struggling to maintain viewers and advertising revenues as cable and satellite providers offered innovative programming. Those same cable and satellite providers now are trying hard to hold on to viewers as more and more people gravitate toward customized content online. To exploit such opportunities, Google acquired YouTube, while Comcast, the largest U.S. cable operator, purchased NBCUniversal.

6

 Comcast’s acquisition helps it integrate delivery services and content, with the goal of establishing itself as a new player in the media industry. In turn, both traditional TV and cable networks are currently under threat from content providers that stream via the internet, such as Netflix, YouTube, and Amazon.

As the adage goes, change is the only constant—and the rate of technological change has accelerated dramatically over the past hundred years. Changing technologies spawn new industries, while others die. This makes innovation a powerful strategic weapon to gain and sustain competitive advantage. 

Exhibit 7.1

 shows how many years it took for different technological innovations to reach 50 percent of the U.S. population (either through ownership or usage). As an example, it took 84 years for half of the U.S. population to own a car, but only 28 years for half the population to own a TV. The pace of the adoption rate of recent innovations continues to accelerate. It took 19 years for the PC to reach 50 percent ownership, but only 6 years for MP3 players to accomplish the same diffusion rate.

EXHIBIT 7.1  Accelerating Speed of Technological Change

Source: Depiction of data from the U.S. Census Bureau, the Consumer Electronics Association, Forbes, and the National Cable and Telecommunications Association.

What factors explain increasingly rapid technological diffusion and adoption? One determinant is that initial innovations such as the car, airplane, telephone, and the use of electricity provided the necessary infrastructure for newer innovations to diffuse more rapidly. Another reason is the emergence of new business models that make innovations more accessible. For example, Dell’s direct-to-consumer distribution system improved access to low-cost PCs, and Walmart’s low-price, high-volume model used its sophisticated IT logistics system to fuel explosive growth. In addition, satellite and cable distribution systems facilitated the ability of mass media such as radio and TV to deliver advertising and information to a wider audience. The speed of technology diffusion has accelerated further with the emergence of the internet, social networking sites, and viral messaging. Amazon continues to drive increased convenience, higher efficiency and lower costs in retailing. The accelerating speed of technological changes has significant implications for the competitive process and firm strategy. We will now take a close look at the innovation process unleashed by technological changes.

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THE INNOVATION PROCESS

LO 7-1

Outline the four-step innovation process from idea to imitation.

Broadly viewed, innovation describes the discovery, development, and transformation of new knowledge in a four-step process captured in the four I’s: idea, invention, innovation, and imitation (see 

Exhibit 7.2

).

7

EXHIBIT 7.2 
 The Four I’s: Idea, Invention, Innovation, and Imitation

The innovation process begins with an idea. The idea is often presented in terms of abstract concepts or as findings derived from basic research. Basic research is conducted to discover new knowledge and is often published in academic journals. This may be done to enhance the fundamental understanding of nature, without any commercial application or benefit in mind. In the long run, however, basic research is often transformed into applied research with commercial applications. For example, wireless communication technology today is built upon the fundamental science breakthroughs Albert Einstein accomplished over 100 years ago in his research on the nature of light.

8

In a next step, 

invention

 describes the transformation of an idea into a new product or process, or the modification and recombination of existing ones. The practical application of basic knowledge in a particular area frequently results in new technology. If an invention is useful, novel, and non-obvious as assessed by the U.S. Patent and Trademark Office, it Page 223can be patented.

9

 A 

patent

 is a form of intellectual property, and gives the inventor exclusive rights to benefit from commercializing a technology for a specified time period in exchange for public disclosure of the underlying idea (see also the discussion on isolating mechanisms in 

Chapter 4

). In the United States, the time period for the right to exclude others from the use of the technology is 20 years from the filing date of a patent application. Exclusive rights often translate into a temporary monopoly position until the patent expires. For instance, many pharmaceutical drugs are patent protected.

Strategically, however, patents are a double-edged sword. On the one hand, patents provide a temporary monopoly as they bestow exclusive rights on the patent owner to use a novel technology for a specific time period. Thus, patents may form the basis for a competitive advantage. Because patents require full disclosure of the underlying technology and know-how so that others can use it freely once the patent protection has expired, many firms find it strategically beneficial not to patent their technology. Instead they use 

trade secrets

, defined as valuable proprietary information that is not in the public domain and where the firm makes every effort to maintain its secrecy. The most famous example of a trade secret is the Coca-Cola recipe, which has been protected for over a century.

10

 The same goes for Ferrero’s Nutella, whose secret recipe is said to be known by even fewer than the handful of people who have access to the Coca-Cola recipe.

11

Avoiding public disclosure and thus making its underlying technology widely known is precisely the reason Netflix does not patent its recommendation algorithm or Google its PageRank algorithm. Netflix has an advantage over competitors because its recommendation algorithm works best; the same goes for Google—its search algorithm is the best available. Disclosing how exactly these algorithms work would nullify their advantage.

Innovation

 concerns the commercialization of an invention.

12

 The successful commercialization of a new product or service allows a firm to extract temporary monopoly profits. As detailed in the ChapterCase, Netflix began its life with a business model innovation, offering unlimited DVD rentals via the internet, without any late fees. However, Netflix gained its early lead by applying big data analytics to its user preferences to not only predict future demand but also to provide highly personalized viewing recommendations. The success of the latter is evident by the fact that movies that were recommended to viewers scored higher than they were scored previously. To sustain a competitive advantage, however, a firm must continuously innovate—that is, it must produce a string of successful new products or services over time. In this spirit, Netflix further developed its business model innovation, moving from online DVD rentals to directly streaming content via the internet. Moreover, it innovated further in creating proprietary content such as House of Cards and Orange Is the New Black.

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Successful innovators can benefit from a number of 

first-mover advantages

,

13

 including economies of scale as well as experience and learning-curve effects (as discussed in 

Chapter 6

). First movers may also benefit from network effects (see the discussion of Apple and Uber later in this chapter). Moreover, first movers may hold important intellectual property such as critical patents. They may also be able to lock in key suppliers as well as customers through increasing switching costs. For example, users of Microsoft Word might find the switching costs entailed in moving to a different word-processing software prohibitive. Not only would they need to spend many hours learning the new software, but collaborators would also need to have compatible software installed and be familiar with the program to open and revise shared documents.

Google—by offering a free web-based suite of application software such as word-processing (Google Docs), spreadsheet (Google Sheets), and presentation programs (Google Slides)—is attempting to minimize switching costs by leveraging cloud computing—a real-time network of shared computing resources via the internet (Google Drive). Rather than requiring each user to have the appropriate software installed on his or her personal computer, the software is maintained and updated in the cloud. Files are also saved in the cloud, which allows collaboration in real time globally wherever one can access an internet connection.

Innovation need not be high-tech to be a potent competitive weapon, as P&G’s history of innovative product launches such as the Swiffer line of cleaning products shows. P&G uses the razor–razor-blade business model (introduced in 

Chapter 5

), where the consumer purchases the handle at a low price, but must pay a premium for replacement refills and pads over time. As shown in 

Exhibit 7.3

, an innovation needs to be novel, useful, and successfully implemented to help firms gain and sustain a competitive advantage.

EXHIBIT 7.3 
 Innovation: A Novel and Useful Idea That Is Successfully Implemented

The innovation process ends with imitation. If an innovation is successful in the marketplace, competitors will attempt to imitate it. Although Netflix has some 50 million U.S. subscribers, imitators are set to compete its advantage away. Amazon offers its Instant Video service to its estimated 65 million Prime subscribers ($99 a year or $8.25 a month), with selected titles free. In addition, Prime members receive free two-day shipping on Amazon purchases. Hulu Plus ($7.99 a month), a video-on-demand service, has some 9 million subscribers. One advantage Hulu Plus has over Netflix and Amazon is that it typically makes the latest episodes of popular TV shows available the day following broadcast, on Hulu; the shows are often delayed by several months before being offered by Netflix or Amazon. A joint venture of NBCUniversal Television Group (Comcast), Fox Broadcasting (21st Century Fox), and Disney/ABC Television Group (The Walt Disney Co.), Hulu Plus uses advertisements along with its subscription fees as revenue sources. Finally, Google’s YouTube with its more than 1 billion users is evolving into a TV ecosystem, benefiting not only from free content uploaded by its users but also creating original programming. As of 2017, the most subscribed channels were by PewDiePie (57 million) and YouTube Spotlight, its official channel (26 million) used to highlight videos and events such as YouTube Music Awards and YouTube Comedy Week

14

. Google’s business is, of course, ad supported. Only time will tell whether Netflix will be able to sustain its competitive advantage given the imitation attempts by a number.

7.2 Strategic and Social Entrepreneurship

LO 7-2

Apply strategic management concepts to entrepreneurship and innovation.

Entrepreneurship

 describes the process by which change agents (entrepreneurs) undertake economic risk to innovate—to create new products, processes, and sometimes new organizations.

15

 Entrepreneurs innovate by commercializing ideas and inventions.

16

 They seek out or create new business opportunities and then assemble the resources necessary to exploit them.

17

 Indeed, innovation is the competitive weapon entrepreneurs use to exploit opportunities created by change, or to create change themselves, in order to commercialize new products, services, or business models.

18

 If successful, entrepreneurship not only drives the competitive process, but it also creates value for the individual entrepreneurs and society at large.

Although many new ventures fail, some achieve spectacular success. Examples of successful entrepreneurs are:

·

▪ Reed Hastings, founder of Netflix featured in the ChapterCase. Hastings grew up in Cambridge, Massachusetts. He obtained an undergraduate degree in math and then volunteered for the Peace Corps for two years, teaching high school math in Swaziland (Africa). Next, he pursued a master’s degree in computer science, which brought him to Silicon Valley. Hastings declared his love affair with writing computer code, but emphasized, “The big thing that Stanford did for me was to turn me on to the entrepreneurial model.”

19

 His net worth today is an estimated $1 billion.

·

·
Dr. Dre, rapper, music and movie producer, as well as highly successful serial entrepreneur.
©JC Olivera/Getty Images Entertainment/Getty Images

▪Dr. Dre, featured in 

ChapterCase 4

, a successful rapper, music and movie producer, and serial entrepreneur. Born in Compton, California, Dr. Dre focused on music and entertainment early on during high school, working his first job as a DJ. Dr. Dre’s major breakthrough as a rapper came with the group N.W.A. One of his first business successes as an entrepreneur was Death Row Records, which he founded in 1991. A year later, Dr. Dre’s first solo album, The Chronic, was a huge hit. In 1996, Dr. Dre founded Aftermath Entertainment and signed famed rappers such as 50 Cent and Eminem. Dr. Dre, known for his strong work ethic and attention to detail, expects nothing less than perfection from the people with whom he works. Stories abound that Dr. Dre made famous rappers rerecord songs hundreds of times if he was not satisfied with the outcome. In 2014, Dr. Dre appeared to become the first hip-hop billionaire after Apple acquired Beats Electronics for $3 billion. In 2015, N.W.A’s early success was depicted in the biographical movie Straight Outta Compton, focusing on group members Eazy-E, Ice Cube, and Dr. Dre, who coproduced the film, grossing over $200 million at the box office, with a budget of $45 million.

20

· ▪ Jeff Bezos, the founder of Amazon.com (featured in 

ChapterCase 8

), the world’s largest online retailer. The stepson of a Cuban immigrant, Bezos graduated with a degree in computer science and electrical engineering, before working as a financial analyst on Wall Street. In 1994, after reading that the internet was growing by 2,000 percent a month, he set out to leverage the internet as a new distribution channel. Listing products that could be sold online, he finally settled on books because that retail market was fairly fragmented, with huge inefficiencies in its distribution system. Perhaps even more important, books are a perfect commodity because they are identical regardless of where a consumer buys them. This reduced uncertainty when introducing online shopping to consumers. In 2017 his personal wealth exceeded $80 billion.

21

· ▪ Elon Musk, an engineer and serial entrepreneur with a deep passion to “solve environmental, social, and economic challenges.”

22

 We featured him in his role as leader of Tesla in 

ChapterCase 1

. Musk left his native South Africa at age 17. He went to Canada and then to the United States, where he completed a bachelor’s degree in economics and physics at the University of Pennsylvania. After only two days in a PhD program in Page 226applied physics and material sciences at Stanford University, Musk left graduate school to found Zip2, an online provider of content publishing software for news organizations. Four years later, in 1999, computer maker Compaq acquired Zip2 for $341 million (and was in turn acquired by HP in 2002). Musk moved on to co-found PayPal, an online payment processor. When eBay acquired PayPal for $1.5 billion in 2002, Musk had the financial resources to pursue his passion to use science and engineering to solve social and economic challenges. He is leading three new ventures simultaneously: electric cars with Tesla, renewable energy with SolarCity, and space exploration with SpaceX.

23

 (In 2016, Tesla Motors acquired SolarCity, renaming itself simply Tesla).

·

Entrepreneurs

 are the agents who introduce change into the competitive system. They do this not only by figuring out how to use inventions, but also by introducing new products or services, new production processes, and new forms of organization. Entrepreneurs can introduce change by starting new ventures, such as Reed Hastings with Netflix or Mark Zuckerberg with Facebook. Or they can be found within existing firms, such as A.G. Lafley at Procter & Gamble (P&G), who implemented an open-innovation model (which we’ll discuss in 

Chapter 11

). When innovating within existing companies, change agents are often called intrapreneurs: those pursuing corporate entrepreneurship.

24

Entrepreneurs who drive innovation need just as much skill, commitment, and daring as the inventors who are responsible for the process of invention.

25

 As an example, the engineer Nikola Tesla invented the alternating-current (AC) electric motor and was granted a patent in 1888 by the U.S. Patent and Trademark Office.

26

 Because this breakthrough technology was neglected for much of the 20th century and Nikola Tesla did not receive the recognition he deserved in his lifetime, the entrepreneur Elon Musk is not just commercializing Tesla’s invention but also honoring Tesla with the name of his company, Tesla, which was formed to design and manufacture all-electric automobiles. Tesla launched several all-electric vehicles based on Tesla’s original invention (see 
ChapterCase 1
).

Strategic entrepreneurship

 describes the pursuit of innovation using tools and concepts from strategic management.

27

 We can leverage innovation for competitive advantage by applying a strategic management lens to entrepreneurship. The fundamental question of strategic entrepreneurship, therefore, is how to combine entrepreneurial actions, creating new opportunities or exploiting existing ones with strategic actions taken in the pursuit of competitive advantage.

28

 This can take place within new ventures such as Tesla or within established firms such as Apple. Apple’s continued innovation in mobile devices is an example of strategic entrepreneurship: Apple’s managers use strategic analysis, formulation, and implementation when deciding which new type of mobile device to research and develop, when to launch it, and how to implement the necessary organizational changes to support the product launch. Each new release is an innovation; each is therefore an act of entrepreneurship—planned and executed using strategic management concepts. In 2015, for example, Apple entered the market for computer wearables by introducing the Apple Watch. In 2017, Apple released the 10th-year anniversary model of its original iPhone, introduced in 2007.

Social entrepreneurship

 describes the pursuit of social goals while creating profitable businesses. Social entrepreneurs evaluate the performance of their ventures not only by financial metrics but also by ecological and social contribution (profits, planet, and people). They use a triple-bottom-line approach to assess performance (discussed in 
Chapter 5
). Examples of social entrepreneurship ventures include Teach For America, TOMS Shoes (which gives a pair of shoes to an economically disadvantaged child for every pair of shoes it sells), Better World Books (an online bookstore that uses capitalism to alleviate illiteracy around the word),

29

 and Wikipedia, whose mission is to collect and develop educational information, and make it freely available to any person in the world (see following and 

MiniCase 14

).

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The founder of Wikipedia, Jimmy Wales, typifies social entrepreneurship.

30

 Raised in Alabama, Wales was educated by his mother and grandmother who ran a nontraditional school. In 1994, he dropped out of a doctoral program in economics at Indiana University to take a job at a stock brokerage firm in Chicago. In the evenings he wrote computer code for fun and built a web browser. During the late 1990s internet boom, Wales was one of the first to grasp the power of an open-source method to provide knowledge on a very large scale. What differentiates Wales from other web entrepreneurs is his idealism: Wikipedia is free for the end user and supports itself solely by donations and not, for example, by online advertising. Wikipedia has 35 million articles in 288 languages, including some 5 million items in English. About 500 million people use Wikipedia each month. Wales’ idealism is a form of social entrepreneurship: His vision is to make the entire repository of human knowledge available to anyone anywhere for free.

Since entrepreneurs and the innovations they unleash frequently create entire new industries, we now turn to a discussion of the industry life cycle to derive implications for competitive strategy.

7.3 Innovation and the Industry Life Cycle

LO 7-3

Describe the competitive implications of different stages in the industry life cycle.

Innovations frequently lead to the birth of new industries. Innovative advances in IT and logistics facilitated the creation of the overnight express delivery industry by FedEx and that of big-box retailing by Walmart. The internet set online retailing in motion, with new companies such as Amazon and eBay taking the lead, and it revolutionized the advertising industry first through Yahoo, and later Google and Facebook. Advances in nanotechnology are revolutionizing many different industries, ranging from medical diagnostics and surgery to lighter and stronger airplane components.

31

Industries tend to follow a predictable 

industry life cycle

: As an industry evolves over time, we can identify five distinct stages: introduction, growth, shakeout, maturity, and decline.

32

 We will illustrate how the type of innovation and resulting strategic implications change at each stage of the life cycle as well as how innovation can initiate and drive a new life cycle.

The number and size of competitors change as the industry life cycle unfolds, and different types of consumers enter the market at each stage. That is, both the supply and demand sides of the market change as the industry ages. Each stage of the industry life cycle requires different competencies for the firm to perform well and to satisfy that stage’s unique customer group. We first introduce the life cycle model before discussing different customer groups in more depth when introducing the crossing-the-chasm concept later in this chapter.

33

Exhibit 7.4

 depicts a typical industry life cycle, focusing on the smartphone industry in emerging and developed economies. In a stylized industry life cycle model, the horizontal axis shows time (in years) and the vertical axis market size. In 
Exhibit 7.4
, however, we are taking a snapshot of the global smartphone industry in the year 2018. This implies that we are joining two different life cycles (one for emerging economies and one for developed economies) in the same exhibit at one point in time.

EXHIBIT 7.4 
 Industry Life Cycle: The Smartphone Industry in Emerging and Developed Economies

The development of most industries follows an S-curve. Initial demand for a new product or service is often slow to take off, then accelerates, before decelerating, and eventually turning to zero, and even becoming negative as a market contracts.

As shown in 
Exhibit 7.4
, in emerging economies such as Argentina, Brazil, China, India, Indonesia, Mexico, and Russia, the smartphone industry is in the growth stage. The market for smartphones in these countries is expected to grow rapidly over the next few years. More and more of the consumers in these countries with very large populations Page 228are expected to upgrade from a simple mobile phone to a smartphone such as the Apple iPhone, Samsung Galaxy, or Xiaomi’s popular Mi6.

In contrast, the market for smartphones is in the maturity stage in 2018 in developed economies such as Australia, Canada, Germany, Japan, South Korea, the United Kingdom, and the United States. This implies that developed economies moved through the prior three stages of the industry life cycle (introductory, growth, and shakeout) some years earlier. Because the smartphone industry is mature in these markets, little or no growth in market size is expected over the next few years because most consumers own smartphones. This implies that any market share gain by one firm comes at the expense of others, as users replace older smartphones with newer models. Competitive intensity is expected to be high.

Each stage of the industry life cycle—introduction, growth, shakeout, maturity, and decline—has different strategic implications for competing firms. We now discuss each stage in detail.

INTRODUCTION STAGE

When an individual inventor or company launches a successful innovation, a new industry may emerge. In this introductory stage, the innovator’s core competency is R&D, which is necessary to creating a product category that will attract customers. This is a capital-intensive process, in which the innovator is investing in designing a unique product, trying new ideas to attract customers, and producing small quantities—all of which contribute to a high price when the product is launched. The initial market size is small, and growth is slow.

In this introductory stage, when barriers to entry tend to be high, generally only a few firms are active in the market. In their competitive struggle for market share, they emphasize unique product features and performance rather than price.

Although there are some benefits to being early in the market (as previously discussed), innovators also may encounter first-mover disadvantages. They must educate potential Page 229customers about the product’s intended benefits, find distribution channels and complementary assets, and continue to perfect the fledgling product. Although a core competency in R&D is necessary to create or enter an industry in the introductory stage, some competency in marketing also is helpful in achieving a successful product launch and market acceptance. Competition can be intense, and early winners are well-positioned to stake out a strong position for the future. As one of the main innovators in software for mobile devices, Google’s Android operating system for smartphones is enjoying a strong market position and substantial lead over competitors.

The strategic objective during the introductory stage is to achieve market acceptance and seed future growth. One way to accomplish these objectives is to initiate and leverage 

network effects

,

34

 the positive effect that one user of a product or service has on the value of that product for other users. Network effects occur when the value of a product or service increases, often exponentially, with the number of users. If successful, network effects propel the industry to the next stage of the life cycle, the growth stage (which we discuss next).

Apple effectively leveraged the network effects generated by numerous complementary software applications (apps) available via iTunes to create a tightly integrated ecosystem of hardware, software, and services, which competitors find hard to crack. The consequence has been a competitive advantage for over a decade, beginning with the introduction of the iPod in 2001 and iTunes in 2003. Apple launched its enormously successful iPhone in the summer of 2007. A year later, it followed up with the Apple App Store, which boasts, for almost anything you might need, “there’s an app for that.” Popular apps allow iPhone users to access their business contacts via LinkedIn, hail a ride via Uber, call colleagues overseas via Skype, check delivery of their Zappos packages shipped via UPS, get the latest news on Twitter, and engage in customer relationship management using Salesforce.com. You can stream music via Pandora, post photos using Instagram, watch Netflix, access Facebook to check on your friends, or video message using Snap.

Even more important is the effect that apps have on the value of an iPhone. Arguably, the explosive growth of the iPhone is due to the fact that the Apple App Store offers the largest selection of apps to its users. By 2017, the App Store offered more than 2 million apps, which had been downloaded more than 130 billion times, earning Apple some $50 billion in revenues. Moreover, Apple argues that users have a better experience because the apps take advantage of the tight integration of hardware and software provided by the iPhone. The availability of apps, in turn, leads to network effects that increase the value of the iPhone for its users. 

Exhibit 7.5

 shows how. Increased value creation, as we know from 
Chapter 6
, is positively related to demand, which in turn increases the installed base, meaning the number of people using an iPhone. As of the spring of 2017, Apple had sold some 80 million iPhone 7 models in just six months. The average selling price of an iPhone was $700; with the latest model (iPhone X) priced at $1,000. As the installed base of iPhone users further increases, this incentivizes software developers to write even more apps. Making apps widely available strengthened Apple’s position in the smartphone industry. Based on positive feedback loops, a virtuous cycle emerges where one factor positively reinforces another. Apple’s ecosystem based on integrated hardware, software, and services providing a superior user experience is hard to crack for competitors.

EXHIBIT 7.5 
 Leveraging Network Effects to Drive Demand: Apple’s iPhone

Page 230

GROWTH STAGE

Market growth accelerates in the growth stage of the industry life cycle (see 
Exhibit 7.4
). After the initial innovation has gained some market acceptance, demand increases rapidly as first-time buyers rush to enter the market, convinced by the proof of concept demonstrated in the introductory stage.

As the size of the market expands, a 

standard

 signals the market’s agreement on a common set of engineering features and design choices.

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 Standards can emerge from the bottom up through competition in the marketplace or be imposed from the top down by government or other standard-setting agencies such as the Institute of Electrical and Electronics Engineers (IEEE) that develops and sets industrial standards in a broad range of industries, including energy, electric power, biomedical and health care technology, IT, telecommunications, consumer electronics, aerospace, and nanotechnology. 

Strategy

High

light 7.1

 discusses the unfolding standards battle in the automotive industry.

Strategy Highlight 7.1

Standards Battle: Which Automotive Technology Will Win?

In the envisioned future transition away from gasoline-powered cars, Nissan Chairman Carlos Ghosn firmly believes the next technological paradigm will be electric motors. Ghosn calls hybrids a “halfway technology” and suggests they will be a temporary phenomenon at best. A number of start-up companies, including Tesla in the United States and BYD Auto in China, share Ghosn’s belief in this particular future scenario.

One of the biggest impediments to large-scale adoption of electric vehicles, however, remains the lack of appropriate infrastructure: There are few stations where drivers can recharge their car’s battery when necessary. With the range of electric vehicles currently limited to some 200 miles, many consider a lack of recharging stations a serious problem, so called “range anxiety.” High-end Tesla vehicles can achieve 250 miles per charge, while a lower priced Nissan Leaf’s maximum is range is roughly 85 miles. Tesla, Nissan, and other independent charging providers such as ChargePoint, however, are working hard to develop a network of charging stations. By early 2017, Tesla claimed a network of some 800 supercharger stations throughout the United States and was building more stalls at many stations. It also enabled the in-car map to identify how many stalls were open at each station in real time.

The Nissan Leaf, the world’s best-selling electric vehicle.
©VDWI Automotive/Alamy Stock Photo RF

Nissan’s Ghosn believes electric cars will account for up to 10 percent of global auto sales over the next decade. The Swedish car maker Volvo has gone even further by announcing that beginning in 2019 it will no longer produce any cars with internal combustion engines. Rather, all its new vehicles will be fully electric or hybrid. This is a strong strategic commitment by one of the traditional car manufacturers. It is also the first of its kind.

In contrast, Toyota is convinced gasoline-electric hybrids will become the next dominant technology. These different predictions have significant influence on how much money Nissan and Toyota invest in technology and where. Nissan builds one of its fully electric vehicles, the Leaf (an acronym for Leading, Environmentally friendly, Affordable, Family car) at a plant in Smyrna, Tennessee. Toyota is expanding its R&D investments in hybrid technology. Nissan put its money where its mouth is and has spent millions developing its electric-car program since the late 1990s. Since it was introduced in December 2010, the Nissan Leaf has become the best-selling electric vehicle, with more than 250,000 units sold. The most recent Nissan Leaf model has a range of more than 100 miles per charge. In 2017, GM introduced the all-electric Chevy Bolt, with a range of over 200 miles per charge, similar to Tesla’s Model 3.

Toyota, on the other hand, has already sold 10 million of its popular Prius cars since they were introduced in 1997. By 2020, Toyota plans to offer hybrid technology in all its vehicles. Eventually, the investments made by Nissan and Toyota will yield different returns, depending on which predictions prove more accurate.

An alternative outcome is that neither hybrids nor electric cars will become the next paradigm. To add even more uncertainty to the mix, Honda and BMW are betting on cars powered by hydrogen fuel cells. In sum, many alternative technologies are competing to become the winner in setting a new standard for propelling cars. This situation is depicted in 

Exhibit 7.6 

, where the new technologies represent a swarm of new entries vying for dominance. Only time will tell which technology will win this standards battle.

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EXHIBIT 7.6 
 Automotive Technologies Compete for Industry Dominance

Page 231

Since demand is strong during the growth phase, both efficient and inefficient firms thrive; the rising tide lifts all boats. Moreover, prices begin to fall, often rapidly, as standard business processes are put in place and firms begin to reap economies of scale and learning. Distribution channels are expanded, and complementary assets in the form of products and services become widely available.

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After a standard is established in an industry, the basis of competition tends to move away from product innovations toward process innovations.

38

 

Product innovations

, as the name suggests, are new or recombined knowledge embodied in new products—the jet airplane, electric vehicle, smartphones, and wearable computers. 

Process innovations

 are new ways to produce existing products or to deliver existing services. Process innovations are made possible through advances such as the internet, lean manufacturing, Six Sigma, biotechnology, nanotechnology, and so on.

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Process innovation must not be high-tech to be impactful, however. The invention of the standardized shipping container, for instance, has transformed global trade. By loading goods into uniform containers that could easily be moved between trucks, rail, and ships, significant savings in cost and time were accomplished. Before containerization was invented some 60 years ago, it cost almost $6 to load a ton of (loose) cargo, and theft was rampant. After containerization, the cost for loading a ton of cargo had plummeted to $0.16 and theft all but disappeared (because containers are sealed at the departing factory). Efficiency gains in terms of labor and time were even more impressive. Before containerization, dock labor could move 1.7 tons per hour onto a cargo ship. After containerization, this had jumped to 30 tons per hour. Ports are now able to accommodate much larger ships, and travel time across the oceans has fallen in half. As a consequence, costs for shipping goods across the globe have fallen rapidly. Moreover, containerization enabled optimization of global supply chains and set the stage for subsequent process innovations such as just-in-time (JIT) operations management. Taken together, a set of research studies estimated that containerization alone more than tripled international trade within five years of adopting this critical process innovation.

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Exhibit 7.7 

shows the level of product and process innovation throughout the entire life cycle.

40

 In the introductory stage, the level of product innovation is at a maximum because new features increasing perceived consumer value are critical to gaining traction in the market. In contrast, process innovation is at a minimum in the introductory stage because companies produce only a small number of products, often just prototypes or beta versions. The main concern is to commercialize the invention—that is, to demonstrate that the product works and that a market exists.

EXHIBIT 7.7 
 Product and Process Innovation throughout an Industry Life Cycle

The relative importance, however, reverses over time. Frequently, a standard emerges during the growth stage of the industry life cycle (see the second column, “Growth,” in 

Exhibit 7.7

). At that point, most of the technological and commercial uncertainties about the new product are gone. After the market accepts a new product, and a standard for the new technology has emerged, process innovation rapidly becomes more important than product innovation. As market demand increases, economies of scale kick in: Firms establish and optimize standard business processes through applications of lean manufacturing, Page 233Six Sigma, and so on. As a consequence, product improvements become incremental, while the level of process innovation rises rapidly.

During the growth stage, process innovation ramps up (at increasing marginal returns) as firms attempt to keep up with rapidly rising demand while attempting to bring down costs at the same time. The core competencies for competitive advantage in the growth stage tend to shift toward manufacturing and marketing capabilities. At the same time, the R&D emphasis tends to shift to process innovation for improved efficiency. Competitive rivalry is somewhat muted because the market is growing fast.

Since market demand is robust in this stage and more competitors have entered the market, there tends to be more strategic variety: Some competitors will continue to follow a differentiation strategy, emphasizing unique features, product functionality, and reliability. Other firms employ a cost-leadership strategy in order to offer an acceptable level of value but lower prices to consumers. They realize that lower cost is likely a key success factor in the future, because this will allow the firm to lower prices and attract more consumers into the market. When introduced in the spring of 2010, for example, Apple’s first-generation iPad was priced at $829 for 64GB with a 3G Wi-Fi connection.

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 Just three years later, in spring 2013, the same model was priced at only one-third of the original price, or $275.

42

 Access to efficient and large-scale manufacturing operations (such as those offered by Foxconn in China, the company that assembles most of Apple’s products) and effective supply chain capabilities are key success factors when market demand increases rapidly. By 2017, Gazelle, an ecommerce company that allows people to sell their electronic devices and to buy pre-certified used ones, offered a mere $15 for a “flawless” first-generation iPad.

The key objective for firms during the growth phase is to stake out a strong strategic position not easily imitated by rivals. In the fast-growing shapewear industry, start-up company Spanx has staked out a strong position. In 1998, Florida State University graduate Sara Blakely decided to cut the feet off her pantyhose to enhance her looks when wearing pants.

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 Soon after she obtained a patent for her body-shaping undergarments, and Spanx began production and retailing of its shapewear in 2000. Sales grew exponentially after Blakely appeared on The Oprah Winfrey Show. By 2017, Spanx had grown to more than 250 employees and sold millions of Spanx “power panties,” with estimated revenues of some $500 million. To stake out a strong position and to preempt competitors, Spanx now offers over 200 products ranging from slimming apparel and swimsuits to bras and activewear. Moreover, it now designs and manufactures body-shaping undergarments for men (“Spanx for Men—Manx”). Spanx products are now available in over 50 countries globally via the internet. Moreover, to strengthen its strategic position and brand image in the United States, Spanx is opening retail stores across the country.

The shapewear industry’s explosive growth—it is expected to reach $6 billion in annual sales by 2022—has attracted several other players: Flexees by Maidenform, BodyWrap, and Miraclesuit, to name a few. They are all attempting to carve out positions in the new industry. Given Spanx’s ability to stake out a strong position during the growth stage of the industry life cycle and the fact that it continues to be a moving target, it might be difficult for competitors to dislodge the company.

Taking the risk paid off for Spanx’s founder: After investing an initial $5,000 into her startup, Blakely became the world’s youngest self-made female billionaire. Blakely was also listed in the Time 100, the annual list of the most influential people in the world.

SHAKEOUT STAGE

Rapid industry growth and expansion cannot go on indefinitely. As the industry moves into the next stage of the industry life cycle, the rate of growth declines (see 
Exhibit 7.4
). Firms begin to compete directly against one another for market share, rather than trying Page 234to capture a share of an increasing pie. As competitive intensity increases, the weaker firms are forced out of the industry. This is the reason this phase of the industry life cycle is called the shakeout stage: Only the strongest competitors survive increasing rivalry as firms begin to cut prices and offer more services, all in an attempt to gain more of a market that grows slowly, if at all. This type of cutthroat competition erodes profitability of all but the most efficient firms in the industry. As a consequence, the industry often consolidates, as the weakest competitors either are acquired by stronger firms or exit through bankruptcy.

The winners in this increasingly competitive environment are often firms that stake out a strong position as cost leaders. Key success factors at this stage are the manufacturing and process engineering capabilities that can be used to drive costs down. The importance of process innovation further increases (albeit at diminishing marginal returns), while the importance of product innovation further declines.

Assuming an acceptable value proposition, price becomes a more important competitive weapon in the shakeout stage, because product features and performance requirements tend to be well-established. A few firms may be able to implement a blue ocean strategy, combining differentiation and low cost, but given the intensity of competition, many weaker firms are forced to exit. Any firm that does not have a clear strategic profile is likely to not survive the shakeout phase.

MATURITY STAGE

After the shakeout is completed and a few firms remain, the industry enters the maturity stage. During the fourth stage of the industry life cycle, the industry structure morphs into an oligopoly with only a few large firms. Most of the demand was largely satisfied in the shakeout stage. Any additional market demand in the maturity stage is limited. Demand now consists of replacement or repeat purchases. The market has reached its maximum size, and industry growth is likely to be zero or even negative going forward. This decrease in market demand increases competitive intensity within the industry. In the maturity stage, the level of process innovation reaches its maximum as firms attempt to lower cost as much as possible, while the level of incremental product innovation sinks to its minimum (see 
Exhibit 7.7
).

Generally, the firms that survive the shakeout stage tend to be larger and enjoy economies of scale, as the industry consolidated and most excess capacity was removed. The domestic airline industry has been in the maturity stage for a long time. The large number of bankruptcies as well as the wave of mega-mergers, such as those of Delta and Northwest, United and Continental, and American Airlines and US Airways, are a consequence of low or zero growth in a mature market characterized by significant excess capacity.

DECLINE STAGE

Changes in the external environment (such as those discussed in 

Chapter 3

 when presenting the PESTEL framework) often take industries from maturity to decline. In this final stage of the industry life cycle, the size of the market contracts further as demand falls, often rapidly. At this final phase of the industry life cycle, innovation efforts along both product and process dimensions cease (see 
Exhibit 7.7
). If a technological or business model breakthrough emerges that opens up a new industry, however, then this dynamic interplay between product and process innovation starts anew.

If there is any remaining excess industry capacity in the decline stage, this puts strong pressure on prices and can further increase competitive intensity, especially if the industry Page 235has high exit barriers. At this final stage of the industry life cycle, managers generally have four strategic options: exit, harvest, maintain, or consolidate:

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· ▪ Exit. Some firms are forced to exit the industry by bankruptcy or liquidation. The U.S. textile industry has experienced a large number of exits over the last few decades, mainly due to low-cost foreign competition.

· ▪ Harvest. In pursuing a harvest strategy, the firm reduces investments in product support and allocates only a minimum of human and other resources. While several companies such as IBM, Brother, Olivetti, and Nakajima still offer typewriters, they don’t invest much in future innovation. Instead, they are maximizing cash flow from their existing typewriter product line.

· ▪ Maintain. Philip Morris, on the other hand, is following a maintain strategy with its Marlboro brand, continuing to support marketing efforts at a given level despite the fact that U.S. cigarette consumption has been declining.

· ▪ Consolidate. Although market size shrinks in a declining industry, some firms may choose to consolidate the industry by buying rivals. This allows the consolidating firm to stake out a strong position—possibly approaching monopolistic market power, albeit in a declining industry.

Although chewing tobacco is a declining industry, Swedish Match has pursued a number of acquisitions to consolidate its strategic position in the industry. It acquired, among other firms, the Pinkerton Tobacco Co. of Owensboro, Kentucky, maker of the Red Man brand. Red Man is the leading chewing tobacco brand in the United States. Red Man has carved out a strong strategic position built on a superior reputation for a quality product and by past endorsements of Major League Baseball players since 1904. Despite gory product warnings detailing the health risk of chewing tobacco and a federally mandated prohibition on marketing, the Red Man brand has remained not only popular, but also profitable.

The industry life cycle model assumes a more or less smooth transition from one stage to another. This holds true for most continuous innovations that require little or no change in consumer behavior. But not all innovations enjoy such continuity.

CROSSING THE CHASM

LO 7-4

Derive strategic implications of the crossing-the-chasm framework.

In the influential bestseller Crossing the Chasm

45

 Geoffrey Moore documented that many innovators were unable to successfully transition from one stage of the industry life cycle to the next. Based on empirical observations, Moore’s core argument is that each stage of the industry life cycle is dominated by a different customer group. Different customer groups with distinctly different preferences enter the industry at each stage of the industry life cycle. Each customer group responds differently to a technological innovation. This is due to differences in the psychological, demographic, and social attributes observed in each unique customer segment. Moore’s main contribution is that the significant differences between the early customer groups—who enter during the introductory stage of the industry life cycle—and later customers—who enter during the growth stage—can make for a difficult transition between the different parts of the industry life cycle. Such differences between customer groups lead to a big gulf or chasm into which companies and their innovations frequently fall. Only companies that recognize these differences and are able to apply the appropriate competencies at each stage of the industry life cycle will have a chance to transition successfully from stage to stage.

Exhibit 7.8

 shows the 

crossing-the-chasm framework

 and the different customer segments. The industry life cycle model (shown in 
Exhibit 7.4
) follows an S-curve leading Page 236up to 100 percent total market potential that can be reached during the maturity stage. In contrast, the chasm framework breaks down the 100 percent market potential into different customer segments, highlighting the incremental contribution each specific segment can bring into the market. This results in the familiar bell curve. Note the big gulf, or chasm, separating the early adopters from the early and late majority that make up the mass market. Social network sites have followed a pattern similar to that illustrated in 
Exhibit 7.8
. Friendster was unable to cross the big chasm. Myspace was successful with the early majority, but only Facebook went on to succeed with the late majority and laggards. Each stage customer segment, moreover, is also separated by smaller chasms. Both the large competitive chasm and the smaller ones have strategic implications.

EXHIBIT 7.8 
 The Crossing-the-Chasm Framework

Source: Adapted from G.A. Moore (1991), Crossing the Chasm: Marketing and Selling Disruptive Products to Mainstream Customers (New York: HarperCollins), 17.

Both new technology ventures and innovations introduced by established firms have a high failure rate. This can be explained as a failure to successfully cross the chasm from the early users to the mass market because the firm does not recognize that the business strategy needs to be fine-tuned for each customer segment. Formulating a business strategy for each segment guided by the who, what, why, and how questions of competition (Who to serve? What needs to satisfy? Why and how to satisfy them?), introduced in 
Chapter 6
, the firm will find that the core competencies to satisfy each of the different customer segments are quite different. If not recognized and addressed, this will lead to the demise of the innovation as it crashes into the chasm between life cycle stages.

We first introduce each customer group and map it to the respective stage of the industry life cycle. To illustrate, we then apply the chasm framework to an analysis of the mobile phone industry.

TECHNOLOGY ENTHUSIASTS

The customer segment in the introductory stage of the industry life cycle is called technology enthusiasts.

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 The smallest market segment, it makes up some 2.5 percent of total market potential.

Technology enthusiasts

often have an engineering mind-set and pursue new technology proactively. They frequently seek out new products before the products are officially introduced into the market. Technology enthusiasts enjoy using beta versions of products, tinkering with the product’s imperfections and providing (free) feedback and suggestions to companies. For example, many software companies such as Google and Microsoft launch beta versions to accumulate customer feedback to work out bugs before the official launch. Moreover, technology enthusiasts will often pay a premium price to have the latest gadget. The endorsement by technology enthusiasts validates the fact that the new product does in fact work.

A recent example of an innovation that appeals to technology enthusiasts is Google Glass, a mobile computer that is worn like a pair of regular glasses. Instead of a lens, Page 237however, one side displays a small, high-definition computer screen. Google Glass was developed as part of Google’s wild-card program. Technology enthusiasts were eager to get ahold of Google Glass when made available in a beta testing program in 2013.

Google Glass allows the wearer to use the internet and smartphone-like applications via voice commands (e.g., conduct online search, stream video, and so on).
©AP Images/Google/REX

Those interested had to compose a Google+ or Twitter message of 50 words or less explaining why they would be a good choice to test the device and include the hashtag #ifihadglass. Some 150,000 people applied and 8,000 winners were chosen. They were required to attend a Google Glass event and pay $1,500 for the developer version of Google Glass.

Although many industry leaders, including Apple CEO Tim Cook, agree that wearable computers such as the Apple Watch or the Fitbit (a physical activity tracker that is worn on the wrist; data are integrated into an online community and phone app) are important mobile devices, they suggest that there is a large chasm between the current technology for computerized eyeglasses and a successful product for early adopters let alone the mass market.

47

 They seem to be correct, because Google was until now unable to cross the chasm between technology enthusiasts and early adopters, even after spending $10 billion on R&D per year.

48

EARLY ADOPTERS

The customers entering the market in the growth stage are early adopters. They make up roughly 13.5 percent of the total market potential.

Early adopters

, as the name suggests, are eager to buy early into a new technology or product concept. Unlike technology enthusiasts, however, their demand is driven by their imagination and creativity rather than by the technology per se. They recognize and appreciate the possibilities the new technology can afford them in their professional and personal lives. Early adopters’ demand is fueled more by intuition and vision rather than technology concerns. These are the people that lined up at Apple Stores in the spring of 2015 when it introduced Apple Watch. Since early adopters are not influenced by standard technological performance metrics but by intuition and imagination (What can this new product do for me or my business?), the firm needs to communicate the product’s potential applications in a more direct way than when it attracted the initial technology enthusiasts. Attracting the early adopters to the new offering is critical to opening any new high-tech market segment.

EARLY MAJORITY

The customers coming into the market in the shakeout stage are called early majority. Their main consideration in deciding whether or not to adopt a new technological innovation is a strong sense of practicality. They are pragmatists and are most concerned with the question of what the new technology can do for them. Before adopting a new product or service, they weigh the benefits and costs carefully. Customers in the early majority are aware that many hyped product introductions will fade away, so they prefer to wait and see how things shake out. They like to observe how early adopters are using the product.

Early majority

customers rely on endorsements by others. They seek out reputable references such as reviews in prominent trade journals or in magazines such as Consumer Reports.

Page 238

Because the early majority makes up roughly one-third of the entire market potential, winning them over is critical to the commercial success of the innovation. They are on the cusp of the mass market. Bringing the early majority on board is the key to catching the growth wave of the industry life cycle. Once they decide to enter the market, a herding effect is frequently observed: The early majority enters in large numbers.

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The significant differences in the attitudes toward technology of the early majority when compared to the early adopters signify the wide competitive gulf—the chasm—between these two consumer segments (see 
Exhibit 7.8
). Without adequate demand from the early majority, most innovative products wither away.

Fisker Automotive, a California-based designer and manufacturer of premium plug-in hybrid vehicles, fell into the chasm because it was unable to transition to early adopters, let alone the mass market. Between its founding in 2007 and 2012, Fisker sold some 1,800 of its Karma model, a $100,000 sports car, to technology enthusiasts. It was unable, however, to follow up with a lower-cost model to attract the early adopters into the market. In addition, technology and reliability issues for the Karma could not be overcome. By 2013, Fisker had crashed into the first chasm (between technology enthusiasts and early adopters), filing for bankruptcy. The assets of Fisker Automotive were purchased by Wanxiang, a Chinese auto parts maker.

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Tesla Motors CEO Elon Musk (left) in front of a Tesla Roadster; Fisker Automotive CEO Henrik Fisker (right) in front of a Fisker Karma.
©Misha Gravenor

In contrast, Tesla, the maker of all-electric vehicles introduced in 
ChapterCase 1
 and a fierce rival of Fisker at one time, was able to overcome some of the early chasms. The Tesla Roadster was a proof-of-concept car that demonstrated that electric vehicles could achieve an equal or better performance than the very best gasoline-engine sports cars. The 2,400 Roadsters that Tesla built between 2008 and 2012 were purchased by technology enthusiasts. Next, Tesla successfully launched the Model S, a family sedan, sold to early adopters. The Tesla Model S received a strong endorsement as the 2013 Motor Trend Car of the Year and the highest test scores ever awarded by Consumer Reports. This may help in crossing the chasm to the early majority, because consumers would now feel more comfortable in considering and purchasing a Tesla vehicle. Tesla is hoping to cross the large competitive chasm between early adopters and early majority with its new, lower-priced Model 3.

LATE MAJORITY

The next wave of growth comes from buyers in the late majority entering the market in the maturity stage. Like the early majority, they are a large customer Page 239segment, making up approximately 34 percent of the total market potential. Combined, the early majority and late majority make up the lion’s share of the market potential. Demand coming from just two groups—early and late majority—drives most industry growth and firm profitability.

Members of the early and late majority are also quite similar in their attitudes toward new technology. The late majority shares all the concerns of the early majority. But there are also important differences. Although members of the early majority are confident in their ability to master the new technology, the late majority is not. They prefer to wait until standards have emerged and are firmly entrenched, so that uncertainty is much reduced. The late majority also prefers to buy from well-established firms with a strong brand image rather than from unknown new ventures.

LAGGARDS

Finally, laggards are the last consumer segment to come into the market, entering in the declining stage of the industry life cycle. These are customers who adopt a new product only if it is absolutely necessary, such as first-time cell phone adopters in the United States today. These customers generally don’t want new technology, either for personal or economic reasons. Given their reluctance to adopt new technology, they are generally not considered worth pursuing. 

Laggards

make up no more than 16 percent of the total market potential. Their demand is far too small to compensate for reduced demand from the early and late majority (jointly almost 70 percent of total market demand), who are moving on to different products and services.

CROSSING THE CHASM: APPLICATION TO THE MOBILE PHONE INDUSTRY

Let’s apply the crossing-the-chasm framework to one specific industry. In this model, the transition from stage to stage in the industry life cycle is characterized by different competitive chasms that open up because of important differences between customer groups. Although the large chasm between early adopters and the early majority is the main cause of demise for technological innovations, other smaller mini-chasms open between each stage.

Exhibit 7.9

 shows the application of the chasm model to the mobile phone industry. The first victim was Motorola’s Iridium, an ill-fated satellite-based telephone system.

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 Development began in 1992 after the spouse of a Motorola engineer complained about being unable to get any data or voice access to check on clients while vacationing Page 240on a remote island. Motorola’s solution was to launch 66 satellites into low orbit to provide global voice and data coverage. In late 1998, Motorola began offering its satellite phone service, charging $5,000 per handset (which was almost too heavy to carry around) and up to $14 per minute for calls.

52

 Problems in consumer adoption beyond the few technology enthusiasts became rapidly apparent. The Iridium phone could not be used inside buildings or in cars. Rather, to receive a satellite signal, the phone needed an unobstructed line of sight to a satellite. Iridium crashed into the first chasm, never moving beyond technology enthusiasts (see 
Exhibit 7.9
). For Motorola, it was a billion-dollar blunder. Iridium was soon displaced by cell phones that relied on Earth-based networks of radio towers. The global satellite telephone industry never moved beyond the introductory stage of the industry life cycle.

EXHIBIT 7.9 
 Crossing the Chasm: The Mobile Phone Industry

The first Treo, a fully functioning smartphone combining voice and data capabilities, was released in 2002 by Handspring. The Treo fell into the main chasm that arises between early adopters and the early majority (see 
Exhibit 7.9
). Technical problems, combined with a lack of apps and an overly rigid contract with Sprint as its sole service provider, prevented the Treo from gaining traction in the market beyond early adopters. For these reasons, the Treo was not an attractive product for the early majority, who rejected it. This caused the Treo to plunge into the chasm. Just a year later, Handspring was folded into Palm, which in turn was acquired by HP for $1 billion in 2010.

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 HP shut down Palm in 2011 and wrote off the acquisition.

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BlackBerry (formerly known as Research in Motion or RIM)

55

 introduced its first fully functioning smartphone in 2000. It was a huge success—especially with two key consumer segments. First, corporate IT managers were early adopters. They became product champions for the BlackBerry smartphone because of its encrypted security software and its reliability in always staying connected to a company’s network. This allowed users to receive e-mail and other data in real time, anywhere in the world where wireless service was provided. Second, corporate executives were the early majority pulling the BlackBerry smartphone over the chasm because it allowed 24/7 access to data and voice. BlackBerry was able to create a beachhead to cross the chasm between the technology enthusiasts and early adopters on one side and the early majority on the other.

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 BlackBerry’s managers identified the needs of not only early adopters (e.g., IT managers) but also the early majority (e.g., executives), who pulled the BlackBerry over the chasm. By 2005, the BlackBerry had become a corporate executive status symbol. As a consequence of capturing the first three stages of the industry life cycle, between 2002 and 2007, BlackBerry enjoyed no less than 30 percent year-over-year revenue growth as well as double-digit growth in other financial performance metrics such as return on equity. BlackBerry enjoyed a temporary competitive advantage.

In 2007, BlackBerry’s dominance over the smartphone market began to erode quickly. The main reason was Apple’s introduction of the iPhone. Although technology enthusiasts and early adopters argue that the iPhone is an inferior product to the BlackBerry based on technological criteria, the iPhone enticed not only the early majority, but also the late majority to enter the market. For the late majority, encrypted software security was much less important than having fun with a device that allowed users to surf the web, take pictures, play games, and send and receive e-mail. Moreover, the Apple iTunes Store soon provided thousands of apps for basically any kind of service. While the BlackBerry couldn’t cross the gulf between the early and the late majority, Apple’s iPhone captured the mass market rapidly. Moreover, consumers began to bring their personal iPhone to work, which forced corporate IT departments to expand their services beyond the BlackBerry. Apple rode the wave of this success to capture each market segment. Likewise, Samsung with its Galaxy line of phones, having successfully imitated the look-and-feel of an Page 241iPhone (as discussed in 
Chapter 4
), is enjoying similar success across the different market segments.

This brief application of the chasm framework to the mobile phone industry shows its usefulness. It provides insightful explanations of why some companies failed, while others succeeded—and thus goes at the core of strategy management.

In summary, 

Exhibit 7.10 

details the features and strategic implications of the entire industry life cycle at each stage.

EXHIBIT 7.10
 Features and Strategic Implications of the Industry Life Cycle

High

Moderate

Few, if any

Non-price competition

Price

Differentiation

Life Cycle Stages
Introduction	Growth	Shakeout	Maturity	Decline
Core Competency	R&D, some marketing	R&D, some manufacturing, marketing	Manufacturing, process engineering	Manufacturing, process engineering, marketing	Manufacturing, process engineering, marketing, service
Type and Level of Innovation	Product innovation at a maximum; process innovation at a minimum	Product innovation decreasing; process innovation increasing	After emergence of standard: product innovation decreasing rapidly; process innovation increasing rapidly	Product innovation at a minimum; process innovation at a maximum	Product & process innovation ceased
Market Growth	Slow		High	Moderate and slowing down	None to moderate	Negative
Market Size	Small		Moderate	Large	Largest	Small to moderate
	Price	Falling	Low	Low to high
Number of Competitors		Few, if any	Many	Fewer	Moderate, but large
Mode of Competition		Non-price competition	Shifting from non-price to price competition	Price or non-price competition
Type of Buyers	Technology enthusiasts	Early adopters	Early majority	Late majority	Laggards
Business-Level Strategy		Differentiation	Differentiation, or integration strategy	Cost-leadership or integration strategy	Cost-leadership, differentiation, or integration strategy
Strategic Objective	Achieving market acceptance	Staking out a strong strategic position; generating “deep pockets”	Surviving by drawing on “deep pockets”	Maintaining strong strategic position	Exit, harvest, maintain, or consolidate

A word of caution is in order, however: Although the industry life cycle is a useful framework to guide strategic choice, industries do not necessarily evolve through these stages. Moreover, innovations can emerge at any stage of the industry life cycle, which in turn can initiate a new cycle. Industries can also be rejuvenated, often in the declining stage.

Although the industry life cycle is a useful tool, it does not explain everything about changes in industries. Some industries may never go through the entire life cycle, while others are continually renewed through innovation. Be aware, too, that other external factors that can be captured in the PESTEL framework (introduced in 
Chapter 3
) such as fads Page 242in fashion, changes in demographics, or deregulation can affect the dynamics of industry life cycles at any stage.

It is also important to note that innovations that failed initially can sometimes get a second chance in a new industry or for a new application. When introduced in the early 1990s as an early wireless telephone system, Iridium’s use never went beyond that by technology enthusiasts. After Motorola’s failure, the technology was spun out as a standalone venture called Iridium Communications. As of 2017, it looks like Iridium’s satellite-based communications system will get another chance of becoming a true breakthrough innovation.

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 Rather than in an application in the end-consumer market, this time Iridium is considered for global deployment by airspace authorities to allow real-time tracking of airplanes wherever they may be. The issue of being able to track airplanes around the globe at all times came to the fore in 2014, when Malaysia Airlines Flight 370 with 239 people on board disappeared without a trace, and authorities were unable to locate the airplane.

For the last few decades, air controllers had to rely on ground-based radar to direct planes and to triangulate their positions. A major problem with any ground-based system is that it only works over land or near the shore, but not over oceans, which cover more than 70 percent of the Earth’s surface. Moreover, radar does not work in mountain ranges. Oceans and mountain terrain, therefore, are currently dead zones where air traffic controllers are unable to track airplanes.

Iridium’s technology is now used as a space-based flight tracking system. In 2017, Elon Musk’s SpaceX launched the first set of 10 satellites (out of a total of 66 needed) into space to begin constructing a space-based air traffic control system. Such a system affords air traffic controllers full visibility of and real-time flight information from any airplane over both water and land. It also allows pilots more flexibility in changing routes to avoid bad weather and turbulence, thus increasing passenger convenience, saving fuel, and reducing greenhouse-gas emissions. In addition, the new technology, called Aireon, would allow planes to fly closer together (15 miles apart instead of the now customary 80 miles), allowing for more air traffic on efficient routes. A research study by an independent body predicts that global deployment of Aireon would also lead to a substantial improvement in air safety.

Providing the next-generation air traffic control technology and services is a huge business opportunity for Iridium Communications. National air traffic control agencies will be the main customers to deploy the new Aireon technology. This goes to show that a second chance of success for an innovation may arise, even after the timing and application of an initial technology were off.

7.4 Types of Innovation

LO 7-5

Categorize different types of innovations in the markets-and-technology framework.

Because of the importance of innovation in shaping competitive dynamics and as a critical component in formulating business strategy, we now turn to a discussion of different types of innovation and the strategic implications of each. We need to know, in particular, along which dimensions we should assess innovations. This will allow us to formulate a business strategy that can leverage innovation for competitive advantage.

One insightful way to categorize innovations is to measure their degree of newness in terms of technology and markets.

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 Here, technology refers to the methods and materials used to achieve a commercial objective.

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 For example, Amazon integrates different types of technologies (hardware, software, big data analytics, cloud computing, logistics, and so on) to provide not only the largest selection of retail goods online, but also an array of services and mobile devices (e.g., Alexa, a digital personal assistant; Page 243Kindle tablets; Prime; cloud-computing services; and so on). We also want to understand the market for an innovation—e.g., whether an innovation is introduced into a new or an existing market—because an invention turns into an innovation only when it is successfully commercialized.

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 Measuring an innovation along these dimensions gives us the 

markets-and-technology framework

 depicted in 

Exhibit 7.11 

. Along the horizontal axis, we ask whether the innovation builds on existing technologies or creates a new one. On the vertical axis, we ask whether the innovation is targeted toward existing or new markets. Four types of innovations emerge: incremental, radical, architectural, and disruptive innovations. As indicated by the color coding in 

Exhibit 7.11

, each diagonal forms a pair: incremental versus radical innovation and architectural versus disruptive innovation.

EXHIBIT 7.11 
 Types of Innovation: Combining Markets and Technologies

INCREMENTAL VS. RADICAL INNOVATION

Although radical breakthroughs such as smartphones and magnetic resonance imaging (MRI) radiology capture most of our attention, the vast majority of innovations are actually incremental ones. An 

incremental innovation

 squarely builds on an established knowledge base and steadily improves an existing product or service offering.

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 It targets existing markets using existing technology.

On the other hand, 

radical innovation

 draws on novel methods or materials, is derived either from an entirely different knowledge base or from a recombination of existing knowledge bases with a new stream of knowledge. It targets new markets by using new technologies.

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 Well-known examples of radical innovations include the introduction of the mass-produced automobile (the Ford Model T), the X-ray, the airplane, and more recently biotechnology breakthroughs such as genetic engineering and the decoding of the human genome.

Many firms get their start by successfully commercializing radical innovations, some of which, such as the jet-powered airplane, even give birth to new industries. Although the British firm de Havilland first commercialized the jet-powered passenger airplane, Boeing was the company that rode this radical innovation to industry dominance. More recently, Boeing’s leadership has been contested by Airbus; each company has approximately half the market. This stalemate is now being challenged by aircraft manufacturers such as Bombardier of Canada and Embraer of Brazil, which are moving up-market by building larger luxury jets that are competing with some of the smaller airplane models offered by Boeing and Airbus.

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A predictable pattern of innovation is that firms (often new ventures) use radical innovation to create a temporary competitive advantage. They then follow up with a string of incremental innovations to sustain that initial lead. Gillette is a prime example for this pattern of strategic innovation. In 1903, entrepreneur King C. Gillette invented and began selling the safety razor with a disposable blade. This radical innovation launched the Gillette Co. (now a brand of Procter & Gamble). To sustain its competitive advantage, Gillette not only made sure that its razors were inexpensive and widely available by introducing the “razor and razor blade” business model, but also continually improved its blades. In a classic example of a string of incremental innovations, Gillette kept adding an additional blade with each new version of its razor until the number had gone from one to six! Though this innovation strategy seems predictable, it worked. Gillette’s newest razor, the Fusion ProGlide with Flexball technology, a razor handle that features a swiveling ball hinge, costs $11.49 (and $12.59 for a battery-operated one) per razor! 

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Dollar Shave Club is disrupting Gillette’s business model based on incremental innovation. As a result, Gillette’s market share in the $15 billion wet shaving industry has declined from some 70 percent (in 2010) to below 60 percent (by 2017).

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The Gillette example, nonetheless, shows how radical innovation created a competitive advantage that the company can sustain through follow-up incremental innovation. Such an outcome is not a foregone conclusion, though. In some instances, the innovator is outcompeted by second movers that quickly introduce a similar incremental innovation to continuously improve their own offering. For example, although CNN was the pioneer in 24-hour cable news, today Fox News is the most watched cable news network in the United States (although the entire industry is in decline as viewers now stream much more content directly via mobile devices, as discussed in 

ChapterCase 7

 about Netflix). Once firms have achieved market acceptance of a breakthrough innovation, they tend to follow up with incremental rather than radical innovations. Over time, these companies morph into industry incumbents. Future radical innovations are generally introduced by new entrepreneurial ventures. Why is this so? The reasons concern economic incentives, organizational inertia, and the firm’s embeddedness in an innovation ecosystem.

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ECONOMIC INCENTIVES

Economists highlight the role of incentives in strategic choice. Once an innovator has become an established incumbent firm (such as Google has today), it has strong incentives to defend its strategic position and market power. An emphasis on incremental innovations strengthens the incumbent firm’s position and thus maintains high entry barriers. A focus on incremental innovation is particularly attractive once an industry standard has emerged and technological uncertainty is reduced. Moreover, many markets where network effects are important (such as online search), turn into 

winner-take-all markets

, where the market leader captures almost all of the market share. As a near monopolist, the winner in these types of markets is able to extract a significant amount of the value created. In the United States, Google handles some 65 percent of all online queries, while it handles more than 90 percent in Europe. As a result, the incumbent firm uses incremental innovation to extend the time it can extract profits based on a favorable industry structure (see the discussion in 
Chapter 3
). Any potential radical innovation threatens the incumbent firm’s dominant position.

The incentives for entrepreneurial ventures, however, are just the opposite. Successfully commercializing a radical innovation is frequently the only option to enter an industry protected by high entry barriers. One of the first biotech firms, Amgen, used newly discovered drugs based on genetic engineering to overcome entry barriers to the pharmaceutical Page 245industry, in which incumbents had enjoyed notoriously high profits for several decades. Because of differential economic incentives, incumbents often push forward with incremental innovations, while new entrants focus on radical innovations.

ORGANIZATIONAL INERTIA

From an organizational perspective, as firms become established and grow, they rely more heavily on formalized business processes and structures. In some cases, the firm may experience organizational inertia—resistance to changes in the status quo. Incumbent firms, therefore, tend to favor incremental innovations that reinforce the existing organizational structure and power distribution while avoiding radical innovation that could disturb the existing power distribution. Take, for instance, power distribution between different functional areas, such as R&D and marketing. New entrants, however, do not have formal organizational structures and processes, giving them more freedom to launch an initial breakthrough. We discuss the link between organizational structure and firm strategy in depth in 
Chapter 11
.

INNOVATION ECOSYSTEM

A final reason incumbent firms tend to be a source of incremental rather than radical innovations is that they become embedded in an 

innovation ecosystem

: a network of suppliers, buyers, complementors, and so on.

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 They no longer make independent decisions but must consider the ramifications on other parties in their innovation ecosystem. Continuous incremental innovations reinforce this network and keep all its members happy, while radical innovations disrupt it. Again, new entrants don’t have to worry about preexisting innovation ecosystems, since they will be building theirs around the radical innovation they are bringing to a new market.

ARCHITECTURAL VS. DISRUPTIVE INNOVATION

Firms can also innovate by leveraging existing technologies into new markets. Doing so generally requires them to reconfigure the components of a technology, meaning they alter the overall architecture of the product.

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 An 

architectural innovation

, therefore, is a new product in which known components, based on existing technologies, are reconfigured in a novel way to create new markets.

As a radical innovator commercializing the xerography invention, Xerox was long the most dominant copier company worldwide.

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 It produced high-volume, high-quality, and high-priced copying machines that it leased to its customers through a service agreement. Although these machines were ideal for the high end of the market such as Fortune 100 companies, Xerox ignored small and medium-sized businesses. By applying an architectural innovation, the Japanese entry Canon was able to redesign the copier so that it didn’t need professional service—reliability was built directly into the machine, and the user could replace parts such as the cartridge. This allowed Canon to apply the razor–razor-blade business model (introduced in 
Chapter 5
), charging relatively low prices for its copiers but adding a steep markup to its cartridges. Xerox had not envisioned the possibility that the components of the copying machine could be put together in an altogether different way that was more user-friendly. More importantly, Canon addressed a need in a specific consumer segment—small and medium-sized businesses and individual departments or offices in large companies—that Xerox neglected.

Finally, a 

disruptive innovation

 leverages new technologies to attack existing markets. It invades an existing market from the bottom up, as shown in 

Exhibit 7.12

.

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 The dashed lines represent different market segments, from Segment 1 at the low end to Segment 4 at the high end. Low-end market segments are generally associated with low profit margins, Page 246while high-end market segments often have high profit margins. As first demonstrated by Clayton Christensen, the dynamic process of disruptive innovation begins when a firm, frequently a startup, introduces a new product or process based on a new technology to meet existing customer needs. To be a disruptive force, however, this new technology has to have additional characteristics:

EXHIBIT 7.12 
 Disruptive Innovation: Riding the Technology Trajectory to Invade Different Market Segments from the Bottom Up

1. It begins as a low-cost solution to an existing problem.

2. Initially, its performance is inferior to the existing technology, but its rate of technological improvement over time is faster than the rate of performance increases required by different market segments. In 
Exhibit 7.12
, the solid upward curved line captures the new technology’s trajectory, or rate of improvement over time.

The following examples illustrate disruptive innovations:

· ▪ Japanese carmakers successfully followed a strategy of disruptive innovation by first introducing small fuel-efficient cars and then leveraging their low-cost and high-quality advantages into high-end luxury segments, captured by brands such as Lexus, Infiniti, and Acura. More recently, the South Korean carmakers Kia and Hyundai have followed a similar strategy.

· ▪ Digital photography improved enough over time to provide higher-definition pictures. As a result, it has been able to replace film photography, even in most professional applications.

· ▪ Laptop computers disrupted desktop computers; now tablets and larger-screen smartphones are disrupting laptops.

· ▪ Educational organizations such as Coursera and Udacity are disrupting traditional universities by offering massive open online courses (MOOCs), using the web to provide large-scale, interactive online courses with open access.

One factor favoring the success of disruptive innovation is that it relies on a stealth attack: It invades the market from the bottom up, by first capturing the low end. Many times, incumbent firms fail to defend (and sometimes are even happy to cede) the low end of the market, because it is frequently a low-margin business. Google, for example, is using its mobile operating system, Android, as a beachhead to challenge Microsoft’s dominance in the personal computer industry, where 90 percent of machines run Windows.

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 Google’s Page 247Android, in contrast, is optimized to run on mobile devices, the fastest-growing segment in computing. To appeal to users who spend most of their time on the web accessing e-mail and other online applications, for instance, it is designed to start in a few seconds. Moreover, Google provides Android free of charge.

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 In contrast to Microsoft’s proprietary Windows operating system, Android is open-source software, accessible to anyone for further development and refinement. Google’s Android holds an 85 percent market share in mobile operating systems, while Apple’s iOS has 12 percent, and the remaining 3 percent is held by Microsoft’s Windows.

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Another factor favoring the success of disruptive innovation is that incumbent firms often are slow to change. Incumbent firms tend to listen closely to their current customers and respond by continuing to invest in the existing technology and in incremental changes to the existing products. When a newer technology matures and proves to be a better solution, those same customers will switch. At that time, however, the incumbent firm does not yet have a competitive product ready that is based on the disruptive technology. Although customer-oriented visions are more likely to guard against firm obsolescence than product-oriented ones (see 

Chapter 2

), they are no guarantee that a firm can hold out in the face of disruptive innovation. One of the counterintuitive findings that Clayton Christensen unearthed in his studies is that it can hurt incumbents to listen too closely to their existing customers. Apple is famous for not soliciting customer feedback because it believes it knows what customers need before they even realize it.

Netflix, featured in the 

ChapterCase

, disrupted the television industry from the bottom up (as shown in 
Exhibit 7.12
) with its online streaming video-on-demand service. Netflix’s streaming service differentiated itself from cable television by making strategic trade-offs. By initially focusing on older “rerun TV” (such as Breaking Bad) and not including local content or exorbitant expensive live sport events, Netflix was able to price its subscription service considerably lower than cable bundles. Netflix improved the viewing experience by allowing users to watch shows and movies without commercial breaks and on-demand, thus enhancing perceived consumer value. By switching quickly from sending DVDs via postal mail to online streaming, Netflix was able to ride the upward-sloping technology trajectory (shown in 
Exhibit 7.12
) to invade the media industry from the bottom up, all the way to providing premium original content such as House of Cards. Netflix’s pivot to online streaming was aided by increased technology diffusion (see 
Exhibit 7.1
) as more and more Americans adopted broadband internet connections in the early 2000s.

HOW TO RESPOND TO DISRUPTIVE INNOVATION?

Many incumbents tend to dismiss the threat by startups that rely on disruptive innovation because initially their product or service offerings are considered low end and too niche-focused. As late as 2010 (the year Blockbuster filed for bankruptcy), the CEO of Time Warner, one of the incumbent media companies to be disrupted by Netflix, did not take it seriously. When asked about the online streaming service as a potential competitor, he ridiculed the threat as equivalent to the likelihood of the Albanian army taking over the entire world.

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 It is critical to have an effective response to disruptive innovation.

Although the examples in the previous section show that disruptive innovations are a serious threat for incumbent firms, some have devised strategic initiatives to counter them:

1. Continue to innovate in order to stay ahead of the competition. A moving target is much harder to hit than one that is standing still and resting on existing (innovation) laurels. Amazon is an example of a company that has continuously morphed through innovation,

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 from a simple online book retailer to the largest ecommerce company, and now to include stores on the ground in the grocery sector. It also offers a personalized digital assistant (Alexa), consumer electronics (Kindle tablets), cloud computing, Page 248and content streaming, among other many other offerings (see 
ChapterCase 8
). Netflix continued to innovate by pivoting to online streaming and away from sending DVDs through the mail.

2. Guard against disruptive innovation by protecting the low end of the market (Segment 1 in 
Exhibit 7.12
) by introducing low-cost innovations to preempt stealth competitors. Intel introduced the Celeron chip, a stripped-down, budget version of its Pentium chip, to prevent low-cost entry into its market space. More recently, Intel followed up with the Atom chip, a new processor that is inexpensive and consumes little battery power, to power low-cost mobile devices.

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 Nonetheless, Intel also listened too closely to its existing personal computer customers such as Dell, HP, Lenovo, and so on, and allowed ARM Holdings, a British semiconductor design company (that supplies its technology to Apple, Samsung, HTC, and others) to take the lead in providing high-performing, low-power-consuming processors for smartphones and other mobile devices.

3. Disrupt yourself, rather than wait for others to disrupt you. A firm may develop products specifically for emerging markets such as China and India, and then introduce these innovations into developed markets such as the United States, Japan, or the European Union. This process is called 

reverse innovation

,

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 and allows a firm to disrupt itself. 

Strategy Highlight 7.2

 describes how GE Healthcare invented and commercialized a disruptive innovation in China that is now entering the U.S. market, riding the steep technology trajectory of disruptive innovation shown in 
Exhibit 7.12
.

Strategy Highlight 7.2

GE’s Innovation Mantra: Disrupt Yourself!

GE Healthcare is a leader in diagnostic devices. Realizing that the likelihood of disruptive innovation increases over time, GE decided to disrupt itself. A high-end ultrasound machine found in cutting-edge research hospitals in the United States or Europe costs $250,000. There is not a large market for these high-end, high-price products in developing countries. Given their large populations, however, these countries have a strong medical need for ultrasound devices.

GE’s Vscan is a wireless ultrasound device priced around $5,000.
©VCG/Getty Images News/ Getty Images

In 2002, a GE team in China, through a bottom-up strategic initiative, developed an inexpensive, portable ultrasound device, combining laptop technology with a probe and sophisticated imaging software. This lightweight device (11 pounds) was first used in rural China. In spring 2009, GE unveiled the new medical device under the name Venue 40 in the United States, at a price of less than $30,000. There was also high demand from many American general practitioners, who could not otherwise afford the $250,000 needed to procure a high-end machine (that weighed about 400 pounds). In the fall of 2009, then GE Chairman and CEO Jeff Immelt unveiled the Vscan, an even smaller device that looks like a cross between an early iPod and a flip phone. This wireless ultrasound device is priced around $5,000. GE views the Vscan as the “stethoscope of the 21st century,” which a primary care doctor can hang around her neck when visiting with patients.

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7.5 Platform Strategy

LO 7-6

Explain why and how platform businesses can outperform pipeline businesses.

Up to this point in our discussion of strategy and competitive advantage, we focused mainly on businesses that operate at one or more stages of the linear value chain (introduced in 
Chapter 4
).

A firm’s value chain captures the internal activities a firm engages in, beginning with raw materials and ending with retailing and after-sales service and support. The value chain represents a linear view of a firm’s business activities. As such, this traditional system of horizontal business organization has been described as a pipeline, because it captures a linear transformation with producers at one end and consumers at the other. Take BlackBerry as an example of a business using a linear pipeline approach based on a step-by-step arrangement for creating and transferring value. This Canadian ex-leader in smartphones conducted internal R&D, designed the phones, then manufactured them (often in company-owned plants), and finally retailed them in partner stores such as AT&T or Verizon, which offered wireless services and after-sales support.

THE PLATFORM VS. PIPELINE BUSINESS MODELS

Read the examples below, and try to figure out how these businesses’ operations differ from the traditional pipeline structure described earlier.

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· Valued at $70 billion in 2017, the ride-hailing service Uber was launched less than 10 years earlier in a single city, San Francisco. Uber is not only disrupting the traditional taxi and limousine business in hundreds of cities around the globe, but also reshaping the transportation and logistics industries, without owning a single car. In the future, Uber might deploy a fleet of driverless cars; it is currently testing autonomous vehicles.

· Reaching close to 2 billion people (out of a total of 7 billion on Earth), Facebook is where people get their news, watch videos, listen to music, and share photos. Garnering some $30 billion in annual advertising revenues in 2016, Facebook has become one of the largest media companies in the world, without producing a single piece of content.

· China-based ecommerce firm Alibaba is the largest web portal that offers online retailing as well as business-to-business services on a scale that dwarfs Amazon.com and eBay combined. On its Taobao site (similar to eBay), Alibaba offers more than 1 billion products, making it the world’s largest retailer without owning a single item of inventory. When going public in 2014 by listing on the New York Stock Exchange (NYSE), Alibaba was the world’s largest initial public offering (IPO), valued at $25 billion. Not even three years later, by early 2017, Alibaba was valued at some $260 billion, making it one of the most valuable technology companies in the world.

What do Uber, Facebook, and Alibaba have in common? They are not organized as traditional linear pipelines, but instead as a 

platform businesses

. The five most valuable companies globally (Apple, Alphabet, Microsoft, Amazon, and Facebook) all run platform business models. ExxonMobil, running a traditional linear business model from raw materials (fossil fuels) to distribution (of refined petroleum products) and long the most valuable company in the world, had fallen to number six by 2016.

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 Based on the 2016 book Platform Revolution by Parker, Van Alstyne, and Choudary, platforms can be defined along three dimensions:

1. A platform is a business that enables value-creating interactions between external producers and consumers.

2. Page 250The platform’s overarching purpose is to consummate matches among users and facilitate the exchange of goods, services, or social currency, thereby enabling value creation for all participants.

3. The platform provides an infrastructure for these interactions and sets governance conditions for them.

The business phenomenon of platforms, however, is not a new one. Platforms, often also called multi-sided markets, have been around for millennia. The town squares in ancient cities were marketplaces where sellers and buyers would meet under a set of governing rules determined by the owner or operator (such as what type of wares could be offered, when the marketplace was open for business, which vendor would get what stand on the square, etc.). The credit card, often hailed has the most important innovation in the financial sector over the last few decades,

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 provides a more recent example of a multi-sided market. Credit cards facilitate more frictionless transactions between vendors and customers because the vendor is guaranteed payment by the bank that issues the credit card, and customers using credit cards can easily transact online without the need to carry cash in the physical world. In addition, credit card users can buy goods or services on credit based on their promise of repaying the bank.

In the digital age, platforms are business model innovations that use technology (such as the internet, cloud computing, etc.) to connect organizations, resources, information, and people in an interactive ecosystem where value-generating transactions (such as hailing a ride on Uber, catching up on news on Facebook, or connecting a Chinese supplier to a U.S. retailer via Alibaba) can be created and exchanged. Effective use of technology allows platform firms to drastically reduce the barriers of time and space: Information is available in real time across the globe, and market exchanges can take place effectively across vast distances (i.e., China to the United States) or even in small geographic spaces (such as Tinder, a location-based dating service).

THE PLATFORM ECOSYSTEM

To formulate an effective platform strategy, a first step is to understand the roles of the players within any 

platform ecosystem

 (see 

Exhibit 7.13

). From a value chain perspective, producers create or make available a product or service that consumers use. The owner of the platform controls the platform IP address and controls who may participate and in what ways. The providers offer the interfaces for the platform, enabling its accessibility online.

EXHIBIT 7.13  The Players in a Platform Ecosystem

SOURCE: Adapted from Van Alystyn, M., Parker. G. G., and Choudary, S. P. (2016, Apr.) “Pipelines, Platforms, and the New Rules of Strategy,” Harvard Business Review.

The players in the ecosystem typically fill one or more of the four roles but may rapidly shift from one role to another. For example, a producer may decide to purchase the platform to become an owner, or an owner may use the platform as a producer. Producer and consumer can also switch, for example, as when a passenger (consumer) who uses Uber for transportation decides to become an Uber driver (producer). This is an example of so-called side switching.

ADVANTAGES OF THE PLATFORM BUSINESS MODEL

Platform businesses tend to frequently outperform pipeline businesses, because of the following advantages:

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1. Platforms scale more efficiently than pipelines by eliminating gatekeepers. Platform businesses leveraging digital technology can also grow much faster—that is, they scale efficiently—because platforms create value by orchestrating resources that reside in the ecosystem. The platform business does not own or control these resources, facilitating rapid and often exponential growth.

In contrast, pipelines tend to be inefficient in managing the flow of information from producer to consumer. When hiring a professional services firm such as consultants or Page 251lawyers, the buyer has to purchase a bundle of services offered by the firm, for example, retaining a consulting team for a specific engagement. This team of consultants contains both senior and junior consultants, as well as administrative support staff. The client is unable to access the services of only one or two senior partners but not the rest of the team, where inexperienced junior associates are also billed at a high rate to the client. Platforms such as Upwork unbundle professional services by making available precisely defined individual services while eliminating the need to purchase a bundle of services as required by gatekeepers in old-line pipelines.

2. Platforms unlock new sources of value creation and supply. Consider how upstart Airbnb (featured in 

ChapterCase 3

) disrupted the hotel industry. To grow, traditional competitors such as Marriott or Hilton would need to add additional rooms to their existing stock. To add new hotel room inventory to their chains, they would need to find suitable real estate, develop and build a new hotel, furnish all the rooms, and hire and train staff to run the new hotel. This often takes years, not to mention the multimillion-dollar upfront investments required and the risks involved.

In contrast, Airbnb faces no such constraints because it does not own any real estate, nor does it manage any hotels. Just like Marriott or Hilton, however, it uses sophisticated pricing and booking systems to allow guests to find a large variety of rooms pretty much anywhere in the world to suit their needs. As a digital platform, Airbnb allows any person to offer rooms directly to pretty much any consumer that is looking for accommodation online. Airbnb makes money by taking a cut on every rental through its platform. Given that Airbnb is a mere digital platform, it can grow much faster than old-line pipeline businesses such as Marriott. Airbnb’s inventory is basically unlimited as long as it can sign up new users with spare rooms to rent, combined with very little if any cost to adding inventory to its existing online offerings. Unlike traditional hotel chains, Airbnb’s growth is not limited by capital, hotel staff, or ownership of real estate. In 2017, Airbnb offered over 2 million listings worldwide for rent.

3. Platforms benefit from community feedback. Feedback loops from consumers back to the producers allow platforms to fine-tune their offerings and to benefit from big data Page 252analytics. TripAdvisor, a travel website, derives significant value from the large amount of quality reviews (including pictures) by its users of hotels, restaurants, and so on. This enables TripAdvisor to consummate more effective matches between hotels and guests via its website, thus creating more value for all participants. It also allows TripAdvisor to capture a percentage of each successful transaction in the process.

Netflix also collects large amounts of data about users’ viewing habits and preferences across the world. This allows Netflix to not only make effective recommendations on what to watch next, but also affords a more effective resource allocation process when making content investments. Before even producing a single episode of House of Cards, for example, Netflix knew that its audience would watch this series. Netflix has continued following the data, which allows the market to shape new content.

NETWORK EFFECTS

For platform businesses to succeed, however, it is critical to benefit from positive network effects. We provided a brief introduction of network effects earlier when discussing how to gain a foothold for an innovation in a newly emerging industry during the introduction stage of the industry life cycle. We now take a closer look at the role of network effects in platforms, including feedback loops that can initiate virtuous growth cycles leading to platform leadership.

Netflix.

Consider how the video-streaming service Netflix (featured in the 
ChapterCase
) leverages network effects for competitive advantage. Netflix’s business model is to grow its global user base as large as possible and then to monetize it via monthly subscription fees. It does not offer any ads. The established customer base in the old-line DVD rental business gave Netflix a head start when entering into the new business of online streaming. Moreover, the cost to Netflix of establishing a large library of streaming content is more or less fixed, but the per unit cost falls drastically as more users join. Moreover, the marginal cost of streaming content to additional users is also extremely low (it is not quite zero because Netflix pays for some delivery of content either by establishing servers hosting content in geographic proximity of users, or paying online service providers for faster content streaming).

As Netflix acquires additional streaming content, it increases the value of its subscription service to customers, resulting in more people signing up. With more customers, Netflix could then afford to provide more and higher-quality content, further increasing the value of the subscription to its users. This created a virtuous cycle that increased the value of a Netflix subscription as more subscribers signed up (see 

Exhibit 7.14

).

EXHIBIT 7.14 Netflix Business Model: Leveraging Network Effects to Drive Demand

Growing its user base is critical for Netflix to sustain its competitive advantage. Netflix has been hugely successful in attracting new users: In 2017 it had some 100 million subscribers worldwide. Yet, while providing a large selection of high-quality streaming content is a necessity of the Netflix business model, this element can and has been easily duplicated by others such as Amazon, Hulu, and premium services on Google’s YouTube. To lock in its large installed base of users, however, Netflix has begun producing and distributing original content such as the hugely popular shows House of Cards and Orange Is the New Black. To sustain its competitive advantage going forward, Netflix needs to rely on its core competencies, including its proprietary recommendation Page 253engine, data-driven content investments, and network infrastructure management.

Uber.

The feedback loop in network effects becomes even more apparent when taking a closer look at Uber’s business model. Like many platforms, Uber performs a classic matching service. In this case, it allows riders to find drivers and drivers to find riders. Uber’s deep pockets, thanks to successful rounds of fund-raising, allow the startup to lose money on each ride in order to initiate a positive feedback loop. Uber provides incentives for drivers to sign up (such as extending credit so that potential drivers can purchase vehicles) and also charges lower than market rates for its rides. As more and more drivers sign up in each city and thus coverage density rises accordingly, the service becomes more convenient. This drives more demand for its services as more riders choose Uber, which in turn brings in more drivers. This positive feedback loop is shown in 

Exhibit 7.15

.

EXHIBIT 7.15 
 Uber’s Business Model: Leveraging Network Effects to Increase Demand

With more and more drivers on the Uber platform, both wait time for rides as well as driver downtime falls. Less downtime implies that a driver can complete more rides in a given time while making the same amount of money, even if Uber should lower its fares. Lower fares and less wait time, in turn, bring in more riders on the platform, and so on. This additional feedback loop is shown in 

Exhibit 7.16

.

This feedback loop also explains the much hated “surge pricing” that Uber employs. It is based on dynamic pricing for its services depending on demand. For example, during the early hours of each New Year, demand for rides far outstrips supply. To entice more drivers to work during this time, Uber has to pay them more. Higher pay will bring more drivers onto the platform. Some users complain about surge pricing, but it allows Uber to match supply and demand in a dynamic fashion. As surge pricing kicks in, fewer people will demand rides, eventually bringing supply and demand back into an equilibrium (see 
Exhibit 7.16
).

EXHIBIT 7.16 
 Uber’s Network Effects with Feedback Loop

The ability of a platform to evince and manage positive network effects is critical to producing value for each participant, and it allows it to gain and sustain a competitive advantage. In contrast, negative network effects describe the situation where more and more users exit a platform and the value that each remaining user receives from the platform declines. The social network Myspace experienced negative network effects as more and more users abandoned it for Facebook. One reason was that Myspace attempted to maximize ad revenues per user too early in its existence, while Facebook first focused on building a social media platform that allowed for the best possible user experience before starting to monetize its user base through selling ads.

7.6 Implications for Strategic Leaders

Innovation drives the competitive process. An effective innovation strategy is critical in formulating a business strategy that provides the firm with a competitive advantage. Successful innovation affords firms a temporary monopoly, with corresponding monopoly pricing power. Fast Company named Amazon, Google, Uber, Apple, and Snap as the top five of its 2017 Most Innovative Companies.

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 Continuous innovation fuels the success of these companies.

Entrepreneurs are the agents that introduce change into the competitive system. They do this not only by figuring out how to use inventions, but also by introducing new products or services, new production processes, and new forms of organization. Entrepreneurs frequently start new ventures, but they may also be found in existing firms.

The industry life cycle model and the crossing-the-chasm framework have critical implications for how you manage innovation. To overcome the chasm, you need to formulate a business strategy guided by the who, what, why, and how questions of competition (
Chapter 6
) to ensure you meet the distinctly different customer needs inherent along the industry life cycle. You also must be mindful that to do so, you need to bring different competencies and capabilities to bear at different stages of the industry life cycle.

It is also useful to categorize innovations along their degree of newness in terms of technology and markets. Each diagonal pair—incremental versus radical innovation and architectural versus disruptive innovation—has different strategic implications.

Moving from the traditional pipeline business to a platform business model implies three important shifts in strategy focus:

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1. From resource control to resource orchestration.

2. From internal optimization to external interactions.

3. From customer value to ecosystem value.

The focus in platform strategy, therefore, shifts from traditional concepts of resource control, industry structure, and firm strategic position to creating and facilitating more or less frictionless market exchanges.

In conclusion, in this and the previous chapter, we discussed how firms can use business-level strategy—differentiation, cost leadership, blue ocean, and innovation—to gain and sustain competitive advantage. We now turn our attention to corporate-level strategy to help us understand how executives make decisions about where to compete (in terms of products and services offered, integration along the value chain, and geography) and how to execute it through strategic alliances as well as mergers and acquisitions. A thorough understanding of business and corporate strategy is necessary to formulate and sustain a winning strategy.

CHAPTERCASE 7 
 Consider This…

THE IMPACT OF NETFLIX’S mega-success House of Cards in reshaping the TV industry cannot be underestimated. The American political TV drama starring Kevin Spacey and Robin Wright was an innovation that fundamentally changed the existing business model of TV viewing on three fronts.

1. Delivery. House of Cards was the first time that a major original TV drama was streamed online and thus bypassed the established ecosystem of networks and cable operators.

2. Access. House of Cards created the phenomenon of binge watching because it allowed Netflix subscribers Page 255to view many or all episodes in one sitting, without any advertising interruptions. As of 2017, spending an estimated $200 million, Netflix produced five seasons for a total of 65 episodes each roughly 45 to 60 minutes long.

3. Management. House of Cards was the first time original programming had been developed based on Netflix’s proprietary data algorithms and not by more traditional methods. When executive producer David Fincher and actor Kevin Spacey brought the proposed show to Netflix, the company approved the project without a pilot or any test-marketing. “Netflix was the only network that said, ‘We believe in you,’” recalls Spacey. “‘We’ve run our data and it tells us that our audience would watch this series. We don’t need you to do a pilot. How many [episodes] do you wanna do?’”

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The success of House of Cards created a huge buzz, attracted millions of new subscribers to Netflix, and helped its stock climb to new highs.

©A-Pix Entertainment/Photofest

Despite riding high, there are some serious challenges for CEO Reed Hastings and Netflix on the horizon. First is the issue of how to ensure that Netflix users have a seamless, uninterrupted viewing experience, without buffering (and seeing the “spinning wheels”). Recall that Netflix is responsible for more than one-third of all downstream internet traffic in the United States during peak hours. For a long time, Netflix has been a strong supporter of net neutrality, with the goal of preventing internet service providers (ISPs) such as Comcast from slowing content or blocking access to certain websites. Conceivably, Comcast may have an incentive to slow Netflix’s content and favor its own NBC content.

To work around the net neutrality rules, ISPs have begun imposing “data caps” on their customers. Once users exceed their data cap, additional data usage incurs added fees. Another ISP practice that concerns Hastings is “zero-rating,” an arrangement where the ISP does not count traffic from preferred data providers such as their own content toward customers’ data caps. These are the reasons Netflix—after refusing to do so for a long time—has begun to pay ISPs directly to ensure a smoother streaming experience for its users. Rather than going through the public internet, in exchange for payment, Netflix is able to hook its servers directly to Comcast’s broadband network. Given its precedent, Netflix is likely to strike similar deals with other ISPs, such as AT&T and Verizon, that control access to Netflix customers.

The second issue for Hastings is how to create sustained future growth. The domestic market seems to be maturing, so growth has to come from international expansion. Some 49 million (or about half of) Netflix subscribers reside outside the United States. To drive future growth, Netflix is rapidly expanding its services internationally from 60 countries in 2016 to 190 countries. Netflix is still noticeably absent from China, a market where Hastings commented that Netflix is still, “in the relationship building phase.”

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 One of the issues Netflix will face is potential censoring of its content; House of Cards has not only explicit content in terms of nudity and violence, but also features a corrupt Chinese businessman meddling in U.S. politics. Moreover, problems with a lack of available titles and few places with broadband internet connections hamper Netflix’s international growth.

Questions

1. Netflix started to pay ISPs to ensure fast and seamless access to its end users.

a. Does this violate net neutrality (the rule that internet service providers should treat all data equally, and not charge differentially by user, content, site, etc.)? Why or why not?

b. Do you favor net neutrality? Explain why or why not?

c. How do ISPs use “zero-rating” of data to circumvent net neutrality rules? Is this legal? Is this ethical? Explain.

d. As ISPs will extract more fees from Netflix, the company continues to invest heavily in its proprietary “Open Connect” network, which allows Netflix to connect its servers directly to those of ISPs (via peering). Since most users upgrade their internet connections to faster broadband in order to watch video, are the incentives of broadband providers aligned with Netflix, or will the broadband providers continue to extract significant value from this industry? Apply a five forces analysis.

2. Netflix growth in the United States seems to be maturing. What other services can Netflix offer that might increase demand in the United States?

3. International expansion appears to be a major growth opportunity for Netflix. Elaborate on the challenges Netflix faces going beyond the U.S. market.

a. Do you think it is a good idea to rapidly expand to 190 countries in one fell swoop, or should Netflix follow a more gradual international expansion?

b. What are some of the challenges Netflix is likely to encounter internationally? What can Netflix do to address these? Explain.

This chapter discussed various aspects of innovation and entrepreneurship as a business-level strategy, as summarized by the following learning objectives and related take-away concepts.

LO 7-1 / Outline the four-step innovation process from idea to imitation.

· ▪ Innovation describes the discovery and development of new knowledge in a four-step process captured in the four I’s: idea, invention, innovation, and imitation.

· ▪ The innovation process begins with an idea.

· ▪ An invention describes the transformation of an idea into a new product or process, or the modification and recombination of existing ones.

· ▪ Innovation concerns the commercialization of an invention by entrepreneurs (within existing companies or new ventures).

· ▪ If an innovation is successful in the marketplace, competitors will attempt to imitate it.

LO 7-2 / Apply strategic management concepts to entrepreneurship and innovation.

· ▪ Entrepreneurship describes the process by which change agents undertake economic risk to innovate—to create new products, processes, and sometimes new organizations.

· ▪ Strategic entrepreneurship describes the pursuit of innovation using tools and concepts from strategic management.

· ▪ Social entrepreneurship describes the pursuit of social goals by using entrepreneurship. Social entrepreneurs use a triple-bottom-line approach to assess performance.

LO 7-3 / Describe the competitive implications of different stages in the industry life cycle.

· ▪ Innovations frequently lead to the birth of new industries.

· ▪ Industries generally follow a predictable industry life cycle, with five distinct stages: introduction, growth, shakeout, maturity, and decline.

· ▪ 
Exhibit 7.10 
details features and strategic implications of the industry life cycle

LO 7-4 / Derive strategic implications of the crossing-the-chasm framework.

· ▪ The core argument of the crossing-the-chasm framework is that each stage of the industry life cycle is dominated by a different customer group, which responds differently to a new technological innovation.

· ▪ There exists a significant difference between the customer groups that enter early during the introductory stage of the industry life cycle and customers that enter later during the growth stage.

· ▪ This distinct difference between customer groups leads to a big gulf or chasm, which companies and their innovations frequently fall into.

· ▪ To overcome the chasm, managers need to formulate a business strategy guided by the who, what, why, and how questions of competition.

LO 7-5 / Categorize different types of innovations in the markets-and-technology framework.

· ▪ Four types of innovation emerge when applying the existing versus new dimensions of technology and markets: incremental, radical, architectural, and disruptive innovations (see 
Exhibit 7.11
).

· ▪ An incremental innovation squarely builds on an established knowledge base and steadily improves an existing product or service offering (existing market/existing technology).

· ▪ A radical innovation draws on novel methods or materials and is derived either from an entirely different knowledge base or from the recombination of the existing knowledge base with a new stream of knowledge (new market/new technology).

· ▪ An architectural innovation is an embodied new product in which known components, based on existing technologies, are reconfigured in a novel way to attack new markets (new market/existing technology).

· ▪ A disruptive innovation is an innovation that leverages new technologies to attack existing markets from the bottom up (existing market/new technology).

Page 257

LO 7-6 / Explain why and how platform businesses can outperform pipeline businesses.

· ▪ Platform businesses scale more efficiently than pipeline businesses by eliminating gatekeepers and leveraging digital technology. Pipeline businesses rely on gatekeepers to manage the flow of value from end to end of the pipeline. Platform businesses leverage technology to provide real-time feedback.

· ▪ Platforms unlock new sources of value creation and supply. Thus they escape the limits faced by a pipeline company working within an existing industry based on physical assets.

· ▪ Platforms benefit from community feedback. Feedback loops from consumers back to the producers allow platforms to fine-tune their offerings and to benefit from big data analytics.

12.1 The Shared Value Creation Framework

LO 12-1

Describe the shared value creation framework and its relationship to competitive advantage.

The shared value creation framework provides guidance to managers about how to reconcile the economic imperative of gaining and sustaining competitive advantage with corporate social responsibility (introduced in 

Chapter 2

).

5

 It helps managers create a larger pie that benefits both shareholders and other stakeholders. To develop the shared value creation framework, though, we first must understand the role of the public stock company.

PUBLIC STOCK COMPANIES AND SHAREHOLDER CAPITALISM

The public stock company is an important institutional arrangement in modern, free market economies. It provides goods and services as well as employment, pays taxes, and increases the standard of living. There exists an implicit contract based on trust between society and the public stock company. Society grants the right to incorporation, but in turn expects companies to be good citizens by adding value to society.

To fund future growth, companies frequently need to go public. Uber, featured in the ChapterCase, is one of the few companies that achieved a huge valuation before an initial public offering. Private start-up companies valued at a billion dollars or more are called unicorns, because at one time they seemed as rare as the mythical beast. But their elusiveness has changed. The tech sector now has the lion’s share: more than 160 unicorns valued at $1 billion or more, for a total of $615 billion.

6

 The top five most valuable private startups (as of the summer of 2017) are Uber, Didi Chuxing (Chinese ride-hailingPage 422 company and mobile logistics network, similar to Uber), Xiaomi (Chinese smartphone maker), Airbnb, and Palantir. These new ventures may eventually go public such as did Snap (2017), Twitter (2013), Facebook (2012), and LinkedIn (2011). As long as these unicorns remain private, however, they do not have to follow the stringent financial reporting and auditing requirements that public stock companies do. Consider that there may be a connection between firm structure and the degree that it integrates ethics. Not needing to expose themselves to as much public scrutiny as a publicly traded company also allows unicorns such as Uber to push the envelope in their legal and ethical business practices. A potential downside is, however, that a track record of ethics and legal problems may prevent a successful initial public offering (IPO) in the future.

In capital markets, private companies that achieve a valuation of $1 billion or greater were once rare enough to be called unicorns.

©Catmando/Shutterstock.com RF

Exhibit 12.1

 depicts the levels of hierarchy within a public stock company. The state or society grants a charter of incorporation to the company’s shareholders—its legal owners, who own stock in the company. The shareholders appoint a board of directors to govern and oversee the firm’s management. The managers hire, supervise, and coordinate employees to manufacture products and provide services. The public stock company enjoys four characteristics that make it an attractive corporate form:

7

EXHIBIT 12.1  The Public Stock Company: Hierarchy of Authority

1. Limited liability for investors. This characteristic means the shareholders who provide the risk capital are liable only to the capital specifically invested, and not for other investments they may have made or for their personal wealth. Limited liability encourages investments by the wider public and entrepreneurial risk-taking.

2. Transferability of investor ownership through the trading of shares of stock on exchanges such as the New York Stock Exchange (NYSE) and NASDAQ,

8

 or exchanges in other countries. Each share represents only a minute fraction of ownership in a company, thus easing transferability.

3. Legal personality—that is, the law regards a non-living entity such as a for-profit firm as similar to a person, with legal rights and obligations. Legal personality allows a firm’s continuation beyond the founder or the founder’s family.

4. Separation of legal ownership and management control.

9

 In publicly traded companies, the stockholders (the principals, represented by the board of directors) are the legal owners of the company, and they delegate decision-making authority to professional managers (the agents).

The public stock company has been a major contributor to value creation since its inception as a new organizational form more than a hundred years ago. Michael Porter and others, however, argue that many public companies have defined value creation too narrowly in terms of financial performance.

10

 This in turn has contributed to some of the black swan events discussed in 
Chapter 2
, such as large-scale accounting scandals and the global financial crisis. Managers’ pursuit of strategies that define value creation too narrowly may have negative consequences for society at large, as evidenced during the global financial crisis. This narrow focus has contributed to the loss of trust in the corporation as a vehicle for value creation, not only for shareholders but also other stakeholders and society.

Nobel laureate Milton Friedman stated his view of the firm’s social obligations: “There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”

11

 This notion is often captured by the term 

shareholder capitalism

. According to this perspective, shareholders—the providers of the necessary risk capital and the legal owners of public companies—have the most legitimate claim on profits. When introducing the notion of corporate social responsibility (CSR) in 
Chapter 2
, though, we noted that a firm’s obligations frequently go beyond the economic responsibility to increase profits, extending to ethical and philanthropic expectations that society has of the business enterprise.

12

Page 423

A survey that measured attitudes toward business responsibility in various countries provides more insights into this debate and how opinions may vary across the globe. The survey asked the top 25 percent of income earners holding a university degree in each country surveyed whether they agree with Milton Friedman’s philosophy that “the social responsibility of business is to increase its profits.”

13

 The results, displayed in 

Exhibit 12.2

, revealed intriguing national differences. The United Arab Emirates (UAE), a small and business-friendly federation of seven emirates, had the highest level of agreement, at 84 percent. Roughly two-thirds agreed in the Asian countries of Japan, India, South Korea, and Singapore, which completed the top five in the survey.

EXHIBIT 12.2  Global Survey of Attitudes toward Business Responsibility
The bar chart indicates the percentage of members of the “informed public” who “strongly agree/somewhat agree” with Milton Friedman’s philosophy, “the social responsibility of business is to increase its profits.”

Source: Depiction of data from Edelman’s, Trust Barometer, 2011 as included in “Milton Friedman goes on tour,” The Economist, January 27, 2011.

The countries where the fewest people agreed with Friedman’s philosophy were China, Brazil, Germany, Italy, and Spain; fewer than 40 percent of respondents in those countries supported an exclusive focus on shareholder capitalism. Although they have achieved a high standard of living, European countries such as Germany have tempered the free market system with a strong social element, leading to so-called social market economies. The respondents from these countries seemed to be more supportive of a stakeholder strategy approach to business. Some critics, however, would argue that too strong a focus on the social dimension contributed to the European debt crisis because sovereign governments such as Greece, Italy, and Spain took on nonsustainable debt levels to fund social programs such as early retirement plans, government-funded health care, and so on. The United States placed roughly in the middle of the continuum—a bit more than half (56 percent) of U.S. respondents subscribed to Friedman’s philosophy.

CREATING SHARED VALUE

In contrast to Milton Friedman, Porter argues that executives should not concentrate exclusively on increasing firm profits. Rather, an effective strategic leader should focus on creating shared value, a concept that involves creating economic value for shareholders while also creating social value by addressing society’s needs and challenges. He argues that managers need to reestablish the important relationship between superior firm performance and societal progress. This dual point of view, Porter argues, will not only allowPage 424 companies to gain and sustain a competitive advantage but also reshape capitalism and its relationship to society.

The 

shared value creation framework

 proposes that managers maintain a dual focus on shareholder value creation and value creation for society. It recognizes that markets are defined not only by economic needs but also by societal needs. It also advances the perspective that externalities such as pollution, wasted energy, and costly accidents actually create internal costs, at least in lost reputation if not directly on the bottom line. Rather than pitting economic and societal needs in a trade-off, Porter suggests that the two can be reconciled to create a larger pie. The shared value creation framework seeks to enhance a firm’s competitiveness by identifying connections between economic and social needs, and then creating a competitive advantage by addressing these business opportunities.

GE, for example, has strengthened its competitiveness by creating a profitable business with its “green” Ecomagination initiative. Ecomagination is GE’s strategic initiative to provide cleaner and more efficient sources of energy, provide abundant sources of clean water anywhere in the world, and reduce emissions.

14

 Jeffrey Immelt, GE’s former CEO, would often say, “Green is green,”

15

 meaning that addressing ecological needs offers the potential of gaining and sustaining a competitive advantage for GE. Through applying strategic innovation, GE is providing solutions for some tough environmental challenges, while driving company growth at the same time. Ecomagination solutions and products allow GE to increase the perceived value it creates for its customers while lowering costs to produce and deliver the “green” products and services. Ecomagination allows GE to solve the trade-off between increasing value creation and lowering costs. This in turn enhances GE’s economic value creation and its competitive advantage.

Moreover, Ecomagination products and services also create value for society in terms of reducing emissions and lowering energy consumption, among other benefits. In 2016, “green” energy obtained from renewables (wind, solar, water, etc.) has for the first time surpassed coal in terms of electricity capacity additions. More than half of new energy capacity now comes from renewables and is estimated to be two-thirds within the next five years. In its sustainability report, GE says, “Investing in clean energy has proven good for business, job creation, the economy and the world.” Since launched in 2005, GE has invested $20 billion in Ecomagination and reported in 2017 that revenues from this strategic initiative alone have reached $270 billion to date.

16

To ensure that managers can reconnect economic and societal needs, Michael Porter recommends that managers focus on three things within the shared value creation framework:

17

1. Expand the customer base to bring in nonconsumers
 such as those at the bottom of the pyramid—the largest but poorest socioeconomic group of the world’s population. The bottom of the pyramid in the global economy can yield significant business opportunities, which—if satisfied—could improve the living standard of the world’s poorest. Muhammad Yunus, Nobel Peace Prize winner, founded Grameen Bank in Bangladesh to provide small loans (termed microcredit) to impoverished villagers, who used the funding for entrepreneurial ventures that would help them climb out of poverty. Other businesses have also found profitable opportunities at the bottom of the pyramid. In India, Arvind Ltd. offers jeans in a ready-to-make kit that costs only a fraction of the high-end Levi’s. The Tata group sells its Nano car for around 150,000 rupees (about $2,500), enabling more Indian families to move from mopeds to cars and potentially adding up to a substantial business.

2. Expand traditional internal firm value chains to include more nontraditional partners such as nongovernmental organizations (NGOs). NGOs are nonprofit organizations that pursue a particular cause in the public interest and are independent of any governments. Habitat for Humanity and Greenpeace are examples of NGOs.

3. Page 425Focus on creating new regional clusters
 such as Silicon Valley in the United States; Electronic City in Bangalore, India; and Chilecon Valley in Santiago, Chile.

In line with stakeholder theory (discussed in 
Chapter 2
), Porter argues that these strategic actions will lead to a larger pie of revenues and profits that can be distributed among a company’s stakeholders. General Electric, for example, recognizes a convergence between shareholders and stakeholders to create shared value. It states in its governance principles: “Both the board of directors and management recognize that the long-term interests of shareowners are advanced by responsibly addressing the concerns of other stakeholders and interested parties, including employees, recruits, customers, suppliers, GE communities, government officials, and the public at large.”

18

 To ensure that convergence takes place, companies need effective governance mechanisms, which we discuss next.

12.2 Corporate Governance

LO 12-2

Explain the role of corporate governance.

Corporate governance

 concerns the mechanisms to direct and control an enterprise in order to ensure that it pursues its strategic goals successfully and legally.

19

 Corporate governance is about checks and balances and about asking the tough questions at the right time. The accounting scandals of the early 2000s and the global financial crisis of 2008 and beyond got so out of hand because the enterprises involved did not practice effective corporate governance. As discussed in the ChapterCase, some observers question whether Uber has effective corporate-governance mechanisms in place, or whether its ethically and legally questionable competitive tactics and decisions are part of a larger intended strategy to first dominate the mobile, on-demand logistics business and then to address any remaining stakeholder grievances.

Corporate governance attempts to address the principal–agent problem (introduced in 

Chapter 8

), which can occur any time an agent performs activities on behalf of a principal.

20

 This problem can arise whenever a principal delegates decision making and control over resources to agents, with the expectation that they will act in the principal’s best interest.

We mentioned earlier that the separation of ownership and control is one of the major advantages of the public stock companies. This benefit, however, is also the source of the principal–agent problem. In publicly traded companies, the stockholders are the legal owners of the company, but they delegate decision-making authority to professional managers. The conflict arises if the agents pursue their own personal interests, which can be at odds with the principals’ goals. For their part, agents may be more interested in maximizing their total compensation, including benefits, job security, status, and power. Principals desire maximization of total returns to shareholders.

The risk of opportunism on behalf of agents is exacerbated by information asymmetry: The agents are generally better informed than the principals. 

Exhibit 12.3

 depicts the principal–agent relationship.

EXHIBIT 12.3  The Principal–Agent Problem

Managers, executives, and board members tend to have access to private information concerning important company developments that outsiders, especially investors, arePage 426 not privy to. Often this informational advantage is based on timing—insiders are the first to learn about important developments before the information is released to the public. Although possessing insider information is not illegal and indeed is part of an executive’s job, what is illegal is acting upon it through trading stocks or passing on the information to others who might do so. Insider-trading cases, therefore, provide an example of egregious exploitation of information asymmetry. The hedge fund Galleon Group (holding assets worth $7 billion under management at its peak) was engulfed in an insider-trading scandal involving private information about important developments at companies such as Goldman Sachs, Google, IBM, Intel, and P&G.

21

 Galleon Group’s founder, Raj Rajaratnam, the mastermind behind a complex network of informants, was sentenced to 11 years in prison and fined more than $150 million. In one instance, an Intel manager had provided Rajaratnam with internal Intel data such as orders for processors and production runs. These data indicated that demand for Intel processors was much higher than analysts had expected. Galleon bought Intel stock well before this information was public to benefit from the anticipated share appreciation.

In another instance, Rajaratnam benefited from insider tips provided by Rajat Gupta, a former McKinsey chief executive who served on Goldman Sachs’ board. Often within seconds after a Goldman Sachs board meeting ended, Gupta called Rajaratnam. In one of these phone calls, Gupta revealed the impending multibillion-dollar liquidity injection by Warren Buffett into Goldman Sachs during the midst of the global financial crisis. This information allowed the Galleon Group to buy Goldman Sachs shares before the official announcement about Buffett’s investment was made, profiting from the subsequent stock appreciation. In another call, Gupta informed Rajaratnam that the investment bank would miss earnings estimates. Based on this insider information, the Galleon Group was able to sell its holdings in Goldman Sachs stock before the announcement, avoiding a multimillion-dollar loss.

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Information asymmetry also can breed on-the-job consumption, perquisites, and excessive compensation. Although use of company funds for golf outings, resort retreats, professional sporting events, or elegant dinners and other entertainment is an everyday manifestation of on-the-job consumption, other forms are more extreme. Dennis Kozlowski, former CEO of Tyco, a diversified conglomerate, used company funds for his $30 million New York City apartment (the shower curtain alone was $6,000) and for a $2 million birthday party for his second wife.

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 John Thain, former CEO of Merrill Lynch, spent $1.2 million of company funds on redecorating his office, while he demanded cost cutting and frugality from his employees.

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 Such uses of company funds, in effect, mean that shareholders pay for those items and activities. Thain also allegedly requested a bonus of up to $30 million in 2009 despite Merrill Lynch having lost billions of dollars and being unable to continue as an independent company. Merrill Lynch was later acquired by Bank of America in a fire sale.

LO 12-3

Apply agency theory to explain why and how companies use governance mechanisms to align interests of principals and agents.

AGENCY THEORY

The principal–agent problem is a core part of 

agency theory

, which views the firm as a nexus of legal contracts.

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 In this perspective, corporations are viewed as a set of legal contracts between different parties. Conflicts that may arise are to be addressed in the legal realm. Agency theory finds its everyday application in employment contracts, for example.

Besides dealing with the relationship between shareholders and managers, principal–agent problems also cascade down the organizational hierarchy (shown in 
Exhibit 12.3
). Senior executives, such as the CEO, face agency problems when they delegate authority of strategic business units to general managers.

One incident at Uber illustrates the principal–agent problem. Uber’s office in Lyon, France, ran a sexist ad campaign that promised rides with “avions de chasse” as drivers,Page 427 which is French for fighter jets, but colloquially it means “hot chicks.” The ads were accompanied by revealing photos of female models. Uber headquarters canceled the ad campaign and apologized for the “clear misjudgment by the local team.” Uber headquarters staff in the United States, therefore, claimed that the sexist ad campaign launched by its French office was based on an agency problem, explaining it as a “clear misjudgment by the local team.” The local team, however, thought this type of ad campaign would serve Uber well in France.

Employees who perform the actual operational labor are agents who work on behalf of the managers. Such frontline employees often enjoy an informational advantage over management. They may tell their supervisor that it took longer to complete a project or serve a customer than it actually did, for example. Some employees may be tempted to use such informational advantage for their own self-interest (e.g., spending time on Facebook during work hours, watching YouTube videos, or using the company’s computer and internet connection for personal business).

The lawsuit between Waymo and Uber (detailed in the ChapterCase) illustrates the thorny issues that arise out of the inherent principal–agent problem in employment relationships.

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 In this case, Anthony Levandowski, the engineer at the heart of the lawsuit between Waymo and Uber, is alleged to have set up his autonomous-vehicle company, Otto, while still working at Waymo as a front to siphon off trade secrets and proprietary technology from his employer. Shortly after Levandowski left Waymo formally, Uber acquired his start-up company for close to $700 million. Waymo alleges that Levandowski set up Otto to steal trade secrets and proprietary designs, and to turn around and use this knowledge to advance self-driving technology at Uber, which acquired Otto later in 2016. Waymo, therefore, alleges that Levandowski and Uber not only acted opportunistically but also illegally. This is a stark turnaround from the earlier close relationship between Alphabet and Uber. In particular, Google Ventures, Alphabet’s venture capital unit, had made a $200 million investment in the fledgling ride-hailing service in 2013. Alphabet’s chief legal counsel was also a board member at Uber. He resigned from Uber’s board one week after Uber acquired Otto.

The managerial implication of agency theory relates to the management functions of organization and control: The firm needs to design work tasks, incentives, and employment contracts and other control mechanisms in ways that minimize opportunism by agents. Such governance mechanisms are used to align incentives between principals and agents. These mechanisms need to be designed in such a fashion as to overcome two specific agency problems: adverse selection and moral hazard.

ADVERSE SELECTION

In general, 

adverse selection

 occurs when information asymmetry increases the likelihood of selecting inferior alternatives. In principal–agent relationships, for example, adverse selection describes a situation in which an agent misrepresents his or her ability to do the job. Such misrepresentation is common during the recruiting process. Once hired, the principal may not be able to accurately assess whether the agent can do the work for which he or she is being paid. The problem is especially pronounced in team production, when the principal often cannot ascertain the contributions of individual team members. This creates an incentive for opportunistic employees to free-ride on the efforts of others.

MORAL HAZARD

In general, 

moral hazard

 describes a situation in which information asymmetry increases the incentive of one party to take undue risks or shirk other responsibilities because the costs accrue to the other party. For example, bailing out homeowners from their mortgage obligations or bailing out banks from the consequences of undue risk-taking in lending are examples of moral hazard. The costs of default are rolled over to society. Knowing that there is a high probability of being bailed out (“too big to fail”) increases moral hazard. In this scenario, any profits remain private, while losses become public.

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In the principal–agent relationship, moral hazard describes the difficulty of the principal to ascertain whether the agent has really put forth a best effort. In this situation, the agent is able to do the work but may decide not to do so. For example, a company scientist at a biotechnology company may decide to work on his own research project, hoping to eventually start his own firm, rather than on the project he was assigned.

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 While working on his own research on company time, she might also use the company’s laboratory and technicians. Given the complexities of basic research, it is often challenging, especially for nonscientist principals, to ascertain which problem a scientist is working on.

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 To overcome these principal–agent problems, firms put several governance mechanisms in place. We shall discuss several of them next, beginning with the board of directors.

THE BOARD OF DIRECTORS

LO 12-4

Evaluate the board of directors as the central governance mechanism for public stock companies.

The shareholders of public stock companies appoint a 

board of directors

 to represent their interests (see 
Exhibit 12.1
). The board of directors is the centerpiece of corporate governance in such companies. The shareholders’ interests, however, are not uniform. The goals of some shareholders, such as institutional investors (e.g., retirement funds, governmental bodies, and so on), are generally the long-term viability of the enterprise combined with profitable growth. Long-term viability and profitable growth should allow consistent dividend payments and result in stock appreciation over time. The goals of other shareholders, such as hedge funds, are often to profit from short-term movements of stock prices. These more proactive investors often demand changes in a firm’s strategy, such as spinning out certain divisions or splitting up companies into parts to enhance overall performance. Votes at shareholder meetings, generally in proportion to the amount of ownership, determine whose representatives are appointed to the board of directors.

The day-to-day business operations of a publicly traded stock company are conducted by its managers and employees, under the direction of the chief executive officer (CEO) and the oversight of the board of directors. The board of directors is composed of inside and outside directors who are elected by the shareholders:

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· ▪ 

Inside directors

 are generally part of the company’s senior management team, such as the chief financial officer (CFO) and the chief operating officer (COO). They are appointed by shareholders to provide the board with necessary information pertaining to the company’s internal workings and performance. Without this valuable inside information, the board would not be able to effectively monitor the firm. As senior executives, however, inside board members’ interests tend to align with management and the CEO rather than the shareholders.

· ▪ 

Outside directors

, on the other hand, are not employees of the firm. They frequently are senior executives from other firms or full-time professionals, who are appointed to a board and who serve on several boards simultaneously. Given their independence, they are more likely to watch out for the interests of shareholders.

The board is elected by the shareholders to represent their interests. Each director has a fiduciary responsibility—a legal duty to act solely in another party’s interests—toward the shareholders because of the trust placed in him or her. Prior to the annual shareholders’ meeting, the board proposes a slate of nominees, although shareholders can also directly nominate director candidates. In general, large institutional investors support their favored candidates through their accumulated proxy votes. The board members meet several times a year to review and evaluate the company’s performance and to assess its future strategic plans as well as opportunities and threats. In addition to general strategic oversight and guidance, the board of directors has other, more specific functions, including:

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· ▪ Selecting, evaluating, and compensating the CEO. The CEO reports to the board. Should the CEO lose the board’s confidence, the board may fire him or her.

· ▪ Overseeing the company’s CEO succession plan.

· ▪ Providing guidance to the CEO in the selection, evaluation, and compensation of other senior executives.

· ▪ Reviewing, monitoring, evaluating, and approving any significant strategic initiatives and corporate actions such as large acquisitions.

· ▪ Conducting a thorough risk assessment and proposing options to mitigate risk. The boards of directors of the financial firms at the center of the global financial crisis were faulted for not noticing or not appreciating the risks the firms were exposed to.

· ▪ Ensuring that the firm’s audited financial statements represent a true and accurate picture of the firm.

· ▪ Ensuring the firm’s compliance with laws and regulations. The boards of directors of firms caught up in the large accounting scandals were faulted for being negligent in their company oversight and not adequately performing several of the functions listed here.

Board independence is critical to effectively fulfilling a board’s governance responsibilities. Given that board members are directly responsible to shareholders, they have an incentive to ensure that the shareholders’ interests are pursued. If not, they can experience a loss in reputation or can be removed outright. More and more directors are also exposed to legal repercussions should they fail in their fiduciary responsibility. To perform their strategic oversight tasks, board members apply the strategic management theories and concepts presented herein, among other more specialized tools such as those originating in finance and accounting.

To make the workings of a board of directors more concrete, 

Strategy Highlight 12.1

 takes a close look at corporate governance at General Electric.

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Strategy Highlight 12.1

GE’s Board of Directors

GE describes the role of its board of directors as follows:

“The primary role of GE’s Board of Directors is to oversee how management serves the interests of shareowners and other stakeholders. To do this, GE’s directors have adopted corporate governance principles aimed at ensuring that the Board is independent and fully informed on the key strategic and risk issues GE faces.… Each independent director is expected to visit at least two GE businesses without the involvement of corporate management.”

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The GE board is composed of individuals from the business world (chairpersons and CEOs of Fortune 500 companies spanning a range of industries), academia (business school and science professors, deans, and provosts), and government (SEC). Including the board’s chairperson, GE’s board has 18 members. Experts in corporate governance consider that an appropriate number of directors for a company of GE’s size (roughly $120 billion in annual revenues, which makes GE the largest industrial enterprise globally).

As of 2017, 17 of the 18 board members (94 percent) are independent outside directors. To achieve board independence, experts in corporate governance recommend that two-thirds of its directors be outsiders. GE’s board tries to maintain only one inside director. This was demonstrated when former CEO Jeffrey Immelt retired in 2017. John Flannery took over in August, with Immelt scheduled to remain chairman of the board through the end of the year, after which Flannery would take over. In roughly half of U.S. public firms, the CEO of the company also serves as chair of the board of directors.

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GE’s board of directors meets a dozen or more times annually. With increasing board accountability in recent years, boards now tend to meet more often. Many firms limit the number and type of directorships a board member may hold concurrently. To accomplish their responsibilities, boards of directors are usually organized into committees. GE’s board has four committees, each with its own chair: the audit committee, the management development and compensation committee, the government and public affairs committee, and the technology and industrial risk committee.

In general, women and minorities remain underrepresented on boards of directors across the United States and throughout most of the world. GE’s board is somewhat more diverse in gender when compared with other Fortune 500 companies, which in 2016 averaged roughly 20 percent women on their boards versus 28 percent for GE.

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Generally, the larger the company, the greater its gender diversity, as demonstrated in recent years by tracking different levels of the Fortune 1000. For example, in 2016 boards of the Fortune 100 companies averaged 22 percent gender diversity; of the Fortune 500 (as noted), 20 percent; and of the bottom half of the Fortune 1000, 16 percent. GE as of this writing ranks number eight in the Fortune 1000 rankings in terms of gender diversity.

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Diversity in backgrounds and expertise in the boardroom is considered an asset: More diverse boards are less likely to fall victim to groupthink, a situation in which opinions coalesce around a leader without individuals critically challenging and evaluating that leader’s opinions and assumptions.

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As discussed in 
Strategy Highlight 12.1
, at GE the CEO normally serves not only as the chief executive officer of the roughly $240 billion conglomerate in market cap, but also as chairman of the board. This practice of 

CEO/chairperson duality

—holding both the role of CEO and chairperson of the board—has been declining somewhat in recent years.

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 Among the largest 500 publicly traded companies in the United States, almost 70 percent of firms had the dual CEO-chair arrangement in 2005 (before the global financial crisis), but this number had declined to 52 percent of companies in 2016 (post global financial crisis).

The functions of the CEO and chairperson of the board roles are distinctly different. A board of directors broadly oversees a company’s business activities. The company’s CEO reports to the board of directors and acts as a liaison between the company and the board. The CEO has high-level responsibilities of strategy and all other management activities of a company while the functions of the board of directors include approving the annual budget and dealing with stakeholders. Moreover, a CEO is the public face of a company or organization and takes the hit or pat on the back if a company fails or succeeds, while the board of directors is there to steer a company on behalf of shareholders.

Arguments can be made both for and against splitting the roles of CEO and chairperson of the board. On the one hand, the CEO has invaluable inside information that can help in chairing the board effectively. The benefit of a combined CEO and chair of the board is the unity streamlines and speeds the decision-making process as well as strategy implementation. On the other hand, the chairperson may influence the board unduly through setting the meeting agendas or suggesting board appointees who are friendly toward the CEO. Because one of the key roles of the board is to monitor and evaluate the CEO’s performance, there can be a conflict of interest when the CEO actually chairs the board.

OTHER GOVERNANCE MECHANISMS

LO 12-5

Evaluate other governance mechanisms.

While the board of directors is the central governance piece for a public stock company, several other corporate mechanisms are also used to align incentives between principals and agents, including

· ▪ Executive compensation.

· ▪ The market for corporate control.

· ▪ Financial statement auditors, government regulators, and industry analysts.

EXECUTIVE COMPENSATION

The board of directors determines executive compensation packages. To align incentives between shareholders and management, the board frequentlyPage 431 grants 

stock options

 as part of the compensation package. This mechanism is based on agency theory and gives the recipient the right, but not the obligation, to buy a company’s stock at a predetermined price sometime in the future. If the company’s share price rises above the negotiated strike price, which is often the price on the day when compensation is negotiated, the executive stands to reap significant gains.

The topic of executive compensation—and CEO pay, in particular—has attracted significant attention in recent years. Two issues are at the forefront:

1. The absolute size of the CEO pay package compared with the pay of the average employee.

2. The relationship between CEO pay and firm performance.

Absolute Size of Pay Package.

The ratio of CEO to average employee pay in the United States is about 300 to 1, up from roughly 40 to 1 in 1980.

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 Based on a 2017 survey of CEOs in the S&P 500 by The Wall Street Journal, the median annual compensation was about $11 million.

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 Note: Annual compensation is broadly defined to include salary, stock options, equity grants, bonuses, and pension payments.

The five highest paid CEOs were Thomas Rutledge of Charter Communications ($98.5 million), Fabrizio Freda of Estée Lauder ($48.4 million), Mark Parker of Nike ($47.6 million), Alex Molinaroli of Johnson Controls ($46.4 million), and Robert Iger of Disney ($43.9 million). Noteworthy are also the two lowest paid CEOs in the S&P 500: Warren Buffett of Berkshire Hathaway ($470,000) and Larry Page of Alphabet ($1, the minimum payment required).

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CEO Pay and Firm Performance.

Overall, survey results also show that two-thirds of CEO pay is linked to firm performance.

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 The relationship between pay and performance is positive, but the link is weak at best. Although agency theory would predict a positive link between pay and performance as this aligns incentives, some recent experiments in behavioral economics caution that incentives that are too high-powered (e.g., outsized bonuses) may have a negative effect on job performance.

40

 That is, when the incentive level is very high, an individual may get distracted from strategic activities because too much attention is devoted to the outsized bonus to be enjoyed in the near future. This can further increase job stress and negatively impact job performance.

THE MARKET FOR CORPORATE CONTROL

Whereas the board of directors and executive compensation are internal corporate-governance mechanisms, the market for corporate control is an important external corporate-governance mechanism. It consists of activist investors who seek to gain control of an underperforming corporation by buying shares of its stock in the open market. To avoid such attempts, corporate managers strive to protect shareholder value by delivering strong share-price performance or putting in place poison pills (discussed later).

Here’s how the market for corporate control works: If a company is poorly managed, its performance suffers and its stock price falls as more and more investors sell their shares. Once shares fall to a low enough level, the firm may become the target of a hostile takeover (as discussed in 

Chapter 9

) when new bidders believe they can fix the internal problems that are causing the performance decline. Besides competitors, so-called corporate raiders (e.g., Carl Icahn and T. Boone Pickens) or private equity firms and hedge funds (e.g., The Blackstone Group and Pershing Square Capital Management) may buy enough shares to exert control over a company.

In a 

leveraged buyout (LBO)

, a single investor or group of investors buys, with the help of borrowed money (leveraged against the company’s assets), the outstanding sharesPage 432 of a publicly traded company in order to take it private. In short, an LBO changes the ownership structure of a company from public to private. The expectation is often that the private owners will restructure the company and eventually take it public again through an initial public offering (IPO).

Private companies enjoy certain benefits that public companies do not. Private companies are not required to disclose financial statements. They experience less scrutiny from analysts and can often focus more on long-term viability. These are also some of the reasons some unicorns delay going public in the first place.

In 2013, computer maker Dell Inc. became a takeover target of famed corporate raider Carl Icahn.

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 He jumped into action after Dell’s founder and its largest shareholder, Michael Dell, announced in January of that year that he intended a leveraged buyout with the help of Silverlake Partners, a private equity firm, to take the company private. In the Dell buyout battle, many observers, including Icahn who is the second-largest shareholder of Dell, saw the attempt by Michael Dell to take the company private as the “ultimate insider trade.”

This view implied that Michael Dell, who is also CEO and chairman, had private information about the future value of the company and that his offer was too low. Dell Inc., which had $57 billion in revenues in its fiscal year 2013, has been struggling in the ongoing transition from personal computers such as desktops and laptops to mobile devices and services. Between December 2004 and February 2009, Dell (which until just a few years earlier was the number-one computer maker) lost more than 80 percent of its market capitalization, dropping from some $76 billion to a mere $14 billion. In late 2013, Dell’s shareholders approved the founder’s $25 billion offer to take the company private, thus avoiding a hostile takeover.

If a hostile takeover attempt is successful, however, the new owner frequently replaces the old management and board of directors to manage the company in a way that creates more value for shareholders. In some instances, the new owner will break up the company and sell its pieces. In either case, since a firm’s existing executives face the threat of losing their jobs and their reputations if the firm sustains a competitive disadvantage, the market for corporate control is a credible governance mechanism.

To avoid being taken over against their consent, some firms put in place a 

poison pill

. These are defensive provisions that kick in should a buyer reach a certain level of share ownership without top management approval. For example, a poison pill could allow existing shareholders to buy additional shares at a steep discount. Those additional shares would make any takeover attempt much more expensive and function as a deterrent. With the rise of actively involved institutional investors, poison pills have become rare because they retard an effective function of equity markets.

Although poison pills are becoming rarer, the market for corporate control is alive and well, as shown in the battle over control of Dell Inc. or the hostile takeover of Cadbury by Kraft (featured in 

Strategy Highlight 9.2

). However, the market for corporate control is a last resort because it comes with significant transaction costs. To succeed in its hostile takeover bid, buyers generally pay a significant premium over the given share price. This often leads to overpaying for the acquisition and subsequent shareholder value destruction—the so-called winner’s curse. The market for corporate control is useful, however, when internal corporate-governance mechanisms have not functioned effectively and the company is underperforming.

AUDITORS, GOVERNMENT REGULATORS, AND INDUSTRY ANALYSTS

Auditors, government regulators, and industry analysts serve as additional external-governance mechanisms. All public companies listed on the U.S. stock exchanges must file a number ofPage 433 financial statements with the Securities and Exchange Commission (SEC), a federal regulatory agency whose task it is to oversee stock trading and enforce federal securities laws. To avoid the misrepresentation of financial results, all public financial statements must follow generally accepted accounting principles (GAAP)

42

 and be audited by certified public accountants.

As part of its disclosure policy, the SEC makes all financial reports filed by public companies available electronically via the EDGAR database.

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 This database contains more than 7 million financial statements, going back several years. Industry analysts scrutinize these reports in great detail, trying to identify any financial irregularities and assess firm performance. Given recent high-profile oversights in accounting scandals and fraud cases, the SEC has come under pressure to step up its monitoring and enforcement.

Industry analysts often base their buy, hold, or sell recommendations on financial statements filed with the SEC and business news published in The Wall Street Journal, Bloomberg Businessweek, Fortune, Forbes, and other business media such as CNBC. Researchers have questioned the independence of industry analysts and credit-rating agencies that evaluate companies (such as Fitch Ratings, Moody’s, and Standard & Poor’s),

44

 because the investment banks and rating agencies frequently have lucrative business relationships with the companies they are supposed to evaluate, creating conflicts of interest. A study of over 8,000 analysts’ ratings of corporate equity securities, for example, revealed that investment bankers rated their own clients more favorably.

45

In addition, an industry has sprung up around assessing the effectiveness of corporate governance in individual firms. Research outfits, such as GMI Ratings,

46

 provide independent corporate governance ratings. The ratings from these external watchdog organizations inform a wide range of stakeholders, including investors, insurers, auditors, regulators, and others.

Corporate-governance mechanisms play an important part in aligning the interests of principals and agents. They enable closer monitoring and controlling, as well as provide incentives to align interests of principals and agents. Perhaps even more important are the “most internal of control mechanisms”: business ethics—a topic we discuss next.

12.3 Strategy and Business Ethics

LO 12-6

Explain the relationship between strategy and business ethics.

Multiple, high-profile accounting scandals and the global financial crisis have placed business ethics center stage in the public eye. 

Business ethics

 are an agreed-upon code of conduct in business, based on societal norms. Business ethics lay the foundation and provide training for “behavior that is consistent with the principles, norms, and standards of business practice that have been agreed upon by society.”

47

 These principles, norms, and standards of business practice differ to some degree in different cultures around the globe. But a large number of research studies have found that some notions—such as fairness, honesty, and reciprocity—are universal norms.

48

 As such, many of these values have been codified into law.

Law and ethics, however, are not synonymous. This distinction is important and not always understood by the general public. Staying within the law is a minimum acceptable standard. A note of caution is therefore in order: A manager’s actions can be completely legal, but ethically questionable. For example, consider the actions of mortgage-loan officers who—being incentivized by commissions—persuaded unsuspecting consumers to sign up for exotic mortgages, such as “option ARMs.” These mortgages offer borrowers the choice to pay less than the required interest, which is then added to the principal while the interest rate can adjust upward. Such actions may be legal, but they are unethical, especially if there are indications that the borrower might be unable to repay the mortgage once the interest rate moves up.

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To go beyond the minimum acceptable standard codified in law, many organizations have explicit codes of conduct. These codes go above and beyond the law in detailing how the organization expects an employee to behave and to represent the company in business dealings. Codes of conduct allow an organization to overcome moral hazards and adverse selections as they attempt to resonate with employees’ deeper values of justice, fairness, honesty, integrity, and reciprocity. Since business decisions are not made in a vacuum but are embedded within a societal context that expects ethical behavior, managers can improve their decision making by also considering:

· ▪ When facing an ethical dilemma, a manager can ask whether the intended course of action falls within the acceptable norms of professional behavior as outlined in the organization’s code of conduct and defined by the profession at large.

· ▪ The manager should imagine whether he or she would feel comfortable explaining and defending the decision in public. How would the media report the business decision if it were to become public? How would the company’s stakeholders feel about it?

Strategy Highlight 12.2

 features Goldman Sachs, which came under scrutiny and faced tough questions pertaining to its business dealings in the wake of the financial crisis of 2007–2008.

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Strategy Highlight 12.2

Why the Mild Response to Goldman Sachs and Securities Fraud?

Long after the SEC sued Goldman Sachs and one of its employees, Fabrice Tourre, for securities fraud, social critics continue to question what is now seen as a mild response by both the SEC and the Justice Department. (The SEC oversees civil enforcement of U.S. securities law; the Justice Department pursues criminal cases, often based on SEC investigations. Both can target institutions and individuals.)

The SEC’s case in April 2010 was narrow, looking at a specific, mortgage-related scheme hatched in 2006 during the height of a U.S. real estate bubble. Then many investors assumed house prices could only go up, after years of consistent real estate appreciation. Indeed, real estate prices in the United States had continued to surge, as speculation was added to organic demand. The frenzy was also fueled by cheap mortgages, many of them extended to home buyers who really couldn’t afford them. John Paulson, founder of the hedge fund Paulson & Co., saw the looming collapse—and a way to profit. He approached Goldman Sachs with a trading idea betting that the bubble would soon burst.

HIDDEN POISON. Paulson asked Goldman Sachs to create an investment instrument, later named “Abacus,” designed specifically to maximize returns on his bet. Goldman Sachs agreed and assigned Tourre to put it together. Tourre bundled thousands of mortgages into bonds, which theoretically would provide stable and regular interest payments (but only as long as the borrowers made mortgage payments). Such a bundle is known as a collateralized debt obligation (CDO). CDOs are considered safer investment choices than owning individual loans themselves; risks of losses through default are evened out across a broad number of loans; the bigger the bundle, theoretically, the more stable the investment. But with Abacus, Paulson was helping Goldman Sachs by identifying the riskiest of CDOs to include in the bundle.

Rating agencies, including Standard & Poor’s, Fitch, and Moody’s, frequently rated CDOs as triple A. This is the highest possible rating and indicates an “extremely strong capacity” for the borrower to meet its financial obligation. Only a few companies, such as Exxon, Johnson & Johnson, and Microsoft, hold a triple A rating. Rating agencies may have been lulled by the traditional stability of CDO offerings and the general euphoria around real estate. They rubber-stamped Abacus as a triple A investment, and many institutional investors, such as pension funds, snapped it up. The investment seemed above reproach: Triple A Abacus was offered by Goldman Sachs, the number-one investment bank in the world.

FABULOUS FAB. Yet according to internal e-mails, Paulson and several Goldman Sachs employees, including Tourre, knew otherwise. For example, Tourre, who had earlier been dubbed “fabulous Fab,” by a colleague, saw the nickname redound publicly to his discredit when it came out under oath. Specifically, one e-mail was from Tourre to his girlfriend at the time, in which he described himself wistfully in the third person, anticipating the burst of the real estate bubble:

The entire building is at risk of collapse at any moment. Only potential survivor, the fabulous Fab (…even though there is nothing fabulous about me…) standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all the implications of these monstrosities.

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SHORTING ABACUS. Goldman Sachs profited by selling Abacus despite internal knowledge of its true intent. For example, Goldman Sachs knew how Paulson had poisoned Abacus to insure its failure. As for Paulson, he took a “short position” in Abacus—meaning he bet it would fail. Paulson & Co. sold shares it did not yet own, in anticipation that the value would fall and Paulson would cover its sold shares by buying them at the fallen price. In contrast, institutional investors, often long-term Goldman clients, believed Abacus was a great investment opportunity. When the real estate bubble burst, Paulson made more than $1 billion from his position in Abacus.

SETTLEMENT AND CONVICTION. Did Goldman Sachs defraud investors? The SEC argued that it did so, by knowingly misleading investors and failing to disclose Paulson’s role in Abacus. Specifically, the SEC alleged that Goldman violated its fiduciary responsibility. Mounting a legalistic defense, Goldman Sachs argued that clients must always assess the risks involved in any investment. Public pressure mounted, however, and Goldman Sachs settled the lawsuit with the SEC by paying a $550 million fine without admitting any wrongdoing. Tourre declined a settlement, and his case went to court. In August 2013, Tourre was convicted of securities fraud.

As for Tourre, he decided not to appeal the decision, stating instead he wished to complete his doctoral studies and hoped to make contributions to scholarship in the field of economics.

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UPDATE. So where do things stand? Between 2011 and 2017, Tourre studied for a PhD degree in economics at the University of Chicago. In 2015, Paulson donated $400 million to Harvard University to endow the School of Engineering and Applied Sciences, and have it renamed after him. No charges were ever filed against Paulson or top executives at Goldman Sachs.

Critics find it odd that the only individual charged was the management-level Tourre. An investigation by journalist Jesse Eisinger was published in The New Yorker in 2016 detailing the SEC’s timidity and was expanded into a book in 2017. Eisinger looks in detail at how prosecutors and investigators can find it easier to sympathize with high-ranking executives they see as real people than they do with the more faceless victims of fraud. The book’s subtitle? “Why the Justice Department Fails to Prosecute Executives.”

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In the aftermath of the Abacus debacle (discussed in 
Strategy Highlight 12.2
), Goldman Sachs revised its code of conduct. A former Goldman Sachs employee, Greg Smith, published a book chronicling his career at the investment bank, from a lowly summer intern (in 2000) to head of Goldman Sachs’ U.S. equity derivatives business in Europe, the Middle East, and Africa (in 2012).

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 Smith’s thesis was that the entire ethical climate within Goldman Sachs changed over that period. For its first 130 years, Goldman Sachs was organized as a professional partnership, like most law firms. In this organizational form, a selected group of partners are joint owners and directors of the professional service firms. After years of superior performance, associates in the professional service firms may “make partner”—being promoted to joint owner. During the time when organized as a professional partnership, Goldman Sachs earned a reputation as the best investment bank in the world. It had the best people and put its clients’ interests first. Smith describes how Goldman’s culture—and with it, employee attitudes—changed after the firm went public (in 1999), from “we are here to serve our clients as honorable business partners, and we have our clients’ best interests in mind,” to “we [Goldman Sachs and our clients] are all grown-ups and just counter parties to any transaction.”

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 In the latter perspective, unsuspecting clients in the Abacus deal were seen just as “counter parties to a transaction,” who should have known better.

BAD APPLES VS. BAD BARRELS

Some people believe that unethical behavior is limited to a few “bad apples” in organizations.

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 The assumption is that the vast majority of the population—and by extension, organizations—are good, and that we need only safeguard against abuses by a few bad actors. According to agency theory, it’s the “bad agents” who act opportunistically, and principals need to be on guard against bad actors.

However, research indicates that it is not just the few “bad apples” but entire organizations that can create a climate in which unethical, even illegal behavior is tolerated.

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 While there clearly are some people with unethical or even criminal inclinations, in general one’s ethical decision-making capacity depends very much on the organizational context. Research shows that if people work in organizations that expect and value ethical behavior, they are more likely to act ethically.

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 The opposite is also true. Enron’s stated key values included respect and integrity, and its mission statement proclaimed that all business dealings should be open and fair.

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 Yet, the ethos at Enron was all about creating an inflated share price at any cost, and its employees observed and followed the behavior set by their leaders.

Sometimes, it’s the bad barrel that can spoil the apples! This is precisely what Smith argues in regard to Goldman Sachs: The ethical climate had changed for the worse, so that seeing clients as mere “counter parties” to transactions made deals like Abacus possible. One could argue that Tourre simply followed the values held within Goldman Sachs (“profit is king” and “clients are grown-ups”). As a mid-level employee, many view Tourre as the scapegoat in the Abacus case.

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Employees take cues from their environment on how to act. Therefore, ethical leadership is critical, and strategic leaders set the tone for the ethical climate within an organization. This is one of the reasons the HP board removed then-CEO Mark Hurd in 2010 even without proof of illegal behavior or violation of the company’s sexual-harassment policy. The forced resignation was prompted by a lawsuit alleging sexual harassment against Hurd by a former adult movie actress who worked for HP as an independent contractor. This action goes to show that CEOs of Fortune 500 companies are under constant public scrutiny and ought to adhere to the highest ethical standards. If they do not, they cannot rationally expect their employees to behave ethically. Unethical behavior can quickly destroy the reputation of a CEO, one of the most important assets he or she possesses.

To foster ethical behavior in employees, boards must be clear in their ethical expectations, and top management must create an organizational structure, culture, and control system that values and encourages desired behavior. Furthermore, a company’s formal and informal cultures must be aligned, and executive behavior must be in sync with the formally stated vision and values. Employees will quickly see through any duplicity. Actions by executives speak louder than words in vision statements.

Other leading professions have accepted codes of conduct (e.g., the bar association in the practice of law and the Hippocratic oath in medicine); management has not.

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 Some argue that management needs an accepted code of conduct,

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 holding members to a high professional standard and imposing consequences for misconduct. Misconduct by an attorney, for example, can result in being disbarred and losing the right to practice law. Likewise, medical doctors can lose their professional accreditations if they engage in misconduct.

To anchor future managers in professional values and to move management closer to a truly professional status, a group of Harvard Business School students developed an MBA oath (see 

Exhibit 12.4

).

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 Since 2009, over 6,000 MBA students from more than 300 institutions around the world have taken this voluntary pledge. The oath explicitly recognizes the role of business in society and its responsibilities beyond shareholders. It also holds managers to a high ethical standard based on more or less universally accepted principles in order to “create value responsibly and ethically.”

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 Having the highest personal integrity is of utmost importance to one’s career. It takes decades to build a career, but sometimes justPage 437 a few moments to destroy one. The voluntary MBA oath sets professional standards, but its effect on behavior is unknown, and it does not impose any consequences for misconduct.

EXHIBIT 12.4  The MBA Oath

As a business leader I recognize my role in society.

· My purpose is to lead people and manage resources to create value that no single individual can create alone. · My decisions affect the well-being of individuals inside and outside my enterprise, today and tomorrow.

Therefore, I promise that:

· I will manage my enterprise with loyalty and care, and will not advance my personal interests at the expense of my enterprise or society. · I will understand and uphold, in letter and spirit, the laws and contracts governing my conduct and that of my enterprise. · I will refrain from corruption, unfair competition, or business practices harmful to society. · I will protect the human rights and dignity of all people affected by my enterprise, and I will oppose discrimination and exploitation. · I will protect the right of future generations to advance their standard of living and enjoy a healthy planet. · I will report the performance and risks of my enterprise accurately and honestly. · I will invest in developing myself and others, helping the management profession continue to advance and create sustainable and inclusive prosperity.

In exercising my professional duties according to these principles, I recognize that my behavior must set an example of integrity, eliciting trust and esteem from those I serve. I will remain accountable to my peers and to society for my actions and for upholding these standards.

This oath I make freely, and upon my honor.

Copyright ©MBA Oath and Max Anderson. All rights reserved. Used with permission.

12.4 Implications for Strategic Leaders

An important implication for the strategic leader is the recognition that effective corporate governance and solid business ethics are critical to gaining and sustaining competitive advantage. Governance and ethics are closely intertwined in an intersection of setting the right organizational core values and then ensuring compliance.

A variety of corporate governance mechanisms can be effective in addressing the principal–agent problem. These mechanisms tend to focus on monitoring, controlling, and providing incentives, and they must be complemented by a strong code of conduct and strategic leaders who act with integrity. The effective strategic leader must help employees to “walk the talk”; leading by ethical example often has a stronger effect on employee behavior than words alone.

The strategist needs to look beyond shareholders and apply a stakeholder perspective to ensure long-term survival and success of the firm. A firm that does not respond to stakeholders beyond stockholders in a way that keeps them committed to its vision will not be successful. Stakeholders want fair treatment even if not all of their demands can be met. Fairness and transparency are critical to maintaining good relationships within the network of stakeholders the firm is embedded in. Finally, the large number of glaring ethical lapses over the last decade or so makes it clear that organizational core values and a code of conduct are key to the continued professionalization of management. Strategic leaders need to live organizational core values by example.

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CHAPTERCASE 12 
Consider This …

Travis Kalanick, Uber’s co-founder, was forced to resign as CEO in the summer of 2017 under mounting pressure by investors over his alleged role in and mishandling of Uber’s litany of ethical challenges. Shortly after Kalanick’s resignation, Uber’s board presented Dara Khosrowshahi as the new Uber CEO. Khosrowshahi was CEO of Expedia (a travel website) at the time of his Uber appointment.
©Danish Siddiqui/REUTERS

WILL TRAVIS KALANICK’S departure as CEO allow Uber to develop a more grounded and ethical corporate culture? It may take several years to answer that question confidently. But in thinking about Uber’s future, we can make some observations.

A Cynic’s View. Critics may see the resignation of Kalanick as just one more stunt to reduce heat and scrutiny, and unlikely to result in meaningful change. Corporate culture is never easy to change, this line of reasoning goes, and Kalanick, as co-founder, remains a strong presence in two ways. First, even should he sever all ties with Uber, as co-founder he contributed much of the company’s DNA (through the imprinting process discussed in 

Chapter 11

), so the company is prone to lapses by nature. And second, Kalanick has not cut his ties; he still remains intimately involved in the company. Although no longer CEO and chairman, he keeps his board seat. In fact he remains one of three company insiders on the board, along with co-founder Garrett Camp and early employee Ryan Graves. This block holds a majority of the voting rights. Camp, Kalanick’s long-time business partner, is now chairman of the board.

Beyond Cynicism. On the other hand, business as usual for Uber is becoming increasingly problematic. For years running, Uber seemed willing to flout rules, laws, and regulations because the service was liked by users who would not like the service to be removed. Uber’s customers were happy because they could hail rides conveniently and cheaply, often in areas that were underserved by regular taxis; drivers were happy because they could choose when and how long to work; and local politicians were cautious about throwing a monkey wrench in the works. Why make your voters unhappy?

But that tactic works best at the local level, and Uber’s challenges are increasingly broader, both nationally and internationally. Uber now fights well-funded lawsuits instead of hamstrung municipal bureaucrats. So Uber can no longer fly under the radar. Uber is so big and established that the CEO’s boorish behavior or an employee’s complaints about sexual harassment quickly go viral on a global basis.

Eye on the Prize. Uber may be at a point in its trajectory where investors simply won’t allow it to continue a self-destructive tendency to cut ethical corners. Too much is at stake. In this line of thought, the biggest opportunity with Uber is not its current business. Uber’s goal remains centered around self-driving cars, supported by high-powered mobile logistics networks, and online mapping systems. Therefore, in this view, its current business is secondary. Recall from the start of the chapter and ChapterCase that even The Wall Street Journal opined in 2014 that Uber’s biggest potential rival was itself—that only Uber was able to bring down Uber.

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Which takes us back to Uber’s naturally disruptive nature. With a fleet of autonomous vehicles offering cheap rides, people don’t need to own cars anymore. When car ownership is no longer needed, it will certainly impact the old-line car manufacturers. From there Uber might expand into the “delivery of everything,” taking over last-mile deliveries for Amazon.com and other online retailers. Uber might even work in concert with shippers such as UPS and FedEx.

One Possible Future. Note that in this version of the future, in which Uber is the primary player and provider for self-driving car technology, and controls the platform under which we might summon a car to our door, some of Uber’s current challenges disappear. Kalanick was pitching benefits to the consumer when he stated: “The reason Uber could be expensive is because you’re not just paying for the car—you’re paying for the other dude in the car. When there’s no other dude in the car, the cost of taking an Uber anywhere becomes cheaper than owning a vehicle.”

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 Not having to deal with drivers must sound attractive to Uber, which has had antagonisms with its work force, as the viral video of the argument between a driver and Kalanick showed. Uber also still has to subsidize rates to the drivers. On the regulatory front it’s reasonable to assume that states will continue to remove obstaclesPage 439 to self-driving cars and the companies that manage them. So in this future, many of its compliance failures go away too.

Current Challenges. But Uber has to get through current challenges to reach its future goals. Before Kalanick resigned, the most visible efforts to deal with scandals and controversies were to manage perception. In 2015 Uber hired David Plouffe as senior vice president of policy and strategy, explicitly to improve public relations and to lobby politicians. Previously, Plouffe had been the manager for the 2008 Obama presidential campaign and then a senior adviser in the administration. At Uber he pitched the social benefit of Uber’s contribution to the transportation ecosystem and its ability to fix traffic congestion, cut down on drunk driving, and provide reliable and safe services to underserved city and suburban areas—even helping to end poverty by providing greater access to reliable transportation. And he minimized criticisms as misguided.

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Exodus of Talent. Plouffe walked away in early 2017. He was followed by Rachel Whetstone, who headed policy and communications globally; she was hired in 2015 and left in April 2017. In fact, a steady trail of senior executives and lead engineers has left Uber in the wake of the continuous scandals that plague the brash startup. They include Uber’s head of autonomous car technology, head of online mapping, and an artificial-intelligence (AI) expert. Some cited issues with the company’s values as the reason for their departure. When resigning after only six months on the job in spring 2017, Uber President Jeff Jones stated, “The beliefs and approach to leadership that have guided my career are inconsistent with what I saw and experienced at Uber.”

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Keep in mind that Uber has not yet gone public, so most executives and engineers likely left millions of dollars on the table when they left. That is, they left behind promised stock options due to their premature departure. Going public is key to understanding Uber in the long run. Uber’s board may have its own timetable for that step, but an IPO will allow Uber’s investors to realize their gains in a big way. If an IPO is part of the board’s plans, the company must develop a more mature, professional, and diverse cadre of managers. Otherwise, Uber’s trail of unresolved ethical issues and lawsuits could derail an envisioned IPO, or at least of realizing full value in the market.

Hope for the Future. If Uber is able to mend its ways—and much depends on how the full board responds to major investors—Uber has a much better chance of realizing the future it hopes will unfold.

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Questions

1. Have you used a ride-hailing service such as Uber or Lyft? How was your experience?

2. Would like to work for Uber? Why or why not?

3. Explain Uber’s business model and deduce its strategic intent.

4. Do you agree with Peter Thiel’s assessment that Uber is the “most ethically challenged company in Silicon Valley”? Why or why not? Explain.

5. Some observers had argued that Uber’s greatest problem was not any of its scandals, but its CEO Travis Kalanick. Now that Kalanick no longer serves that role, how much better off is Uber really? Where do you come down? Do you think Kalanick’s reduced profile will turn the tide for Uber? Or is Kalanick’s drive and competitiveness necessary to Uber’s continued success, regardless of the title he holds? If you were on the board, what would you recommend? And why?

6. Uber’s new CEO, Dara Khosrowshahi, declared that he envisions Uber going public in early 2019, that is, within 18 months of his appointment. What would he and Uber need to accomplish to make this a reality? List Uber’s current challenges in rank order, and provide recommendations to the new CEO of how to address them. Be specific.

In this final chapter, we looked at stakeholder strategy, corporate governance, business ethics, and strategic leadership, as summarized by the following learning objectives and related take-away concepts.

LO 12-1 / Describe the shared value creation framework and its relationship to competitive advantage.

· ▪ By focusing on financial performance, many companies have defined value creation too narrowly.

· ▪ Companies should instead focus on creating shared value, a concept that includes value creation for both shareholders and society.

· ▪ The shared value creation framework seeks to identify connections between economic and social needs, and then leverage them into competitive advantage.

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LO 12-2 / Explain the role of corporate governance.

· ▪ Corporate governance involves mechanisms used to direct and control an enterprise to ensure that it pursues its strategic goals successfully and legally.

· ▪ Corporate governance attempts to address the principal–agent problem, which describes any situation in which an agent performs activities on behalf of a principal.

LO 12-3 / Apply agency theory to explain why and how companies use governance mechanisms to align interests of principals and agents.

· ▪ Agency theory views the firm as a nexus of legal contracts.

· ▪ The principal–agent problem concerns the relationship between owners (shareholders) and managers and also cascades down the organizational hierarchy.

· ▪ The risk of opportunism on behalf of agents is exacerbated by information asymmetry: Agents are generally better informed than the principals.

· ▪ Governance mechanisms are used to align incentives between principals and agents.

· ▪ Governance mechanisms need to be designed in such a fashion as to overcome two specific agency problems: adverse selection and moral hazard.

LO 12-4 / Evaluate the board of directors as the central governance mechanism for public stock companies.

· ▪ The shareholders are the legal owners of a publicly traded company and appoint a board of directors to represent their interests.

· ▪ The day-to-day business operations of a publicly traded stock company are conducted by its managers and employees, under the direction of the chief executive officer (CEO) and the oversight of the board of directors. The board of directors is composed of inside and outside directors, who are elected by the shareholders.

· ▪ Inside directors are generally part of the company’s senior management team, such as the chief financial officer (CFO) and the chief operating officer (COO).

· ▪ Outside directors are not employees of the firm. They frequently are senior executives from other firms or full-time professionals who are appointed to a board and who serve on several boards simultaneously.

LO 12-5 / Evaluate other governance mechanisms.

· ▪ Other important corporate mechanisms are executive compensation, the market for corporate control, and financial statement auditors, government regulators, and industry analysts.

· ▪ Executive compensation has attracted significant attention in recent years. Two issues are at the forefront: (1) the absolute size of the CEO pay package compared with the pay of the average employee and (2) the relationship between firm performance and CEO pay.

· ▪ The board of directors and executive compensation are internal corporate-governance mechanisms. The market for corporate control is an important external corporate-governance mechanism. It consists of activist investors who seek to gain control of an underperforming corporation by buying shares of its stock in the open market.

· ▪ All public companies listed on the U.S. stock exchanges must file a number of financial statements with the Securities and Exchange Commission (SEC), a federal regulatory agency whose task it is to oversee stock trading and enforce federal securities laws. Auditors and industry analysts study these public financial statements carefully for clues of a firm’s future valuations, financial irregularities, and strategy.

LO 12-6 / Explain the relationship between strategy and business ethics.

· ▪ The ethical pursuit of competitive advantage lays the foundation for long-term superior performance.

· ▪ Law and ethics are not synonymous; obeying the law is the minimum that society expects of a corporation and its managers.

· ▪ A manager’s actions can be completely legal, but ethically questionable.

· ▪ Some argue that management needs an accepted code of conduct that holds members to a high professional standard and imposes consequences for misconduct.

8.1 What Is Corporate Strategy?

LO 8-1

Define corporate strategy and describe the three dimensions along which it is assessed.

Strategy formulation centers around the key questions of where and how to compete. Business strategy concerns the question of how to compete in a single product market. As discussed in 

Chapter 6

, the two generic business strategies that firms can follow to pursue their quest for competitive advantage are to increase differentiation (while containing cost) or lower costs (while maintaining differentiation). If trade-offs can be reconciled, some firms might be able to pursue a blue ocean strategy by increasing differentiation and lowering costs. As firms grow, they are frequently expanding their business activities through seeking new markets both by offering new products and services and by competing in different geographies. Strategic leaders must formulate a corporate strategy to guide continued growth. To gain and sustain competitive advantage, therefore, any corporate strategy must align with and strengthen a firm’s business strategy, whether it is a differentiation, cost-leadership, or blue ocean strategy.

Corporate strategy

 comprises the decisions that leaders make and the goal-directed actions they take in the quest for competitive advantage in several industries and markets simultaneously.

3

 It provides answers to the key question of where to compete. Corporate strategy determines the boundaries of the firm along three dimensions: vertical integration along the industry value chain, diversification of products and services, and geographic scope (regional, national, or global markets). Strategic leaders must determine corporate strategy along the three dimensions:

1. Vertical integration: In what stages of the industry value chain should the company participate? The industry value chain describes the transformation of raw materials into finished goods and services along distinct vertical stages.

2. Diversification: What range of products and services should the company offer?

3. Geographic scope: Where should the company compete geographically in terms of regional, national, or international markets?

In most cases, underlying these three questions is an implicit desire for growth. The need for growth is sometimes taken so much for granted that not every manager understands all the reasons behind it. A clear understanding will help strategic leaders to pursue growth for the right reasons and make better decisions for the firm and its stakeholders.

WHY FIRMS NEED TO GROW

LO 8-2

Explain why firms need to grow, and evaluate different growth motives.

Several reasons explain why firms need to grow. These can be summarized as follows:

1. Increase profits.

2. Lower costs.

3. Increase market power.

4. Reduce risk.

5. Motivate management.

Let’s look at each reason in turn.

INCREASE PROFITS

Profitable growth allows businesses to provide a higher return for their shareholders, or owners, if privately held. For publicly traded companies, the stock market valuation of a firm is determined to some extent by expected future revenue and profit streams. As featured in the ChapterCase,

Amazon

’s high stock market valuation is based to a large extent on expectations of future profitability, because the company invests for the long term and as such has yet to show consistent profitability.

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If firms fail to achieve their growth target, their stock price often falls. With a decline in a firm’s stock price comes a lower overall market capitalization, exposing the firm to the risk of a hostile takeover. Moreover, with a lower stock price, it is more costly for firms to raise the required capital to fuel future growth by issuing stock.

LOWER COSTS

Firms are also motivated to grow in order to lower their cost. As discussed in detail in 
Chapter 6
, a larger firm may benefit from economies of scale, thus driving down average costs as their output increases. Firms need to grow to achieve minimum efficient scale, and thus stake out the lowest-cost position achievable through economies of scale.

INCREASE MARKET POWER

Firms might be motivated to achieve growth to increase their market share and with it their market power. When discussing an industry’s structure in 

Chapter 3

, we noted that firms often consolidate industries through horizontal mergers and acquisitions (buying competitors) to change the industry structure in their favor (we’ll discuss mergers and acquisitions in detail in 

Chapter 9

). Fewer competitors generally equates to higher industry profitability. Moreover, larger firms have more bargaining power with suppliers and buyers (see the discussion of the five forces in 
Chapter 3
).

REDUCE RISK

Firms might be motivated to grow in order to diversify their product and service portfolio through competing in a number of different industries. The rationale behind these diversification moves is that falling sales and lower performance in one sector (e.g.,

GE

’s oil and gas unit) might be compensated by higher performance in another (e.g., GE’s health care unit). Such conglomerates attempt to achieve economies of scope (as first discussed in 
Chapter 6
).

MOTIVATE MANAGEMENT

Firms need to grow to motivate management. Growing firms afford career opportunities and professional development for employees. Firms that achieve profitable growth can also pay higher salaries and spend more on benefits such as health care insurance for its employees and paid parental leave, among other perks.

Research in behavioral economics, moreover, suggests that firms may grow to achieve goals that benefit managers more than stockholders.

4

 As we will discuss in detail when presenting the principal–agent problem later in the chapter, managers may be more interested in pursuing their own interests such as empire building and job security—plus managerial perks such as corporate jets or executive retreats at expensive resorts—rather than increasing shareholder value. Although there is a weak link between CEO compensation and firm performance, the CEO pay package often correlates more strongly with firm size.

5

Finally, we should acknowledge that promising businesses can fail because they grow unwisely—usually too fast too soon, and based on shaky assumptions about the future. There is a small movement counter to the need for growth, seen both in small businesses and social activism. Sometimes small-business owners operate a business for convenience, stability, and lifestyle; growth could threaten those goals. In social entrepreneurship, business micro-solutions are often operated outside of capital motives, where the need to solve a social problem outweighs the need of the firm to insure longevity beyond the solution of the problem.

THREE DIMENSIONS OF CORPORATE STRATEGY

All companies must navigate the three dimensions of vertical integration, diversification, and geographic scope. Although many managers provide input, the responsibility for corporate strategy ultimately rests with the CEO. Jeff Bezos, Amazon’s CEO, determined in what stages of the industry value chain Amazon would participate (question 1). With its prevalent delivery lockers in large metropolitan areas and its first brick-and-mortar retail store opened Page 270in New York City, Amazon moved forward in the industry value chain to be closer to its end customer. With its offering of Amazon-branded electronics and other everyday items, it also moved backward in the industry value chain toward manufacturing, production. Similarly, the creation of AWS, now the largest cloud-computing service provider globally with some 100 million customers, is a backward vertical integration move. AWS provides Amazon with back-end IT services such as website hosting, computing power, data storage and management, etc., which in turn are all critical inputs to its online retail business.

Bezos also chooses what range of products and services to offer, and which not to offer (question 2). The ChapterCase discusses Amazon’s diversification over time. Finally, Bezos also decided to customize certain country-specific websites despite the instant global reach of ecommerce firms. With this strategic decision, he decided where to compete globally in terms of different geographies beyond the United States. In short, Bezos determined where Amazon competes geographically (question 3).

Where to compete in terms of industry value chain, products and services, and geography are the fundamental corporate strategic decisions. The underlying strategic management concepts that will guide our discussion of vertical integration, diversification, and geographic competition are core competencies, economies of scale, economies of scope, and transaction costs.

· ▪ Core competencies are unique strengths embedded deep within a firm (as discussed in 

Chapter 4

). Core competencies allow a firm to differentiate its products and services from those of its rivals, creating higher value for the customer or offering products and services of comparable value at lower cost. According to the resource-based view of the firm, a firm’s boundaries are delineated by its knowledge bases and core competencies.

6

 Activities that draw on what the firm knows how to do well (e.g., Amazon’s core competency in developing proprietary recommendation algorithms) should be done in-house, while noncore activities such as payroll and facility maintenance can be outsourced. In this perspective, the internally held knowledge underlying a core competency determines a firm’s boundaries.

· ▪ Economies of scale occur when a firm’s average cost per unit decreases as its output increases (as discussed in 
Chapter 6
). Anheuser-Busch InBev (AB InBev), the largest global brewer (producer of some 225 brands worldwide, including famous ones such as Budweiser, Bud Light, Miller, Stella Artois, and Beck’s), reaps significant economies of scale. After AB InBev merged with SABMiller in a more than $100 billion deal in 2016, it now captures some 30 percent of global beer consumption.

7

 As a consequence of its huge scale, the beer giant captures some 50 percent of global beer profits. In terms of beer volume, the new AB InBev is also more than double the size of Heineken, the number-two competitor worldwide. Given its tremendous size, AB InBev is able to spread its fixed costs over the millions of gallons of beer it brews each year, in addition to the significant buyer power its large market share affords. Larger market share, therefore, often leads to lower costs.

· ▪ Economies of scope are the savings that come from producing two (or more) outputs or providing different services at less cost than producing each individually, though using the same resources and technology (as discussed in 
Chapter 6
). Leveraging its online retailing expertise, for example, Amazon benefits from economies of scope: It can offer a large range of different product and service categories at a lower cost than it would take to offer each product line individually.

· ▪ Transaction costs are all costs associated with an economic exchange. Applying the logic of transaction cost economics enables managers to answer the question of whether it is cost-effective for their firm to expand its boundaries through vertical integration or diversification. This implies taking on greater ownership of the production of needed inputs or of the channels by which it distributes its outputs, or adding business units that offer new products and services.

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We continue our study of corporate strategy by drawing on transaction cost economics to explain vertical integration, meaning the choices a firm makes concerning its boundaries. Later, we will explore managerial decisions relating to diversification, which directly affect the firm’s range of products and services in multi-industry competition. The third question of geographic scope will receive attention later, especially in 

Chapter 10

.

8.2 The Boundaries of the Firm

LO 8-3

Describe and evaluate different options firms have to organize economic activity.

Determining the boundaries of the firm so that it is more likely to gain and sustain a competitive advantage is the critical challenge in corporate strategy.

8

 T

ransaction cost economics

 provides useful theoretical guidance to explain and predict the boundaries of the firm. Insights gained from transaction cost economics help strategic leaders decide what activities to do in-house versus what services and products to obtain from the external market. This stream of research was initiated by Nobel Laureate Ronald Coase, who asked a fundamental question: Given the efficiencies of free markets, why do firms even exist? The key insight of transaction cost economics is that different institutional arrangements—markets versus firms—have different costs attached.

Transaction costs

 are all internal and external costs associated with an economic exchange, whether it takes place within the boundaries of a firm or in markets.

9

 

Exhibit 8.2

 visualizes the notion of transaction costs. It shows the respective internal transactions costs within Firm A and Firm B, as well as the external transactions that occur when Firm A and Firm B do business with one another.

EXHIBIT 8.2 Internal and External Transaction Costs

The total costs of transacting consist of external and internal transaction costs, as follows:

· ▪ When companies transact in the open market, they incur 

external transaction costs

: the costs of searching for a firm or an individual with whom to contract, and then negotiating, monitoring, and enforcing the contract.

· ▪ Transaction costs can occur within the firm as well. Considered 

internal transaction costs

 these include costs pertaining to organizing an economic exchange within a firm—for example, the costs of recruiting and retaining employees; paying salaries and benefits; setting up a shop floor; providing office space and computers; and organizing, Page 272monitoring, and supervising work. Internal transaction costs also include administrative costs associated with coordinating economic activity between different business units of the same corporation such as transfer pricing for input factors, and between business units and corporate headquarters including important decisions pertaining to resource allocation, among others. Internal transaction costs tend to increase with organizational size and complexity.

FIRMS VS. MARKETS: MAKE OR BUY?

Predictions derived from transaction cost economics guide strategic leaders in deciding which activities a firm should pursue in-house (“make”) versus which goods and services to obtain externally (“buy”). These decisions help determine the boundaries of the firm. In some cases, costs of using the market such as search costs, negotiating and drafting contracts, monitoring work, and enforcing contracts when necessary may be higher than integrating the activity within a single firm and coordinating it through an organizational hierarchy. When the costs of pursuing an activity in-house are less than the costs of transacting for that activity in the market (Cin–house < Cmarket), then the firm should vertically integrate by owning production of the needed inputs or the channels for the distribution of outputs. In other words, when firms are more efficient in organizing economic activity than are markets, which rely on contracts among many independent actors, firms should vertically integrate.

10

For example, rather than contracting in the open market for individual pieces of software code, Google (a unit of Alphabet) hires programmers to write code in-house. Owning these software development capabilities is valuable to the firm because its costs, such as salaries and employee benefits to in-house computer programmers, are less than what they would be in the open market. More importantly, Google gains economies of scope in software development resources and capabilities and reduces the monitoring costs. Skills acquired in writing software code for its different internet-based service offerings are transferable to new offerings. Programmers working on the original proprietary software code for the Google search engine leveraged these skills in creating a highly profitable online advertising business (AdWords and AdSense).

11

 Although some of Google’s software products are open source, such as the Android operating system, many of the company’s internet services are based on closely guarded and proprietary software code. Google, like many leading high-tech companies such as Amazon, Apple,

Facebook

, and Microsoft, relies on proprietary software code and algorithms, because using the open market to transact for individual pieces of software would be prohibitively expensive. Also, the firms would need to disclose the underlying software code to outside developers, thus negating the value-creation potential.

Firms and markets, as different institutional arrangements for organizing economic activity, have their own distinct advantages and disadvantages, summarized in 

Exhibit 8.3.

EXHIBIT 8.3 Organizing Economic Activity: Firms vs. Markets

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The advantages of firms include:

· ▪ The ability to make command-and-control decisions by fiat along clear hierarchical lines of authority.

· ▪ Coordination of highly complex tasks to allow for specialized division of labor.

· ▪ Transaction-specific investments, such as specialized robotics equipment that is highly valuable within the firm, but of little or no use in the external market.

· ▪ Creation of a community of knowledge, meaning employees within firms have ongoing relationships, exchanging ideas and working closely together to solve problems. This facilitates the development of a deep knowledge repertoire and ecosystem within firms. For example, scientists within a biotech company who worked together developing a new cancer drug over an extended time period may have developed group-specific knowledge and routines. These might lay the foundation for innovation, but would be difficult, if not impossible, to purchase on the open market.

12

The disadvantages of organizing economic activity within firms include:

· ▪ Administrative costs because of necessary bureaucracy.

· ▪ Low-powered incentives, such as hourly wages and salaries. These often are less attractive motivators than the entrepreneurial opportunities and rewards that can be obtained in the open market.

· ▪ The principal–agent problem.

The 

principal–agent problem

 is a major disadvantage of organizing economic activity within firms, as opposed to within markets. It can arise when an agent such as a manager, performing activities on behalf of the principal (the owner of the firm), pursues his or her own interests.

13

 Indeed, the separation of ownership and control is one of the hallmarks of a publicly traded company, and so some degree of the principal–agent problem is almost inevitable.

14

 For example, a manager may pursue his or her own interests such as job security and managerial perks (e.g., corporate jets and golf outings) that conflict with the principal’s goals—in particular, creating shareholder value. One potential way to overcome the principal–agent problem is to give stock options to managers, thus making them owners. We will revisit the principal–agent problem, with related ideas, in 

Chapters 11

 and 

12.

The advantages of markets include:

· ▪ High-powered incentives. Rather than work as a salaried engineer for an existing firm, for example, an individual can start a new venture offering specialized software. High-powered incentives of the open market include the entrepreneur’s ability to capture the venture’s profit, to take a new venture through an initial public offering (IPO), or to be acquired by an existing firm. In these so-called liquidity events, a successful entrepreneur can make potentially enough money to provide financial security for life.

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· ▪ Increased flexibility. Transacting in markets enables those who wish to purchase goods to compare prices and services among many different providers.

The disadvantages of markets include:

· ▪ Search costs. On a very fundamental level, perhaps the biggest disadvantage of transacting in markets, rather than owning the various production and distribution activities within the firm itself, entails nontrivial search costs. In particular, a firm faces search costs when it must scour the market to find reliable suppliers from among the many firms competing to offer similar products and services. Even more difficult can be the search to find suppliers when the specific products and services needed are not offered by firms currently in the market. In this case, production of supplies would require transaction-specific investments, an advantage of firms.

· Page 274

▪ Opportunism by other parties. Opportunism is behavior characterized by self-interest seeking with guile (we’ll discuss this in more detail later).

· ▪ Incomplete contracting. Although market transactions are based on implicit and explicit contracts, all contracts are incomplete to some extent, because not all future contingencies can be anticipated at the time of contracting. It is also difficult to specify expectations (e.g., What stipulates “acceptable quality” in a graphic design project?) or to measure performance and outcomes (e.g., What does “excess wear and tear” mean when returning a leased car?). Another serious hazard inherent in contracting is information asymmetry (which we discuss next).

· ▪ Enforcement of contracts. It often is difficult, costly, and time-consuming to enforce legal contracts. Not only does litigation absorb a significant amount of managerial resources and attention, but also it can easily amount to several million dollars in legal fees. Legal exposure is one of the major hazards in using markets rather than integrating an activity within a firm’s hierarchy.

Frequently, sellers have better information about products and services than buyers, which creates 

information asymmetry

, a situation in which one party is more informed than another, because of the possession of private information. When firms transact in the market, such unequal information can lead to a lemons problem. Nobel Laureate George Akerlof first described this situation using the market for used cars as an example.

16

 Assume only two types of used cars are sold: good cars and bad cars (lemons). Good cars are worth $8,000 and bad ones are worth $4,000. Moreover, only the seller knows whether a car is good or is a lemon. Assuming the market supply is split equally between good and bad cars, the probability of buying a lemon is 50 percent. Buyers are aware of the general possibility of buying a lemon and thus would like to hedge against it. Therefore, they split the difference and offer $6,000 for a used car. This discounting strategy has the perverse effect of crowding out all the good cars because the sellers perceive their value to be above $6,000. Assuming that to be the case, all used cars offered for sale will be lemons.

©Big Pants Production/Shutterstock.com RF

The important take-away here is caveat emptor—buyer beware. Information asymmetries can result in the crowding out of desirable goods and services by inferior ones. This has been shown to be true in many markets, not just for used cars, but also in ecommerce (e.g., eBay), mortgage-backed securities, and even collaborative R&D projects.

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ALTERNATIVES ON THE MAKE-OR-BUY CONTINUUM

The “make” and “buy” choices anchor each end of a continuum from markets to firms, as depicted in 

Exhibit 8.4

. Several alternative hybrid arrangements are available between these two extremes.

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 Moving from transacting in the market (“buy”) to full integration (“make”), alternatives include short-term contracts as well as various forms of strategic alliances (long-term contracts, equity alliances, and joint ventures) and parent–subsidiary relationships.

EXHIBIT 8.4 Alternatives on the Make-or-Buy Continuum

SHORT-TERM CONTRACTS

When engaging in short-term contracting, a firm sends out requests for proposals (RFPs) to several companies, which initiates competitive bidding for contracts to be awarded with a short duration, generally less than one year.

19

 The benefit to this approach lies in the fact that it allows a somewhat longer planning period than individual market transactions. Moreover, the buying firm can often demand lower prices due to the competitive bidding process. The drawback, however, is that firms responding to the RFP have no incentive to make any transaction-specific investments (e.g., buy new machinery to improve product quality) due to the short duration of the contract. This is exactly what happened in the U.S. automotive Page 275industry when GM used short-term contracts for standard car components to reduce costs. When faced with significant cost pressures, suppliers reduced component quality in order to protect their eroding margins. This resulted in lower-quality GM cars, contributing to a competitive advantage vis-à-vis competitors, most notably Toyota but also Ford, which used a more cooperative, longer-term partnering approach with suppliers.

20

STRATEGIC ALLIANCES

As we move toward greater integration on the make-or-buy continuum, the next organizational forms are strategic alliances. 

Strategic alliances

 are voluntary arrangements between firms that involve the sharing of knowledge, resources, and capabilities with the intent of developing processes, products, or services.

21

 Alliances have become a ubiquitous phenomenon, especially in high-tech industries. Moreover, strategic alliances can facilitate investments in transaction-specific assets without encountering the internal transaction costs involved in owning firms in various stages of the industry value chain.

Strategic alliances is an umbrella term that denotes different hybrid organizational forms—among them, long-term contracts, equity alliances, and joint ventures. Given their prevalence in today’s competitive landscape as a key vehicle to execute a firm’s corporate strategy, we take a quick look at strategic alliances here and then study them in more depth in 
Chapter 9
.

Long-Term Contracts.

We noted that firms in short-term contracts have no incentive to make transaction-specific investments. Long-term contracts, which work much like short-term contracts but with a duration generally greater than one year, help overcome this drawback. Long-term contracts help facilitate transaction-specific investments. 

Licensing

, for example, is a form of long-term contracting in the manufacturing sector that enables firms to commercialize intellectual property such as a patent. The first biotechnology drug to reach the market, Humulin (human insulin), was developed by Genentech and commercialized by Eli Lilly based on a licensing agreement.

In service industries, 

franchising

 is an example of long-term contracting. In these arrangements, a franchisor, such as McDonald’s, Burger King, 7-Eleven, H&R Block, or Subway, grants a franchisee (usually an entrepreneur owning no more than a few outlets) the right to use the franchisor’s trademark and business processes to offer goods and services that carry the franchisor’s brand name. Besides providing the capital to finance the expansion of the chain, the franchisee generally pays an up-front (buy-in) lump sum to the franchisor plus a percentage of revenues.

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Equity Alliances.

Yet another form of strategic alliance is an equity alliance—a partnership in which at least one partner takes partial ownership in the other partner. A partner purchases an ownership share by buying stock or assets (in private companies), and thus making an equity investment. The taking of equity tends to signal greater commitment to the partnership. 

Strategy Highlight 8.1

 describes how soft drink giant

Coca-Cola

Co. formed an equity alliance with energy-drink maker Monster.

Strategy Highlight 8.1

Is Coke Becoming a Monster?

While Americans are drinking ever more nonalcoholic beverages, the demand for longtime staples such as the full-calorie Coke or Pepsi are in free fall. More health-conscious consumers are moving away from sugary drinks at the expense of Coke and Pepsi, the two archrivals among regular colas. Unlike in the 1990s, however, Americans are not replacing them with diet sodas, but rather with bottled water and energy drinks. Indeed, Coca-Cola was slow to catch the trend toward bottled water and other more healthy choices such as vitamin water. Protecting its wholesome image, the conservative Coca-Cola Co. shunned energy drinks. The makers of energy drinks, such as 5-hour Energy, Red Bull, Monster, Rockstar, and Amp Energy, have faced wrongful death lawsuits. PepsiCo, on the other hand, was much more aggressive in moving into the energy-drink business with Amp Energy (owned by PepsiCo) and Rockstar (distributed by PepsiCo).

The Coca-Cola Co. holds an ownership stake through an equity alliance in the Monster Beverage Corp., which sponsors the NASCAR top racing series.
©Chris Graythen/Getty Images Sport/Getty Images

Albeit late to the party, Coca-Cola decided to not miss out completely on energy drinks, one of the fastest-growing segments in nonalcoholic beverages. After years of deliberation, in 2014 the Coca-Cola Co. formed an equity alliance with Monster Beverage Corp., spending $2 billion for a 16.7 percent stake in the edgy energy-drink company. This values the privately held Monster Beverage at roughly $12 billion. What might have finally persuaded Coca-Cola to make this decision? Not only was Monster now number one with 40 percent market share of the over $6 billion energy-drink industry, but the company also had settled a number of wrongful death lawsuits out of court. Meanwhile, however, the U.S. Food and Drug Administration is still investigating some 300 “adverse event” reports allegedly linked to the consumption of energy drinks, including 31 deaths. While the Coca-Cola Co. insists that it completed its due diligence before concluding that energy drinks are safe, it hedges its bets with a minority investment in Monster rather than an outright acquisition. This allows the market leader in nonalcoholic beverages to benefit from the explosive growth in energy drinks, while limiting potential exposure of Coca-Cola’s wholesome image and brand. Meanwhile, Monster paid about $20 million to sponsor NASCAR’s top racing series in 2017.

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Why is the Coca-Cola Co. forming an equity alliance with Monster Beverage Corp. and not just entering a short- or long-term contract, such as a distribution and profit-sharing agreement? One reason is that an equity investment in Monster might give Coca-Cola an inside look into the company. Gaining more information could be helpful if Coca-Cola decides to acquire Monster in the future. Gaining such private information might not be possible with a mere contractual agreement. Buying time is also helpful so Coca-Cola Co. can see how the wrongful death lawsuits play out, and thus limit the potential downside to Coke’s wholesome brand image (as mentioned in 
Strategy Highlight 8.1
).

Page 277

Moreover, in strategic alliances based on a mere contractual agreement, one transaction partner could attempt to hold up the other by demanding lower prices or threatening to walk away from the agreement (with whatever financial penalties might be included in the contract). This might be a real concern for Monster because Coca-Cola, with about $50 billion in annual sales, is about 20 times larger than Monster with $2.5 billion in revenues. To assuage Monster’s concerns, with its equity investment, Coca-Cola made a 

credible commitment

—a long-term strategic decision that is both difficult and costly to reverse.

Joint Ventures.

In a 

joint venture

, which is another special form of strategic alliance, two or more partners create and jointly own a new organization. Since the partners contribute equity to a joint venture, they make a long-term commitment, which in turn facilitates transaction-specific investments. Dow Corning, initially created and owned jointly by Dow Chemical and Corning, is an example of a joint venture. Dow Corning focuses on silicone-based technology and employs roughly 10,000 people with $5 billion in annual revenues. That success shows that some joint ventures can be quite large.

23

 Since 2017, Dow Corning is now owned by DowDuPont, after Dow Chemical and DuPont merged, creating a chemical-agricultural giant with some $120 billion in annual sales.

Hulu, a subscription video-on-demand service, is also a joint venture, owned NBCUniversal, Fox,

Disney

-ABC, and Turner Broadcasting System (TBS). In the United States, Hulu, with some 12 million subscribers in 2017, is a smaller competitor to Netflix (50 million) and to Amazon Prime with its 65 million members.

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PARENT–SUBSIDIARY RELATIONSHIP.

The parent–subsidiary relationship describes the most-integrated alternative to performing an activity within one’s own corporate family (and thus anchors the make-or-buy continuum in 
Exhibit 8.4
 on the “make” side). The corporate parent owns the subsidiary and can direct it via command and control. Transaction costs that arise are frequently due to political turf battles, which may include the capital budgeting process and transfer prices, among other areas. Other areas of potential conflict concern how centralized or decentralized a subsidiary unit should be run.

For example, although GM owned its European carmakers (Opel in Germany and Vauxhall in the United Kingdom), it had problems bringing some of their know-how and design of small fuel-efficient cars back into the United States. This failure put GM at a competitive disadvantage vis-à-vis the Japanese competitors when they were first entering the U.S. market with more fuel-efficient cars. In addition, the Japanese carmakers were able to improve the quality and design of their vehicles faster, which enabled them to gain a competitive advantage, especially in an environment of rising gas prices.

The GM versus Opel and Vauxhall parent–subsidiary relationship was burdened by political problems because managers in Detroit did not respect the engineering behind the small, fuel-efficient cars that Opel and Vauxhall made. They were not interested in using European know-how for the U.S. market and didn’t want to pay much or anything for it. Moreover, Detroit was tired of subsidizing the losses of Opel and Vauxhall, and felt that its European subsidiaries were manipulating the capital budgeting process.

25

 In turn, the Opel and Vauxhall subsidiaries felt resentment toward their parent company: GM had threatened to shut them down as part of its bankruptcy restructuring, whereas they instead hoped to be divested as independent companies.

26

GM CEO Mary Barra divested both Opel and Vauxhall by selling the GM subsidiaries to Peugeot, a French carmaker. Over many years the conflict in the parent–subsidiary relationship between GM and its European units shows that even the most integrated form of corporate relationships can be prone to high transaction costs.
©Bill Pugliano/Getty Images News/Getty Images

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After many years of acrimonious parent–subsidiary relationships, GM sold Opel and Vauxhall to Peugeot, a French carmaker, for a bit over $2 billion in 2017.

27

 This marks GM’s exit from the European car market, which has been a notorious money-losing venture for the Detroit automaker. Europe is one of the most competitive automobile markets in the world, and home to several strong car brands. The European market also is consistently plagued by excess capacity because of fickle consumer tastes. Rather than focusing on being the world’s largest carmaker in terms of volume, GM CEO Mary Barra is now focusing more on profitability. In contrast to Europe, GM is much stronger in its home market and highly profitable, especially in large pickup trucks and SUVs. Divesting its European operations also allows Barra to focus the Detroit-based carmaker more on growth markets in Asia, especially in China, where GM holds a strong position, with Shanghai GM Co., the 50-50 joint venture between GM and SAIC Motor Corp., a Chinese carmaker.

Having laid a strong theoretical foundation by fully considering transaction cost economics and the boundaries of the firm, we now turn our attention to the firm’s position along the vertical industry value chain.

8.3 

Vertical Integration

along the Industry Value Chain

The first key question when formulating corporate strategy is: In what stages of the industry value chain should the firm participate? Deciding whether to make or buy the various activities in the industry value chain involves the concept of vertical integration. 

Vertical integration

 is the firm’s ownership of its production of needed inputs or of the channels by which it distributes its outputs. Vertical integration can be measured by a firm’s value added:

· What percentage of a firm’s sales is generated within the firm’s boundaries?

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 The degree of vertical integration tends to correspond to the number of industry value chain stages in which a firm directly participates.

Exhibit 8.5

 depicts a generic 

industry value chain

. Industry value chains are also called vertical value chains, because they depict the transformation of raw materials into finished goods and services along distinct vertical stages. Each stage of the vertical value chain typically represents a distinct industry in which a number of different firms are competing. This is also why the expansion of a firm up or down the vertical industry value chain is called vertical integration.

EXHIBIT 8.5 Backward and Forward Vertical Integration along an Industry Value Chain

To explain the concept of vertical integration along the different stages of the industry value chain more fully, let’s use your cell phone as an example. This ubiquitous device is the result of a globally coordinated industry value chain of different products and services:

· ▪ Stage 1: Raw Materials. The raw materials to make your cell phone, such as chemicals, ceramics, metals, oil for plastic, and so on, Page 279are commodities. In each of these commodity businesses are different companies, such as DuPont (United States), BASF (Germany), Kyocera (Japan), and

ExxonMobil

(United States).

· ▪ Stage 2: Intermediate Goods and Components. Elements such as integrated circuits, displays, touchscreens, cameras, and batteries are provided by firms such as ARM Holdings (United Kingdom), Jabil (United States), Intel (United States), LG Display (Korea), Altek (Taiwan), and BYD (China).

· ▪ Stage 3: Final Assembly and Manufacturing. Original equipment manufacturing firms (OEMs) such as Flextronics (Singapore) or Foxconn (China) typically assemble cell phones under contract for consumer electronics and telecommunications companies such as Apple (United States),

Samsung

and LG (both South Korea), Huawei and Oppo Electronics (both China), and others. If you look closely at an iPhone, for example, you’ll notice it says, “Designed by Apple in California. Assembled in China.”

· ▪ Stages 4 and 5: Marketing, Sales, After-Sales Service, Support. Finally, to get wireless data and voice service, you pick a service provider such as AT&T, Sprint, T-Mobile, or Verizon in the United States; América Móvil in Mexico; Oi in Brazil; Orange in France; T-Mobile or Vodafone in Germany; NTT Docomo in Japan; Airtel in India; or China Mobile in China, among others. In 2015, Google launched a low-cost wireless service in the United States. Called ProjectFi, the wireless service plans offered by Google cost $20 a month for talk and text, including Wi-Fi and international coverage. Each gigabyte of data costs $10 per month. Google’s goal is that by providing lower-priced wireless services, more people will connect to the internet, which means more demand for its core online search business and ad-supported YouTube video service. On the downside, initially it is available only with Google phones such as the Pixel.

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All of these companies—from the raw-materials suppliers to the service providers—make up the global industry value chain that, as a whole, delivers you a working cell phone. Determined by their corporate strategy, each firm decides where in the industry value chain to participate. This in turn defines the vertical boundaries of the firm.

TYPES OF VERTICAL INTEGRATION

LO 8-4

Describe the two types of vertical integration along the industry value chain: backward and forward vertical integration.

Along the industry value chain, firms pursue varying degrees of vertical integration in their corporate strategy. Some firms participate in only one or a few stages of the industry value chain, while others comprise many if not all stages. In general, fewer firms are fully vertically integrated. Most firms concentrate on only a few stages in the industry value chain, and some firms just focus on one. The following examples illuminate different degrees of vertical integration along the industry value chain.

E&J Gallo Winery is the world’s largest family-owned winery. With sales in some 90 countries, it is also the largest exporter of California wines. As a fully vertically integrated producer and distributor, it participates in all stages of the industry value chain. E&J Gallo’s corporate strategy and resulting activities along the industry value chain are guided by the mantra “from grape to glass.” E&J Gallo owns its own vineyards, bottling Page 280plants, distribution and logistics network, and retails via the internet where allowed. (Some states in the United States ban direct-to-consumer sale of alcoholic beverages.)

E&J Gallo, the California winery, is fully vertically integrated, following its corporate strategy mantra “from grape to glass.” E&J Gallo is also the largest exporter of California wines.

©Sherri Camp/123RF

Being fully vertically integrated allows E&J Gallo to achieve economies of scale, resulting in lower cost. Additional operational efficiency is achieved by effective coordination such as scheduling along the industry value chain. E&J Gallo also emphasizes that being fully vertically integrated allows it to control quality better and to provide the end user with a better experience. Offering a house of brands, consisting of many different wines at different price points, also allows E&J Gallo to differentiate its product and to reap economies of scope. E&J Gallo’s value added approaches 100 percent. The California winery, therefore, competes in a number of different industries along the entire vertical value chain. As a consequence, it faces different competitors in each stage of the industry value chain, both domestically and internationally.

On the other end of the spectrum are firms that are more or less vertically disintegrated with a low degree of vertical integration. These firms focus on only one or a few stages of the industry value chain. Apple, for example, focuses only on design, marketing, and retailing; all other value chain activities are outsourced.

Be aware that not all industry value chain stages are equally profitable. Apple captures significant value by designing mobile devices through integration of hardware and software in novel ways, but it outsources the manufacturing to generic OEMs. The logic behind these decisions can be explained by applying Porter’s five forces model and the VRIO model. The many small cell phone OEMs are almost completely interchangeable and are exposed to the perils of perfect competition. However, Apple’s competencies in innovation, system integration, and marketing are valuable, rare, and unique (non-imitable) resources, and Apple is organized to capture most of the value it creates. Apple’s continued innovation through new products and services provides it with a string of temporary competitive advantages.

Exhibit 8.6

 displays part of the industry value chain for smartphones. In this figure, note HTC’s transformation from a no-name OEM manufacturer in stage 2 of the vertical value chain to a player in the design, manufacture, and sale of smartphones (stages 1 and 3). It now offers a lineup of innovative and high-performance smartphones under the HTC label.

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EXHIBIT 8.6 HTC’s Backward and Forward Integration along the Industry Value Chain in the Smartphone Industry

Firms regularly start out as OEMs and then vertically integrate along the value chain in either a backward and/or forward direction. With these moves, former contractual partners to brand-name phone makers such as Apple and Samsung then become their competitors. OEMs are able to vertically integrate because they acquire the skills needed to compete in adjacent industry value chain activities from their alliance partners, which need to share the technology behind their proprietary phone to enable large-scale manufacturing.

Over time, HTC was able to upgrade its capabilities from merely manufacturing smartphones to also designing products.

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 In doing so, HTC engaged in 

backward vertical integration

—moving ownership of activities upstream to the originating inputs of the value chain. Moreover, Page 281by moving downstream into sales and increasing its branding activities, HTC has also engaged in 

forward vertical integration

—moving ownership of activities closer to the end customer. Although HTC has long benefited from economies of scale as an OEM, it is now also benefiting from economies of scope through participating in different stages of the industry value chain. For instance, it now can share competencies in product design, manufacturing, and sales, while at the same time attempting to reduce transaction costs.

Although, HTC with some 9 percent market share in the smartphone industry (in 2011) was the third largest handset maker–just behind Samsung and Apple—the Taiwanese smartphone has fallen on hard times since. By 2017, HTC’s market share had plummeted to less than 1 percent. New technology firms from China such as Huawei, Oppo, Vivo, and Xiaomi performed better than HTC. Yet, HTC’s vertical integration into design as well as manufacturing and sales and marketing of smartphones allowed it build a core competency that Google, a unit of Alphabet found valuable. Google contracted HTC to design and build its new high-end phone (the Pixel) for the California-based high-tech company. In 2017, Google acquired HTC’s smartphone engineering group for $1.1 billion. Integrating HTC’s smartphone unit within Google will allow engineers to more tightly integrate hardware and software. This in turn will allow Google to differentiate its high-end Pixel phone more from the competition, especially Apple’s newly released iPhone X and Samsung’s Galaxy 8 line of phone, including the Note 8. Even though HTC by itself lost out to Samsung, Apple, and a handful of new Chinese firms in the highly competitive smartphone industry, vertical integration along the industry value chain allowed HTC to build a core competency in the design and manufacturing of smartphones for which Google paid over $1 billion to acquire, and thus to integrate it more fully with its Android group that develops the software for Google’s mobile operating system.

Likewise, Foxconn, Apple’s largest OEM, is also vertically integrating along the industry value chain.

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 In 2016, it purchased the struggling Japanese electronics manufacturer Sharp for some $4 billion. Sharp is known for its high-quality display panels (used in smartphones and elsewhere) as well as other innovative consumer electronics such as microwave ovens and air purifiers.

Foxconn hopes to move upmarket by leveraging Sharp’s strong brand name, and to benefit from the Japanese high-tech company’s efforts to produce organic light-emitting diode (OLED) displays. Similarly to HTC, Foxconn is moving backward in the industry value chain into design of consumer electronics and forward into marketing and sales by using the Sharp brand. This shows that OEMs, over time, tend to acquire skills, know-how, and ambition to move beyond mere manufacturing, where profit margins are often razor thin.

LO 8-5

Identify and evaluate benefits and risks of vertical integration.

BENEFITS AND RISKS OF VERTICAL INTEGRATION

To decide the degree and type of vertical integration to pursue, strategic leaders need to understand the possible benefits and risks of vertical integration. At a minimum, they need to proceed with caution, and carefully consider the countervailing risks at the same time they consider the benefits.

BENEFITS OF VERTICAL INTEGRATION

Vertical integration, either backward or forward, can have a number of benefits, including

33

· ▪ Lowering costs.

· ▪ Improving quality.

· ▪ Facilitating scheduling and planning.

· ▪ Facilitating investments in specialized assets.

· ▪ Securing critical supplies and distribution channels.

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As noted earlier, HTC started as an OEM for brand-name mobile device companies such as Motorola and Nokia (both defunct) and telecom service providers AT&T and T-Mobile. More recently, HTC has been manufacturing phones for Google (which uses Motorola’s patents after its acquisition of Motorola; the handset-making unit of Motorola was sold later by Google to Lenovo, a Chinese computer company). HTC backwardly integrated into smartphone design by acquiring One & Co., a San Francisco-based design firm.

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 The acquisition allowed HTC to secure scarce design talent and capabilities that it leveraged into the design of smartphones with superior quality and features, enhancing the differentiated appeal of its products. Moreover, HTC can now design phones that leverage its low-cost manufacturing capabilities.

Likewise, forward integration into distribution and sales allows companies to more effectively plan for and respond to changes in demand. HTC’s forward integration into sales enables it to offer its products directly to wireless providers such as AT&T, Sprint, and Verizon. HTC even offers unlocked phones directly to the end consumer via its own website. With ownership and control of more stages of the industry value chain, HTC is now in a much better position to respond if, for example, demand for its latest phone should suddenly pick up.

Vertical integration along the industry value chain can also facilitate investments in specialized assets. What does this mean? 

Specialized assets

 have a high opportunity cost: They have significantly more value in their intended use than in their next-best use.

35

 They can come in several forms:

36

· ▪ Site specificity—assets required to be co-located, such as the equipment necessary for mining bauxite and aluminum smelting.

· ▪ Physical-asset specificity—assets whose physical and engineering properties are designed to satisfy a particular customer. Examples include the bottling machinery for E&J Gallo. Given the many brands of wine offered by E&J Gallo, unique equipment, such as molds and a specific production process, is required to produce the different and trademarked bottle shapes.

· ▪ Human-asset specificity—investments made in human capital to acquire unique knowledge and skills, such as mastering the routines and procedures of a specific organization, which are not transferable to a different employer.

Investments in specialized assets tend to incur high opportunity costs because making the specialized investment opens up the threat of opportunism by one of the partners. Opportunism is defined as self-interest seeking with guile.

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 Backward vertical integration is often undertaken to overcome the threat of opportunism and to secure key raw materials.

In an effort to secure supplies and reduce the costs of jet fuel, Delta was the first airline to acquire an oil refinery. In 2012, it purchased a Pennsylvania-based facility from ConocoPhillips. Delta estimates that this backward vertical integration move not only will allow it to provide 80 percent of its fuel internally, but will also save it some $300 million in costs annually. Fuel costs are quite significant for airlines; for Delta, they are some 40 percent of its total operating cost.

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RISKS OF VERTICAL INTEGRATION

It is important to note that the risks of vertical integration can outweigh the benefits. Depending on the situation, vertical integration has several risks, some of which directly counter the potential benefits, including

39

· ▪ Increasing costs.

· ▪ Reducing quality.

· ▪ Reducing flexibility.

· ▪ Increasing the potential for legal repercussions.

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A higher degree of vertical integration can lead to increasing costs for a number of reasons. In-house suppliers tend to have higher cost structures because they are not exposed to market competition. Knowing there will always be a buyer for their products reduces their incentives to lower costs. Also, suppliers in the open market, because they serve a much larger market, can achieve economies of scale that elude in-house suppliers. Organizational complexity increases with higher levels of vertical integration, thereby increasing administrative costs such as determining the appropriate transfer prices between an in-house supplier and buyer. Administrative costs are part of internal transaction costs and arise from the coordination of multiple divisions, political maneuvering for resources, the consumption of company perks, or simply from employees slacking off.

The knowledge that there will always be a buyer for their products not only reduces the incentives of in-house suppliers to lower costs, but also can reduce the incentive to increase quality or come up with innovative new products. Moreover, given their larger scale and greater exposure to more customers, external suppliers often can reap higher learning and experience effects and so develop unique capabilities or quality improvements.

A higher degree of vertical integration can also reduce a firm’s strategic flexibility, especially when faced with changes in the external environment such as fluctuations in demand and technological change.

40

 For instance, when technological process innovations enabled significant improvements in steelmaking, mills such as U.S. Steel and Bethlehem Steel were tied to their fully integrated business models and were thus unable to switch technologies, leading to the bankruptcy of many integrated steel mills. Non-vertically integrated mini-mills such as Nucor and Chaparral, on the other hand, invested in the new steelmaking process and grew their business by taking market share away from the less flexible integrated producers.

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U.S. regulators such as the Federal Trade Commission (FTC) and the Justice Department (DOJ) tend to allow vertical integration, arguing that it generally makes firms more efficient and lowers costs, which in turn can benefit customers. However, due to monopoly concerns, vertical integration has not gone entirely unchallenged.

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 Before engaging in vertical integration, therefore, strategic leaders need to be aware that this corporate strategy can increase the potential for legal repercussions.

Amazon.com, featured in the ChapterCase, is facing potential legal repercussions because of its increasing scale and scope. Amazon now accounts for roughly one-half of all internet retail spending in the United States. In addition, with AWS, physical retail stores, and drone deliveries, Amazon is increasingly becoming a fully vertically integrated enterprise. Many argue that Amazon is much like a utility, providing the backbone for internet commerce, both in the business-to-consumer (B2C) as well as in the business-to-business (B2B) space. This paints a future picture in which rivals are depending more and more on Amazon’s products and services to conduct their own business. Amazon’s tremendous scale and scope can bring it increasingly into conflict with governments. Antitrust enforcers such as the Department of Justice might train their sights on Amazon.

WHEN DOES VERTICAL INTEGRATION MAKE SENSE?

U.S. business saw a number of periods of higher than usual vertical integration, and looking back may reveal useful lessons on how a company can make better decisions around its corporate strategy.

43

In the early days of automobile manufacturing, Ford Motor Co. was frustrated by shortages of raw materials and the limited delivery of parts suppliers. In response, Henry Ford decided to own the whole supply chain, so his company soon ran mining operations, rubber plantations, freighters, blast furnaces, glassworks, and its own parts manufacturer. In Ford’s River Rogue plant, raw materials entered on one end, new cars rolled out the other Page 284end. But over time, the costs of vertical integration caught up, both financial costs that undid earlier cost savings and operational costs that hampered the manufacturer’s flexibility to respond to changing conditions. Indeed, Ford experienced diseconomies of scale (see 

Exhibit 6.5

) due to its level of vertical integration and the unwieldy size of its huge plants.

In the 1970s, the chipmakers and the manufacturers of electronic products tried to move into each others’ business. Texas Instruments went downstream into watches and calculators. Bowmar, which at first led the calculator market, tried to go upstream into chip manufacturing and failed. The latter 2000s saw a resurgence of vertical integration. In 2009, General Motors was trying to reacquire Delphi, a parts supplier that it had sold in 1997. In the 2010s, PepsiCo and Coca-Cola, the two major soft drink companies, purchased bottling plants (and later divested them again).

Rita McGrath suggested that the siren call of vertical integration looms large for companies seeking to completely change the customer’s experience: “An innovator who can figure out how to eliminate annoyances and poor interfaces in the chain can build an incredible advantage, based on the customers’ desire for that unique solution.”

44

 So what should company executives do as they contemplate a firm’s corporate strategy? As far back as the 1990s, the consulting firm McKinsey was counseling clients that firms had to consider carefully why they were looking at integrating along their industry value chain. McKinsey identified the main reason to vertically integrate: failure of vertical markets.

Vertical market failure

 occurs when transactions within the industry value chain are too risky, and alternatives to integration are too costly or difficult to administer. This recommendation corresponds with the one derived from transaction cost economics earlier in this chapter. When discussing research on vertical integration, The Economist concluded, “Although reliance on [external] supply chains has risks, owning parts of the supply chain can be riskier—for example, few clothing-makers want to own textile factories, with their pollution risks and slim profits.” The findings suggest that when a company vertically integrates two or more steps away from its core competency, it fails two-thirds of the time.

45

The risks of vertical integration and the difficulty of getting it right bring us to look at alternatives that allow companies to gain some of the benefits of vertical integration without the risks of full ownership of the supply chain.

ALTERNATIVES TO VERTICAL INTEGRATION

LO 8-6

Describe and examine alternatives to vertical integration.

Ideally, one would like to find alternatives to vertical integration that provide similar benefits without the accompanying risks. Taper integration and strategic outsourcing are two such alternatives.

TAPER INTEGRATION

One alternative to vertical integration is 

taper integration

. It is a way of orchestrating value activities in which a firm is backwardly integrated, but it also relies on outside-market firms for some of its supplies, and/or is forwardly integrated but also relies on outside-market firms for some if its distribution.

46

 

Exhibit 8.7

 illustrates the concept of taper integration along the vertical industry value chain. Here, the firm sources intermediate goods and components from in-house suppliers as well as outside suppliers. In a similar fashion, a firm sells its products through company-owned retail outlets and through independent retailers. Both Apple and

Nike

, for example, use taper integration: They own retail outlets but also use other retailers, both the brick-and-mortar type and online.

EXHIBIT 8.7 Taper Integration along the Industry Value Chain

Taper integration has several benefits:

47

· ▪ It exposes in-house suppliers and distributors to market competition so that performance comparisons are possible. Rather than hollowing out its competencies by relying too much on outsourcing, taper integration allows a firm to retain and Page 285fine-tune its competencies in upstream and downstream value chain activities.

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· ▪ Taper integration also enhances a firm’s flexibility. For example, when adjusting to fluctuations in demand, a firm could cut back on the finished goods it delivers to external retailers while continuing to stock its own stores.

· ▪ Using taper integration, firms can combine internal and external knowledge, possibly paving the path for innovation.

Based on a study of 3,500 product introductions in the computer industry, researchers have provided empirical evidence that taper integration can be beneficial.

49

 Firms that pursued taper integration achieved superior performance in both innovation and financial performance when compared with firms that relied more on vertical integration or strategic outsourcing.

STRATEGIC OUTSOURCING

Another alternative to vertical integration is 

strategic outsourcing

, which involves moving one or more internal value chain activities outside the firm’s boundaries to other firms in the industry value chain. A firm that engages in strategic outsourcing reduces its level of vertical integration. Rather than developing their own human resource management systems, for instance, firms outsource these noncore activities to companies such as PeopleSoft (owned by Oracle), EDS (owned by HP), or Perot Systems (owned by Dell), which can leverage their deep competencies and produce scale effects.

In the popular media and in everyday conversation, you may hear the term outsourcing used to mean sending jobs out of the country. Actually, when outsourced activities take place outside the home country, the correct term is offshoring (or offshore outsourcing). For example, Infosys, one of the world’s largest technology companies and providers of IT services to many Fortune 100 companies, is located in Bangalore, India. The global offshoring market for services peaked at more than $1 trillion in 2015, but has since been declining somewhat.

50

 Banking and financial services, IT, and health care are the most active sectors in such offshore outsourcing. More recently, U.S. law firms began to offshore low-end legal work, such as drafting standard contracts and background research, to India.

51

 We discuss global strategy in detail in 
Chapter 10
.

8.4 Corporate Diversification: Expanding Beyond a Single Market

Early in the chapter, we listed three questions related to corporate strategy and, in particular, the boundaries of the firm. We discussed the first question of defining corporate strategy in detail:

1. Vertical integration: In what stages of the industry value chain should the firm participate?

We explored this question primarily in terms of firm boundaries based on the degree of vertical integration. We now turn to the second and third questions that determine corporate strategy and the boundaries of the firm.

2. Page 286Product diversification: What range of products and services should the firm offer?

The second question relates to the firm’s degree of product diversification: What range of products and services should the firm offer? In particular, why do some companies compete in a single product market, while others compete in several different product markets? Coca-Cola, for example, focuses on soft drinks and thus on a single product market. Its archrival PepsiCo competes directly with Coca-Cola by selling a wide variety of soft drinks and other beverages, and also offering different types of chips such as Lay’s, Doritos, and Cheetos, as well as Quaker Oats products such as oatmeal and granola bars. Although PepsiCo is more diversified than Coca-Cola, it has reduced its level of diversification in recent years.

3. Geographic diversification: Where should the firm compete in terms of regional, national, or international markets?

The third and final of the key questions concerns the question of where to compete in terms of regional, national, or international markets. This decision determines the firm’s degree of geographic diversification. For example, why do some firms compete beyond state boundaries, while others are content to focus on the local market? Why do some firms compete beyond their national borders, while others prefer to focus on the domestic market?

Kentucky Fried Chicken (KFC), the world’s largest quick-service chicken restaurant chain, operates 20,000 outlets in some 120 countries.

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 Interestingly, KFC has more restaurants in China with over 5,000 outlets than in the United States, its birthplace, with some 4,500 outlets. Of course, China has 1.4 billion people and the United States has a mere 320 million. PepsiCo CEO Indra Nooyi was instrumental in spinning out KFC, as well as Pizza Hut and Taco Bell, to reduce PepsiCo’s level of diversification. In 1997, the three fast food chains were established as an independent company under the name Yum Brands. In 2014, Yum Brands annual revenues were $13 billion. In 2016, after being pressured by activist investors, Yum Brands sold a stake in its China operation to Alibaba Group (a Chinese internet conglomerate) and an individual Chinese investor. (After spinning out its China operation, the remaining Yum Brands had annual revenues of $4.2 billion.)

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 The activist investors argued that Yum’s China operation was really the crown jewel in Yum Brand’s portfolio, and that more value for shareholders would be unlocked if the China operation would be managed as a standalone unit, rather than being part of the geographically diversified Yum Brands.

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Compare KFC, active in 120 countries across the globe, with the privately held Chick-fil-A, the world’s second-largest quick-service chicken restaurant.

55

 KFC and Chick-fil-A are direct competitors in the United States, both specializing in chicken in the fast food market. But Chick-fil-A operates only in the United States; by 2016 it had some 2,100 locations across 45 states and earned $6 billion in sales.

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Why are KFC and Chick-fil-A pursuing different corporate strategies? Although both companies were founded roughly during the same time period (KFC in 1930 and Chick-fil-A in 1946), one big difference between KFC and Chick-fil-A is the ownership structure. KFC is a publicly traded stock company, as part of Yum Brands (stock ticker symbol: YUM) and Yum China (traded under YUMC, also on the New York Stock Exchange). Chick-fil-A, in contrast, is privately owned. Indeed, the privately owned Chick-fil-A is one of the largest family-owned businesses in the United States.

Public companies are often expected by shareholders to achieve profitable growth to result in an appreciation of the stock price and thus an increase in shareholder value (see the discussion in 

Chapter 5

). That is also the reason Yum’s China operation was spun off from Yum Brands, because it is performing much better. In addition, investors were Page 287concerned that the lower-performing units at Yum Brands (e.g., KFC in the United States) would continue to be subsidized by the higher-performing China unit.

In contrast, private companies generally grow slower than public companies because their growth is mostly financed through retained earnings and debt rather than equity. Before an initial public offering, private companies do not have the option to sell shares (equity) to the public to fuel growth. This is one explanation why KFC focuses on international markets, especially China, where future expected growth continues to be high, while Chick-fil-A focuses on the domestic U.S. market. KFC is geographically diversified, while Chick-fil-A is not.

Answers to questions about the number of markets to compete in and where to compete geographically relate to the broad topic of 

diversification

. A firm that engages in diversification increases the variety of products and services it offers or markets and the geographic regions in which it competes. A non-diversified company focuses on a single market, whereas a diversified company competes in several different markets simultaneously.

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There are various general diversification strategies:

· ▪ A firm that is active in several different product markets is pursuing a 

product diversification strategy

.

· ▪ A firm that is active in several different countries is pursuing a 

geographic diversification strategy

.

· ▪ A company that pursues both a product and a geographic diversification strategy simultaneously follows a 

product–market diversification strategy

.

Because shareholders expect continuous growth from public companies, strategic leaders frequently turn to product and geographic diversification to achieve it. It is therefore not surprising that the vast majority of the Fortune 500 companies are diversified to some degree. Achieving performance gains through diversification, however, is not guaranteed. Some forms of diversification are more likely to lead to performance improvements than others. We now discuss which diversification types are more likely to lead to a competitive advantage, and why.

TYPES OF CORPORATE DIVERSIFICATION

LO 8-7

Describe and evaluate different types of corporate diversification.

To understand the different types and degrees of corporate diversification, Richard Rumelt developed a helpful classification scheme that identifies four main types of diversification by identifying two key variables:

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· ▪ The percentage of revenue from the dominant or primary business.

· ▪ The relationship of the core competencies across the business units.

Note that this classification scheme concerns product markets, and not geographic diversification. Knowing the percentage of revenue of the dominant business (the first variable), lets us identify the first two types of diversification: single business and dominant business. Asking questions about the relationship of core competencies across business units allows us to identify the other two types: related diversification and unrelated diversification. Taken together, the four main types of business diversification are

1.

Single business

.

2.

Dominant business

.

3. Related diversification.

4. Unrelated diversification: the conglomerate.

Please note that related diversification (type 3) is divided into two subcategories. We discuss each type of diversification below.

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SINGLE BUSINESS

A single-business firm is characterized by a low level of diversification, if any, because it derives more than 95 percent of its revenues from one business. The remainder of less than 5 percent of revenue is not (yet) significant to the success of the firm.

Founded in 1774, the German company

Birkenstock

only makes one product: its namesake contoured cork shoes. Although of a more recent vintage, Facebook is also a single business at this point because it receives almost all of its revenues from online advertising.

DOMINANT BUSINESS

A dominant-business firm derives between 70 and 95 percent of its revenues from a single business, but it pursues at least one other business activity that accounts for the remainder of revenue. The dominant business shares competencies in products, services, technology, or distribution. In the schematic figure shown here and those to follow, the remaining revenue (R) is generally obtained in other strategic business units (SBU) within the firm. This remaining revenue is by definition less than that of the primary business. (Note: The areas of the boxes in this and following graphics are not scaled to specific percentages.)

Harley-Davidson

, the Milwaukee-based manufacturer of the iconic Harley motorcycles, is a dominant-business firm. Of its $5 billion in annual revenues, some 80 percent comes from selling its iconic motorcycles.

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 The remaining 20 percent of revenues come from other business activities such as motorcycle parts and accessories as well as general merchandise, including licensing the Harley logo. The brand has a loyal following overseas as well as in the United States.

RELATED DIVERSIFICATION.

A firm follows a 

related diversification strategy

 when it derives less than 70 percent of its revenues from a single business activity and obtains revenues from other lines of business linked to the primary business activity. The rationale behind related diversification is to benefit from economies of scale and scope: These multi-business firms can pool and share resources as well as leverage competencies across different business lines. The two variations of this type, which we explain next, relate to how much the other lines of business benefit from the core competencies of the primary business activity.

Related-Constrained Diversification.

A firm follows a 

related-constrained diversification strategy

 when it derives less than 70 percent of its revenues from a single business activity and obtains revenues from other lines of business related to the primary business activity. Executives engage in a new business opportunity only when they can leverage their existing competencies and resources. Specifically, the choices of alternative business activities are limited—constrained—by the fact that they need to be related through common resources, capabilities, and competencies.

ExxonMobil’s strategic move into natural gas is an example of related diversification. In 2009, ExxonMobil bought XTO Energy, a natural gas company, for $31 billion.

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 XTO Energy is known for its core competency to extract natural gas from unconventional places such as shale rock—the type of deposits currently being exploited in the United States. ExxonMobil hopes to leverage its core competency in the exploration and commercialization of oil into natural gas extraction. The company is producing nearly equal amounts of crude oil and natural gas, making it the world’s largest producer of natural gas. The company believes that roughly 50 percent of the world’s energy for the next 50 years will continue to come from fossil fuels, and that its diversification into natural gas, the cleanest of the fossil fuels in terms of greenhouse gas emissions, will pay off. ExxonMobil’s strategic Page 289scenario may be right on the mark. Because of major technological advances in hydraulic fracking to extract oil and natural gas from shale rock by companies such as XTO Energy, the United States has emerged as the world’s richest country in natural gas resources and the third-largest producer of crude oil, just behind Saudi Arabia and Russia.

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Related-Linked Diversification.

If executives consider new business activities that share only a limited number of linkages, the firm is using a 

related-linked diversification strategy

.

Amazon.com, featured in the ChapterCase, began business by selling only one product: books. Over time, it expanded into CDs and later gradually leveraged its online retailing capabilities into a wide array of product offerings. As the world’s largest online retailer, and given the need to build huge data centers to service its peak holiday demand, Amazon decided to leverage spare capacity into cloud computing, again benefiting from economies of scope and scale. Amazon also offers a variety of consumer electronics such as tablets, e-readers, and digital virtual assistants in speakers, as well as proprietary content that can be streamed via the internet and is free for its Prime service. Amazon follows a related-linked diversification strategy.

UNRELATED DIVERSIFICATION: THE CONGLOMERATE

A firm follows an 

unrelated diversification strategy

 when less than 70 percent of its revenues comes from a single business and there are few, if any, linkages among its businesses. A company that combines two or more strategic business units under one overarching corporation and follows an unrelated diversification strategy is called a 

conglomerate

.

Some research evidence suggests that an unrelated diversification strategy can be advantageous in emerging economies.

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Such an arrangement helps firms gain and sustain competitive advantage because it allows the conglomerate to overcome institutional weaknesses in emerging economies, such as a lack of capital markets and well-defined legal systems and property rights. Companies such as Samsung and LG (representing a uniquely South Korean form of organization, the chaebol), Warren Buffet’s

Berkshire Hathaway

, and the Japanese

Yamaha

group are all considered conglomerates due to their unrelated diversification strategy. 

Strategy Highlight 8.2

 features the Tata group of India, a conglomerate that follows an unrelated diversification strategy.

Strategy Highlight 8.2

The Tata Group: Integration at the Corporate Level

Tata Nano GenX starts at $3,100.
©PUNIT PARANJPE/AFP/Getty Images
The Range Rover 5.0L V8 Supercharged SV Autobiography starts at $200,000.
©Bloomberg/Getty Images

Founded in 1868 as a trading company by then 29-year-old entrepreneur Jamsetji Nusserwanji Tata, the Tata group today has roughly 660,000 employees and $105 billion in annual revenues. A widely diversified multinational conglomerate, headquartered in Mumbai, India, its activities include tea, hospitality, steel, IT, communications, power, and automobiles. Some of its strategic business units are giants in their own right. Tata includes Asia’s largest software and steel companies (TCS and Tata Steel) and the renowned Taj Hotels Resorts and Palaces.

This diversified approach can be seen in microcosm within two divisions of one of its holdings in the automotive industry. Tata Motors started producing cars in the 1950s. In 2008 it bought luxury brands Jaguar and Land Rover from Ford for $2.3 billion. In a seemingly disjointed effort, in 2009 the company unveiled the Tata Nano, the world’s lowest-priced car. Each division follows a separate business strategy (low-cost versus differentiation).

Page 290Tata Motors designed the Nano to wean India’s emerging middle class from mopeds and bikes, expanding the market. Ratan Tata, then chairman of the Tata group, famously conceived of the Nano while seeing a family of four cramped on a moped in heavy rains.

When Ratan Tata saw a family cramped on a motorcycle in heavy rains, he conceived of the Tata Nano, a super low-cost and affordable car. As the lowest-cost car on the market, the Tata Nano does not compete with other cars (the next lowest is twice the price of a Nano), but with motorcycles, thus with current nonconsumption.
©NARINDER NANU/AFP/Getty Images

LOW-COST LEADER

Tata Motors hoped the Nano, engineered for a price point about 50 percent cheaper than the previously available cheapest car, would reach tens of millions of customers in the Indian and Chinese markets. But initial sales were flat. Families able to trade up from two wheels apparently found more value in a used full-featured car than a stripped-down version of a new car. The tiny Nano used much less steel than traditional cars; lacked such basics as a radio, glove compartment, and operable rear hatch; would not accommodate passengers much over 6 feet tall; and could barely reach speeds topping 60 mph. As a plus, however, the Nano gets 67 mpg, beating the Toyota Prius for fuel consumption.

Tata Motors tried again with the Nano GenX in 2015, which brought more customizability and such features as USB ports, an audio system, Bluetooth compatibility, and an automatic transmission with a special “creeping” mode—designed to allow the car to creep forward with the engine at idle if the brake is released—a valuable feature in China and India with their massive traffic jams.

HIGH-END ICONS

Contrast the Nano car division strategy of focused cost-leadership with the luxury division’s strategy of focused differentiation. Launched in 2017, the Range Rover Autobiography starts at $200,000. Tata is attempting to carve out different strategic positions in its different segments of the automotive industry. To accomplish this, the company integrates distinctly different business strategies at the corporate level.

FUTURE AT THE LOW END

Sales of the Nano models had their ups and downs but generally declined in 2016 and 2017. Consumers were more tempted by competing low-cost options priced roughly at the Nano GenX price point. One competitor was the Renault Kwid. But the other Nano competitor came from Tata Motors itself. Its new Tiago model, launched in 2016 and priced similarly to the Nano GenX, is faring much better. With the Tiago, Tata may yet realize some of its ambition around the Nano.

Taken together, we can see that Tata’s corporate strategy pursues distinctly different strategic positions by different strategic business units, each with its own profit and loss responsibility, and with integration at the corporate and not the operational level.

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Page 291

Exhibit 8.8

 summarizes the four main types of diversification—single business, dominant business, related diversification (including its subcategories related-constrained and related-linked diversification), and unrelated diversification.

EXHIBIT 8.8  Four Main Types of Diversification

Revenues from Primary Business	Type of Diversification	Competencies (in products, services, technology or distribution)	Examples	Graphic
>95%	Single business	Single business leverages its competencies.	Birkenstock Coca-Cola Facebook
70%–95%	Dominant business	Dominant and minor businesses share competencies.	Harley-Davidson Nestlé UPS
	Related Diversification
Related-constrained	Businesses generally share competencies.	ExxonMobil Johnson & Johnson Nike
<70%	Related-linked	Some businesses share competencies.	Amazon Disney GE
Unrelated diversification (conglomerate)	Businesses share few, if any, competencies.	Samsung Berkshire Hathaway Yamaha

Note: R = Remainder revenue, generally in other strategic business units (SBU) within the firm.
Source: Adapted from R.P. Rumelt (1974), Strategy, Structure, and Economic Performance (Boston, MA: Harvard Business School Press).

LO 8-8

Apply the core competence–market matrix to derive different diversification strategies.

LEVERAGING CORE COMPETENCIES FOR CORPORATE DIVERSIFICATION

In 
Chapter 4
, when looking inside the firm, we introduced the idea that competitive advantage can be based on core competencies. Core competencies are unique strengths embedded deep within a firm. They allow companies to increase the perceived value of their product and service offerings and/or lower the cost to produce them.

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 Examples of core competencies are

· ▪ Walmart’s ability to effectively orchestrate a globally distributed supply chain at low cost.

· ▪ Infosys’ ability to provide high-quality information technology services at a low cost by leveraging its global delivery model. This implies taking work to the location where it makes the best economic sense, based on the available talent and the least amount of acceptable risk and lowest cost.

To survive and prosper, companies need to grow. This mantra holds especially true for publicly owned companies, because they create shareholder value through profitable Page 292growth. Managers respond to this relentless growth imperative by leveraging their existing core competencies to find future growth opportunities. Gary Hamel and C.K. Prahalad advanced the 

core competence–market matrix

, depicted in 

Exhibit 8.9

, as a way to guide managerial decisions in regard to diversification strategies. The first task for managers is to identify their existing core competencies and understand the firm’s current market situation. When applying an existing or new dimension to core competencies and markets, four quadrants emerge, each with distinct strategic implications.

EXHIBIT 8.9  The Core Competence–Market Matrix

Source: Adapted from G. Hamel and C.K. Prahalad (1994), Competing for the Future (Boston, MA: Harvard Business School Press).

The lower-left quadrant combines existing core competencies with existing markets. Here, managers must come up with ideas of how to leverage existing core competencies to improve the firm’s current market position. Bank of America is one of the largest banks in the United States and has at least one customer in 50 percent of U.S. households.

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 Developed from the Bank of Italy and started in San Francisco, California, in 1904, it became the Bank of America and Italy in 1922. Over the next 60 years it grew in California and then nationally into a major banking powerhouse. And then in 1997, in what was the largest bank acquisition of its time, NationsBank bought Bank of America.

You could say that acquisitions were a NationsBank specialty. While still the North Carolina National Bank (NCNB), one of its unique core competencies was identifying, appraising, and integrating acquisition targets. In particular, it bought smaller banks to supplement its organic growth throughout the 1970s and ’80s, and from 1989 to 1992, NCNB purchased over 200 regional community and thrift banks to further improve its market position. It then turned its core competency to national banks, with the goal of becoming the first nationwide bank. Known as NationsBank in the 1990s, it purchased Barnett Bank, BankSouth, FleetBank, LaSalle, CountryWide Mortgages, and its eventual namesake, Bank of America. This example illustrates how NationsBank, rebranded as Bank of America since 1998, honed and deployed its core competency of selecting, acquiring, and integrating other commercial banks to grow dramatically in size and geographic scope and emerge as one of the leading banks in the United States. As a key vehicle of corporate strategy, we study acquisitions in more detail in 
Chapter 9
.

The lower-right quadrant of 
Exhibit 8.9
 combines existing core competencies with new market opportunities. Here, leaders must strategize about how to redeploy and recombine existing core competencies to compete in future markets. During the global financial crisis in 2008, Bank of America bought the investment bank Merrill Lynch for $50 billion.

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 Although many problems ensued for Bank of America following the Merrill Lynch acquisition, it is now the bank’s investment and wealth management division. Bank of America’s corporate managers applied an existing competency (acquiring and integrating) into a new market (investment and wealth management). The combined entity is now leveraging economies of scope through cross-selling when, for example, consumer banking makes customer referrals for investment bankers to follow up.

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The upper-left quadrant combines new core competencies with existing market opportunities. Here, managers must come up with strategic initiatives to build new core competencies to protect and extend the company’s current market position. For example, in the early 1990s, Gatorade dominated the market for sports drinks, a segment in which it had been the original innovator. Some 25 years earlier, medical researchers at the University of Florida had created the drink to enhance the performance of the Gators, the university’s football team, thus the name Gatorade. Stokely-Van Camp commercialized and marketed the drink, and eventually sold it to Quaker Oats. PepsiCo brought Gatorade into its lineup of soft drinks when it acquired Quaker Oats in 2001.

By comparison, Coca-Cola had existing core competencies in marketing, bottling, and distributing soft drinks, but had never attempted to compete in the sports-drink market. Over a 10-year R&D effort, Coca-Cola developed competencies in the development and marketing of its own sports drink, Powerade, which launched in 1990. In 2015, Powerade held about 20 percent of the sports-drink market, making it a viable competitor to Gatorade, which still holds close to 80 percent of the market.

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Finally, the upper-right quadrant combines new core competencies with new market opportunities. Hamel and Prahalad call this combination “mega-opportunities”—those that hold significant future-growth opportunities. At the same time, it is likely the most challenging diversification strategy because it requires building new core competencies to create and compete in future markets.

Salesforce.com, for example, is a company that employs this diversification strategy well.

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 In recent years, Salesforce experienced tremendous growth, the bulk of it coming from the firm’s existing core competency in delivering customer relationship management (CRM) software to its clients. Salesforce’s product distinguished itself from the competition by providing software as a service via cloud computing: Clients did not need to install software or manage any servers, but could easily access the CRM through a web browser (a business model called software as a service, or SaaS). In 2007, Salesforce recognized an emerging market for platform as a service (PaaS) offerings, which would enable clients to build their own software solutions that are accessed the same way as the Salesforce CRM. Seizing the opportunity, Salesforce developed a new competency in delivering software development and deployment tools that allowed its customers to either extend their existing CRM offering or build completely new types of software. Today, Salesforce’s Force.com offering is one of the leading providers of PaaS tools and services.

Taken together, the core competence–market matrix provides guidance to executives on how to diversify in order to achieve continued growth. Once managers have a clear understanding of their firm’s core competencies (see 
Chapter 4
), they have four options to formulate corporate strategy:

Four Options to Formulate Corporate Strategy via Core Competencies

1. Leverage existing core competencies to improve current market position.

2. Build new core competencies to protect and extend current market position.

3. Redeploy and recombine existing core competencies to compete in markets of the future.

4. Build new core competencies to create and compete in markets of the future.

LO 8-9

Explain when a diversification strategy does create a competitive advantage and when it does not.

CORPORATE DIVERSIFICATION AND FIRM PERFORMANCE

Corporate managers pursue diversification to gain and sustain competitive advantage. But does corporate diversification indeed lead to superior performance? To answer this question, we need to evaluate the performance of diversified companies. The critical question Page 294to ask when doing so is whether the individual businesses are worth more under the company’s management than if each were managed individually.

The diversification-performance relationship is a function of the underlying type of diversification. A cumulative body of research indicates an inverted U-shaped relationship between the type of diversification and overall firm performance, as depicted in 

Exhibit 8.10

.

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 High and low levels of diversification are generally associated with lower overall performance, while moderate levels of diversification are associated with higher firm performance. This implies that companies that focus on a single business, as well as companies that pursue unrelated diversification, often fail to achieve additional value creation. Firms that compete in single markets could potentially benefit from economies of scope by leveraging their core competencies into adjacent markets.

EXHIBIT 8.10  The Diversification-Performance Relationship

Source: Adapted from L.E. Palich, L.B. Cardinal, and C.C. Miller (2001), “Curvilinearity in the diversification-performance linkage: An examination of over three decades of research,” Strategic Management Journal 21: 155–174.

Firms that pursue unrelated diversification are often unable to create additional value. They experience a 

diversification discount

: The stock price of such highly diversified firms is valued at less than the sum of their individual business units.

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 For the last decade or so, GE experienced a diversification discount, as its capital unit contributed 50 percent of profits on one-third of the conglomerate’s revenues. The presence of the diversification discount in GE’s depressed stock price was a major reason GE’s then CEO, Jeffrey Immelt, decided in 2015 to spin out GE Capital. On the day of the announcement, GE’s stock price jumped 11 percent, adding some $28 billion to GE’s market capitalization. This provides some idea of the diversification discount that firms pursuing unrelated diversification may experience.

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 Through this restructuring of the corporate portfolio, GE is now better positioned to focus more fully on its core competencies in industrial engineering and management processes.

The presence of the diversification discount, however, depends on the institutional context. Although it holds in developed economies with developed capital markets, some research evidence suggests that an unrelated diversification strategy can be advantageous in emerging economies as mentioned when discussing Tata in 
Strategy Highlight 8.2
.

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 Here, unrelated diversification may help firms gain and sustain competitive advantage because it allows the conglomerate to overcome institutional weaknesses in emerging economies such as a lack of a functioning capital market.

In contrast, companies that pursue related diversification are more likely to improve their performance. They create a 

diversification premium

: The stock price of related-diversification firms is valued at greater than the sum of their individual business units.

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Why is this so? At the most basic level, a corporate diversification strategy enhances firm performance when its value creation is greater than the costs it incurs. 

Exhibit 8.11

 lists the sources of value creation and costs for different corporate strategies, for vertical integration as well as related and unrelated diversification. For diversification to enhance firm performance, it must do at least one of the following:

EXHIBIT 8.11  Vertical Integration and Diversification: Sources of Value Creation and Costs

Related Diversification

· Financial economies
· Restructuring
· Internal capital markets

· Influence costs

Corporate Strategy	Sources of Value Creation (V)	Sources of Costs (C)
Vertical Integration	· Can lower costs · Can improve quality · Can facilitate scheduling and planning _____________________________ · Facilitating investments in specialized assets · Securing critical supplies and distribution channels	· Can increase costs · Can reduce quality · Can reduce flexibility _____________________________ · Increasing potential for legal repercussions
· Economies of scope · Economies of scale	· Financial economies · Restructuring · Internal capital markets	· Coordination costs	· Influence costs
Unrelated Diversification

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· ▪ Provide economies of scale, which reduces costs.

· ▪ Exploit economies of scope, which increases value.

· ▪ Reduce costs and increase value.

We discussed these drivers of competitive advantage—economies of scale, economies of scope, and increase in value and reduction of costs—in depth in 
Chapter 6
 in relation to business strategy. Other potential benefits to firm performance when following a diversification strategy include financial economies, resulting from restructuring and using internal capital markets.

RESTRUCTURING

Restructuring describes the process of reorganizing and divesting business units and activities to refocus a company to leverage its core competencies more fully. The Belgium-based Anheuser-Busch InBev sold Busch Entertainment, its theme park unit that owns SeaWorld and Busch Gardens, to a group of private investors for roughly $3 billion. This strategic move allows InBev to focus more fully on its core business of brewing and distributing beer across the world.

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Corporate executives can restructure the portfolio of their firm’s businesses, much like an investor can change a portfolio of stocks. One helpful tool to guide corporate portfolio planning is the 

Boston Consulting Group (BCG) growth–share matrix

, shown in 

Exhibit 8.12

.

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 This matrix locates the firm’s individual SBUs in two dimensions:

· Relative market share (horizontal axis).

· Speed of market growth (vertical axis).

The firm plots its SBUs into one of four categories in the matrix: dog, cash cow, star, and question mark. Each category warrants a different investment strategy. All four categories shape the firm’s corporate strategy.

EXHIBIT 8.12  Restructuring the Corporate Portfolio: The Boston Consulting Group Growth–Share Matrix

SBUs identified as dogs are relatively easy to identify: They are the underperforming businesses. Dogs hold a small market share in a low-growth market; they have low and Page 296unstable earnings, combined with neutral or negative cash flows. The strategic recommendations are either to divest the business or to harvest it. This implies stopping investment in the business and squeezing out as much cash flow as possible before shutting it or selling it.

Cash cows, in contrast, are SBUs that compete in a low-growth market but hold considerable market share. Their earnings and cash flows are high and stable. The strategic recommendation is to invest enough into cash cows to hold their current position and to avoid having them turn into dogs (as indicated by the arrow in 
Exhibit 8.12
). As a general rule, strategic leaders would want to manage their SBU portfolio in a clockwise manner (as indicated by three of the four arrows).

A corporation’s star SBUs hold a high market share in a fast-growing market. Their earnings are high and either stable or growing. The recommendation for the corporate strategist is to invest sufficient resources to hold the star’s position or even increase investments for future growth. As indicated by the arrow, stars may turn into cash cows as the market in which the SBU is situated slows after reaching the maturity stage of the industry life cycle.

Finally, some SBUs are question marks: It is not clear whether they will turn into dogs or stars (as indicated by the arrows in 
Exhibit 8.12
). Their earnings are low and unstable, but they might be growing. The cash flow, however, is negative. Ideally, corporate executives want to invest in question marks to increase their relative market share so they turn into stars. If market conditions change, however, or the overall market growth slows, then a question-mark SBU is likely to turn into a dog (as indicated by the arrow). In this case, executives would want to harvest the cash flow or divest the SBU.

INTERNAL CAPITAL MARKETS

Internal capital markets can be a source of value creation in a diversification strategy if the conglomerate’s headquarters does a more efficient job of allocating capital through its budgeting process than what could be achieved in external capital markets. Based on private information, corporate managers are in a position to discover which of their strategic business units will provide the highest return on invested capital. In addition, internal capital markets may allow the company to access capital at a lower cost.

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Until recently, for example, GE Capital brought in close to $70 billion in annual revenues and generated more than half of GE’s profits.

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 In combination with GE’s triple-A debt rating, having access to such a large finance arm allowed GE to benefit from a lower cost of capital, which in turn was a source of value creation in itself. In 2009, at the height of the global financial crises, GE lost its AAA debt rating. The lower debt rating and the smaller finance unit were likely to result in a higher cost of capital, and thus a potential loss in value creation through internal capital markets. As mentioned above, GE sold its GE Capital business unit in 2015 in a restructuring of its corporate portfolio.

A strategy of related-constrained or related-linked diversification is more likely to enhance corporate performance than either a single or dominant level of diversification or an unrelated level of diversification. The reason is that the sources of value creation include not only restructuring, but also the potential benefits of economies of scope and scale. To create additional value, however, the benefits from these sources of incremental value creation must outweigh their costs. A related-diversification strategy entails two types of costs: coordination and influence costs. Coordination costs are a function of the number, size, and types of businesses that are linked. Influence costs occur due to political maneuvering by managers to influence capital and resource allocation and the resulting inefficiencies stemming from suboptimal allocation of scarce resources.

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8.5 Implications for Strategic Leaders

An effective corporate strategy increases a firm’s chances to gain and sustain a competitive advantage. By formulating corporate strategy, strategic leaders make important choices along three dimensions that determine the boundaries of the firm:

· ▪ The degree of vertical integration—in what stages of the industry value chain to participate.

· ▪ The type of diversification—what range of products and services to offer.

· ▪ The geographic scope—where to compete.

Since a firm’s external environment never remains constant over time, corporate strategy needs to be dynamic over time. As firms grow, they tend to diversify and globalize to capture additional growth opportunities. 

Exhibit 8.13

 shows the dynamic nature of corporate strategy through decisions made by two top competitors in the sports footwear and apparel industry: Nike and Adidas.

EXHIBIT 8.13  Dynamic Corporate Strategy: Nike vs. Adidas

Adidas was founded in 1924 in Germany. It began its life in the laundry room of a small apartment. Two brothers focused on one product: athletic shoes. Initially, Adidas was a fairly integrated manufacturer of athletic shoes. The big breakthrough for the company came in 1954 when the underdog West Germany won the soccer World Cup in Adidas cleats. As the world markets globalized and became more competitive in the Page 298decades after World War II, Adidas not only vertically disintegrated to focus mainly on the design of athletic shoes but also diversified into sports apparel. Adidas’ annual revenues are $21 billion. It is a diversified company active across the globe in sports shoes (40 percent of revenues), sports apparel (50 percent of revenues), and sports equipment (10 percent of revenues). The change in Adidas’ corporate strategy from a small, highly integrated single business to a disintegrated and diversified global company is shown in 
Exhibit 8.13
.

Nike is the world’s leader in sports shoes and apparel with annual sales of $34 billion. Founded in 1978, and thus much younger than Adidas, Nike was vertically disintegrated from the very beginning. After moving beyond importing Japanese ASICS shoes to the United States, Nike focused almost exclusively on R&D, design, and marketing of running shoes. Although Nike diversified into different lines of business, it stayed true to its vertical disintegration by focusing on only a few activities (see 
Exhibit 8.13
). Nike is a global company and its revenues come from sports shoes (50 percent) and apparel (25 percent), as well as sports equipment and other businesses, such as affiliate brands Cole Haan, Converse, Hurley, and Umbro.

The changes in the strategic positions shown in 
Exhibit 8.13
 highlight the dynamic nature of corporate strategy. Also, keep in mind that the relationship between diversification strategy and competitive advantage depends on the type of diversification. There exists an inverted U-shaped relationship between the level of diversification and performance improvements. On average, related diversification (either related-constrained or related-linked such as in the Nike and Adidas example) is most likely to lead to superior performance because it taps into multiple sources of value creation (economies of scale and scope; financial economies). To achieve a net positive effect on firm performance, however, related diversification must overcome additional sources of costs such as coordination and influence costs.

In the next chapter, we discuss strategic alliances in more depth as well as mergers and acquisitions, both are critical tools in executing corporate strategy. In 
Chapter 10
, we take a closer look at geographic diversification by studying how firms compete for competitive advantage around the world.

CHAPTERCASE 8  Consider This…

©Mike Kane/Bloomberg/Getty Images

ALTHOUGH AMAZON is one of the largest technology companies globally in terms of its stock market valuation, several problems loom at the horizon. Amazon’s annual revenues are some $140 billion, but consistent profitability continues to elude the company. Moreover, as technology has evolved, traditional boundaries between hardware and software, products and services, and online and brick-and-mortar stores have become increasingly blurred. As a result, Amazon finds itself engaged in a fierce competitive battle for control of the emerging digital ecosystem, pitted against technology giants such as Apple, Alphabet, and Facebook. In retailing Amazon competes with Walmart and the Chinese ecommerce company Alibaba. In data services and cloud computing, it competes with Microsoft, IBM, and others. Indeed, the list of Amazon’s competitors keeps increasing rapidly, as this passage from its 2016 annual report makes clear:

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“Our businesses encompass a large variety of product types, service offerings, and delivery channels.… [W]e face a broad array of competitors from many different industry sectors around the world [including]: (1) online, offline, and multichannel retailers, publishers, vendors, distributors, manufacturers, and producers of the products we offer…; (2) publishers, producers, and distributors of physical, digital, and interactive media of all types and all distribution channels; (3) web search engines, comparison shopping websites, social networks, [and] web portals…; (4) companies that provide ecommerce services…; (5) companies that provide fulfillment and logistics services…online or offline; (6) companies that provide information technology services or products…; and (7) companies that design, manufacture, market, or sell consumer electronics, telecommunication, and electronic devices.”

Even Amazon’s 2017 acquisition (spending close to $14 billion, more than any previous acquisition) on high-end grocer Whole Foods raises as many potential problems as opportunities. With the purchase, Amazon is likely looking to maximize a hybrid of online sales with physical delivery points, and use its huge data stockpile to reverse-engineer the retail experience in the grocery space. There are also suggestions that Amazon’s ability to squeeze labor costs out of an operation and to operate for extended periods at a loss provides an opportunity to push competitors into an area where they won’t be able to compete effectively. However, we don’t know how well Amazon’s tactics will succeed. And the grocery industry has shown itself to be fiercely competitive in the past. In terms of opportunities, the purchase of Whole Foods Market allows Amazon to compete more effectively with Walmart, which is the largest grocer in the United States, and has been quite successful with its hybrid approach to retailing, combining online purchases with same day in-store pick-ups.

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Questions

1. Describe Amazon’s diversification strategy using 
Exhibit 8.8
. What type of diversification strategy is Amazon pursuing? Explain.

2. What is Amazon’s core business? Is AWS related to Amazon’s core business? Why or why not? Some investors are pressuring Jeff Bezos to spin out AWS as a standalone company. Do you agree with this corporate strategy recommendation? Why or why not? Hint: Do you believe AWS would be more valuable within Amazon or as a standalone company?

3. Amazon.com is now 25 years old and makes $140 billion in annual revenues. As an investor, would it concern you that Amazon.com has yet to deliver any consistent profits? Why or why not? How much longer do you think investors will be patient with Jeff Bezos as he continues to pursue billion-dollar diversification initiatives?

4. Amazon.com continues to spend billions on seemingly unrelated diversification efforts. Do you believe these efforts contribute to Amazon gaining and sustaining a competitive advantage? Why or why not?

This chapter defined corporate strategy and then looked at two fundamental corporate strategy topics—vertical integration and diversification—as summarized by the following learning objectives and related take-away concepts.

LO 8-1 / Define corporate strategy and describe the three dimensions along which it is assessed.

· ▪ Corporate strategy addresses “where to compete.” Business strategy addresses “how to compete.”

· ▪ Corporate strategy concerns the boundaries of the firm along three dimensions: (1) industry value chain, (2) products and services, and (3) geography (regional, national, or global markets).

· ▪ To gain and sustain competitive advantage, any corporate strategy must support and strengthen a firm’s strategic position, regardless of whether it is a differentiation, cost-leadership, or blue ocean strategy.

LO 8-2 / Explain why firms need to grow, and evaluate different growth motives.

· ▪ Firm growth is motivated by the following: increasing profits, lowering costs, increasing market power, reducing risk, and managerial motives.

· ▪ Not all growth motives are equally valuable.

· ▪ Increasing profits and lowering expenses are clearly related to enhancing a firm’s competitive advantage.

· ▪ Page 300Increasing market power can also contribute to a greater competitive advantage, but can also result in legal repercussions such as antitrust lawsuits.

· ▪ Growing to reduce risk has fallen out of favor with investors, who argue that they are in a better position to diversify their stock portfolio in comparison to a corporation with a number of unrelated strategic business units.

· ▪ Managerial motives such as increasing company perks and job security are not legitimate reasons a firm needs to grow.

LO 8-3 / Describe and evaluate different options firms have to organize economic activity.

· ▪ Transaction cost economics help managers decide what activities to do in-house (“make”) versus what services and products to obtain from the external market (“buy”).

· ▪ When the costs to pursue an activity in-house are less than the costs of transacting in the market (Cin-house < Cmarket), then the firm should vertically integrate.

· ▪ Principal–agent problems and information asymmetries can lead to market failures, and thus situations where internalizing the activity is preferred.

· ▪ A principal–agent problem arises when an agent, performing activities on behalf of a principal, pursues his or her own interests.

· ▪ Information asymmetries arise when one party is more informed than another because of the possession of private information.

· ▪ Moving from less integrated to more fully integrated forms of transacting, alternatives include short-term contracts, strategic alliances (including long-term contracts, equity alliances, and joint ventures), and parent–subsidiary relationships.

LO 8-4 / Describe the two types of vertical integration along the industry value chain: backward and forward vertical integration.

· ▪ Vertical integration denotes a firm’s addition of value—what percentage of a firm’s sales is generated by the firm within its boundaries.

· ▪ Industry value chains (vertical value chains) depict the transformation of raw materials into finished goods and services. Each stage typically represents a distinct industry in which a number of different firms compete.

· ▪ Backward vertical integration involves moving ownership of activities upstream nearer to the originating (inputs) point of the industry value chain.

· ▪ Forward vertical integration involves moving ownership of activities closer to the end (customer) point of the value chain.

LO 8-5 / Identify and evaluate benefits and risks of vertical integration.

· ▪ Benefits of vertical integration include securing critical supplies and distribution channels, lowering costs, improving quality, facilitating scheduling and planning, and facilitating investments in specialized assets.

· ▪ Risks of vertical integration include increasing costs, reducing quality, reducing flexibility, and increasing the potential for legal repercussions.

LO 8-6 / Describe and examine alternatives to vertical integration.

· ▪ Taper integration is a strategy in which a firm is backwardly integrated but also relies on outside-market firms for some of its supplies, and/or is forwardly integrated but also relies on outside-market firms for some if its distribution.

· ▪ Strategic outsourcing involves moving one or more value chain activities outside the firm’s boundaries to other firms in the industry value chain. Offshoring is the outsourcing of activities outside the home country.

LO 8-7 / Describe and evaluate different types of corporate diversification.

· ▪ A single-business firm derives 95 percent or more of its revenues from one business.

· ▪ A dominant-business firm derives between 70 and 95 percent of its revenues from a single business, but pursues at least one other business activity.

· ▪ A firm follows a related diversification strategy when it derives less than 70 percent of its revenues from a single business activity, but obtains revenues from other lines of business that are linked to the primary business activity. Choices within a related diversification strategy can be related-constrained or related-linked.

· ▪ A firm follows an unrelated diversification strategy when less than 70 percent of its revenues come from a single business, and there are few, if any, linkages among its businesses.

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LO 8-8 / Apply the core competence–market matrix to derive different diversification strategies.

· ▪ When applying an existing/new dimension to core competencies and markets, four quadrants emerge, as depicted in 
Exhibit 8.9
.

· ▪ The lower-left quadrant combines existing core competencies with existing markets. Here, managers need to come up with ideas of how to leverage existing core competencies to improve their current market position.

· ▪ The lower-right quadrant combines existing core competencies with new market opportunities. Here, managers need to think about how to redeploy and recombine existing core competencies to compete in future markets.

· ▪ The upper-left quadrant combines new core competencies with existing market opportunities. Here, managers must come up with strategic initiatives of how to build new core competencies to protect and extend the firm’s current market position.

· ▪ The upper-right quadrant combines new core competencies with new market opportunities. This is likely the most challenging diversification strategy because it requires building new core competencies to create and compete in future markets.

LO 8-9 / Explain when a diversification strategy does create a competitive advantage and when it does not.

· ▪ The diversification-performance relationship is a function of the underlying type of diversification.

· ▪ The relationship between the type of diversification and overall firm performance takes on the shape of an inverted U (see 
Exhibit 8.10
).

· ▪ Unrelated diversification often results in a diversification discount: The stock price of such highly diversified firms is valued at less than the sum of their individual business units.

· ▪ Related diversification often results in a diversification premium: The stock price of related-diversification firms is valued at greater than the sum of their individual business units.

· ▪ In the BCG matrix, the corporation is viewed as a portfolio of businesses, much like a portfolio of stocks in finance (see 
Exhibit 8.12
). The individual SBUs are evaluated according to relative market share and the speed of market growth, and are plotted using one of four categories: dog, cash cow, star, and question mark. Each category warrants a different investment strategy.

· ▪ Both low levels and high levels of diversification are generally associated with lower overall performance, while moderate levels of diversification are associated with higher firm performance.